The pension challenge - can you afford to retire?
Original article written in Winter 2006 - Updated April 2008
by Russell Waite, Senior Investment Counsellor, Fairbairn
Private Bank
Retirement has been described as ‘twice as
much husband on half as much pay’ – a humorous definition of
retirement and one I first came across on a fridge magnet in my
parents’ kitchen. A ringing endorsement, if one was needed, of my
mother’s take on life with my retired father.
Financial security in retirement is an
objective for us all, and estimating the level of income required,
let alone achieving this target, is a daunting challenge. Ten years
ago, this challenge was far less formidable, particularly for those
people who were members of employer sponsored final salary
retirement benefit schemes, also known as defined benefits (DB)
schemes. The benefits, underwritten by the employer, would commonly
secure a pension for the scheme member linked to his or her final
salary. Consequently, the individual could estimate with some
certainty the level of their retirement income, and the burden of
building an investment strategy to secure this income would fall
squarely on the shoulders of the employer.
Fast-forwarding to today, whilst many
people will still be members of DB schemes, many more will not.
They will have changed employer and become members of the
employer’s sponsored money purchase or defined contribution (DC)
schemes, or established their own personal arrangements by way of a
personal pension plan (PPP) or self-invested pension plan (SIPP).
The common disadvantage of these schemes is the transfer of
investment risk from the employer to the scheme member.
Against this backdrop, my thoughts return
to that fridge magnet and retiring on ‘half as much pay’. Many
people are now faced with developing a long-term investment
strategy, either from within a retirement scheme or outside, on
which they must rely to finance themselves through old age. Where
do they start and what must they think about before committing to
an investment strategy that may have 20 years or more to run?
Ironically – ‘half as much pay’ – is a good
place to start. Using the example of a man aged 40 who earns
£50,000 per year and wishes to retire at age 60, it is a
straightforward task to calculate his salary at age 60. Assuming he
enjoys an inflation linked rise in salary of 2.5% every year for 20
years, his salary at 60 will be approximately £82,000 per annum.
Half of this salary, as a pension, is clearly £41,000 a year.
Currently, a lump sum of around £965,000 would be required to
secure this level of income.
Our individual now has an idea of the size
of the ‘pension pot’ he must build. His next task is to understand
how much he must save and from this develop his investment
strategy. Let us assume our individual, having recently changed
employer, has transferred £50,000 from his previous retirement
saving schemes into his employer’s sponsored DC scheme and his
contract of employment dictates 12% of his annual salary will be
invested into this pension scheme. £6000 per year, rising by
inflation of 2.5% per year over 20 years, results in a total
investment of £153,000. Financial calculations allow us to estimate
the ‘present day’ value of these future contributions, resulting in
a figure of approximately £100,000. Therefore, our individual is
faced with structuring an investment strategy which builds £150,000
(£50,000 + £100,000) to £965,000 over 20 years.
These numbers allow us to calculate that an
annual rate of return of almost 10% per annum is required to
achieve this investment goal. This is a very high number and to
calibrate the challenge faced to achieve this return, tabulated
below are the annual compound rates of return delivered by the
major asset classes over the last 10 years.
| |
Annual Compound Rate of Return (Sterling) |
| Cash |
5.30% |
| Global Bonds |
4.57% |
| Global Equities |
5.42% |
| Private Equity |
17.06% |
| Property |
8.83% |
| Hedge Funds* |
7.37% |
| Commodities |
7.27% |
| |
Source: Lipper. Dates: 31 Dec 1997 to 31 Dec 2007 |
* Based on Credit Suisse/Tremont Hedge
Multi Strategy Index
Historic performance can only ever be used
as a guide, however, it is very clear from this table a traditional
investment strategy incorporating exposure to equities, bonds and
cash would not have generated the required rate of return. The
benefits of adopting a multi asset class investment strategy are
demonstrated by the rates of return delivered by property and the
‘alternative’ asset classes of private equity, hedge funds and
commodities. For this reason, we adopt this multi asset class
approach when developing investment strategies for clients, whether
they are saving for retirement or have a shorter investment term
horizon.
The historic investment returns we have
reviewed highlight, with stark reality, how very difficult a task
it is likely to be for our 40 year old to retire on ‘half as much
pay’. However, a diversified and well-managed investment strategy
will help him maximise his retirement income.