Why you should save 20% of your salary into a pension

Office workerA new report suggests that unless you are putting a fifth of your salary aside to pay for your retirement, you may have an unpleasant surprise in later life.

A report based on the most comprehensive analysis of global investment returns shows that the next generation of investors should expect low returns for the next 20-30 years, and therefore need to save a lot more if they want a good retirement.

The report comes from Elroy Dimson, Paul Marsh and Mike Staunton, three men behind the groundbreaking book, The Triumph of the Optimists: 101 Years of Global Investment Returns, as well as the CSFB Global Investment Returns Yearbooks.

The authors, with the help of researchers all over the world, have put together the most comprehensive and accurate information about historical returns on shares and other assets that you can get anywhere.

Quality research doesn't mean good news
Unfortunately, by stripping out or reducing many of the biases found in other research, and by using more and better information, the authors show that most of the time our investments do worse than we'd expect and worse than we're told.

That's not new. They first demonstrated that back in 2000. What's new from this year's report – the biggest takeaway for individuals like you and me – is that we need to sacrifice a lot more now if we want to earn the retirement income we expect.

The authors estimate that a 25-year-old paying into a pension that relies on investments will need to contribute at least 16%-20% of his salary to retire on half salary at 65. From my own estimates, based on those figures, if you're just five years older, it's a lot tougher still. You might need to contribute 20%-24%.

Why so much?
Using the mass of quality data they have collected, they believe that the most reasonable forecast of investment returns after inflation and costs is just 1%-2% per year for the next 20-30 years. (If you stick solely with cash and earn interest, though, they expect you'll actually be poorer after deducting inflation.)

This very slow growth is actually not unusual, but people's expectations have been raised by the massive investment returns that we experienced in the 1980s and 1990s. Those sorts of gains were extraordinary, however, and we can't expect them to be repeated.

It's not much better if you're on a final salary scheme
You might not be investing your pension contributions. You might be in a company pension scheme that will give you a proportion of your final salary in retirement instead. However, you're not much safer. The authors write:

"In the UK, unfunded public sector pension liabilities (all defined-benefit schemes) are at least £1 trillion, while unfunded state pension liabilities total at least £4.3 trillion. The increased liabilities from the lower interest rates can be met only by raising taxes, by increasing the pension age, or by cutting benefits. These are harsh choices."

Something will eventually have to give at many firms, and it would be naïve to think that employees won't be forced to take at least some of the hit – again.

Everyone is way too optimistic
The financial regulator is one of the most pessimistic forecasters out there, and yet its medium projection would still result in investment returns after inflation and costs of around double those in this report.

The authors find it worth pointing out that the regulator's most negative forecast is still in positive territory, yet it's not far-fetched for investors to lose money over a couple of decades. It's not the norm, but it happens more than most people think.

They also note: "Interestingly, the UK's Department for Work and Pensions calculates the prospective wealth of tomorrow's pensioners using an assumed return that exceeds the most optimistic projection that the [regulator] now permits."

The Government probably doesn't want to frighten anyone, but the whole industry has even more to lose: it doesn't want people to throw in the towel on the investment services they provide. Hence, they can sometimes be even more upbeat. You still read projections of 6% or more after costs. Guessing precisely how fast investments will grow is impossible, but that is absurdly optimistic.

Wishful thinking doesn't help
Peter Bernstein wrote in a letter to Howard Marks of Oaktree Capital: "The market's not a very accommodating machine; it won't provide high returns just because you need them."

His point is that you shouldn't go taking bigger risks to get higher returns just because average returns are going to be low. This is called "chasing yield" and it often ends with you losing a lot of money.

It's more complicated than all this
The authors of the report are experts on investment returns, but I doubt they're experts on the benefits system.

How benefits interact with your private wealth and income when you retire is very complicated, so they probably haven't considered a great many scenarios in coming to their estimates.

From my other research it seems that some retirees get far more from the state than they expect (so long as they claim all their benefits). State benefits to retirees have also climbed significantly in the past few decades, but whether that will continue or reverse remains to be seen.

It's also clear from previous research of mine that retirees, on average, need less money than they expect (although everyone is different). There's a fair chance that those earning more than the average wage won't need half of their final salaries, for example.

