So, what will your life be like when you reach “pension age”, when you’re “allowed to retire”, when you can “draw your pension”? Have you assumed the state will take care of you?
We’ve evolved a language of dependency and assumption over the past century that seems to absolve us of responsibility. But it’s not like that. It was never like that and never meant to be like that.
In the beginning, the UK state pension, although non-contributory, was means-tested. It was paid to those over 70 at a time when you could expect to live another nine years or so and was worth about one fifth of the average wage for a male manual worker.
The state pension was always intended to alleviate poverty, not to provide a comfortable living.
Fast-forward to today. The current state pension (for a single person in tax year 2026-27) is £12,548 per year. The amount required for a “minimum standard of living” is £13,900 and, crucially, this doesn’t include any rent or mortgage costs – it assumes you’ve already paid off a mortgage.
Despite our cosy language, we can’t expect the state to provide for our old age. We need to take a sovereign professional approach and do it ourselves.
Auto-enrolment – free money and a partial answer
Automatic Enrolment is part of the answer. It was designed to address the fact that people aren’t saving enough for when they stop work; possibly because of our cosy language but mostly through inertia and lack of knowledge.
Auto-enrolment means that , if you are 22 or over, earn at least £10,000 pa and are classed as a worker in the UK, your employer will automatically enrol you in a pension scheme. A minimum of 4% is deducted from your gross pay and paid into the scheme on your behalf. The government gives tax relief on this so, at basic rate tax, that’s equal to an additional 1%. Your employer also contributes a minimum of 3% (of qualifying earnings, not total). So, for every £4 that leaves your pay packet, £8 lands in your pension.
That’s free money.
And if you choose to make higher contributions, the tax relief rises with it. Some employers will also increase their contribution.
More free money.
The money you save into your pension pot is invested and grows, tax-free, until you need it. You can’t get your hands on it until you’re 55 (rising to 57 in 2028) but, after that, “pension age”, being “allowed to retire” and “drawing your pension” are all up to you. Providing you can afford it.
The three-layer model
The state pension – £12,500 when you’re 68 (for those born after 6 April 1977) – is the base layer.
Auto-enrolment is the second layer, but auto-enrolment at the minimum level won’t get you where you need to be. “Less than half of private sector employees who save into a workplace pension contribute more than 8% of their earnings. A fifth still do not save in a workplace pension so they miss out on their employer’s pension contribution.” Missing out on free money!
And, as the IFS, “found approximately 30% to 40% of private sector employees (5 to 7 million people) saving in defined contribution pension schemes are on course to have individual incomes that fall short of standard benchmarks in retirement.”
You need a third layer to get you where you want to be: higher-than-minimum contributions.
What is a pension anyway?
It’s worth taking a moment to understand what we’re talking about. The base layer just happens. For the second layer, you just do as you’re told and enrol (automatically). For layer three, to start building a pension that will deliver the retirement standard you want, we should understand what we’re talking about.
In all of this, we’re discussing “defined-contribution” pension schemes, where your pension is based on the contributions you’ve made (i.e. the amount you’ve saved in your pot). This is in contrast to defined-benefit schemes (which now only persist in the public sector), where your pension is defined, usually, by your final salary (or an average over the final few years).
Effectively, personal and nearly all company pension schemes are now defined-contribution schemes and these are, in effect, a piggybank, albeit a piggy on steroids.
Through your working life you fill it up. Then, when you retire, you drain it down. Simple.
The steroid parts are access, compounding and tax benefits.
Access
The simplest “steroid” benefit is simply that you can’t lay hands on your money until you reach 55. Unlike your childhood piggybank, you can’t smash it open when you feel tempted. Your piggy pension pot is locked up and growing until at least 55 (57 from 2028).
The power of compounding
The famous investor, and one of the world’s wealthiest people, Waren Buffett ascribed his success to the power of compounding or compound interest. What’s compounding? In many ways it’s the simplest thing on earth. All it needs is patience and willpower. Oh.
Compounding is usually explained like this. If you put £100 in a savings account paying 5% interest, at the end of the year you’ll have £100 + (5% of £100) = £105. That’s just interest.
If you have will power and leave that money alone, by the end of year 2, you’ll have £105 + (5% of £105) = £110.25. The extra £0.25 doesn’t sound so very interesting but what if you leave it untouched for, say, 40 years? That might take you from age 25 to age 65. At that point, without adding anything else, your £100 will be worth £704. That’s more interesting.
And, if you had continued to add £100 each year for 40 years, so a total of 40 x 100 = £4,000, it would be worth a total of £12,684. That’s much more interesting, and that’s the power of compound interest.
If you had saved £100 each month, then after 40 years, it would be worth £152,208.
Patience and the willpower to leave it alone to do its work. As Warren Buffett said, “Life is like a snowball. The important thing is finding wet snow and a really long hill.”
