This week we are going to tackle a subject that most people really don’t like: Pension calculations. Number crunching is hard and pensions are complicated and dare I say it, ever so slightly boring. So much so that they become one of those things that people like to put off sorting out. Many until its too late. And this is especially true for expats. And true with bells on for the UK passport holding variety.
I’ve met a lot of pension aged people working on my travels, not because they want to, but because they have to. Don’t let that be you.
I’m sure there are a million reasons why people end up in this situation, but at the same time I’m quite sure a couple of them are UK related.
First, like all things money related, pensions are one of those things we Brits don’t talk about as much as we should. And this applies whether home or abroad.
Second, is the one and only State Pension.
Whilst item one is pretty self explanatory, I usually find item two needs a bit of further explanation.
Though controversial in some circles, the state pension is a major benefit to UK residents. Sure, it’s not perfect, but the fact remains if you live and work in the UK you’ll have some money to spend when you retire.
And whilst the latest studies suggest its less than the ‘minimum standard’ required, the addition of the compulsory work place scheme post 2012 should fill the short fall.
All good so far. That is unless you opt out. (More and more people are).
Or don’t even live in the UK.
The fact of the matter is, many British expats will have zilch, nada, naught, diddly-squat when they hit retirement.
Plenty of Brits left the UK before 2012 and plenty others haven’t kept up with their national insurance contributions.
Now, if you work for a big international then you may have something respectable waiting for you, but even then you might just find yours doesn’t quite cut the mustard when it comes to spending requirements.
But here’s the thing, its never too late to improve your situation. In fact, even if you are reading this with zero put aside for retirement there’s nothing stopping you from taking action.
In the end, all most people really need is a little knowledge, a target and a dash of self discipline to get the job done.
And whilst I can’t help with discipline, I’m pretty confident you’ll be armed with each of the others when you’ve finished reading this.
If you haven’t got a pension, or the one you do have isn’t enough, I’m going to show how do take matters into your own hands.
You’ll know what pensions are, be able to calculate how much you’ll need in retirement, your time to retirement, retirement age and much much more.
What is a pension?
Let’s start by taking a look under the pension hood. A little bit like an engineer. If we know what’s in there and how it works we can replicate it ourselves. Spoiler alert: This is going to be easier than car mechanics.
You see, in practice, a pension is simply savings that we are going to use in retirement.
Traditional pension providers usually take our money and invest some if not all of it into the stock and bond markets to take advantage of compound interest and tax sheltering.
Bonds provide stability to counteract stocks volatility and increase in risk.
And just in case you are questioning why to take the risk here’s my take.
Whilst nobody knows exactly what investment returns stocks are going to provide it has been somewhere between 9 and 10% historically over the long term depending on whether we are looking at the UK, US or globally (Source: Credit Suisse Global Returns Yearbook).
So we can use that to make a quick comparison. (I’ll use 10% to keep things simple):
Save £1K a year for 30 years and you’ll have……….£30K
Invest £1K a year for 30 years with 10% returns and you’ll have……… £181K
Nice work if you can get it!
Of course you may not get those returns, particularly as most pension providers will allocate some of your money to the bond markets which tend to generate lower returns. But over the long term it is likely to leave you with a lot more in your pot than you would have had you simply saved.
Incidentally, though you get lower returns, you invest in the bond markets because they are less risky. They help to even out the ride.
And you’ll notice I said over the long term. That’s an important differentiator between a pension and saving for something near-term like a car or property deposit.
In the short term stock markets are volatile. They can go up like a rocket on occasion, but at the same time they can drop twice as fast. 10% drops occur all the time. Everybody experiences 20% plummets with their investments and there’s a strong likelihood you’ll experience at least one halving during the course of your investment timeline.
Now that said, if history is anything to go by none of that should matter.
That’s because since the dawn of time most country’s stock markets, most of the time have bounced back to reach new highs and the global market as a whole as always done this.
The key is giving the market time to recover. In many cases this takes months, but in some cases it takes years. That’s why you only invest in stocks for long term savings goals like pensions.
Why you don’t need a pension per se
However, if you are one of the many that doesn’t have any kind of pension provision outside the state pension, don’t worry, you can still put a pension together easily if you want to.
Everybody in the UK can make tax sheltered investments for their future through the SIPP (Self Invested Personal Pension), or ISA (Individual Savings Account).
And British expats can still invest tax efficiently by buying index tracking ETFs from one of the many investment platforms that accept non residents out there.
Depending on where you live, it might not be just as tax efficient but for most people, most of the time it will get the job done. And if you are one of the lucky expats out there that lives in a low tax country you may just find your DIY pension does better than the big UK pension providers.
The State Pension
And let’s not forget the institution that is the State Pension. The pinnacle of German ingenuity! But we didn’t hang around implementing the Old Age Pension in the UK. It came into effect in 1909.
Yes, expats should be eligible to receive it no matter where you live. The key is to make sure you continue to contribute while you are abroad.
To receive the State Pension you need to have paid National Insurance Contributions for at least 10 years. But to receive the full State Pension you’ll need to have 35 years worth of contributions. You can check how many years you’ve contributed and arrange contributions here. Don’t put it off its the next best thing to free money.
