personal finance: early retirement pensions
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The standard advice for anyone in connection with pensions is start early, young man, start early. Do it, and do it now – your early savings are what makes all the difference.
I didn’t. I effectively started at 28, and even worse because I want to retire early I effectively started later in my working life. For a normal worker in my industry retiring at 60 I would have been saving for 32 years whereas I’ll be lucky to reach 25 years. I’m therefore like a normal worker starting at 35. Because my company pension is a final-salary one, the difference is less than it would be with a DC scheme. However, I’ve had to make changes in the last three years to try and make up for the difference.
Because I own my house outright this has been easier for me, and it make me wonder if the standard advice is simplistic, and people should take a systems approach to their lifetime finances. In a later post, I will try and work out what proportion of income I did spend on the various key aspects of life (housing, hedonism, tax and pensions). The information isn’t precise for some of the early years, and yet I believe it shows that as long as you do save for some key asset classes in your 20s, it doesn’t have to be a pension in those earlier years.
I’ve analysed my working life, and mortgage, rescaling values to eliminate the scourge of inflation which makes it so hard to compare values over a thirty-year working life. Here, I have looked at various pension saving scenarios and how they would work out, as if I were saving into a defined contribution pension at 15%, about twice the rate of NEST’s 8%. Defined Benefit (final salary) pensions are better than NEST largely because more money goes into them, usually from the employer so it is not always visible to employees. However, a pension is deferred pay, so two employers both offering the same salary but one offering more contribution to a pension are actually offering different salaries.
First off, an extreme wealth warning. If you are in your 20s and looking for an excuse to live it up at the expense of saving this is not your ticket to ride. You have far more unknowns ahead of you that I have in describing this story, because I am in my early 50s and my career trajectory is known. If you’re young and you use this to justify not saving your 8% of income into a pension then you need to save 8% of your income into some other asset, and assets do not include most of the things you might want to buy 😉
I got into deserved hot water over here for the assertion that you can make up for a lack of saving in your 20s, and that compound interest will not necessarily ride to the rescue. Not because I didn’t get away with it, but because
@ermine — Thanks for the follow-up. I’m going to argue strongly against what you’re saying, for the sake especially of young readers reading, as I think it’s dangerously misleading.[…] I don’t want Monevator to help put people on the exactly the opposite path that I set out to postulate, and that we post on every day – i.e. at a minimum, realistically aiming to achieve financial security within their lifetime, or better yet some financial freedom.
Consider yourself warned young person, Monevator is right in that you can’t know until you are 50 that you won’t take some important hits I didn’t. I am looking back over my working life and I know what happened. Young reader, you are looking forward over an unknown career arc. You may have less luck that me. In particular, if you are a woman in your 20s do not follow my path. I will explain why later, but you are exposed to more serious risks statistically that men at the same age. It’s not feminist, it’s not fair, but it seems to be what happens, and you should protect yourself against the world as it is, not as it should be.
Having said all that, I consider this pretty clear proof that the magic of compound interest is not all that it is cracked up to be, and that is is perfectly possible for someone who has a career path similar to mine to catch up for the lack of early pension savings in ther 20s. Observe that I did not accumulate any debts in my 20s, and my savings went towards putting down part of a 20% deposit on a house I stupidly bought at the height of the Lawson boom. For all the good those savings did me I could have drunk it all in the Television Centre bar and had twice yearly holidays in the sun, but I stuck with just reasonably excessive drinking and one holiday most years.
The community that can take inspiration from this analysis is the one of the greybeards who didn’t follow the recommended route, and delayed saving till their thirties or even forties. As long as they didn’t screw up with debt, and as long as they paid their mortgage down at the recommended rate, they can recover without working till they drop, through the application of ERE’s methods, but perhaps calling it Earlyish Retirement Extreme
Setting the scene – how I simulated different saving approaches
To try and make sense of the last three decades, I have taken my salary and normalised it to 1 for my first proper job with the BBC in 1984. I am British, and unlike our American friends I just don’t like talking about how much I earn. Regular readers have probably roughed it out by now, but you ought to have to work for it.
I’ve then rebased everything by scaling for inflation using the RPI index, setting that first BBC job to a nominal value of 10000 pounds. In the RPI adjusted world I have created, that 10000 pounds holds its value across the three succeeding decades, because I deflate prices and my salary by RPI inflation.
You can see that over the years I improved my income in real terms by over two times. The dip in 1987 was when I took an MSc with a Manpower Services Commission grant. You can also see that the ermine is taking a hit from the stinginess of my employer and the rampant inflation of late towards the end. The actual high-water-mark of my real income was in 2008.
