We dream of long, easy days in retirement, enjoying new-found freedom. But the illusion is shattered when we find we have to live on a pittance. A combined state and private pension amounts to an average monthly income of just £500, according to figures from Friends Provident, so if you don't want to live out your days in poverty, it's time to do something about it.
This dire situation is down to several factors. Few of us realise exactly how much we need in retirement to achieve a comfortable standard of living, nor how long it has to last. The big problem is that we are all living longer, so our pensions have to last longer. Average life expectancy following retirement at 65 is 18.5 years, so realistically a pension has to provide for two decades, if not longer, after your salary stops. However, despite having to last longer, the returns that most people's pensions are seeing at the moment are greatly reduced.
Pension pots have shrunk by as much as 30 per cent during the market turmoil hitting those close to retirement hardest. The recession also means that those paying into pensions may not have increased contributions or may have scaled back to lower their outgoings. Funds are therefore growing more slowly and reduced returns on smaller funds can only mean a lower annuity value and lower retirement income.
In order to draw a basic income in retirement, we need to accumulate a fund of at least £184,704, which would provide a monthly income of roughly £1,040 gross, according to Friends Provident. "When you retire you'll have fewer outgoings, but this is still not a comfortable standard of living," Martin Palmer, the head of corporate pensions marketing at Friends Provident says. "This would be added to a basic state pension but would only cover basic day to day living."
However, today the average annuity purchase is just £25,000, which will pay out roughly £125 per month. If you add maximum state benefit of around £90 per week, this is still only a monthly total of less than £500 gross to live on. "People generally need half to two thirds of pre-retirement income after they retire," says Andy Tully, a senior pensions policy manager for Standard Life. "If we live on average 25 years in retirement you need to multiply this amount by 25 for a ballpark figure. Working on a retirement income of £10,000 per year, for 25 years, that's at least £250,000. That's way beyond what the vast majority people have."
If you aren't already investing in a pension, the best place to start is with a stakeholder product, either as part of a company scheme or a personal stakeholder. Opting out of an occupational scheme which your employer contributes to is tantamount to saying no to tax relief and free money. If you don't have the option of an occupational scheme you can contribute towards a personal scheme.
The amount you should contribute depends on age. A good measure is to halve your age and invest that percentage of your salary. A 40-year-old should be investing 20 per cent of their salary, for example.
"The kind of contribution rates being put into schemes in the past would be anywhere between 9 to 15 per cent of your salary," says Dennis Hall, the managing director of Yellowtail Financial Planning. "Even at those rates there is a huge shortfall within large funded schemes. If you're doing it on your own and you're not putting in at least 7 to 10 per cent, you're going to be woefully short." In fact, to achieve that £184,704 fund, you will need to put away £140 per month for 35 years, £280 per month for 25 years and £650 per month for 15 years. And yet more than 40 per cent of us fail to make any pensions contributions at all.
This is for a myriad of reasons. Attitudes towards saving and finance have changed and are today much more short-term orientated. Before the latest recession hit, many people were living on credit and not worrying about how they were going to pay it back, experts suggest. Although the recession has brought personal finance much more into focus, it has not done much to change attitudes towards pensions. "People should be more responsible now, but are increasingly focused on providing for just the next year or two," says Mr Palmer. "As a result, their pension gets forgotten."
There is also a negative stigma attached to pensions, following a string of corporate pension fund scandals and the fact that pensions are about the end of our lives – something most of us would rather not think about.
And pensions are far from straightforward. Many people shy away from any sort of investment, Mr Palmer adds, even where the decisions are made for you, and few really grasp how risk works. Although investing in a pension does necessitate some risk, it is smoothed by continual investment. By putting in a little each month, you are never solely investing at the very top or the very bottom of the market, giving you less exposure to market ups and downs. In fact, now is one of the best times to pile money into a pension, buying while the market is low and investment units are cheap.
A pension is a long-term investment and although the market may go up and down in the short-term, the long-term trend is growth, ensuring a good return. But most pension specialists admit that not being able to touch such a significant amount of money for a long time does make people nervous.
The key to saving for later life is to start early. Once you have accumulated a good amount you can start to look at diversifying your portfolio. Those with a good 20 years to go before retirement should be looking to invest more in shares and real assets as they can afford to take more risk. Those who do not start early will not be able to maximise their returns from this type of investment, as once you are closer (within five or 10 years) to retirement you should switch to safer assets with lower returns. Mr Palmer says, "It's no good waiting until your 50s to contribute. You need to start much earlier which will make it much easier and give you a decent chance to give yourself a good income."
Today, many rely on working longer to provide for themselves in later life. Over 40 per cent of 46- to 65-year-olds intend on working past retirement. This is a good strategy, many agree, and could be the status quo for most of us in future. "If you're going to contribute to a pension for 30 years and then be in retirement for another 30, the sums look scary," says Mr Tully. "But just five more years even in part-time work can make a big difference." The key is the just how long you defer for. If you don't draw any money from a pension you reduce the time over which you have to spread it and the fund can potentially increase as a result of the extra time it is invested.
However relying solely on working after retirement age can be risky, as you simply do not know how healthy you'll be at that stage and whether you will be able to work. One thing is for sure, it's time to start saving regardless of how old you are.
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