Pensions, why bother?

Question

Ok this question is going to show my age, but its something I've been thinking about for a while and can't quite figure it out

Why bother with a pension?

I don't understand, why should I put away £1000 per year for a pension now. I'm thinking of it this way:

Putting away £100 or so a month now is a reasonable chunk of money. When I come to retire in 40-45 years or so, £1000 will be getting swallowed up in inflation. I'm thinking, that say for example 30, or even 20 years ago. Income was a lot lower, so maybe putting in £20 a month was reasonable? But now, that £20's they have put away is pennies in todays money.

Wouldn't it be best, to wait until 10 years before you retire, then start saving hard? Or are there other options? Or is the interest on pensions so good that £100 a month now (around 8% of salary) will be matched to 8% of my salary in 40 years time?

Also, another couple of things, what is to stop the pension company going bust before you get to retire? Seen a few articles on the news recently where people have been stung from this. Also, (for the record I've always worked hard and paid my taxes, no handouts etc), but why pay into a pension when you can get one from the state anyway?

Can someone answer these? Might be good for a community wiki ;)

Answer 1

The stock market at large has about a 4.5% long-term real-real (inflation-fees-etc-adjusted) rate of return. Yes: even in light of the recent crashes. That means your money invested in stocks doubles every 16 years. So savings when you're 25 and right out of college are worth double what savings are worth when you're 41, and four times what they're worth when you're 57.

You're probably going to be making more money when you're 41, but are you really going to be making two times as much? (In real terms?) And at 57, will you be making four times as much? And if you haven't been saving at all in your life, do you think you're going to be able to start, and make the sacrifices in your lifestyle that you may need? And will you save enough in 10 years to live for another 20-30 years after retirement? And what if the economy tanks (again) and your company goes under and you're out of a job when you turn 58?

Having tons of money at retirement isn't the only worthy goal you can pursue with your money (ask anyone who saves money to send kids to college), but having some money at retirement is a rather important goal, and you're much more at risk of saving too little than you are of saving too much. In the US, most retirement planners suggest 10-15% as a good savings rate. Coincidentally, the standard US 401(k) plan provides a tax-deferred vehicle for you to put away up to 15% of your income for retirement.

If you can save 15% from the age of 20-something onward, you probably will be at least as well-off when you retire as you are during the rest of your life. That means you can spend the rest on things which are meaningful to you. (Well, you should also keep around some cash in case of emergencies or sudden unemployment, and it's never a good idea to waste money, but your responsibilities to your future have at least been satisfied.)

And in the UK you get tax relief on your pension contribution at your income tax rate and most employers will match your contributions.

Answer 2

James, money saved over the long term will typically beat inflation. There are many articles that discuss the advantage of starting young, and offer: A 21 year old who puts away $1000/yr for 10 years and stops depositing will be ahead of the 31 yr old who starts the $1000/yr deposit and continues through retirement. If any of us can get a message to our younger selves (time travel, anyone?) we would deliver two messages: Start out by living beneath your means, never take on credit card debt, and save at least 10%/yr as soon as you start working. I'd add, put half your raises to savings until your rate is 15%.

I can't comment on the pension companies. Here in the US, our accounts are somewhat guaranteed, not for value, but against theft. We invest in stocks and bonds, our funds are not mingled with the assets of the investment plan company.

Answer 3

Your gut feeling is absolutely spot on - you shouldn't be worrying about pension now, not at the age of 25. Assuming that you're not a footballer in the middle of the most productive part of your career and already have a fat wad of crunchy banknotes under your pillow that you're looking to set aside for a rainy day when you won't be able to play at your prime any longer. That doesn't mean you shouldn't invest, nor that means that you mustn't save.

There are several factors at play here.

First of all as a young person you are likely to have a high tolerance for risk, there is still plenty of time to recover should expected returns not materialise. Even a pension fund with the most aggressive risk / return strategy might just not quite do it for you. You could invest into education instead, improve health, obtain a profitable skill, create social capital by building connections, pay for experience, buy a house, start a family or even a business.

Next, as a young professional you're unlikely to have reached your full earning potential yet and due to the law of diminishing marginal utility a hundred pounds per month now have greater utility (i.e. positive impact on your lifestyle) than a seven hundred pounds will in 7-10 years time once your earnings plateaued. That is to say it's easier to save £700 month from £3000 and maintain a reasonable level of personal comfort than carve £100 from £1300 monthly income.

And last, but not the least, lets face it from a human point of view - forty years is a very long investment horizon and many things might and will change. One of the downsides of UK pensions is that you have very little control over the money until you reach a certain age.

Tactically I suggest saving up to build a cushion consisting of cash or near cash assets; the size of the stash should be such that it is enough to cover all of your expenses from a minimum of 2 months to a maximum of a year. The exact size will depend on your personal comfort level, whatever social net you have (parents, wife, partner) and how hard it will be to find a new source of income should the current cease to produce cash.

On a strategic level you can start looking into investing any surplus cash into the foundation of what will bring joy and happiness into the next 40 years of your life. Your or your partners training and education is one of the most sensible choices whilst you're young. Starting a family is another one. Both might help you reach you full earning potential much quicker. Finding what you love to do and learning how to do it really well - cash can accelerate this process bringing you quicker there you want to be.

If you were a start-up business in front of a huge uncaptured market would you rather use cash to pay dividends or finance growth?