In our discussions of pension plan consolidation, we always comment that it usually makes sense to consolidate your employee pension plans, but only once you have left your job. That’s because employer contributions are essentially ‘free money’ that makes up for the relatively mediocre performance and lack of flexibility that is unfortunately common among these pension plans.
That begs 2 questions:
1. How much do employers normally contribute to employee pension plans?
2. Is that enough to provide you with a comfortable or early retirement?
Anecdotally, financial advisors see contributions of about 5%, with varying rules on matching. Some employers only contribute if employees match contributions, while others might contribute 5% but be willing to go up to as much as 10% if employees match.
In 2013, Towers Watson, a consultancy, surveyed the FTSE 100 and found that employers claimed to contribute to employees’ pension plans:
- Around 9%, if they contribute regardless of employee contributions
- Around 5%, as a base contribution with up to an additional 5% if employees make use of all matching opportunities.
Of course, these are among the very largest UK companies, so these numbers are likely to be at the high end of the normal range.
Okay, but what does that mean for your retirement planning? If you are fortunate enough to work for a FTSE 100 company that pays into employee’s pension plans at the top end of the range, can you stop plugging numbers into your pension calculator, break out the sunscreen, and look forward to early retirement?
Unfortunately not.
The basic maths is simple enough that you don’t even need a retirement calculator to understand it. Most people would like to pay into pensions for around 35 years (from 20 to 55 say) and then enjoy up to 35 years of retirement (to about 90).
So let’s assume for a moment that interest rates after inflation, fees and taxes are zero. Whatever you save in the first 35 years is what you have to spend in the second 35 years. So if you wanted to maintain the same standard of living in retirement that you had while working, you’d have to save half your income – 50%!
So in this simple example, we see how far the 5-10% employer contributions are from what you might need. Now, of course, the real-world situation is not quite this bad:
- Although UK government interest rates are close to zero, if you invest your pension and savings in slightly riskier assets such as stocks, long-maturity bonds or real-estate, you can expect to achieve a return in the low single percentages.
- Foregoing early retirement makes a huge difference. In the zero-interest-rate example above, if you retire at 67, that’s 47 years of contributions to just 23 of retirement – you contribute twice as long as you retire for – so you’d only have to save a third of your salary, rather than half.
So what does this look like with interest rates and spending patterns factored in? Well, consider Tom. He is 30 years old and works at an accounting firm in Hong Kong. He makes £50,000 per year, but hasn’t managed to save anything so far. Assuming he works until 67, lives until 90, can live on £30,000 per year in retirement, and makes a 2% after-tax real return on all his savings (including his pensions, real estate and personal investments), how much would he have to save?
Around 20% of his gross wages. With that, he would build up overall equity (including his home, pension plans and savings) of £560,000 by 67 and draw it down until he is left with £20,000 at 90.
Importantly, 20% monthly savings is still 2-4x higher than typical employer contributions.
This means you have to plan and save for your own retirement.
A quick summary:
- Plan for retirement and start saving early
- Be realistic about the amount you must save, when you can afford to retire and how comfortably you can retire. To keep yourself motivated, remember – the two are connected. The more you save, the earlier or more comfortably you can retire.
- Don’t turn down free money: make as much use of pension plan tax advantages and employer contributions as you possibly can.
- Make your money work for you: ensure that it is properly invested with an adequate yield. Don’t waste your money by leaving it in savings accounts or a string of small employee pension plans.
- This is serious business. If you need help with pension calculations or retirement planning, talk to a trusted financial advisor.
