One of the most popular questions when it comes to personal pensions is "How much should I start paying in?". Unfortunately, there isn't a simple answer because it depends on so many factors and so the answer will be different depending on who is asking the question. For example how old are you? When do you want to retire? How much can you realistically afford to pay in? In this article, I explain how you can build a sizeable pension pot by paying in relatively small amounts. I explain the importance of starting early, keeping costs low and how to take advantage of the power of compounding.
Importance of starting early
The classic problem with retirement planning is that people put off dealing with it until it is looming on the horizon. By that point it is extremely difficult to build a pension pot sufficient enough to give you the retirement you want – especially if you are starting from scratch. People are told to build a sustainable pension income but how can you do it realistically? For the rest of this article I will ignore the state pension until the very end as there is no guarantee that it will be around by the time you retire.
Before we start, you may also be interested in our articles "How much income could I get from a £100,000 pension pot?", "How much do you need to retire and what will your pension be worth?" and "How to get £30,000 a year pension by saving just £55 a month".
Start with a realistic expectation
Most people do not have a realistic concept of how much money they need to have saved in order to have a decent retirement income.
A person retiring at 65 with a £100,000 pension pot would get around £7,000 income a year from it whether they took an annuity or provided a sustainable income via income drawdown. That's not exactly much.
Only you can decide how much of a retirement income you want. But using the figures above you can get a sense of how much of a pension fund you would need to produce that income as well as the size of the savings task ahead. Yet you shouldn’t get too downhearted as you can stack the odds of achieving your desired retirement income in your favour. I show you how in the rest of this article.
Ditch the idea of raiding your pension
Let's say you want a retirement pension of £25,000, then a person aged 65 will need a pension pot of around £500,000. That is a lot and that’s assuming they do not take 25% of that pension pot as a tax-free lump sum and blow it. If you want an income of £25k a year and a tax-free lump sum you’d need a pension pot of around £666,666!
Yet most people will have paid off their mortgage by the time they retire bringing their required income down i.e you won't need money to pay your mortgage each month once you retire. Therefore most people need a retirement income of around 2/3 of their salary to maintain their standard of living. So that brings down the required gross pension to £16,666, from £25k.
If we also ditch the idea of raiding your pension and taking a lump sum, instead using it to just produce an income in retirement, the required pension pot now drops down to around £330,000 which is a bit more sensible.
Start paying into a pension early
Now the power of compound returns mean that the earlier you start putting money into a pension the less you have to save a month.
To get a pension pot worth around £330,000 by age 65 you would need to save
- £720 a month if you are aged 30
- £1,020 a month if you are aged 40
- £1,720 a month if you are aged 50
These are big numbers but by starting early you can more than halve your required monthly contributions.
Keep charges low
Now the above figures assume that you pay an annual charge on your pension (be a personal pension or a SIPP) of around 1.5%. Yet these days it is possible with passive funds to get the annual charge much lower. Charges have a huge impact on the size of your pension fund over time.
If in my example above the 30 year old cut their charges then rather than their pension pot being worth around £330,000 when they hit 65, it would be worth £422,000, which could provide a much bigger income. Alternatively, it could mean that they could reduce their pension contributions to £590 a month to achieve the original objective of £16,666 a year.
Investment risk
Now one of the benefits of starting to save for retirement early is that you can take a little more risk. The above figures assume an average return of 5% a year. If that 30 year old took more risk and the average annual return was say 8% a year, then it would mean they would only need to save £200 a month and still achieve the required retirement income of £16.6k a year, as mentioned earlier.
Of course there is no certainty of achieving 8% a year return, but if your investment timeline is 35 years (as it is for the 30 year old in my example) you can take more risk. Older savers can’t do this.
Save via a pension
Retirement saving doesn’t have to be done via a pension it can be achieved using Stocks and Shares ISAs. The downside of ISAs is that you don’t get tax relief on the way in, but the plus side is that you don’t get taxed on the way out and you can access it at any time.
Yet with a relatively modest pension income requirement most of it will be tax-free anyway when you come to draw it. To save for retirement using a pension you have to be happy that you won’t have access to the fund until you retire.
Yet the big plus of saving via a pension is that you get tax relief on the contributions. So for a 30 year old, a £200 a month pension contribution will only cost them £160 a month.
Join your company scheme
If you are employed, over 22 and earn more than £10,000 per year then you will be automatically enrolled in your company's auto-enrolment pension scheme. You'll need to contribute a minimum of 5% and your employer must contribute a minimum of 3%, however, some will contribute more. While you do have the option of opting out, it would be foolish not to take advantage of free money from your employer.
Lets say an employer matched an employee's pension contributions, then that 30 year old would pay just £80 a month net and get it topped up to £200 by his employer and HMRC (pension contributions receive tax relief).
So suddenly that unachievable retirement income has got a whole lot more realistic. Other than saving lots of money there is no simple answer to pension saving. The secret lies in doing a number of things mentioned above to stack the odds in your favour. But while you may say that the 8% return is pretty punchy the figures above don’t take into account the fact that you will likely increase your pension contributions as your earnings increase. That would mean you wouldn't need to make 8% a year return on the money invested.
Of course, the final choice is to delay retirement, for example until age 70. For a lot of older people who have neglected their pension funding this is an inevitability. But it significantly reduces the the amount you need to save for retirement
Pension vs ISAs
Before the new pension freedoms, ISAs offered the most flexible way to save for retirement. Now the pension versus ISA debate is less clear cut. Using a stocks and shares ISA to save for retirement has the flexibility of allowing you to access the funds in an emergency. So it is a sensible approach to save via ISAs to start with and then when you are sure you don’t need access to the funds move them into a pension to get the tax relief, assuming you have paid sufficient income tax that year.
Yet whichever route you go down, pensions and ISAs are just tax wrappers and the underlying investments can be the same.
Summary
If you follow the example above, a 30 year old could retire comfortably with an income equivalent to £25,000 in today's money by putting away just £80 a month. That is before you add in a state pension which is currently £11,502 a year.
So take action today and start saving into a pension. I strongly suggest that having come this far that you read our article 'How to build a low cost DIY pension' and if you are ready to start looking at the best pension providers, then check out our article "Best pension cashback offers and fee-free deals".
