Three rules for building a pension that you can retire on

Pension Clinic: Steve Webb provides tips on how to build up a pot that funds savers’ retirement expectations.

One of the most frequently asked questions about pensions is “how much do I need to save?”. But despite the best efforts of government and the pensions industry, a one-size-fits-all answer is hard to come by.

In previous generations, the question didn’t really arise for most people. A worker simply stayed in the workplace scheme, contributed in line with the rules, and with a long working life could expect a pretty decent retirement.

But that has all changed. Most people outside the public sector no longer have access to a salary-related pension. Instead, most are contributing to a defined contribution (DC) arrangement where they build up a pot of money that has to support them through retirement. The vast majority of the 10 million people who have been “automatically enrolled” into workplace pensions in recent years are in such arrangements. But the mandatory minimum level of contributions is widely agreed to be too low to give most people the sort of retirement they would want for themselves.

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Three simple rules

It is probably unrealistic to expect younger workers to know what their wants and needs might be in retirement. So for this group in particular, the best strategy is to follow three rules of thumb.

First, stay in the workplace pension rather than opting out. From the age of 22, employees will be put in a pension by their employer and the most important thing is simply not to opt out; that way, money from employee, employer and the government will be going into a pot and invested for decades.

Second, increase contributions when your pay rises. If you know you are going to get one, you should have a plan to nudge up the percentage contribution into your pension, gradually building up to a realistic level. For younger workers, most people would say that a total contribution rate of 12-15% of pay should generate a decent pension.

Lastly, “max out” on what the employer will contribute. Larger employers will often match additional pension contributions made by their employees up to a limit; this means that your £1 pension contribution – which may cost 80p net of tax relief on the contribution – turns into £2 once the employer match is added. There are very few investments where 80p turns into £2 overnight!

For older workers, it makes sense to review what pensions have already been built up and then compare that with a target level of income. That target will obviously vary from individual to individual, but the Pensions and Lifetime Savings Association (PLSA) recently published three benchmarks which help to give a flavour of the kind of retirement to be expect at different income levels.

According to the PLSA, an income of  £10,200 for a single person would support a “minimum living standard”, £20,200 would support a “moderate lifestyle” with greater security and flexibility, and £33,000 would generate a “comfortable” retirement, including things like theatre trips and several weeks’ holiday abroad each year.

These figures are of course averages and may not be appropriate if your regular income in work was well above (or well below) average, but they do provide a helpful benchmark.

Get a pension forecast

You can obtain a state pension forecast and up-to-date pension forecasts from your company and private pensions, to see where the projected income falls on the scale from “minimum living standard” to comfortable. If the forecast is short of where you want to be, many pension providers offer “sliding-scale” calculators that provide a feel for how much to save to generate a pension of a specified level. Making maximum use of any available employer contribution to a workplace pension is likely to be the least painful way of achieving the desired level of contributions.

For many people, this exercise may be discouraging, as their expected retirement income may be well short of the desired level. Part of the solution may be to work on a bit longer, both to build up a bigger retirement pot and to reduce the number of years over which it has to last. But the sooner you take a look at your retirement income prospects, the sooner you can put in place a plan to reach the kind of retirement you want to enjoy.

Steve Webb is a partner at pensions consultancy Lane Clark & Peacock.