The answer to the question “How much should I put in my pension?” is surprisingly simple.
You need enough in your pot to sustainably generate a comfortable retirement income that will last you the rest of your life.
This post enables you to estimate how much pension pot you need to deliver that income.
Once you hit your target number, you can fire your job, and start a brand new life doing whatever you please.
Your pension pot target number depends on knowing how much income you can live on in retirement.
That might sound like an impossible ask. But you can arrive at an estimate using the method explained in our How much do I need retire? post.
With that retirement income target in hand, you need only complete one more step to calculate how much you should put in your pension.
The ‘How much should I put in my pension?’ calculation
Here’s a quick example that’ll show you how much you need in your pension pot.
Imagine that you want a retirement income of £15,000 on top of your State Pension.
The size of pension pot you need to retire is:
£15,000 divided by 0.03 = £500,000
Your required annual income = £15,000 (not including other income sources such as the State Pension.)
Your sustainable withdrawal rate = 3% (or 0.03)
In this example, you can retire once your pension pot hits £500,000.
Substitute the £15,000 above with the retirement income you need from your pot.
Divide your income figure by 0.03 to discover how big your pension pot should be.
Add your State Pension and any other reliable income sources to tally your total retirement income.
Run this calculation twice if you’re part of a couple.
Account for tax using the tips in last week’s post.
Is that all I need to know?
The calculation really is that simple.
What’s more complicated is explaining why this approach is the best way to estimate how much pension pot you need.
You also need to adjust your numbers for inflation and the tax-free status of your Stocks and Shares ISAs, but that’s mercifully straightforward.
Keeping up with inflation
The example above produces £15,000 income from a pension pot of £500,000 at today’s prices.
If you’re retiring years from now – rather than today – then your numbers must be updated for inflation. Otherwise, you’ll lose purchasing power as prices rise.
All you need do is adjust your number once a year by the UK’s CPIH annual rate of inflation.
For example: let’s say inflation is 2.5% one year from now.
Just multiply your pension pot target figure by 2.5%:
£500,000 x 1.025 = £512,500
You need £512,500 in your pension pot to generate enough retirement income after 2.5% inflation.
Let’s double-check that pot will produce enough inflation-adjusted income:
£512,500 x 0.03 = £15,375
Your 3% withdrawal rate now delivers £15,375 in retirement income.
If you multiply our original £15,000 income figure by the inflation rate of 2.5% you get £15,375.
Hallelujah! The calculation checks out.
Do this once a year and your target number and retirement income will keep pace with CPIH inflation.
Stocks and Shares ISAs
Many people retire with a mix of pensions plus Stocks and Shares ISAs.
Calculate the target figure for your ISAs in exactly the same way as for pension pots.
If you want £5,000 of annual retirement income from your ISAs then divide that figure by the 3% sustainable withdrawal rate to work out your ISA target number:
£5,000 / 0.03 = £166,667
To gauge how much retirement income your ISAs will generate…
Multiply your ISA’s value by the sustainable withdrawal rate:
£166,667 x 0.03 = £5,000
This calculation applies to invested Lifetime ISAs and Stocks and Shares ISAs, but not to cash ISAs.
While we’re here, usually pensions beat ISAs for retirement saving, but not absolutely always.
Our pensions vs ISAs piece illustrates why tax relief and employer contributions mean most people will be better off favouring pensions.
However a clear-cut case for using ISAs in retirement is to shelter your pension’s 25% tax-free lump sum.
By getting your tax-free lump sum reinvested within ISAs as quickly as you can – subject to the ISA annual allowance – you can generate a tax-free income for the rest of your days.
The 25% tax-free lump sum – Incidentally, our 3% withdrawal rate assumes you will reinvest any 25% tax-free lump sum you take from your pension. If you take that money and reinvest it (whether in ISAs or in taxable investment accounts) then it still counts towards your overall retirement income. Money isn’t withdrawn unless you intend to spend it. Apply the 3% sustainable withdrawal rate to all your investments to understand how much annual retirement income they can deliver.
The sustainable withdrawal rate
We’ve used a 3% withdrawal rate to calculate the income your retirement pot can sustain.
This is the percentage you can withdraw from your pension (and other investments) in the first year of retirement.
That amount is your baseline retirement income figure.
You then increase your income figure for annual inflation every year thereafter to pay yourself a consistent retirement salary.
(That means the 3% element is only used in year one.)
But why a 3% withdrawal rate?
Leading retirement researchers have concluded this is the amount you can withdraw while minimising the risk of running out of money during a retirement lasting 40 years or more.
You’ll often hear that higher withdrawal rates than 3% are achievable. Usually that’s because people gloss over the problems of unpredictable future investment returns on retirements.
Happily, the State Pension – and any defined benefit pensions you’re lucky enough to have – don’t suffer from unpredictability to the same degree.
They should both deliver a reliable stream of inflation-proof income throughout your retirement, so long as UK PLC doesn’t go bust.
But few of us can live comfortably on the State Pension. Fewer still are lucky enough to enjoy defined benefit pensions these days.
The problem with pension pots
Most people in the UK now have defined contribution pensions. These do not offer a guaranteed income.
Instead you own a pot of investments in assets such as equities and bonds.
