Fool's Eye View

[ October 10, 2000 ]

We Are Going To Frighten You

By Rob Davies (TMFEssex)

Colchester, Essex -- Have you ever thought about all the things you will need to buy during your lifetime? The obvious things are items like houses, cars, white goods, soft furnishings, holidays and education. But there is one item that most people forget, but in fact it is the largest item by miles. It probably comes as no surprise to Fools that this large item is a pension, or some sort of fund to provide for your retirement.

In a previous article we looked at how much we needed to save and invest to make a decent amount that would fund our retirement. That could be in a pension, or simply through tax efficient ISAs. The Motley Fool was not over keen on pensions, certainly of the personal sort, because of the obligation to use the fund to purchase an annuity at some point before age 75. However, the news last week that the Tories plan to abolish that rule does change things. That may or may not happen, but either way the fund needs to be at least about £250,000 in order to generate an annual income of about £15,000 a year. That should be adequate for most couples, although more would be nicer.

A quarter of a million pounds is a lot of money and the task of saving that much should not be underestimated. However, that is not the only financial hurdle we have to surmount in the course of our working life. We need somewhere to live. Normally, that is achieved through house purchase, but the cost of renting is not dissimilar. The difference is that at the end the homeowner has something to show for it; the renter doesn't. The debate about repayment or interest only mortgage is almost irrelevant here because the loan has to be paid off at some point before you retire. The crucial difference between the two is whether you think your investing strategy will consistently beat the 6% or so it costs you in borrowed money on the house year in year out. Borrowing £100,000 for 25 years in an IO mortgage will cost a lot more than borrowing £100,000 for effectively half that time in a repayment mortgage. Assuming a house costs £100,000 that means we need to fund £175,000 to buy it through an IO, or £250,000 through a repayment mortgage.

Oh dear, these targets are beginning to look a little daunting. But there is more. We need to buy a car, and the biggest element of running a car is the depreciation cost. Conservatively, we can allow £1,000 a year for that. Over a working life that could be at least £50,000. On top of that are the running costs, but we won't concern ourselves with those here. This exercise is about capital goods.

What else is there? Household goods and furnishing can be pretty significant items, say another £25,000 as basic level. Then perhaps school fees. If you go that route it could add another £50,000 to the bill. And of course these days there are student loans to repay, or perhaps save for to fund your children through university. That could be another £20,000. We've probably got enough now to make a little list now. But let's make two: a modest one for someone on average earnings and a more ambitious one for someone on twice that pay.

              Average Salary     Twice Average Salary             

Pension           £250                  £350
House             £175                  £500
Cars               £50                   £75
White Goods        £25                   £50        
Student loan       £20                   £20
School fees         --                   £50

Total             £520                £1,045       

Quite big numbers aren't they? The modest case assumes a £100,000 house bought on a repayment mortgage and the ambitious case assumes a £200,000 house bought on an interest only mortgage. Yes, borrowing £200,000 borrowed at 6% for 25 years will cost £300,000, the interest will be more than the cost of the house in other words. But, in both cases the pension is going to be a pretty large item we will have to buy during our working life. The size of the house can be optional, but there is not much flexibility in what we require for a pension. I have put these two tables in the context of average salaries. Today the average wage is £22,000, so twice the average wage is about £45,000. That means that over a working life total income will be, in round numbers, £1m for the average worker and £2m for the guy on twice the average wage. Yet in both cases the amount required for the basic capital requirements still adds up to half the income. The rest still has to go on food, petrol holidays etc.

These numbers are pretty loose and I am sure I will be attacked for some of the assumptions. But the question remains though as to whether most of us have factored these "big numbers" into our financial planning. Are we directing enough money at our pension? Or are we putting too much money into the house?

Tell us what you think on the Fool's Eye View discussion board.