I’ve also represented my mortgage on that. Look at that awesome income multiple of what, 5 times? Millennials and the Priced Out generation take note, I had to stump up a deposit of about 10% to bring that multiple down to within spec so my debt was lower. I then had to borrow another 10% interest-free on a credit card advance to avoid taking the shaft from high loan to value insurance, which I paid down in the first year. Whenever it looks like a good idea to pay more than 4*salary for a starter house, STOP. You are either earning too little or paying too much, just like me 🙂 What isn’t shown here was I had an endowment mortgage which I only managed to conclude a mis-selling case on in 2004. Friends Provident sold a single ermine with no dependents a life insurance product, FFS. Fundamentally I shouldn’t have been so stupid, but at least I did get the situation restored to what a repayment mortage would have been (the endowment had fallen behind by 1/3). That payment from the endowment is why it looks like I robbed a bank in 2003/4…
Although I was a feckless young ermine, taking my BBC final salary pension as a cash lump sum on moving to my current company, I am lucky enough to have been in a final salary pension scheme since then for the rest of my working life. Taking a leaf from SG, I have simulated that pension with a steady pension saving rate of 15% from my rebased and inflation-free income, compounding at 5% which seems a reasonable estimate for the long run stock market total investment return after inflation. Mind you, someone who has been saving using an index tracker over the last decade may take a dim view of that 5% assertion! I’ve then modelled how various different variants of me would have done with different pension savings strategies.
Meet the Cast of Characters
First we have Steady Eddie. He starts work, saves his 15% gross into a pension scheme from 1983 until he retires at the end of 2010, 27 years later. He is the benchmark for how you should save into a pension. In all these graphs, the magenta bars are the parts contributed by the magic of compound interest. Note that most of this is Eddie’s own saving, though I do agree it would be churlish to deny the value of compound interest, as it makes up 48% of his pension capital.
He has experienced the same career progression in real terms as I did, so he earns just over twice as much as a greybeard as when he got his first real job. I normalised his wages to £10000 in 1984. I don’t count my very first job as that was a poorly paid technician post; I started looking for work in 1982, into the teeth of Margaret Thatcher’s first serious recession, so I took the first vaguely relevant job I could get. Eddie is sitting pretty with a pension of 6554 pounds in my normalised universe with a pension capital of £131000. That’s slightly under 40% of his average salary and 28% of his final salary. I am lucky; if I left and drew my pension now I would get a higher percentage of my final salary, and I am duly grateful for my good fortune in that I have had a stable job that has been interesting and rewarding for the vast majority of my time there, regardless of things that may have gone wrong in the recent past.
The only lady in the bunch, Sensible Susan follows the same path as Steady Eddie for 11 years. Ball-breaking feminists are going to hate this, but she then quits work to have children.
What can I say? I’ve observed it happen that way often enough, and even if Susan returns to the workplace the missing years are critical to one’s career deveopment. Though my pay didn’t go anywhere in real terms in my 30s the projects I worked on built the platform on which I got the next decade’s rises. However, since she was sensible, Susan has built the classic early starter ‘magic of compound interest’ example of saving for ten years and stopping. Except I’ve had her save for eleven years, because I took time out to to an MSc in 1987 and it seems a bit tough on the Sensible Susan version of me to KO 10% of her earnings as well as well as have her stop work early. Articles like this, this and this lead us to believe that the magic of compound interest will save her pension, but a casual inspection of her savings graphs relative to some of the later more feckless versions of me will show that just isn’t true. I have kept the vertical axes the same scale.
Sensible Susan is on less than half of Steady Eddie. Compound interest makes up more than half her pension capital (66% of a total of £53000). She’s going to feel the pinch with less than half the pension of Eddie. On the other hand, she’s contributed less than a third of Eddie’s contributions. That she is closer to half than a third of his pension speaks something for the magic of compound interest but no way as much as you’re led to believe.
He’s a lazy B’stard, our Freddie. He spends far too much time in the BBC Television Centre bar eyeing up the beautiful people of the luvvie set, who are far prettier, and, er, of the right sex, than the hairy-arsed engineers in the bowels of TVC where he works. As a result, he doesn’t realise till too late that London prices appear to be getting away from him. One day he ends up in the Broadcasting House bar (a classier lot in those days, the Radio types than Freddie’s Television Centre chums) and listens to yet another gorgeous sylph-like Rebecca and her pretty-boy BF talking about how much the price of their house has gone up and “oh gawd, Tarquin, ahhhrn’t we rich, dahlink”. On the radio Freddie hears Elvis Presley singing “We can’t go on like this”.
and thinks to himself that yes, London, we can’t go on living like this, I am caught in a trap. As Freddie pulls his head from yet another pint of E.S.B. he looks up and gets his coat. Freddie figures he needs to go up the value chain a bit from being a studio engineer, and get away from the city that won’t let him live in it without paying exorbitant rent. After a Tube journey he gets on his bike to cycle up the Western Avenue from TVC to Hanger Lane, and thinks about a research job with more pay and a chance to buy a house. But first he needs to fix his ropey Batchelor’s degree. When he gets home he notes the beginnings of a gleaming white pelt starting to show.