You generate an income from the pot by selling off these assets and spending the proceeds, along with the dividends and interest they pay.
However the income level you can safely spend depends on the investment returns of your assets. Those returns are inherently unpredictable.
If you withdraw too much too soon from your pot, your money could run out before you die.
Yet if future investment returns are strong, you’ll be positioned to withdraw a higher income than the 3% sustainable withdrawal rate suggests.
The retirement dilemma is you could spend too little (bad) or too much (really bad).
Running out of money is worse than not knowing what to do with it all.
Therefore, it’s best to use a lower withdrawal rate which drastically reduces that possibility, without setting you an impossible retirement savings target.
The 3% rate is derived from the worst investment return sequences world markets have suffered in the past 120-odd years.
It further depends on you holding a pretty aggressive asset allocation of 70% global equities and 30% UK government bonds.
If you’ve previously come across ‘the 4% rule’ then it’s worth you understanding why a 4% withdrawal rate may be too optimistic.
To find out more about the sustainable withdrawal rate check out:
Beware simplistic assumptions
Watch out for media sources or pension income calculators that base your retirement on assumptions like: “Your investments will grow by 5% a year.”
Such simplifications are too risky because they assume your pension pot will grow every year.
But everyone knows that investments can go down, as well as up.
The big mistake the standard calculations make is to use a simple average growth number that ignores losses.
Let’s detour through a quick illustration of the problem.
Constant growth scenario
This scenario assumes positive returns every year:
Year 1 return: 25%
Year 2 return: 25%
Simple average return: 25+25 = 50 / 2 years = 25%
A £10,000 investment would grow to £15,625 at 25% per year. Very healthy.
Volatile return scenario
This scenario includes losses, just like real investment returns:
Year 1 return: 100% growth
Year 2 return: -50% growth
Simple average return: 100-50 = 50 / 2 years = 25%
£10,000 grows to £20,000, but falls back again to £10,000 in year 2. We made no gain.
Both scenarios showed a 25% simple average return, but one is much worse than the other.
Unfortunately for us, our world looks more like scenario two.
What makes things even worse for retirees is that you’re drawing down your portfolio by spending it over time.
And in fancy terms, as a spender you’re subject to sequence of returns risk.
In simple English – the stock market could slump early in your retirement, meaning you need to withdraw a bigger chunk of an already-dwindling pot. You’d then have less money invested to benefit from any market rebound.
There’s no escaping the fact that sometimes investments inflict large losses.
Major downturns can permanently damage your retirement prospects, even if declines in the market prove temporary.
Don’t keep it simple
This all makes it dangerous to use simple average investment growth numbers when judging how much pension you need.
The next example reinforces this warning.
Assume you start retirement with a heady £1,000,000 in your pension pot.
You withdraw 5% or £50,000 in income every year:
A constant annual return of 5% means that your pension pot’s growth exactly covers your spending every year. Your wealth never drops below £1,000,000.
This portfolio’s simple average return is 5% over four years.
But as we’ve noted, in the real world investments are volatile. We take losses as well as gains.
The next table shows how losses can knock a big hole in a pension pot early in retirement.
We start with the same £1,000,000 pension pot. But a 50% loss in the first year cuts our pot to £500,000.
Then we withdraw our £50,000 retirement income. Our pot is down to £450,000 by the end of the year:
Our bad luck continues with another 50% loss in year two.
Thankfully the losses are temporary. The market bounces back strongly in the next two years.
Overall, we’ve experienced the same simple average return of 5%.
But our pot looks very different compared to the sunny constant growth scenario.
It’s shrunk to £318,000 instead of sitting pretty at £1,000,000.
The volatility of returns has left us in a far more precarious situation.
Recovering from losses
A major issue is that large losses require much greater gains to recover the lost money:
A 10% loss is recovered by an 11% gain.
But you need a 100% gain to recover from a 50% loss.
The 60% gains in the previous example were nowhere near enough to make us whole after that nightmare two years.
And a steep hill becomes a mountain to climb when you’re forced to sell your investments at low prices to pay your bills in retirement.
This inescapable truth is why the best retirement researchers advocate using a 3% sustainable withdrawal rate.
A 3% rate keeps withdrawals low enough – especially early on – to enable you to ride out historically bad investment returns, should you be unlucky enough to experience them.
Many happy returns
I’ve focused on the downside to show you why it’s important to use a cautious and sustainable withdrawal rate.
But investment volatility can work in your favour, too. A brilliant sequence of returns can boost your portfolio to giddy heights. Here’s hoping!
Ultimately, navigating the “How much should I put in my pension?” dilemma does involve an element of luck. As in poker, you can be dealt a terrible hand or a Royal Flush.
The important thing is to play your cards well and avoid being wiped out.
That’s what a 3% sustainable withdrawal rate helps you to do.
Take it steady,
PS – If your State Pension and/or defined benefit pensions arrive later in your retirement, then you can increase your sustainable withdrawal rate a little.
This means you’ll work your pension pot harder at the outset, until your other pensions arrive to relieve the pressure later.
This is a complex area but if you want to follow one researcher’s solution then follow the walkthrough in this post. See the ‘Investment fees and the State Pension SWR bonus‘ section.
PPS – If you’re close to retirement, here’s the decumulation strategy I put in place to help me manage my volatile retirement funds.