How to fix a pension shortfall

Not saved enough for a decent pension? There are four ways to get round this. Save more, spend less, work longer.

That's only three.

No-one ever mentions the fourth.

Which is?

Die young.

I prefer the other alternatives.

Very well - lets go through them: save more.  This strategy has a bonus side effect. Suppose you want to retire on two-thirds of your salary. You increase  your savings as much as you can - say up to one-third of your salary. So when you finally retire on two-thirds your net spendable income doesn't go down at all. It might actually go up as you won't be paying national insurance.

Spending less has a big impact. Cut back by £4.50/day - every day for the rest of your life as a pensioner- and you can knock £50 000 off your required pensions saving.* Sure you will miss that coffee and croissant, or the odd liqueur, but how long would you have have had to work to save an extra £50 000?

Working longer. Not only will your savings keep going up, you will also get more for your money when you turn it into a pension.

Because?

Because by retiring late you have less long to ...

OK I get the picture.

*Who would have thought cutting out a large cappuccino and a cream doughnut would save you £50 000.  But divide by 25 and  the resulting £2000 a year then turns into £1600 a year after tax. £4.50/day. Pensions seem absurdly expensive, but the flip side is that the naturally frugal can retire years before the rest of us.

How to save a quarter of a million....

... because thats what a £10 000 a year pension will cost.

Who says?

Well if you use the rule of 25, then 25 x £10 000 is....

Yeah I saw that calculation, looked a bit flakey to me

OK, check out inflation-proofed pension quotes for this month and for a 65 year old woman £250 000 gets you...

Let me guess.

£10 000 a year.

And for a man?

For a 63 year old man - about £10 grand a year.

I can't live on £10 grand a year.

There's state pension on top of that.

True. I suppose my house will be worth a bit too.

Yes but don't forget - if you sell it and buy an annuity, you will also need to pay rent out of that £10 000.

So I can't have my house and eat it. I think I will live in it.

Fine - you will still have a quarter of a million in assets; you  won't have  much income, but you won't have rent to pay either. And do you get a pension from work?

I'm freelance

Oh

Look this has come as a bit of a shock - a quarter of a million! Nobody mentioned that to me. I have got £40k put away and I thought I was doing rather well. What's that worth?

About £5 a day. Before tax. How about your wife?

She's a deputy head teacher  - she will be retiring on £25 grand at 60 ... Hey - thats worth over half a million.

I'd stick with her then

The Rule of 25

The rule of 25 says that if you want an income of £10000 you need to save a quarter of a million.

What? That's too much, haven't  you got ...

A rule of 20

Yes that would be...

Or 15?

Better.

How about 12?

Then I would only need to save half as much. So which one is right?

All of them in a way.....  x25 is not a bad estimate, but if you can live on 2/3 of your income that gets you to x15

No it doesn't it gets you to 16.66

Ah, but you don't pay national insurance  at 10% anymore. So maybe you can make do with x15

And x12?

If you have been saving  20% of your income, then you won't need the full x15, x12 will do.

Ah....where does x20 come in?

Thats how the government values pensions in payment. If you have a £5000 pension that counts as equivalent to £100 000 in value.

So what should I use?

Better go x25 for safety

But that means to get a pension of £10000 I will need to save..

That's right, a quarter of a million.

The big 4: how? where? what? when?

 You can't hope to know the answers without first figuring out the questions. And  even with plain vanilla personal finance there are four of them.  How? Where? What? When?

How much shall I save?  You need to save at least  slice of your income, preferably a chunk. A sliver isn't enough. [ A chunk is 2 slices, a slice is two slivers].  A slice is 8.33%. 

Its a piece of cake. A twelfth. A month's salary. Two months is good, three months great. Perhaps not coincidentally the new style UK  personal pension schemes will kick in at 8%. And the old style pensions rules used to limit tax relief to 15% of your income. Again that's saving around  1-2 months salary every year. 

Where shall I stash my savings? This isn't a what to buy? question. That comes next. This is about which tax regime? should my savings grow in. The three most popular are ISAs, pensions, and your home. Each has special tax concessions. 

