Liam Croke: The formula to guarantee a satisfactory pension

There are many different theories as to how much you need to be saving each month for retirement.

There are many different theories as to how much you need to be saving each month for retirement.

People want to know how much should be in the pot when they retire so I am almost always asked if there are any “secrets” or do I have any “insights” into guaranteeing a successful income in retirement.

It is a difficult question to answer, because everyone’s required level of income will be specific to them.

Also, at its core, planning for your future income is based on guesswork and assumptions.

You have to make a guess as to what your expenses will be in 25 or 30 years’ time. In my opinion, you should benchmark them off what your current outgoings are. It also amazes me how stupid the idea is that most banks and financial advisors peddle where they say that you should plan on replacing your current income when planning for retirement rather than letting your current expenses be your guide.

You have to estimate how much your pension fund will grow by, what age you want to retire at and so on and some of these things are hard to predict and control.

But there is an actual mathematical formula that I have found and something I share with people when it comes to planning for retirement and it is based on what the most important three variables are when it comes to working out what your pension income will become.

And the formula is:

(P(1+i)^t)= FV

Of course, this formula is something only the likes of a Dr Sheldon Cooper from The Big Bang Theory would understand, so let me translate it into layman terms for everyone

It is: Savings x return x time = your income in retirement.

This formula looks less like something out of a NASA manual, but it is an incredibly important one to be aware of because it is these three components that have the greatest impact on what your income in retirement will become.

But which of them is the most important factor? Is it better to save more? Does this even matter if your returns are great each year, or is time the most important of all?

Getting any one of them wrong can have a serious impact on your retirement income; if you don’t save enough you will end up with very little; if you don’t make a decent return each year you will end up with next to nothing and if you are only saving for a few years then you won’t end up with very much.

I remember reading about a pension guru being asked about this equation and which factor he thought was the most important out of all three and he said it was like having to choose between your brain, heart or lungs – you need all of them.

But I still wanted to look at all three myself and see if there was one more important than the other, so I decided to crunch the numbers and I was even surprised by the results.

My starting point was someone saving €200 per month, earning an annual return of 5% over a 25-year period.

If I was to increase each factor by 10% in isolation, what impact would it have on my final fund value?

Which one would give me the greatest fund?

Before you look at the answers, if someone was to ask you would you prefer an extra 10% on the amount you saved, your annual investment return or on the length of time you save for, what order would you rank them in?

Here are the results:

Savings – an extra 10% means that €200 now becomes €220 @ 5% x 25 years = €131,558

Return – an extra 10% means that 5% now becomes @ 5.5% x 25 years @ €200 pm = €128,996

Time – an extra 10% means 25 years now becomes 27.5 years @ €200 x 5% = €149,044

So, what can we learn from this?

For me, it shows that the rate of return – something every pension provider keeps going on about, how they are the best and how important it is – is actually the least important of the three. Increasing the rate of return by 10% above the amount saved and the time it was saved over, gives the lowest return over a 25-year time period.

And the other thing with rates of return, they are the one factor you have least control over, because it is impossible to know for certain what way markets will perform, what way interest rates, bond yields or property will perform either.

Time is the big winner of the three variables, but unfortunately people delay starting a pension because they think they can catch up at a later date by increasing the amount they contribute each month or by trying to get better returns.

The biggest risk, therefore, to your future fund value and annual income is delaying starting a pension; the sooner you start the better.

If time is not on your side, then for me the most important factor is something you do have control over and that is the amount you can save each month.

So try to find savings if you can and, when you factor in tax relief, an extra €100 per month might only cost you €60. Can you find a way to say an extra €2 per day?

Look, all three factors are important, of course they are. From purely a figures point of view, some are more important than others but it is just being conscious of all three and how linked to one another they are.