Yup, Feckless Freddie was me. I did the MSc, returned to London for a year then moved up to Suffolk. House prices were still sky rocketing, and I had to get on the ladder before it became out of reach. Oh dear…
I did investigate whether my BBC pension could be transferred to my current employer, but it didn’t work out. If I had those three/four years they’d be useful but I’ve been here long enough it isn’t a huge amount. As a deferred pension it would be diddly squat, as it is referred to my final salary on leaving the BBC, so even if it didn’t lose over the years to inflation it would be referred to as final salary less than half of the one I retire on. So I used the £700 surrender value to a good purpose towards the deposit on the house. Oops…
So how does my alter ego Feckless Freddie get on?
The three yellow bars are the savings I have managed over the last two and a bit years, effectively twice my gross annual salary. If we ignore these, we still see that Feckless Freddie has an accumulated pension capital of £78000, less than Steady Eddie but still a lot more than Sensible Susan. Why is this? It is because twenty years of compound interest doesn’t make up for Susan’s shortage of contributions, and this is made a lot worse by her lack of the boost provided by career progression.
It is the weakness of compound interest at realistic rates of real return, combined with the fact early pension contributors are contributing from a low earnings base that means all those stories about early starters staying ahead are just wrong. Feckless is obviously feckless, because he is about half short of Steady Eddie. However, he’s paid off his mortgage by the end, so he can now hit the tax-advantaged pension savings hard. His risk of the government shafting his plans is reduced as he is within a few years of drawing his funds, and the tax-free-pension-commencement lump sum could be just the ticket to make up for his fecklessness earlier. Feckless Freddie ends up with £129k, compared with Steady Eddie’s £131k. After three years of austerity, Freddie can sign up for his pipe, slippers and cruise brochures too.
The fact that Freddie ends up with the same as Eddie isn’t totally coincidental. I targeted making up for the lack of pension contributiuons due to my missing years as well as compensating for retiring early. I can’t compensate for both unless I work another two or three years, but I can eliminate one. The bar was set by what my own pension would be if I stayed to 60. My assumed real rate of return was 5%, and though I can realise that as dividends I don’t believe I will get a total return of that much even though I have bought mostly since the crash, and a lot at the early 2008 low. I think my share capital value will fall behind inflation in the years to come, but this will hopefully happen slowly so if won’t kill me off in the period between leaving work and actually drawing my pension. If my share capital and dividend income starts to get nuked, well, that’s why I have about the same amount as my shares ISA in cash savings, because there is the mother of all economic shitstorms coming our way. I won’t be a forced seller in that intervening period unless the value of that cash is destroyed because this sort of thing happens.
Looking at Sensible Susan’s holdings, note that what early saving and compound interest have bought her is insurance. She is unlikely to be totally unable to work again, and if she returns to the workforce then some of the same techniques used by Freddie are open to her. She is likely to reach a lower maximum salary in real terms than if she hadn’t taken time out of the workplace because other workers will have been honing their skills and schmoozing their way up the greasy pole in the gap, but there’s nothing stopping her making up some of the difference. Had he not done something drastic, Feckless Freddie would be closer to her pension than to Steady Eddie’s.
Finally, let’s meet
Steve couldn’t see the point of all this saving for retirement malarkey, life was for the living here and now. He’s been a bit stupid, really, our Steve, and only started saving for retirement for the last ten years of his working life. He’s almost like Sensible Susan in the number of contributions, but what makes him stupid and her sensible is he did it the wrong way round. Everybody tells you you have to save early on, right? So what happens to Steve, he’s going to get slaughtered, right?
He’s had the same career progression as I did, so his pension contributions are made at the peak of his earning power. He’s on a pension capital of 43,000 compared to Susan’s 53,000. But he’s still got one ace to play that she doesn’t necessarily have. He’s still working, so if he manages to sock away twice his gross salary towards the end, getting himself up to 94,000.
Now there are some things about Stupid Steve that make you think perhaps he may not be the most financially savvy cookie. But there may be mitigating factors. Say Steve is self employed, and he’s been building up his business all his life. When you or I leave work, we have nothing to show for it expect a few beers down the pub, a gold watch and of course the pension. When Steve leaves work and retires, maybe he has a viable business he can either get someone to run and it pays a dividend, or he can sell the company as a going concern and recover the capital he built up over his working life. Suddenly Stupid Steve isn’t so Stupid at all, perhaps he is Smart Steve. He’s only doing the pension saving at the end because it’s rude to say no to a 40% tax break with five years or less to run.
