Saving for retirement
Retirement saving has undoubtedly got harder. Not only is the gold-plated defined benefit pension scheme a thing of the past (where pension income is based on final salary), but low interest rates mean that you need a larger pot to generate an income. Put simply, if you can get 5% on your savings, you need £500,000 for an income of £25,000 per year. If that rate drops to 2.5%, you need £1m.
Until relatively recently, however, inflation hadn’t been a serious concern. The UK hadn’t seen persistent price rises since the 1970s1. Today, there are reasons to be more worried. Food and fuel shortages as a result of the Ukraine crisis have collided with supply bottlenecks and higher labour costs to push up prices. The last set of inflation data show a rise of 7% year on year2 and the Bank of England now suggests inflation could hit 10% this year3. Even though it is expected to drop next year, many economists are assuming inflation will settle at a higher level than it has over the past few decades.
This is a problem for investors. Even if inflation stays in line with the Bank of England’s targets, long-term investors need their savings to grow by around 2% a year just to ensure it maintains its purchasing power. It is also worth remembering that people are exposed to different prices – education costs, for example, have consistently risen well above the broader level of inflation.
Cash: not ‘safe as houses’
The most important rule for any long-term investor is to avoid ‘reckless caution’. Investors often don’t recognise that there is a risk associated with keeping their long-term savings in cash. After all, optically, they will have more or less the same amount at the end as they did at the beginning. However, it will buy them progressively less and less.
As an example, with inflation at 2% a pension pot of £100,000 will be worth just £82,000 in real terms after a decade4. That drops to £67,000 after 20 years - about the same length as a normal retirement. At 3% inflation, it would fall to £74,700 after 10 years and just £55,350 after 20 years. In other words, it could be catastrophic. There is a temptation to see cash as the ‘risk free’ option because your capital value stays the same. It isn’t.
Stock market investment has generally provided greater protection against inflation. Stock market returns have been higher historically, even with periods of significant volatility such as the financial crisis or dotcom bubble. Research from Goldman Sachs shows that over the past 140 years, US stocks averaged 10-year returns of over 9.2%. The worst decade was the 1930s, which delivered an average annual return of negative 4%, while the best was the 1950s, which returned 21% a year5.
There are sound reasons for this. Companies can usually raise prices at a time of higher inflation. Also, investors demand a higher return for the greater risk associated with investing in companies.
That said, investors need to manage the additional risks that are associated with stock market investment. Starting early is ideal: £1,000 invested at 20 could be worth £9,440 at 65 (assuming a 5% average annual return). That same £1,000 invested at 40? Just £3,480.
There are also tax incentives. For every £100 you invest, you get £20 back from the government (£40 or £45 if you’re a higher rate tax payer). If you are employed, there will be a workplace scheme and your employer will contribute as well. This can really turbo-charge your retirement savings, so it's often wise to opt in and contribute the full amount. Most employers will also offer salary sacrifice options, whereby employees can trade some of their salary for pension contributions. This can be a tax efficient option to build up your pension pot.
Saving month by month, rather than putting big lump sums into the market in one go can also help manage the ups and downs associated with stock market investment. You will buy in at different prices, which minimises the risk of investing when the market is very expensive (and therefore vulnerable to a fall).
For many, retirement saving isn’t necessarily about saving more (though that always helps), but could be about saving smarter. If you’re saving for the long-term, inflation will be one of your key risks. Make sure you don’t let caution get the better of you.
Talk to Evelyn Partners
If you want to know more about saving for retirement, Evelyn Partners can help. Contact our experts now by booking an initial consultation online or calling 020 7189 2400.
The value of an investment may go down as well as up, and you may get back less than you originally invested.
This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.
Prevailing tax rates and reliefs depend on your individual circumstances and are subject to change.
Past performance is not a guide to future performance.
1. ONS, Changes in the economy since the 1970s, 2019
4. RL 360, Impact of inflation calculator, 2021
5. S&P Global, S&P 500 returns to halve in coming decade – Goldman Sachs, 2020
This article was previously published on Tilney prior to the launch of Evelyn Partners.