How much should you save?
by George Hatjoullis
The more relevant question for most is; how much can you save? Few can save enough. Nevertheless it is worth understanding something of how much you need to save in order to achieve specific objectives such as retirement income. Nutmeg, the Robo-adviser, offers a neat little calculator to enable you to work this out. Of course, it all depends on what assumptions you make. So let us make it real.
You are 30 years old and expect to retire at 68. You want to save for a private income of £25k pa in today’s money. You will be saving monthly and continuously. If you assume average inflation of 2% (the BoE target), a nominal return of 5% (so real 3%) and a 75 basis point fee (0.0075 typical), you must save £591 per month. If you do this through a pension scheme you should get tax relief and an employer contribution so the amount you actually give up from disposable income should be a lot less. How you fund and wrap savings is a separate issue. Here we will concentrate on what the invested amount needs to be irrespective of how it is funded. Let us look at the assumptions.
First, the fee. If the fee were zero you would only need to save £504 per month. You are paying the manager £87 per month, which is rather a lot. If you can avoid or reduce fees this can make a huge difference. Passive management is normally much cheaper than active and frankly, over the long-term, no worse. If you are in an employer scheme, the employer may subsidise the fee. It is advisable to look carefully at the fee structure and your options. If you opt for passive funds you may be able to get total fees down to 35 basis points (or even less), so let us go with this assumption. Your monthly saving need is now £543.
Second, the inflation assumption of 2%. The assumption is the Bank of England will be successful on average over time. The compound average inflation rate since 1997 (when the BoE was made independent) is about 2.75%, somewhat higher than the target. However, over the next 38 years it is not unreasonable to assume the BoE will hit the target, on average.
Third, the return assumption. The evidence for equity returns over very long periods (over 100 years) is that 5% real is not unreasonable. The initial assumption is thus quite pessimistic compared to the past. The investment will occur continuously over 38 years so there is good reason to expect a result that converges on the long-term expectation. Hence we can risk raising the return assumption. Bear in mind that dividend yields are quite high at the moment (3% plus common) and the strategy involves dividend reinvestment a 5% real equity return assumption is not absurd. This gets us to the 7% nominal often used in projection.
If we assume 7% nominal (5% real), 2% inflation, and a fee of 35 bp, we get an invested amount needed of £351 pm. This sounds much more manageable. If we deduct £100 pm for tax relief and employer contributions (arbitrary) you could get a pension of £25k pa in today’s money by saving a mere £251 pm or £3012 per year in deferred disposable income. This is still a lot for many 30 year olds that need to make rent but it is less daunting than number we began with. So what is the purpose of this blog?
My experience with people and money (all ages) is if the amounts seem impossible then people do nothing. In this case they do not save anything. If however the numbers seem manageable and can have meaningful outcomes they are more likely to respond. What is required is consistent saving over a long period rather than a lot of saving right from the start. One can always step it up as income rises. It is also vital not to fall for the hype of the financial services sector. Low cost passive equity investments will do just fine. Finally, tax relief and employer contributions can reduce the amount of disposable income. Look at the possibilities.
Finally, and my coup de grace did you know that you can invest up to £3600 pa even if you have no income and pay no tax and that it will cost you only £2880? This is almost enough to get £25k pa in today’s money in 38 years.