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