The advantages of compound interest are vastly overrated as they apply to real-world pension saving. Real people
- don’t have enough time
- can’t get enough real investment return
- haven’t advanced enough in their careers
for the much vaunted example of Sensible Susan ending up with more pension capital than Feckless Freddie, even if he starts 10 years later. They’d have to achieve an investment return of > 8.5% in real terms for that to be true, and it just ain’t going to happen.
The main thing you buy by saving into a pension early is insurance – against long spells of job loss, unpaid sabbaticals or incapacity.
Earlyish Retirement Extreme
The message to greybeards who have spent too little time saving in their youth – there is hope! You can do it. Austerity is a lot less painful for a 50-year old with their house owned mortgage-free than it would be for a 25-year old. Most of the things that are wrong in my life are to do with the fact I am working, the environment is enervating and it consumes a lot of my time. Very few of the things wrong in my life can I solve by spending more money!
The Archdruid identified the key issue in this post.
What most Americans do not know, and have no interest in learning, is that it’s possible to be poor in relative comfort.
I found the transition, from a normal average consuming lifestyle to one of consuming less, very hard. I was far more motivated to go through it because I was under the impression I would become unable to work or ejected from work in months. I wouldn’t have been able to complete the transition otherwise, but after six months of consumerism detox I was off it.
Above all else, if you’re doing Late Retirement Extreme saving as opposed to Early Retirement Extreme saving, you are probably saving at the peak of your earning power. To save in real terms what I saved in the last nearly three years would have taken me nearly seven years of saving at the BBC – I didn’t work there that long! Plus my outgoings were a higher proportion of my pay than they are now; what would I have done about paying the rent? Not only that, the money I saved would be locked away for three decades for governments to try and get their sweaty mitts on it, and I would have saved less tax.
As for seven years staying in my sleazy bedsit as opposed to three years reduced outgoings at home with the lovely company of DW, well, I dunno. Getting on isn’t all bad 🙂
the young person’s dilemma
Even for young people, and subject to this dire warning I’m just not so sure that locking your savings in a pension for 40 years (by the time you are 30 the retirement age is probably going to be 70+) is the best thing to do with any cash you may be able to save between 20 and 30. There’s lots of contrary opinion, like this and this to the effect that I am wrong here, so you have to make this call yourself. The primary risks that mitigate against later saving are if you expect to take significant time out of the workplace to pursue lifestyle choices or you expect career progression to be lower than mine. Taking time out tends to lower career progression, switching jobs between and within organisations more than me tends to increase it.
Look at those charts, and they are for a relatively short working life of thirty years, compared to 40 or 50 years that are implied by State retirement ages of nearly 70. As long as you start by the time you are 30, giving you 40 years to save before retirement, I’d say there may be other more pressing calls on your saveable cash. After all, though I was a dipstick for using my BBC pension funds towards a house, the financial strategy was right – put this into a capital asset. You recognise an asset because it either saves you more money in its lifetime than it costs you, or it pays you an income.
A house is a capital asset if it saves you rent, and the many reasons for not buying a house don’t outweigh the many reasons for buying a house. Machinery, services and supplies for a business are an asset if the business can turn a better profit than the cost of those assets properly depreciated would return on the stock market on in a bank. Your van is an asset if it lets you get more work than it costs, your Ferrari, designer suits and your Sky subs are not assets.
So as long as you understand assets, and as long as you save into assets or RPI index-linked cash the amount you would save into a pension (at least the equivalent of 8% pre-tax), I would say a young person might do well to take a strategic view that saving to a house or saving to buy assets for a business or saving cash is more relevant to their financial lifestream. Pensions advice is so one-dimensional. Do it. Do it now. How about no, let’s work out that this makes sense?
Assets can help you save in a pension later on. My house contributes £9800 p.a. to my pension saving – it would cost me £7k to rent it but I don’t pay myself rent or a mortgage and I’d have to pay 41% tax and NI on that, which I save going into a pension. That’s not a bad ROI, it’s actually over 10% p.a. on the RPI adjusted price I paid for it.
There’s a time and a place for pension savings. As long as you heed the dire warning and understand it, I’m not so sure between your 20s and 30s are that time. Just save that 8% of income somewhere accessible and tax-sheltered if in financial assets. Yes, you’ll lose the tax break now, but heck, you’ll probably pay basic rate tax on it on the way out so don’t sweat it. Who knows what tax will be in 40 years’ time! It is possible to make up for lost time. The amount I have in pension AVCs alone is enough, at a real return of 5%, to compensate for the six years of contributions I am short.