ISAs have no further tax to pay, and a very flexible. Buying your own home isn't flexible, but there is no income tax [on the rent you save] and no capital gains tax. The pensions tax regime offers a tax free lump sum [25% of pension value] and tax deferment. On the downside it is the least flexibile. You can't access any cash until you are at least 55  [or 65 for men's state pension], and even then you can't get your hands on all of it.  

So you could stash all your savings in an ISA, or use it to pay off your mortgage early, and have very little to do with the pensions  tax regime even though you think of yourself a saving for your 'pension' [as in 'my house is my pension']. Governments like the pensions  (tax)  route because it limits you to when you can spend it [see the last question, below]. And the finance industry like it 'cos they can charge you fees. Of course home owning isn't a fee-free zone - as anyone switching mortgages can testify.

What to buy?  Is the traditional big question. The industry is ready with the answer: 'Buy our unit trusts, endowments , emerging markets funds....' by which they really mean 'pay our fees'. For vanilla investors this question is about your asset allocation. How much in boring assets [gilts and cash] and how much in bouncy  [shares and  commercial property].

When to cash in?  Even within the state scheme you can opt to delay your pension. Those with money-purchase pension schemes also have an additional question. Do I take an income (also known as drawdown) from my personal pension fund, while leaving it invested - or do I buy an annuity with it. Or can I do both?

Thats the questions - what are the answers?

It depends.

How much?

Lets look at what Robert  on £36 000 a year does..

Robert decides he can save £4500  a year  [an eighth - a month and a half's worth, not bad]. Over  35 years thats £250000 - [if the real interest rate after inflation is 2.5%, ie he ends up with  £250 000 in todays money].

Where?

Robert decides to pile it all into paying off his mortgage early. He manages this by his mid40s, and switches his savings into an ISA. There was a five year period when he did both - because he was worried his ISA allowance might not be big enough to cover all the savings he wanted to make in his fifties. He was hoping he would hit the 40% tax band, when he would have started saving into a pensions  wrapper because of the tax relief. But he never quite earned enough. And the standard tax relief wasn't enough to tempt him.

What to buy?

Robert just splits his fund equally between index linked gilts and shares [the FTSE 100] . He finds an etf [like a tracker] for each area. He only has two holdings. Its not ideal. He has no overseas holding. And gilt funds are not the same as gilts [the latter are redeemed - gilt funds aren't]; but compared to many of his friends he has done ok. Most of his money went to pay off the mortgage. His friends still have a mortgage - and a big hole in the value of their shares holding

When to take your pension?

Because Robert's money is in his ISA he can take the money out any time....  He doesn't have to wait until he is 55 - or be pushed into buying an annuity before he is 75. We'll come back to this later when we look at someone who has  saved/trapped all his money in a pension scheme.

Three questions

Brent, Homer and Richie each have a net worth of zero. Add up their assets, deduct debts: zilch.

1 Brent rents his flat: should he take out a loan to invest in the stock market?

2 Homer has a mortgage. Should he increase his mortgage to invest in the stock market?

3 Richie has a mortgage, and some shares. What should he do?

For the vanilla investor there is only one answer. You don't borrow to buy shares. Ritche should sell his shares and pay off the mortgage.

Vanilla in a nutshell

The personal finance industry is a drain on resources: yours.  Vanilla Finance came about as a way of saying to us ordinary punters: this is what you need to know and its not a bad plan [maybe not the best, but that is unknowable in advance].

Vanilla Finance says 

1 Own asset classes, rather than individual shares or loan stock. Passive investing.
2 Over a lifetime of saving, your asset allocation determines your outcome.
3 Work out an allocation that suits you, and stick with it unless your circumstances change.

Just as dieting can be summed up in a few words [eat less, exercise more], so can vanilla finance [index and rebalance]. Like dieting it can be hard to stick to the rules. Unlike dieting it gets easier the lazier you get. Rebalancing is the most active part, and that can be left for years [every two or three years still seems to work as well as anything].

Implicit in this approach is that professional managers [eg unit trusts] do not add value [some do, some don't, but you don't know which in advance].