Just one more point. The long hill gets you a long way, but compounding has a huge hockey-stick effect. Looking again at the £100 per month example, at the end of year 1, your interest earned would be (5% of £1200 =) £60. But, at the end of year 40, your annual interest earned would be £7,247.99!
Patience and willpower. Wet snow and a really long hill.
Tax benefits
Another steroid boost to your pension piggy are the tax benefits, which come in three ways.
Firstly, as we said before, you get a tax allowance on the money you put in. You get 20% (basic rate) tax relief on your salary contributions so for every £4 you put in, the government puts in £1 (20% of the total £5). If you pay higher-rate (40%) or additional-rate (45%) tax, you can claim the additional relief via a tax return and/or adjusted tax code.
Employer contributions are also exempt from income tax and national insurance.
Secondly, any investment growth within your pension scheme is exempt from capital gains or income tax. So, from our £100 per year example above, the growth of (£12,684-£4000=) £8,684 is all tax-free.
And finally, when you reach the minimum retirement age (55, soon to be 57) you can withdraw up to 25% of your pot as a tax-free lump sum, although, of course, this will reduce the amount left to live off. The rest of your pot is subject to income tax when you withdraw it (as your pension income).
How much do you need and how do you get there?
Now that we understand a bit about the amped-up pension piggybank, how much do you need in there and how do you build it up?
The organisation Retirement Living Standards, calculates that a single person needs £32,700 per annum for a moderate living standard (and, as we said, £13,900 for a minimum).
That means you need your pension pot to generate £20,152 (£32,700 – £12,548 state pension, net of tax in today’s money) per year from retirement until the end of your life.
Lots of assumptions and simplifications here (see below) but that means you’ll need a pension pot of around £685,000 in today’s money at the point you retire. That would provide £25,000 a year (gross, equivalent to £20,152 after tax) for 40 years, from age 65 to 105.
Why 105? Simply safety margin. There may be a certain nihilistic attraction to “dying with zero”, but you’re going to feel a tad silly if the money runs out before you do. 85 and penniless? No, thanks.
So, 40 years of saving (from 25 to 65, roughly) gives you 40 years of retirement.
Based on these assumptions, someone starting at 25, and on the median salary for that age-group of £32,350, needs total pension contributions of around 23% of salary to fund a moderate lifestyle in retirement.
That sounds huge! But, critically, as we said at the beginning, this doesn’t all come out of your take-home pay. Assuming the employer pays the median (not minimum) contribution of 5% of salary, and with basic rate tax relief, then the effective net cost to you, the employee, is 14.6%.
On a median salary, that would be £394 per month of net employee cost and a total contribution of £625 per month going into your pension pot.
That’s still a substantial amount, but it’s based on a deliberately demanding and conservative set of assumptions:
- Retirement at 65 – but many choose to work longer
- A Moderate, not minimal, lifestyle in retirement
- Income lasting until age 105
- Staying single – a Moderate lifestyle for a couple is only £45,400, not two times £32,700
- A 1.75% per year salary increase in real terms, i.e. from career progression, promotions and job moves
- A conservative 2.5% investment growth rate (in real terms) during the accumulation stage, while you’re still working
- A more cautious 2.0% return rate during the drawdown stage (most people choose a lower-risk/lower return investment profile once they retire)
- No reliance on inheritance or other assets.
The model also assumes that both the state pension and Retirement Living Standards increase in line with inflation.
Half-Your-Age: an alternative approach?
The above assumes you can save the same percentage of salary throughout your career. In reality, people often find money tight when they’re younger and earlier in their careers. As they progress, they can often manage a higher percentage of pension contribution.
The Half-Your-Age rule recognises this with the suggestion that you pay pension contributions (including tax relief and employer contribution) at a percentage that’s half your age, e.g. 12% at age 24, 20% at age 40. On the assumptions above – and, importantly, as long as you remember to increase your percentage each year – the Half-Your-Age model takes you close to what you need without being wholly unmanageable at an early age. Half-Your-Age would generate a pot of £641,000 (in today’s money) compared to £685,000 in our earlier model – around 6% short.
The bottom line
No-one thinks about retirement until it’s on the horizon, certainly not in your twenties or maybe even thirties. But thinking ahead will pay dividends.
The statutory minimum 8% auto-enrolment and the state pension won’t buy you a moderate lifestyle in retirement. You, we, all of us, need to save more than we generally do.
But, thanks to the wonders of compound interest, the earlier you begin the better (the early money works hardest for you in the long run).
The “call to action” is to take a couple of hours now, whatever your age, to assess and understand your current position and to plan consciously for the future you want. Don’t miss out on free money and make the most of compound interest.
Caveat: I’m not a financial advisor. This article is the result of reading something online that was clearly incorrect and misleading. It’s my attempt to unpick the complexities and make the realities a little clearer. You should speak to a financial advisor to get appropriate advice about your own particular situation.
Photo by Andre Taissin on Unsplash
