Fool's Eye View

[ October 5, 2000 ]

How to Retire without a Pension

By Rob Davies (TMFEssex)

Carburton Street, London. Conventional wisdom is that everyone needs a pension. It is drilled into our subconscious that you, or your employer, must make regular contributions into a tax-privileged pension fund that will look after you in retirement. But is that the only way?

No, we don't believe it is. For reasons we have explained before pensions have a number of drawbacks, most notably inflexibility and the inability to pass wealth on to the next generation. And the much acclaimed tax privilege is really tax deferral rather than tax avoidance. Pensions are taxable whether paid from an occupational scheme or from an annuity. The major benefit is that for higher rate taxpayer's contributions are exempt from tax at 40%, but the chances are that the benefits will be taxed at a lower rate when they are paid out. That aside, the problem remains that any money put into a pension fund is inaccessible until age 65 makes it an even more illiquid asset than a house.

However, there is an alternative that is much more flexible and allows an individual to build up their own retirement fund that can, if necessary, be used for other purposes. That alternative route is to accrue your own fund for old age through steady investments in ISAs, which really are tax avoidance machines. This year we are allowed to subscribe £7,000 to an ISA, but it does fall to £5,000 next year. Compare that to the average Personal Pension Plan contribution of £300 a year or the average £2,000 a year funding for the average Occupational Pension and the ISA allowance looks more than sufficient. It is true that there is a risk that future governments will remove, or reduce, this perk. But that risk applies equally to pension funds. Indeed, it happened when this government took office and removed the tax credit on dividends for pension funds.

Saving £5,000 a year is a tough objective. But if you can achieve it, and let compound returns work for you, it is possible to get some impressive results. A lot depends on exactly how much you need to save. Of course the exact figure will vary a lot between individuals but a reasonable figure would seem to be £250,000 in today's money. On the conservative assumption that the market returns 6% a year a fund of that size would generate an income of £15,000 annually through a combination of dividends and capital growth. Most couples could live reasonably on that income, after all it is about two thirds of the average wage.

Now I appreciate that to most people, me included, a quarter of a million pounds is a lot of money. Don't get me wrong, it is, but it is also achievable. The key question is how many years of investing £5,000 a year do we need to get to our target of £250,000.

With the benefits of modern computing power we can do that calculation very simply. If we take the figure of 6% that the FSA recommends as an average rate of return for the future it will take 24 years to achieve our goal. Being a bit more optimistic and taking the 8% figure that is the highest of the three rates the FSA use, our time frame comes down to 21 years. The third scenario we took assumed a 12% annual return and that tells us that we can achieve our aim in only 17 years.

While all these periods are relatively long, none of them are unrealistic. Even the worst case scenario of only achieving 6% a year means you can leave it as late as 40 before getting serious about building up a fund for your retirement. Although we would strongly advocate that you actually start earlier than that. Nevertheless, these crude calculations show that it is perfectly possible to make your own arrangements for funding your retirement outside a pension scheme.

The key to making it work though is to start early and ensure you make substantial contributions to your investment plan each and every year. Of course contributions you make to your retirement fund are in addition to house purchase commitments and all the other demands of a funding a family theses days. But if we look at our financial goals as a whole we can see that buying a retirement fund is actually going to be a bigger financial challenge than buying a house or any of the other capital items we need.

This article has not addressed the issue of inflation. So in practice we would probably need to aim for a larger target than the £250,000 we talked about. After all, who knows what that amount of money would actually buy in 20 years? Even so, it is minimum target to aim at. So get cracking.

To learn more about ISAs read our guide to ISAs and for more information about investing for retirement this part of the site is the place to go.