We’ve all heard of “final salary pension schemes” – most often enjoyed by public sector employees and those who have worked for large corporations for a long period of time. The common misconception is that these pensions are simple and very generous – the pension you receive when you retire is the same as the salary you were enjoying when you retired. In reality this is not the case. The calculation of a “final salary” pension is actually based on a number of different factors and the money paid out is often a fraction of the salary the individual was earning when they retired.
In addition the ability for these pension schemes to meet their obligations has been called into question recently with more and more schemes being taken over by the governments Pension Protection Fund with payouts being capped at £30,000 per year.
Approx 11m in the UK have access to schemes like this – but what about the rest of us? How can we maintain the same standard of living throughout retirement that we have enjoyed during our working life? In reality it is quite simple and we’ll show you how to do it over the next few pages.
Lets assume that by the time you retire you are earning £50,000 – thats our goal – £50,000 a year income throughout your retirement.
Now lets assume that during your employment you earn an average of £27,600 annually (the national average). This gives an average income of £2,300 per month before tax. Now you need to set aside around 9.5% of your gross income (£220) and put it towards retirement.
In reality your income will start lower and grow over time so you’ll need to adjust the % over time to keep to your target of £220 per month. The good news is the younger you are, the more disposable income you’re likely to have so it shouldn’t be too difficult to achieve these savings goals.
Invest that £220 in a tax efficient personal pension plan or SIPP (self invested personal pension) and invest it in a fairly conservative managed index tracker fund that tracks the FTSE 100.
Avoid high risk, get rich quick schemes you come across on the internet. Avoid day trading or stock picking. Your managed fund will simply track the overall performance of the FTSE 100 through a low-fee index tracker fund. You will be tracking the performance of the largest 100 publicly traded companies in the UK.
Let’s assume your money will grow at 7.5 percent annually. That’s a realistic estimate over the long term (although the short term returns may be lower than this). Stocks have historically grown at a rate of about 8 percent to 9 percent annually. The precise number varies through the years so we’ll assume an 7.5 percent annualised average as a realistic estimate.
No continue to contribute £220 per month into this fund every month. Reinvest all dividends and capital gains (profits) – don’t be tempted to withdraw the profits of you’ll miss out on the benefits of compound growth. If we assume you work for at least 40 years, by the time you retire your fund will have grown to over £665,000.
That’s fairly impressive given the average Briton has only £53,000 in their pension pot.
With £665,000 in your fund you’ll be able to live off the annual profits without touching your overall savings. 7.5% of £665,000 will give you an annual income of £49,875 which will make for a very comfortable retirement.
What about inflation?
Thanks to inflation, £50,000 in 40 years won’t be worth the same as £50,000 today. However, if inflation continues to run 2 percent annually over the next 40 years (as predicted by the OECD) and your investments gain at 7.5 percent annually, you’re still outpacing inflation by more than 5%.
The first step towards guarding against the impact of inflation is to leave your £665,000 invested at retirement. Do not be tempted to withdraw any lump sums. Lets assume you live for another 25 years after retirement. If you reduce your overall pension pot then your annual income is going to reduce. In addition the impact of inflation, even at 2% will start to bite.
Think of it this way, when you start withdrawing the 7.5% annual returns (£50,000) to live on at retirement, the size of your pension pot will stop increasing. If inflation is at 2% then the effect of this on your buying power accumulates over time. After 20 years your annual income will have almost halved.
How to guard against this? Build this 2% into your forecasts. Either increase the amount you are saving during your working life or reduce the % of your annual returns you take out each year during retirement so that the impact of inflation is nullified.
In addition, here at MyMoneyExpert we strongly recommend paying off your mortgage alongside the investment strategy we have just reviewed. Paying off your mortgage provides the following benefits:
- You’ll retire with a guaranteed place to live.
- You won’t have to worry about making mortgage payments in retirement.
- The value of your home will keep pace with inflation over time, assuming there is no major property market crash.
We hope this article has been useful as a simple guide to maintaining your final salary throughout your retirement and enjoying a very comfortable retirement Anybody can achieve this just by starting early, being disciplined, patient, and riding out the ups and downs of the UK stock markets.
With investment, your capital is at risk. Pension rules apply and tax rules may change in future.