Why 'lifestyling' could destroy your pension pot

Consider alternatives to pensions
Although I've explicitly mentioned pensions in this article, you don't just have to save for retirement in a pension. You have share ISAs and peer-to-peer lending to consider as well, and they both have advantages (and disadvantages) over pensions.

In addition, there's no reason why you can't make it easier on yourself by using your home as part of your pension. You can release equity after you've retired by downsizing or through housing equity-withdrawal, which is a kind of mortgage for life that your estate will pay after you die. The only reason not to do either is if you're determined that your children or someone else should inherit the lot.

For millions of people, downsizing and equity-withdrawal currently have advantages thanks to the retirement benefits system. By withdrawing equity from your home only when you need it, you can continue to be paid most of your income benefits.

Want to save for your retirement with a tax-free ISA? See the latest options

Seven retirement nightmares
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Why you should save 20% of your salary into a pension
Figures from charity Age UK show that 29% of those over 60 feel uncertain or negative about their current financial situation - with millions facing poverty and hardship. Even though saving for retirement is not much fun, the message is therefore that having to rely on dwindling state benefits in retirement is even less so. To avoid ending up in this situation, adviser Hargreaves Lansdown recommends saving a proportion of your salary equal to half your age at the time of starting a pension. In other words, if you are 30 when you start a pension, you should put in 15% throughout your working life. If you start at 24, saving 12% of your salary a year should produce a similar return.
Many older couples rely on the pension income of one person - often the man. Should that person die first, the other person can therefore be left in a difficult position financially.
One way to prevent financial hardship for the surviving person is to take out a joint life annuity that will continue to pay out up to 67% of the original payments to the surviving partner should one of them die.

The disadvantage of this approach, however, is that the rate you receive will be lower. Again, the Pensions Advisory Service on 0845 601 2923 is a useful first port of call if you are unsure what to do.

Around 427,000 households in the over-70 age groups are either three months behind with a debt repayment or subject to some form of debt action such as insolvency, according to the Consumer Credit Counselling Service (CCCS).

Its figures also show that those aged 60 or older who came to the CCCS for help last year owed an average of £22,330. Whether you are retired or not, the best way to tackle debt problems is head on.

Free counselling services from the likes of CCCS and Citizens Advice can help with budgeting and dealing with creditors.

Importantly, they can also conduct a welfare benefits check to make sure you are receiving the pension credit, housing and council tax benefits, attendance and disability living allowances you are entitled to.


The average UK pensioner household faces a £111,400 tax bill in retirement as increasing longevity means pensioners are living on average up to 19 years past the age of 65, according to figures from MetLife. And every year in retirement adds an extra £5,864 in direct and indirect taxes based on current tax rates to the costs for the average pensioner household. You can be forced to go bankrupt if you fail to pay your taxes, so it is vital to factor these costs into your retirement planning.It is also important to check that you are receiving all the benefits and tax breaks you are entitled to if you want to make the most of your retirement cash.

The cost of a room in a care home in many parts of the country is now over £30,000 a year, according to figures from Prestige Nursing and Care. So even if the prime minister announces a cap on care costs - last year the economist Andrew Dilnot called for a new system of funding which would mean that no one would pay more than £35,000 for lifetime care - families will still face huge accommodation costs. Ways to cut this cost include opting for home care rather than a care home. Jonathan Bruce, managing director of Prestige Nursing and Care, said: "For older people who may need care in the shorter term, home care is an option which allows people to maintain their independence for longer while living in their own home and should be included in the cap." However, the only other answer is to save more while you can.
Older Britons are often targeted by unscrupulous criminals - especially if they have a bit of money put away. For example, many over 50s were victims of the so-called courier scam that tricked into keying their pin numbers into their phones and handing their cards to "couriers" who visited their homes. It parted consumers from £1.5 million in under two years. Detective Chief Inspector Paul Barnard, head of the bank sponsored dedicated cheque and plastic crime unit (DCPCU), said: "Many of us feel confident that we can spot fraudsters, but this type of crime can be sophisticated and could happen to anyone." The same is true of boiler room scams that target wealthier Britons with money to invest, offering "once-in-a-lifetime" opportunities to snap up shares at bargain prices. Tactics to watch out for include cold calling, putting you under pressure to pay up or lose the opportunity for good, and claiming to have insider information that they are prepared to share with you.

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