Figures in the landscape
When I give examples I mostly use real [not nominal returns]; I also assume 1.5% advisor charges with funds, but only 0.5% with trackers and etfs. Benchmark returns [ie 'what if', not predictions] are 1% for gilts, 2.5% for corporate bonds, 4% for equities; an equity risk premium of 3% [until recently that was the on low side of the consensus]. They also give handy doubling times of 70, 30 and 18years which have a very human scale to them.

As befits vanilla simplicity I only have two asset uber classes. Boring and bouncy. Boring has reliable returns, 'bouncy' doesn't. Index-linked gilts, and shares are examples of each. 

In the simplest version of vanilla 'boring' contains' 3  asset classes: cash, short-term gilts, and index-linked gilts.  Bouncy contains: shares, overseas shares and commercial property.

Other asset classes, like private equity or timber turn up later; hedge funds never show up. Commodities have been shown the door but keep trying to climb back in through the window.

So the big decision comes down to the mix between boring and bouncy in your asset allocation. 

If you only make one decision in your investing life, this should be it. Once you have made it the rest is detail.

It's like mixing a cocktail. How much from the boring bottle - and how much from the fizzing bubbling bottle that hints at the promise of riches to come? A bit of fizz can be more fun, but it can also give you a headache in the morning [or worse, 40 years later on retirement].  The sheer weight of responsibility might make you hesitate before mixing up this cocktail of assets for your lifetime - but in fact you will have already done it. You have an asset allocation right now, its just you haven't checked out what it is.  The variations are practically endless - but vanilla suggests 3, as yet unamed, benchmark cocktails: 

adventurous 2:1; balanced 1:1 or cautious 1:3.

Note even the most adventurous allocation only has 67% 'bouncy' -  far short of 100% equities, and certainly nothing over 100% [which would be leverage with a loan]. The cautious cocktail has 75% in cash and gilts - once upon a time this was thought suitable for a 75year old...

So finally we get there: mixing up first a balanced cocktail we have 50/50:

20% gilts, 20% index linked gilts, 10% cash - the boring bit
20% shares, 20% overseas shares, 10% commercial property - the bouncy bit

There's enough of a kick from the 'bouncy' side to leave you a bit dizzy from recent market falls. And the strong hint of commercial property that added zest a few years ago, now just leaves a nasty taste in the mouth.

The cautious cocktail gives you

30% gilts, 30% index linked, 15% cash

10% shares, 10% overseas, 5% property

There's a hint of fizz and a lot of boredom. And right now boredom is in short supply.

You can get this coverage with trackers or etfs [eg ishares]. The contentious bit is there are no corporate bonds. Opinions differ as to whether they offer the best of both worlds or the worst. Vanilla is in the latter camp and recent events have confirmed it. Next year may be a great year for corporate bonds, but then it may be a great year for equities too.

Also overseas equities have a strong covariance [move in tune with] with domestic, so they ain't a great diversifier.  But as the pound has dropped overseas  holdings have been useful. Overall the 50/50 portfolio would have saved you from the worst excesses of the market slump.


So far, so what?

Well if you cut 1% off your charges, that makes a big difference. Chances are a disciplined approach will save you even more. Studies of what investors actually earn make for depressing reading. Money-weighted rates of return are very different from time-weighted. Money-weighted is the one you eat.  

Earning 100% on £50 is not much use. Next year you earn 0% having been encouraged to invest £50000. Your charts say you have earned a simple average of 50% a year. You would be the pin-up of the funds industry, maybe feature in their ads. But your spouse knows you have earned £50 over two years.

Also vanilla finance favours delaying paying into a pension fund until you can get a 40% rebate - and that might mean waiting until your 40s.

And last but not least vanilla finance says you can usefully use all your savings to pay down the mortgage - and forget the rest. Once the loans are off your back then you can start with the cocktails.

The man who had six pensions...

The pensions landscape is littered with forgotten tax breaks, misguided schemes and failed initiatives. Even the 25% tax free cashback rule  is the result of some long-forgotten compromise dating back to the 1930s. And over it all hover the birds of prey of the finance industry, looking for easy pickings. But all of us have to find a way through somehow - so what is the best path to choose?

