How are you going to build up enough savings to see you through retirement?
Most people will choose the pension route, not least because with a workplace scheme your employer will normally match your contributions while the government offers tax relief of 20 per cent or more.
So, in essence, free money.
Topped up by tax-free growth, tax-free cash, and higher rate tax relief for those on large salaries.
However, despite all this being hugely attractive, some, mostly the younger generations, have a completely different handle.
They invest in property, they choose Isas, they opt for Venture Capital Trusts, while company sharesave schemes offer an alternative avenue.
All have advantages and disadvantages.
Nevertheless, let’s assume you do go with the traditional pension.
How much of a pot are you going to need?
Internet commentator Unbiased states: “Some advisers recommend that you save up ten times your average working-life salary by the time you retire. If your average salary is £30,000 you should aim for a pension pot of around £300,000.
“Another top tip is that you should save 12.5 per cent of your monthly salary. If your annual salary is £30,000 you would save £312.50 a month – which over 40 years at four per cent growth could build a pension pot of over £300,000.
“With a workplace pension this is even more achievable. You would only need to pay in £125 per month (five per cent of your salary).”
How much do you need to live comfortably in retirement? It depends on whether you want to take luxury holidays, and the like.
For a quick estimate, Unbiased recommends trying the ’50-70′ rule. Aim for an annual income that is between 50 and 70 per cent of your working income. So if you earn £50,000 now, you will want to achieve somewhere between £25,000 and £35,000 a year. Insert a safety margin as, typically, the cost of living doubles every 25 years.
Next, plump for your desired retirement age and estimate your likely life expectancy – an average 40-year-old today who steps back aged 65 could expect to live to 82.
If you qualify for the full new state pension, you’ll receive £168.60 per week or £8,767 per year.
Hence, you will need other sources of support.
In calculating how much, deduct your guaranteed income, such as the state pension, from your preferred annual income in retirement.
Final salary or defined benefit is the Rolls-Royce of pensions, providing a guaranteed income for life. However, most companies decided they could no longer afford them and accordingly these are now largely confined to the public sector.
Annuities too provide a guaranteed income for life but you will usually get a lower return than using drawdown.
The golden rule of saving for retirement is the earlier you start, the more you potentially benefit from compound growth.
Here is an example:
Male, aged 30, paying £250 per month gross, assuming 4.6 per cent (example growth rate has been reduced by price inflation at two per cent), fund value at age 65, £98,600. The same scenario but for a male starting at age 40, produces a fund value of just £80,200.
For higher earners, there is an annual allowance (how much you can pay into your pension each year) and a lifetime allowance (how much you can pay into your pension in your lifetime) that limit the amount you can save into pensions and still get tax relief.
The moral of this story is that restraining your lifestyle spending when you are young will set you up for a decent standard of living when you are old.