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Saving for Retirement (part 3)

Back to part 1, part 2

Okay, so at 65 (or whenever) you retire. What happens? You have a certain amount of money, divided into savings, pensions, and the value of your house. The question now is how far does that money take you? Look at the pensions - do you immediately have to convert them to annuities or can you defer them? Can you take a cash lump sum? Generally speaking, I would take as much cash out as possible and live on that rather than buy an annuity. You can look up annuity rates online to estimate what your cash pile or pension funds will buy you - remember to use an index linked annuity in order to stick to the assumption of using today's money - there will still be inflation in the future. Also, you might want to use the rates for say, 5 years younger than your retirement age - life expectancy is likely to increase over time, so unless you're retiring soon, you will probably be fitter than the average person of that age is today. You could also add on the state pension at this point, but who knows what value (in todays money) that will have in 30 years time.

Shocked by the result? I was a bit.

I'd try to defer the annuity for as long as possible - you want to insure yourself against running out of money before you die, but you should try to do that as late as possible - if you die earlier, you win because you didn't give all your money to the annuity company who'll stop paying out as soon as you go. If you die later, at least you'll get a better rate for your money.

So look at when any pensions you have start paying out, and estimate what they'll pay from annuity tables. That's your new income. Assume your expenditure is still what it was before you retired (same over your lifetime remember). Most likely expenditure is bigger than income now. That's okay - you're done saving. Remember to keep compounding the savings you have left, and see what age you get to when the money runs out. You can use the same spreadsheet from part 1

If that age is much older than your life expectancy then you don't have to worry. For the rest of us - that's not the point at which you're thrown onto the street (or your children buy you a special one way flight to Dignitas). That's the point before which you have to move to a smaller house, or look at some kind of equity release. If that age is implausibly young, then you need to think about whether you can save more now, or at least for some extended time before you retire. You can go back and use different figures in the savings column to see the effect of different levels of saving on the amount you have when your retire. Compounding means that even saving a little more now makes a big difference later on. If that doesn't look realistic either, then you do have a problem - but at least it's a quantifiable problem, ie - I need to save x pounds more a month to keep my standard of living until age 80 or whatever. Probably the government will help, or you can look at what happens if you assume you can cut your expenditure levels in retirement. Beware of doing that too much though - remember you're looking at today's money. Look at the income level you set for yourself and ask if you could really live on it. The good thing about a constant level is that you know you can live on what you're living on now - you just don't know how long you can do it for.

Saving for Retirement (part 2)

Back to part 1, forward to part 3

So a short middle section before I get onto what happens when you actually retire.

Ironically, I haven't mentioned pensions themselves so far (btw, there's a fantastic post by Dan Davies about pensions which you should read) If you have a final salary pension then you know what you're getting, modulo the risk that your scheme collapses. If you're like me and have a "defined contribution" scheme, then essentially it's just more savings, but in a different pot. The good bit is that you don't pay tax on the contributions, the bad bit is that you're more restricted what you can do with the money when you retire - you may have to buy an annuity at some stage.

Anyway, repeat the compounding procedure for each pension fund - how much do you have now, how much do you (or your company) put in per year, and compound to retirement (look carefully at what your pension is invested in. I've moved a lot of mine out of equities and into lower risk securities because when it comes to pensions I'd rather have lower growth and less risk than be worrying about whether my pension will be wiped out if the market crashes).

another thing you might or might not want to think about is whether you will inherit any money at some point. If you do, you can either just put it in the savings pot at roughly the point you think you'll receive it (later rather than sooner let's hope) and compound it from that point, or you can also do a "what if" calculation just by taking the likely amount you'll receive and compounding it for how long you think you'll have the money for up to retirement.

Finally (before I talk about retirement) you might want to think about whether you'll buy a bigger house. In that case your savings go down, and your mortgage term may extend, but at the end of the day, you are hopefully sitting on a bigger asset than if you'd stayed put. Note that that means that if you don't have enough cash then you may need to trade down your house sooner rather than later, but hopefully you'll get some growth in the value of the house anyway.

That's it for this part. At this stage you should have a picture of how much money you'll have at retirement, both in savings, pensions, and in the value of your house. The final part will talk about how to think about what happens to that money when you stop earning.

Saving for Retirement (part 1)

Forward to part 2, part 3

As I've been gradually looking into my finances, the biggest question I've had to look at is: how well am I doing in saving for retirement? I've accumulated a number of pensions from my past employers, who all send me statements which I tend not to read. Why not? Because I can't be bothered to unpick the assumptions they've made about growth and whether they're showing me today's money or retirement time money. Then I have savings, and equity in my house. How do I turn that into something I can actually use to help me understand what's likely to happen.

Fortunately, I read a paper from the Institute of Actuaries called Family Fortunes [pdf], from which I've freely cribbed a central idea: you should aim to make your real disposable income to stay constant over your lifetime. Using that, I wrote a spreadsheet to model what that actually implies. The paper I mentioned has its own version [zip], which is probably better than mine, but I understand mine so it's easier for me to fiddle with it.

So the way I did it was this:

• I worked in today's money. That actually makes things a lot easier - you can see what the retirement income actually means. It's pretty easy to scale it up by compounding inflation on afterwards. The key thing you have to remember if you do it this way is that you ignore anything that's inflation related. Basically that just means not factoring any cost of living raises into salary assumptions, and reducing savings growth by the rate of inflation.
• I assumed that there'll be no changes to my status until I retire at 65 (I can't see it being any earlier than that). Already, you can object to that on various grounds - my salary might well rise before then. Or I might get to 50 and be unable to find another job because of ageism. Or my pension fund might be stolen. Yeah, yeah, any of those things could happen, but by modelling the "nothing changes" case, it makes it easier to see the impact of various good and bad alternatives.
• I looked at what I can realistically save each year (no point fooling yourself about this - if you're saving only £100 a year at the moment, then that's the number you should use). This is just ordinary saving - I'll look at pension saving in part 2, but it's not much different. Another key point I got out of the family fortunes paper is that this number is not flat over time. Pension companies often give you a "you should save x per month" figure which seems wholly unrealistic because they assume you have the same amount of spare money at all times. The key thing that changes is that in 18 years or so, I'll have paid off my mortgage. I've assumed that I save all that money thereafter (remember - constant real disposable income over time). Of course, it would be better to save it now, because of compounding, but I could only do that by stretching the family budget to breaking point.
• Put all that information in a column with your current (long term) savings at the top. Multiply each years figure by whatever growth rate you're assuming (I've gone with 2% which is about what I get on savings after subtracting inflation) and add on the next year. Repeat until you are retirement age. See the attached sheet for details.

I've attached a version of this with pretend numbers as a Numsum spreadsheet below. In part 2, I'll look at pension savings, and other things you might want to take into account.

Investing - Introduction

I've been meaning to write about this topic for a while, and I haven't got round to it because there's too much for one post, and I only really get to think about blogging during the time I'm doing it, so it has to be fairly off the cuff.

So I've decided to do this in bits and use my personal experiences to hang the various bits on.

I'm now in my mid-thirties. I left University at 22 and started work on a modest graduate salary with the Woolwich Building Society (as was). Probably the first couple of years I didn't save anything - I spent what came in on rent, food and going out. So on that basis I've been saving for about 10 years.

Once my salary hit about 18k (after I'd been at the Woolwich for a while) I started putting some money into a separate account. In fact that's probably Lesson One as far as I'm concerned: hide the money you don't want to spend. Just having it in a different account makes you think about it separately.

I'm going to stick to my small chunks rule: more soon. Probably on IFAs.