Here's the vanilla guide to the key features.

Broadly there are three places to go to get a pension. And each offers two choices. That's six different pensions....

The big three pensions organisers you can look to are

• the government
• your employer or
• you can do it yourself.
  

The government provides the basic state pension, and also offers an additional state pension [ASP] that used to be called SERPS [state earnings related pension] and then became the Second State Pension. Savers could skip the ASP by contracting out. Recently the UK governments focus has changed to making sure we all contract in for an additional basic minimum. Their solution is the personal pension accounts from 2012, but these really belong in the 'employers' section.

Employers provide two kinds of pension schemes. The old style 'defined benefit' promised a pension based on number of years worked. Your pension savings didn't bounce around with the stock market. As long as your employer didn't go bust your pension was secure. Very nice to have but also expensive [for the employer], which is why 'defined contribution' schemes are taking over. Here your pension depends on how much money is in the pot when you retire. And that depends on how your savings have done. These are also known as money purchase schemes. Employers usually pay towards the admin costs of these schemes, and may add in their own contribution. Think of it as free money. 

Finally you can organise your own pension two ways too: by paying into a personal pension plan [ie from an insurance company] or by doing the whole thing yourself [a self-invested pension plan, SIPP].

So which is best?  Whatever's cheapest, most secure, and index-linked.

In first place:

Anything from the government is about as good as it gets [unless you are CEO of a failed bank]. The state pension is due to be indexed in line with earnings [not just inflation linked]. And if you work for the government, so much the better. [Better still for women]

In second place

Almost any 'defined benefit' scheme - because the good ones will have insulated savers from the roller coaster ride of 21st century equity markets. [Also good for women]

In third place

Anything with free money - eg where the employer makes a contribution. Or you can get national insurance rebates ['salary sacrifice'].

And languishing outside the medals is the whole of the personal pensions industry. It has to, almost by definition. It feels the full lash of market forces with no protective buffer [unlike defined benefit schemes, or those with employer contributions.]  But even here there is a winner.

In fourth place:

The SIPP - self invested pension.

Which puts the personal pension plan - the raison d'etre of much of the finance industry - firmly in last place.  Why? Because it charges the most with no discernible uplift in performance.

So what am I supposed to do?

Hold back on the traditional personal pension plan until you have checked out the other options

Which are?

Buying additional years if you can; seeing if employer will match any of your contributions; exploring salary sacrifice [national insurance rebates]; seeing if  your employer's additional voluntary contributions [AVCs] have low charges; start your own SIPP...

SIPPS are expensive

Yes they can be - but for the very simplest SIPPs set up costs and annual running costs can be under £50, or even zero. Google cheap SIPP. I got Hargreaves Lansdown, SIPPDEAL and Alliance Trust. But if you don't want to pay the  1.5% charges of managed funds [and vanilla investors don't] then be wary of HL -  they will hit you for 0.5% anyway [capped at £200] on other investments. Either way they are looking to get their 0.5%.

Does the odd 0.5% make such a difference?

Every year. Until you retire? Yes. You should aim to get all your expenses under 0.5%, under 0.3% you are doing well, under 0.1% and you are probably in a US government scheme. UK fund expenses usually start around 1.5% and in practice [by the time you buy, and then sell] will have exceeded 2% per year.

What about stakeholder schemes?

Capped at 1.5% expenses for the first ten years? Poor value. The government wanted to make the charges a flat 1% - and failed. That tells you something about the importance of the odd 0.5%.

Are women really better off in defined benefits schemes?

If you buy a pension for cash it cost about 10% more if you are a woman.

My friend's been a teacher all her life. She's retiring at 60.

If she is in the state system she will be ok

But she says she is only get £20 000 pa pension

That would cost £600 000 to buy. How may people save that much in their lifetime? Tell her to cheer up.

Is it true women get their state pensions early?

Up until 2020, yes. Are you a woman?

No

Would you like to be?

?

If you have a sex change and get a Gender Recognition Certificate you can claim your pension early.

I'd rather have a small pension and a ...

Just checking