Be frugal at 40 and prioritise your pension

As millennials start to enter their fifth decade, their thoughts need to turn to funding retirement.

For millennials, 2021 is a milestone: the year when the generation born between 1981 and 1996 begins to turn 40. 

This is often a “wake-up” moment in terms of personal finances, when people stand back and take a serious look towards their retirement, realising that the next 20 years can fly by as fast as their kids navigated the primary school years.

For those tempted to grasp the nettle, it is not a bad time to make this assessment: last week marked Pension Awareness Day 2021 (perhaps next year it should upgrade to Pension Awareness Week, as it actually runs over five days) to raise awareness of the importance of saving for retirement.

Now in its eighth year, the campaign has useful resources at pensionawarenessday.com, is backed by the pensions minister Guy Opperman — at 56 old enough to be drawing his private pension — and has celebrity endorsement from TV presenter Steph McGovern, representing millennials.

It’s also the year in which the Best Picture winner at the Academy Awards — Nomadland — depicted the harsh realities of not having a nest egg for later years — possibly the biggest “pension awareness” media event of all time. Few would want to spend their 60s living in a van and struggling to find work as a seasonal labourer.

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Most millennials will fit neither the stereotype of the avocado toast and latte-swilling spendthrift, nor the frugal FIRE (financial independence, retire early) advocate. But millennials have had to wait longer than their parents to reach the standard financial milestones, with homebuying coming later (in their mid-30s) and often after having children. So, for many, pensions have not yet been a priority. 

Is it too late to sort retirement planning at the age of 40? No, there are always steps you can take. And the first is to know what you’re going to need to save.

According to the Pension and Lifetime Savings Association, a single person in retirement will need £10,200 a year at current prices to achieve a minimum living standard; £20,200 a year for a moderate standard; and £33,000 a year for a comfortable one.

With the full state pension paying £9,339 a year you might think there’s nothing to worry about. But you’ll have to wait until age 68 to get it and to qualify you’ll need 35 years of national insurance contributions, so check your records at gov.uk.

Note that the UK’s state pension provisions have been labelled as among the worst in the developed world by the OECD and there’s no personal NIC fund for you — state pensions are paid out of current taxation, so there are no guarantees.

Last week, prime minister Boris Johnson announced a 1.25 percentage point increase in national insurance and dividend tax, branded as a “health and social care levy”, while suspending the triple lock on increases to the state pension. Pressure on state funding is not going to go away, so best to achieve that minimum retirement living standard through your own means, if you can.

Most people invest for retirement by combining the tried and tested tax wrappers of pension and individual savings accounts (via stocks and shares ISAs rather than the cash versions). Money held within these is sheltered from income and capital gains taxes, so is not affected by last week’s levy and potential future raids.

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What’s more, saving into a pension gives you free money in the form of upfront income tax relief on contributions, which is hugely valuable in the context of rising taxation. The more you put into a pension, the less tax you pay. 

For a 40-year-old, the age at which you can draw money from a private pension has risen to 58, as it is now always 10 years before state pension is paid. So if you need some of the money before age 58, you’ll need to invest in an ISA, which allows withdrawals at any time.

But having an ISA or a pension scheme is only half the story. How that works out depends on investment choices and the charges that you pay, alongside your contribution levels.

Younger workers (you are still one of these) often don’t realise the benefits of accepting more investment risk in exchange for the prospect of higher returns. High risk in this context doesn’t mean crypto trading — it just means a higher proportion of equities.

Research by Opinium on behalf of interactive investor found four in 10 (39%) under-40s think the most appropriate risk level for their pension is “medium”, with 28% saying that “low risk” is the most appropriate. Only 20% of workers under the age of 40 thought that a higher-risk pension was the most appropriate level for their age.

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Dan Mikulskis, head of investment and partner at pensions consultancy LCP, says: “There is no free lunch. Higher-return portfolios also carry more risk, but younger investors can often afford to take this risk — a fact that can often get missed.

Over decades, the difference becomes very large, he adds. By investing all their money in equities, an average earner would expect to have £46,000 more at retirement compared to a balanced moderate risk fund, by his calculations. That is equivalent to increasing lifetime contributions from 8 to 12%, or working a decade longer.

“Every percentage point counts,” Mikulskis says. “People should think like an investor, making sure they look under the bonnet to see how their funds are invested and also that the way their pension is invested is right for them.”

Small differences in charges can compound into thousands of pounds over the subsequent 15-25 years, so consider reducing them. The average charge for an automatic enrolment pension scheme is 0.48%. while many old-style pensions have charges of 1% or more. You could reduce these by switching fund options or transferring to a cheaper pension.

Popular funds among millennial investors on interactive investor include Vanguard LifeStrategy 100% Equity and 80% Equity, which have low ongoing charges of 0.22% and have delivered strong returns (I hold them too).

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If you’re starting a pension from scratch at 40, the rough rule of thumb is to put aside 20% of income.

But if you want to draw £10,000 income by age 55, maybe to free yourself up to change career, retrain or launch a new business, you’ll either need a pot of between £130,000 (if you just want to plug the gap to state pension age) and £300,000 (to draw a 3.5% income).

With 8% annual growth (highly optimistic), you could achieve this in an ISA by contributing £450-£1,000 a month, which is well under the £20,000 annual limit for ISA contributions. At 5 % growth, £550-£1,500 a month would achieve this.

That level of saving may seem extreme, but it is what many millennials have paid out in monthly childcare costs. It’s time to make your retirement savings your new “baby” and nurture them well.

Moira O’Neill is head of personal finance at interactive investor, the author of Finance at 40 and a former winner of the Wincott Personal Finance Journalist of the Year. 

This article was written for the Financial Times and published there on 17 September 2021.