The full new State Pension is £221.50 a week right now. That’s £960 per month or just over £11.5K per year.
To get it you’ll likely need to pay Class 2 contributions, which are about £15/month at the time of writing. Here’s some quick number crunching which hopefully shows you why you need to be contributing.
35 x 12 x £15 = £6,300
In other words, the total you expect to contribute is just over £6K. You’d get that back after six months of retirement!
Well worth it.
But I think I know your next question.
When can I get the state pension?
Once upon a time the UK had a default retirement age of 65. However, since 2011 that’s no longer the case. The law was changed to prevent employers forcing people to retire at 65.
In other words, according to UK law you can work for as long as you want.
55 is the minimum age you can start receiving a personal or workplace pension, whilst 66 is the age at which you can start collecting your state pension. An increase to 67 is just around the corner, though.
Depending on how young you are, that might sound like a world away, but as anybody around that age will tell you. It feels like only yesterday they were your age. Time flies when your having fun.
In theory, expats and others who handle things themselves could start their withdrawals at any time. But you might not want to do that.
In fact, most people really do underestimate how long they are going to be investing for. Your pension investments still need to work for you in retirement. You don’t suddenly stop investing the day you retire. And here’s the thing.
White collar workers from the developed world should be planning for their 90s and beyond. Not only that but anybody with heirs might want to be thinking in much longer terms.
If you are doing a job you hate, you’ll probably be looking to quit early, but that doesn’t mean you have to give up work altogether. People with other income such as pensions can do lower paying jobs that they actually want to do.
For your information, Reg Buttress chose to work at the Cwymbran, South Wales branch of Sainsbury’s until he was 95 years old… because he wanted to.
Heart surgeon Dr. Ellsworth Wareham of Loma Linda, California assisted surgeries until he was 95 years old…… because he enjoyed his job.
According to Love Money, British men on average retire at 64.7 years old on average, and women leave work at 63.6 years old.
Globally that looks about average to me. There are places with lower averages like South Africa (60) and France (60.8) but at the same time there are places with higher averages like Japan (69.95) and South Korea (72.3).
My guess is, its only going one way…UP.
How to estimate your retirement income?
OK, so you’ve drank the kool aid and decided you want to get to grips with this pension malarkey. Where to start?
Well, the best place, for most people, most of the time is going to be to estimate your future income requirements.
Essentially, when thinking about retirement income there are two ways to figure out how much you need.
You can either base it on your current spending or aim for a preset living standard.
With option one the consensus seems to be assuming you’ll need 80% of what you spend pre retirement. So if you spend £40K assume you’ll need £32K in retirement. Simple.
The alternative approach is to pick a pre-determined living standard that suits you.
Lots of places have come up with these but the most well known seem to come from the Pension and Lifetime Savings Association (Which Magazine or The Minimum Income Calculator are also options – more on this below):
Pension income required for different living standards
Simply pick your standard and you are off.
A few things to bear in mind with the living standards approach.
- These aren’t suitable for London. If you want to retire in London you are going to need to increase these numbers somewhere between 20 and 50% based on how centrally you intend to locate.
- These are after tax numbers, so you’ll need a bit more before tax. Tax is complicated, and depends on your exact situation. Because all Brits are eligible for the Personal Allowance this should only impact the moderate and comfortable numbers. For ball park figures I’d add 20% to the numbers to take account of this and be happy in the knowledge with the fact that Which Magazine have similar standards which are lower.
- As all ready mentioned there are a few alternatives to those Living Standards. Which Magazine has a good one. The Minimum Income Calculator is another great alternative. You key in your situation and it will determine how much you need to live off for a decent standard of living. There’s a couple of good benefits with this one. First, it gives you both pre and post tax amounts and breaks everything down for you. And second, it gives you a value based on your actual situation. You can put in children and their ages for example. And finally British Expat Money have gone into a lot more detail about how much you need to live in the UK here.
Once you have a figure in mind you can subtract any income you know you’ll have. The most obvious being any pensions, and in turn, as a minimum you can knock off the State Pension providing you are waiting until you are 67 to retire.
So let’s say you and your partner are the same age, are both eligible for the full state pension, live outside London and are aiming for a “Moderate” living standard.
Your target is £43K after tax, but £52K before tax (£43K x 1.2)
You can subtract your State Pensions to give you £29K (£52K-£23K).
Any other income is dealt with in the same way. Let’s say you also have a Buy to let which generates £9K per year.
Simply rinse and repeat.
£29K – £9K = £20K
Once you have a target number you can move onto the next stage.
How to calculate how much you need in your pension pot to fund your annual spend
Following on from the example above I’m going to assume you need £20K a year in retirement.
We can use this number to calculate how much of a pension pot you need to cover your life expenses throughout your entire retirement period.
You use the 4% rule. (More on this a bit later).
With this all you do is divide your annual income target number by 4% or 0.04. Like this:
£20,000/0.04=£500,000
It’s that easy.
In other words, you need a pension pot of half a million pounds to provide you with £20K a year.
How much do you have in your pension pot now?
