The key to success when saving for retirement is to start early, plan ahead and invest sensibly. he very first step is to determine how big a pension ‘pot’ you are aiming for.
Working out the figures will almost inevitably lead you to the realisation that you’re unlikely to be able to hit your target using just a savings account. While your cash may nominally be safe, current rock-bottom interest rates are unlikely to generate the returns you need to build a decent nest egg.
Shares have historically delivered higher returns over the long term, but have been riskier. Bonds have been more stable, but with lower returns. For most people, investing in funds that include a mix of shares and bonds attuned to your appetite for risk should provide a good balance between the two, with the potential for better growth than cash.
Funds provide a number of major advantages for time- starved savers. Diversification is arguably the most important point. In simple terms, this is the tried-and-trusted principle of not putting all your eggs in one basket. Investing in a range of assets means some of them should hold up if others are hit by a downturn in markets.
Of course, not all funds are created equal. The fees charged by the manager can significantly reduce returns over long periods.
To get the best from your retirement pot, you need to adjust your savings portfolio as you get older. Given that younger people seldom have large savings, their priority is to build them as fast as they prudently can.
Younger savers can and should take on more financial risk to provide potentially higher returns, even if there is no guarantee that they will achieve them. They can afford to take these risks because, while their actual assets may be small, their potential assets – in the form of many years of saving to come – are substantial.
Although we tend to earn and save more financial capital as we age, our human capital decreases as we approach retirement and our time to save falls accordingly.
In practical terms, this means investing when you are young in a portfolio of mainly shares, say around 80%, with the balance in bonds to maintain diversification.
Once you get into your 40s – when research1 suggests we hit peak earnings – the equities element of the portfolio can start gradually reducing to reach around 50% at retirement. While it is still necessary to build your pot in middle age, a much smaller percentage growth rate can still have a big impact because the size of your fund should be that much larger. Increasing amounts of bonds will provide a growing measure of protection as your portfolio becomes more vulnerable to losses.
Your strategy in the run-up to retirement will depend very much on how you intend to take your retirement income.
If you are planning to buy an annuity, which generally pays a regular fixed sum until you die, a lower-risk strategy with a preponderance of bonds will be most sensible.
If you intend to live off the retirement pot itself, ie drawdown, you need to bear in mind you may need to survive two or three decades on the income it provides. This means you will probably still need to keep a proportion of shares in your portfolio to maintain the necessary growth, perhaps as much as a third of your investments from the age of 75 onwards.
Beware of income traps
One way of producing the necessary income in retirement that savers have traditionally focused on is drawing what is naturally produced by their portfolio through dividends and interest. This can appear safe because you are not drawing down on capital. However, this income-focused approach has become more challenging with yields on most investments at historically low levels. Inevitably, it can mean income investors are drawn to shares and bonds that pay higher-than-average yields. But there’s no free lunch: such yields on shares and bonds can reflect companies in trouble.
We recommend the more rounded approach of so-called ‘total-return investing’. This means harnessing capital gains as well as dividends and interest to generate a retirement income. There are several benefits for retired savers:
- Better diversification. Because you are not constantly seeking an increasingly narrow range of high-income investments, your choice is much wider. It follows that you will find it easier to maintain the diversification of your portfolio and hence avoid unnecessary risks.
- More control over income. The problem for a retiree pegging their income to dividends and/ or interest is that they cannot rely on it. In the second quarter of 2020, for instance, the global pandemic meant UK companies cut dividend payments by more than a half2. Retirees’ incomes will inevitably have suffered.
- Increased tax efficiency. Other things being equal, paying yourself wholly in dividends and interest will increase your tax bill. For a start, rates are higher:
a UK additional-rate tax payer pays 37.5% on dividends, compared with 28% for capital gains. In addition, tax-free allowances are currently higher for capital gains, although, of course, the tax regime is subject to change.
- Improved resilience. Taken together, the benefits of total- return investing should make your portfolio better able to weather storms and see out the rest of your days.
Following a few ground rules like these will take much of the pain out of investing for retirement. But, remember, the most vital ingredient is maintaining the discipline to stay the course and stick with your long-term investment strategy.
1Annual Survey of Hours and Earnings: 2014, Office for National Statistics, 19 Novemer 2014
2What lessons can investors learn from cuts to dividends?
See also: Maximise your tax-free income in retirement – Tips on how to power up your pension