Money Guide

Pensions: How much do I need to save?

Updated: Monday 12 March, 2012

By Martin Fagan

If you want to avoid a financially difficult retirement, the sooner you start saving into a pension, the more time your pension has to grow. Creditchoices.co.uk shows you how much you need to put away.

How much you need to save for your pension depends on how much you think you will need to live on in your retirement - and how early you start your pension.

Unless you can afford to live solely off the state pension, which is £107.45 a week for a single person (2012/13 tax year), you will need to make sure you put some money aside now for your future.

How soon should I start saving?

To get the biggest pension pot, you need to start saving as much as you can as early as you can. Utilising a pension is important because the money you save will get tax relief. As a rough guide, to invest £100 in a pension will only cost you £80, as the government contributes £20, which is the tax it assumes you’ve already paid on the contribution. Also, in some types of company pension scheme, your employer will also contribute to your pension pot.

When you retire, you will probably use your pension pot to buy an annuity, which will provide you with an income for the rest of your life.

How much do I need to save?

You can use the Money Advice Service calculator to work out how much how much you need to save to have an adequate income in retirement. It will also help you work out where you stand so far, if you have already paid into a scheme.

As a rough guide, someone starting to save £100 a month onto a pension (£80 contribution and £20 tax relief) from the age of 25 and hoping to retire at 65 will end up with a total pension pot of £196, 857 (assuming an annual growth rate of 6% after charges).

Delay starting the pension until you’re 30 and those missing five years will reduce that fund to £141,745 (a loss of £55,112); delay 10 years and the value of the fund drops by almost half, to £100,562 (a loss of £96,295). The longer you leave it, the bigger the shortfall will be as the fund will have less time for the miracle of compound interest to work its magic.

Can I make up the shortfall if I delay saving?

The only way to compensate for the loss of time is to contribute more money. Waiting five years means upping your contributions to £140 a month and delaying 10 years means contributing almost £200 a month to get the same pension when you retire.

Many people seeing a pension pot of £100,000 will assume it’s enough to featherbed their retirement and, at first glance, it’s a not inconsiderable sum.But when it is when it comes to buying an annuity and the annuity rate at the time of purchase that determines the income you’ll receive in retirement.

For example, with current annuity rates (as of thursday 8 March, 2012) assuming you’ve already taken 25% of the fund as tax-free cash and have a pension pot of £100,000, for a 65-year-old male looking at a single life (no spouse benefits) level annuity would pay £5,937 a year (£495 a month). If you decide you need a 3% escalation a year guaranteed for five years, this would lower the annual income to £4,103 (£342 a month).

Just as delaying the start of a pension means paying more money in, so adding options to your annuity reduces the income you get from it.

What affects annuity rates?

Annuity rates change all the time and the biggest factor influencing annuity rates is gilt yields, which are affected by interest rates. Gilt yields are the return investors get from buying UK government bonds (known as gilts) and are a key indicator as to which direction annuity rates might go. Higher gilt yields mean higher annuity rates.

The only problem is, for the past decade, gilt yields have been falling with a concomitant impact on annuity rates. For example, in August 2006 the yield on 10-year gilts was 4.5%, but five years later in August 2011, the yield was 2.36% - a 48% drop. This is the chief reason annuity rates have fallen over the last decade. That and the fact we’re all living longer, as life expectancy also plays its part in determining the level of annuity rates.

And finally...

Choosing what type of pension or pensions to invest your money is a very important decision and you are strongly advised to seek personalised advice from an independent financial adviser (IFA) when making this decision.

Get free annuities brochures: make the most from your retirement and increase your income by up to 30%

Get free annuity information with no obligation.