Have you already began saving and investing or do you need to raise the entire amount?
If you already have some savings or investments that you intend to put towards your retirement now is the time to figure out how much you have now so that you can bridge the gap.
Any money you can use counts. Savings, investments, money from a house sale, inheritance and any other pensions you have are probably the most obvious examples.
If you are one of those people who does have workplace or personal pensions but doesn’t know how much you have just get in-touch with your provider.
Most providers should allow you to login to their online portal. But where this isn’t the case, you should receive a pension statement annually, which will show a a pension breakdown.
This will explain how much you have and project your retirement income.
You are now ready to figure out when you can retire.
How long before I can retire?
Calculating the time you have left until retirement isn’t the easiest number crunching you’ll ever do. Now, nobody said pension calculations were easy, did they?
The good news is, we’ve got a handy calculator to crunch those numbers for you. Here’s an example.
Let’s say I’m aiming to save up £600K and I already have £500K in the bank. How long will it take me to reach my goal if I’m saving £1K per month?
We can stick those numbers in the calculator. The only number that we don’t really know for sure is investment returns. But as already said, over the very long term data suggest 9-10% for broad basket of stocks and whilst nothing is set in stone highly rated government bonds are providing around 4-5% at the moment. So my best guess is to expect about 7% for a 60/40 portfolio.
Key in those numbers and you should have just over two years to reach your target.
How much should I save?
Of course, some people might want to slow things down a bit by saving less. Most people won’t, though. The quicker the target is hit the better.
In other words, you should nearly always save as much as you can. And if that’s not enough…. save more. The two most obvious methods are:
- Earn more money
- Cut back on costs
OK, I appreciate that for many neither of them will be easy. But some people will be able to do one if not both of the above. It just depends on who you are, and what your current situation is.
I’m not going to patronize people about how to earn more money or wax lyrical about the power of budgeting. Wiser heads than me have written books about both. I’ll only say Martin Lewis’ Budget Planner is supposed to be pretty good.
The 4% rule
Here’s a bit of house keeping before we finish.
The theory behind some of the things we’ve covered here is based on financial concept termed the 4% rule. It is based on some stellar research, including that of William Bengen and the Trinity Study.
In short, it suggests you withdraw 4% of your pension in the first year of retirement and then the same amount adjusted for inflation in subsequent years.
Here’s an example assuming I have £500K in my pot.
4% of £500K means I withdraw £20K in year one and then the same but inflation adjusted in year two.
So let’s then say the cost of living rises 2% I would then withdraw £20,400 in year two.
Simple stupid!
It’s a great guide, but I would be remiss if I didn’t mention that there are a few people out there who have a problem with this.
In the main, they don’t think it is conservative enough and they are unhappy that it is based on data and research focused on the US stock market.
So for what its worth my take on it goes something like this.
4% is too high
The first thing to say is that based on average returns, when you look in detail at the research, the safe withdrawal rate should in fact be more like 6.5%.
The reason it is reduced to 4% is to account for the possibility that the stock market may have a mega crash within the first 10 years of your retirement if you are unlucky.
Now, there have been a number of studies looking at the 4% rule. In each case, whilst the odd person did run out of money, most people adhering to the rule end up with far more money than they started with. Not only that but the man behind the 4% rule (Bengen) uses 4.5% for his calculations (Source: Forbes 2016/04/19/the-4-rule-and-the-search-for-a-safe-withdrawal-rate/) .
And let’s be honest if you have the wherewithal to reach your retirement goals and you were super unlucky because there was a humongous crash in your first decade of retirement couldn’t you just withdraw a little less until things sorted themselves out?
And I’m pretty sure these naysayers didn’t predict the current interest rate environment. At the time of writing you can get over 5% on bank held cash. That means you could withdraw 4% without ever running out of money by having your cash in a savings account!
In other words, maybe I’m wrong, but I think 4% is pretty conservative already (especially in our current environment).
Americans only
Then as for it being only valid to US investors, I’m not having it:
The best long run global data I’ve seen comes from famed professors Dimson, Marsh and Staunton and that shows plenty of countries’ stock markets doing similar to the US. The UK being one of them!
And this whole idea that the US has done well in the past so will continue to do well at the expense of all the others simply doesn’t add up. One of the biggest phenomenons in finance is reversion to the mean. In case you are interested, the man behind the first index fund and the founder of Vanguard, Jack Bogle, discusses it in great detail in Chapter 9 his excellent book, ‘Clash of the Cultures.’
Here’s the key. If one country’s stock market out-performs during one time period the chances are it won’t during the next time period.
In other words, if the US stock market has beaten Europe for that last 10 years, it is unlikely to do so over the next 10 years.
Additionally, I think it’s hard to argue that UK investors shouldn’t be globally diversified these days anyway. Investing in UK markets is an active bet that the UK will outperform other markets. It’s gambling and you probably shouldn’t be gambling with the retirement.
All that said, if you decide 4% isn’t conservative enough for you all you need to do is replace 4% with a lower number. 3% and 3.5% often get bandied about. At the end of the day playing it safe never did anybody any harm ( I’m still good with 4%, though).