Don't let inflation destroy the value of your pension contributions.
This article has already been emailed to Fools as part of our 'Afternoon' series of articles.
It's always difficult to predict how inflation (rising prices) will change over time. But one thing I do know is no matter how high or low inflation is it's always bad news for your pension.
It makes good Foolish sense to think about the effects of inflation on your retirement planning. That's because pensions are normally very long-term investments (if you start early enough!), and so the value of the money you put into your pension fund today, won't be worth anywhere near as much in 30 or 40 years' time.
Flat contributions
Let's say you pay £100 into your pension scheme every month and you plan to retire after 30 years. If you keep your contributions the same, then in real terms your £100 monthly payment would actually be worth less than £48 in 30 year's time (where inflation is assumed to rise at a rate of 2.5% a year).
In other words, by the time you reach retirement you'll effectively be contributing less than half of what you did when you first started your pension. Of course, inflation could be much higher than this rate, as it is today, so your contributions could be worth even less over time.
If you think about it in terms of what your pension could be worth at retirement, inflation looks even more scary. After investing £100 a month into your pension fund for 30 years, your pot would have a nominal value of £127,662 if it grew by 7% a year. But once you take inflation into account (again at 2.5% each year), your pension would be worth just £59,731 in real terms.
But there's a simple way to counter the effects of inflation on your pension: increase your contributions every year in line with inflation, or better still, ahead of inflation to generate the best possible pension pot when you come to retire.
The trouble is that's sounds pretty daunting, particularly when inflation is running high as it is now. Unfortunately, most people don't realise the importance of stepping up their contributions, or they decide an increase isn't affordable. Research shows that while 68% of people feel they should be saving more into their pensions, only 14% ever actually up their contributions at any time during the life of their plan*.
Save more tomorrow
That's why pension provider, AXA, has just launched a new pension: Save More Tomorrow. The scheme is unique in making automatic increases to contribution levels over the duration of the plan. Contributions will rise gradually and can coincide with pay rises to lessen the impact on your finances.
At the moment Save More Tomorrow can only be set up as a group personal pension through employers. Although the plan is not yet offered to individual savers, I think this new feature is a good idea, and I hope this type of scheme becomes available more widely soon.
In the meantime, there's nothing to stop you taking a leaf out of AXA's book by adopting a `Save More Tomorrow' strategy of your own.
How much more should I pay into my pension?
Of course, the more you can pay into your pension each year, the better. There's a general rule of thumb which says ideally your contributions should be half your age. So at 20 you would pay 10% of your salary into your pension. And by the time you reach 30 you should have increased your contributions to 15% and so on. Luckily, that means stepping up the payments into your pension by just 0.5% every year.
Take a look at the figures below which show how a modest increase of 1% a year over just three years, from 5% to 8%, can have a huge impact on your final fund value, if you continue to fund your pension at 8% for the rest of your working life:
Age at start of plan | Fund at retirement based on flat contributions
| Fund at retirement based on increasing contributions* | Percentage Increase |
|---|---|---|---|
20 | £402,000 | £627,000 | 56% |
30 | £190,000 | £296,000 | 56% |
40 | £83,100 | £128,000 | 54% |
Source: AXA. Assumptions: Figures are based on someone who earns £20,000 a year and contributes 5% of salary. *Contributions start at 5% of salary and increase to 8% over 3 years. The pension fund grows at 7% a year.
As you can see by increasing your contributions from 5% to 8% over three years and then continuing to fund it at 8% a year, the final pension fund value could be well over 50% higher at retirement.
So keeping on top of your retirement planning doesn't have to be as tricky as it seems. Good luck!
*Research: Choi et al