Since 2012, auto-enrolment into a workplace pension scheme has gradually become mandatory for all employers. There are a few exceptions, but if you’re in employment, you’ll almost certainly have been enrolled. It’s tempting to think this means you can now forget about saving for retirement. But is that true? Before auto-enrolment many people wrongly assumed that the state pension guaranteed them a secure retirement. Now, adding in your workplace pension should certainly improve prospects. But will it be enough? Let’s delve a bit deeper.
Opting out
If you’re young, retirement may seem such a long way off that losing part of your salary to auto-enrolment feels like a tax. Maybe you won’t live long enough to retire. Your daily expenses may seem far more urgent. Why not put off saving for retirement till you’re a bit older and you can afford it? There are several problems with this thinking.
A 22-year-old today has more than a 74% chance of reaching age 70. As you get older, the probability increases. By the time you reach 40, the probability is over 82%. So betting on not reaching retirement would probably lose.
If you opt out, you’re actually turning away free money from both your employer and HMRC. The minimum employee contribution is 5% of any gross salary over £6,240 (the qualifying salary). Assuming you’re a basic rate taxpayer, you’ll get back 20% of your contribution as tax relief. This reduces your net contribution to just 4% of qualifying salary. But your employer will also contribute a minimum of 3% of your qualifying salary, tax-free. This means that at least 8% will go into your pension pot. In effect, for every £1 taken from your net pay, you’ll get £2 paid into your pension. This works out even better if you’re a higher rate taxpayer. Also some employers may offer even more generous pension terms.
The earlier you start building a pension pot, the more time it has to grow. Let’s assume average real growth (i.e. adjusted for inflation) will be 5%. £1,000 invested for 35 years would grow to £5,516, compared to £3,385 after 25 years, or £1,629 after just 10 years. So if you start later, you’ll need to pay much more in to achieve the same result at retirement.
Auto-enrolment plus state pension
It’s very hard to make a convincing argument for opting out.
Okay, let’s assume you stay opted in. Is that enough? Is it safe to spend the rest of your disposable income on your lifestyle, relying only on auto-enrolment and your state pension for retirement? Received wisdom from financial planning experts is that it’s not safe, and that you should save more. I decided to put this to the test, using projections created by the EvolveMyRetirement® retirement calculator.
I assumed a single 40-year-old man starting with no savings. He was not a home owner, and had no motivation to leave a legacy. He was employed, and opted in to auto-enrolment, based on the minimum statutory contributions. I wanted to compare the situation assuming different gross annual salaries: £30,000, £40,000 and £60,000. In each case I assumed that the salary would grow by 1% above the rate of inflation, to take account of career progression. And I set the essential spending in all cases to £15,000 per year.
For each of these examples I used the calculator to find a strategy with at least a 95% success rate. In all cases additional savings were essential, mostly into ISAs. Interestingly, for these scenarios making additional pension contributions instead didn’t noticeably improve outcomes. For the £30K salary, the sustainable level of discretionary spending (increasing each year by inflation) was £4,000 per year. For the £40K salary it was £7,500 per year. And for the £60K salary it was £14,000 per year. Any money left over each year was invested into an ISA with balanced investment risk.
Consequences of not saving
So what would happen in each case if we doubled the discretionary spending? In all cases the risk of running out of money increased dramatically. Ranging from 50% to 70%. What this means is that by overspending, you’re relying on a future magic money tree to rescue your retirement. Overspending implies under-saving, since you can only save what you haven’t spent.
One of the problems you might face is the way you think about saving. It’s very common to set oneself a savings target. If you achieve it, you pat yourself on the back, and reward yourself by spending any money left over. But that’s the wrong way around. You should instead set yourself a sustainable spending budget. You should save every penny left over that’s not spent; depending on personal circumstances this could best be into a pension or an ISA.
The key point is that everyone has a sustainable level of spending, which you can optimise to some extent. Rather than use over-simplistic rules of thumb like the 4% rule, instead use the EvolveMyRetirement® retirement calculator to arrive at sustainable spending.