Pensions can seem confusing but you can increase your chances of the achieving the retirement you want by simply working out how much you’re likely to need and how to get there. So how do you do it?
First, work out how much you’ll need to live on. For the moment, don’t worry about inflation. Simply take the cost of your living today. Adjust for the fact that you’ll hopefully have paid off your mortgage and that your children will have left the roost!! Consider everything, including holidays and nights out.
If for example, you think £25,000 (before tax) a year would suffice, that would equate to £1,841.67 per month (under the current allowance for a 65-74 year old person). Obviously, personal allowances are subject to change so I would recommend periodical reviews. You then have to calculate what size of savings pot will give you the annual equivalent of £25,000 a year (in today’s prices) on retiring.
The Savings Pot
The size of the pot depends on how you plan to generate an income. If you use a pension fund, you have to think about what annuity rates will be on retirement. At present, a 65 year old man with £100,000 can buy an income of just over £6,000 a year (6% of the fund). If you add inflation protection, joint life or a guarantee period, income can range from 3.5% – 5.5%.
Future annuity rates will depend on things such as government bond yields and life expectancy. For the purpose of this exercise, we will say that they stay at 6%. If you want an income equivalent to £25,000 in today’s money, you will need a pension pot of £416,667 (divide £25,000 by 0.06 to calculate). Because of inflation, the actual pot will need to be bigger than this, but I’ll get to that in a moment.
What return can I expect?
We now know the size of the pot needed in today’s money, how do we go about getting there? A key part of the sum is the rate at which you can expect the money to in years to come. Remember, we are looking at returns over a long period of time so it is best to be conservative. You also have to factor inflation into the equation, in other words we need the “real rate of return”. Again for the purpose of the equation, we will use 3% (return less inflation and charges). Always review you pension to make sure the current investment is producing a “real rate of return”.
How much needs to be saved?
Annuity factors (AF) helps you work out how much you’ll have if you regularly invest a fixed amount for a period of time, at a fixed rate of interest. The sum used is:-
AF= (1+rate of interest)^number of years invested -1/rate of interest
(^ means to the power of)
This can either be calculated on a scientific calculator or spreadsheet.
A 30 year old person plans to retire at 65. They save for 35 years expecting to earn a “real rate of return” of 3% on the investment. This gives an AF of 60.46
Now divide your total estimated pension pot by the AF to get the amount you have to save each year in order to get there. For my example, you would need £416,667 to generate £25,000 a year in today’s money. £416,667 divided by 60.46 equals £6,891.61 per annum or roughly £574 per month.
Tax relief on pension contributions cuts that to £459 for a basic rate tax-payer or £344 for a higher rate tax payer.
It is never too early to review your pension!!
Let Hoskin Financial Planning make sure you are on track for the retirement you are planning for.
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