Most people realise that they need to save for their retirement as the State is not going to be able to look after them. But how much should you be putting away each month? There are a number of factors to take into account such as your current age, the age at which you want to retire and how much retirement income you want.
Bewildered by the apparent complexity of the question most people immediately hit a mental brick wall. They don't know how to even start or how much to save? So they give up.
Despite what the financial industry tries to tell you this isn't a difficult question and you don't need to pay someone to answer it. In fact I can tell you how to roughly calculate how much you need to save on the back of an envelope. After all, physicist Enrico Fermi famously calculated the energy produced during the first atomic bomb test on the back of an envelope in 1945. Pensions are far easier in comparison! Yes you'll need a calculator but the whole exercise should take no more than 2 minutes.
Armed with this foundation you can then begin building a retirement plan.
How to work out your retirement saving on the back of an envelope in 2 minutes
My worked example is shown in blue font.
1 - Write down how much income a year your would like in today's money e.g. £30,000
2 - Write down at what age you want to retire e.g age 65
3 - Find the most appropriate annuity rate in the table below based on the age at which you want to retire e.g. 0.06088
4 - Then work out the pension fund you'd need to get your desired annual income by performing the following calculation
(desired annual income)/(your annuity rate). e.g. £30,000/0.06088 = £492,772
5 - Write down how many years you have left until your desired retirement age e.g. 30 years, assuming I am 35 years old today
6 - Choose your assumed annual return (after inflation which has historically run at around 3% a year) for your monthly savings. If you plan to stick to safe investments such as cash then use a real rate of no more than 2% a year. If you plan on being more adventurous and investing in equities (via funds or directly) assume a conservative rate of 4-5% a year. Write down the annual rate as a decimal, so 5% is noted down as 0.05.
7 - To calculate how much you need to put away each month first work out what is known as your annuity factor (AF) by performing the following calculation (^ means ‘to the power of'). This is where you will need a calculator
AF = ((1 + rate of interest from step six)^number of years until retirement from step five) – 1) /rate of interest from step six.
e.g. AF = ((1+0.05)^35) - 1)/0.05 = 90.32
8 - Now divide your required pension pot from step four by the AF in step seven to give the annual amount your need to save in order to achieve your dream e.g. £492,772 / 90.32 = £5,455
9 -Now divide this figure by 12 to get the approximate monthly amount you need to save e.g. £5,455/12 = £454.65
Don't forget that if you save via a pension then you get tax relief on your pension contributions at your marginal income tax rate (20% for basic rate tax payers) up to the annual limit, which is the lower of your annual earnings or £50,000 in the 2013/13 tax year (£40,000 in 2014/15). So in my example, assuming you were a basic rate tax payer you would need to put £363.72 away a month (that is £454.65 x 0.8).
Annuity rates are based on there being no spouse benefit with income paid monthly with no increase or guarantee. They also don't take into account your health but they are a pretty good indicator of what you can expect
(image by cbenjasuwan, freedigitalphotos.net)