How much should you be saving for your retirement?
In most cases, the answer to this question is more than you’re putting in now! The minimum that you should be putting aside for your retirement plans, if you’re free of unsecured debts like credit cards and loans, is 12.5% of your income.
But why 12.5%? Because it’s the first hour of an eight-hour working day, so the first hour you work every day goes to paying yourself before anyone else, including HMRC. That’s not the maximum proportion I recommend – it’s the minimum. If you’re nowhere near 12.5%, then it’s a case of trying to build up to it.
An important step in doing that is to cut out all unnecessary expenses and follow my Bank Account System to reduce your outgoings.
There’s no hiding that 12.5% is a chunk of anyone’s income, and we need to enjoy life now as well as in the future; we want to take holidays, have a great Christmas with the kids, enjoy new experiences – retirement is not the target of our life.
12.5% is a starting point. Some people will think, ‘no problem’. Others will think I’m off the planet, because every month they have more days left over than pay cheque.
That comes back to step 2 of my book The Money Plan: get financially well organised. You’ve got to know what you want in life and have a plan in place to get there. You’ve got to get your mindset right, which is why I spend about one-third of The Money Plan on financial mindset. It’s that important.
If you are miles away from your targets, go through your expenditure items and see if you can squeeze them down. Look at all payments coming out of your account and ask the holy trinity of questions about each: do I need this, do I want this, can I get a similar experience for less elsewhere?
You’ve got to plan for your future, and 12.5% is just the start; if you’re in your 50s or 60s with little in your pension pot, you’ve got to make big sacrifices to put more away so you can make your pension income last longer in your retirement.
With that said, I’m realistic. If your employer pays a significant contribution to your pension, say 10% or even 15%, then that can make a big difference. You might even decide to redirect your savings onto your mortgage.
The 40/40/20 principle
After all unsecured debts are repaid and the financial fundamentals such as emergency cash, a will and power of attorneys are in place, I refer to what’s left over between your income and expenditure as a snowball, a surplus.
A good way to be financially organised is to take that snowball and allocate it 40/40/20: 40% goes to overpaying your mortgage, 40% goes into your retirement plan, and 20% goes back to you to enjoy today. I repay 20% back to enjoying today because I strongly believe that although we need to plan to ensure we have sufficient income for when we decide to stop working and retire, we should not live our life for our retirement – for the last quarter of our life, the 40/40/20 rule helps us achieve this financial balance in life.
So while 12.5% might seem like a huge proportion of your income to start off with, what I’m trying to do is shift your mindset from 1% or 2% to a bigger figure. The 40/40/20 ratio allows you to change how you think about things, without missing out on enjoying the here and now.
Stock markets have been in the news again, with some substantial drops around the world recently. It’s easy to think of the markets as a plaything for the rich, but the reality is that everyone with a pension is invested in them. Should you be concerned about a bigger market correction (fall) coming soon, particularly if you’re trying to increase your pension contributions?
It comes down to mindset again: we should only worry about things we can control. You can’t control the FTSE or other stock exchanges, but you can control your asset allocation – how your money is invested. That’s determined by your risk tolerance and your risk capacity.
Your risk tolerance is how much your investment i.e. pension could fall in value before you begin to feel uncomfortable, before you start to worry. Your risk capacity is how much can your investment can fall before it starts affecting your lifestyle, what you can afford, and whether you have time for the value to recover after a fall.
A 100% stock market exposure portfolio, which almost nobody has, will typically fall around 50% in value during a significant market correction (such as the dotcom bubble bursting in 2000 or the financial crisis 2007). That can happen more than once if you’re investing over the long-term, such as with a pension.
A 50% stock market investment portfolio is therefore likely to fall around 25% in value during a correction.
To work out your risk tolerance and capacity, put the numbers above into real pounds for your circumstances. If you have £100,000 saved in your pension and it dropped in value by 25%, do you have long enough left before retirement to wait for the market recovery and an increase in value again? Or are you going to be sick with worry and upset?
If the latter, you’ve got too much stock market exposure and you need to reduce it. When investing, time is your friend, you need enough of it to ride out the inevitable waves in the market.
As a very general rule of thumb, think 100 minus your age to work out the rough proportion of your retirement plan investment that should be allocated to the stock market. If you’re in your 20s, you could have 80% (100 minus 20) of your investment in the market, because you’ve got 40-plus years until you need access to it. If you’re in your 50s, around 50% exposure to the markets is likely more sensible, because you have less time to see out the peaks and troughs.
And remember, even if you’re in your 80s, this rule still leaves 20% exposure to the stock market. You don’t want to remove it altogether because it’s your engine for driving growth and returns.
The Budget takes place on Monday 29 October. Pretty much every year since I’ve been in financial planning, there have been rumours that it will include measures to tinker with higher rate tax relief and how it works with pensions. This year is no different.
If you’re concerned about it, then make your pension contributions early if you can – squeeze as much in as you can before the Budget, don’t wait until afterwards.
I think politicians are more focused on Brexit at the moment, but they do need to find more money, so it’s worth keeping an eye out for any announcements on Monday.