I'm planning to look at three scenarios in this post.
1, How much does automatic enrolment get you?
2, How much do you need to save to top up your state pension to a comfortable retirement?
3, How much do you need for a comfortable early retirement?
Nest
A recent interview with an executive from Nest (the government workplace pension company) prompted this idea. He said that they aim to turn the current contributions for automatic enrolment into half the top-up from state pension to the retirement you'd want.
Now, I dislike how Nest approach investment. For my taste, they force people into low performing investments because people will be scared of volatility. I don't agree with their logic. 90% of their customers never log in or look at their investment pot, so I doubt they're going to be all that scared when they don't know what's happening! For the first five years they put people into low performing assets, so that they don't become scared. And in the final fifteen years they "lifestyle" them into - you guessed it - low performing assets so that there are no upsets.
This strikes me as a case of "planning to fail". Many of Nest's customers are lower earners, who can ill afford pension contributions, but by the same token they need a good top-up from this pension to boost their state pension. If Nest know that their strategy will fall short of customer needs, wouldn't that sway them to use a less cautious approach?
Anyway, enough of that particular soapbox. Nest's approach inspired me to wonder what someone would achieve if, with a willing employer, they instead put the same contributions into a SIPP and practised low-cost global index fund investing.
The Auto Enrolment Plan
In my head, auto enrolment means 5% contribution from the employee and 3% from the employer, making 8% of wages going into the pension.
Only, it's not! It only applies to people aged 22 or older, earning £10k or more (from a single job). Then the first £6,240 of earnings doesn't have any pension contribution taken off.
So let's take a typical person and work out what would happen to them. Meet Geoff, he's 30 and earns minimum wage (£12.21/hr) working 37.5 hour week (9-5 with a half hour lunch break), about £458 per week or £23,924 per year. The 8% of contributions will come from (£23,924-£6,240)=£17,684 of earnings, giving £1,414 per year.
Note that this is pre-tax money, so when putting it into a SIPP it already includes any pension credit top-up.
Time to fire up the Compound Interest Calculator. I'm going to keep all figures in today's pounds, so that we can see the spending power of this pension pot. I'll use a growth rate of 7%, which I think is a good long-term average for a global equities fund, net of inflation.
I'll break things down into monthly contributions too. That's £1,414 /12 = £117.83pm. Geoff should get his state pension at 68 perhaps? Who knows how the politicians will tweak things by then, but let's figure on 38 years of contributions and growth.
Running the numbers, this gives a total pot at the end of £266,354. The real figure when Geoff retires should be far higher, but we've stripped inflation out to give us today's pounds. A relatively safe 4% annual drawdown from that pot would give Geoff £10,654 on top of his £11,973 state pension, for a total of £22,627.
That's before Income Tax. He'd get a taxfree personal allowance of £12,570, and 25% of his personal pension withdrawal would also be taxfree, so I think he would pay about £1,478 tax, leaving him £21,149.
I came into this with a figure in my head, for a comfortable retirement of about £20k. It turns out that my scenarios 1 and 2 are the same - auto enrolment, properly invested, is just about enough to top up your state pension to give a comfortable retirement. Yay!
Early Retirement
And how about my other scenario? How much would Geoff need to contribute in order to retire early?
The first problem is, how long's a piece of string? What do we call "early" retirement? We want something significantly earlier than age 68, so let's just pick an easy example which still allows the personal pension to fund retirement: the personal pension should be accessible ten years before state pension age, so let's try age 58.
The maths isn't quite as simple as firing up the calculator and plugging in some bigger numbers. Geoff will now have two stages to retirement. From age 58 the personal pension will do all of the lifting, and then at age 68 his state pension will kick in.
From age 58 we want to draw about £20k after tax. Let's use those figures from above and aim for £22,627 gross. The 25% taxfree element will be a little different, but not enough to matter.
Then from age 68 the spending from our pot reduces because state pension is covering part of the spending. We'll want to draw £10,654 as above.
I can cheat a little bit here and save myself some donkey work. Instead of working out both of these stages, I'll instead just shoot for that £266,354 figure at age 68, leaving part two as it was above.
My quick-and-dirty approach to this is to plug in some best-guess numbers and then adjust until I get the desired result. Then I can read off the input figures.
I want to know a total Geoff needs at start of his age 58 retirement, in order to draw down £22,627 per year for ten years and leave £266,354 remaining. So my calculation is for 10 years pulling £1,885.58 per month out.
Note that I'm not trying to account for lumpy returns or adjust for a fully safe plan here, I'm just trying to estimate what is most likely to happen to Geoff's money.
After four tries, I ended up with a starting pot size of £295,000 needed to give Geoff £266,484 left at 68. So Geoff needs to get to £295k by 58. Back to the calculator...
Inputs: Age 30 to age 58 is 28 years. Same 7% growth rate. Striking for an end figure of £295,000.
£284 per month is the total amount Geoff needs to contribute to reach £294,987 at age 58.
How does £284 per month relate to Geoff's earnings of £23,924? Well, his employer contributions will be unchanged, so he'll have a further (284*12=£3,408-£1,414)=£1,994 to add, or £166.17 per month. When he pays this into his SIPP he only needs to contribute 80% of this, as this is from tax-paid money and the tax will be claimed back automatically by the SIPP. Meaning he should throw £132.93 per month at his SIPP on top of his work contributions.
Conclusions
Instead of the 8% contribution from auto-enrolment, including 5% gross contribution from Geoff, for a ten year earlier retirement he needs to hike his contributions to 14.2%. Or add 7.6% of his net pay to put him on a trajectory to buy an extra ten years of retirement.
Many of us are starting later than Geoff, so we often have to throw everything at it that we possibly can. But for someone starting at age 30, spending a modest 7.6% of your take-home pay to buy ten years of extra freedom seems a good deal.
And for someone simply aiming to retire at state pension age, all they have to do to achieve a comfortable retirement is to turn that stodgy default-fund workplace pension into one in the equivalent of a global index fund.