Investing for retirement is more complicated than simply opening a personal pension plan or joining your company’s pension scheme. In fact, many people find the thought of planning their retirement a bigger challenge than dealing with expenses or saving money. And no wonder: Pensions have mostly given way to so-called defined contribution plans which have placed the burden of investing to provide for a steady income on your shoulders. Here are 10 ways to navigate this maze:
1. Go to the max. The Government sets annual contribution limits into pension plans. Do your best to maximise your contributions: The amount of your pension savings that benefits from tax relief is limited to an annual allowance equal to you salary and subject to an overall ceiling, currently £50,000. From tax year 2014-15 onwards the annual allowance will go down to £40,000. If you save more than this amount you may have to pay a tax charge on the excess.
The lifetime allowance is currently £1.5 million but this will go down to £1.25 million from 6 April 2014. Even following this reduction, most people won’t have to pay the lifetime allowance charge.
2. Save even more. Any extra savings for retirement should go first into an Individual Savings Account (ISA) followed by investments without any tax wrapper, but enabling you to utilise your capital gains tax allowance. A common ‘rule of thumb’ is to save at least 20% of your income each year, more if you’re way behind on achieving your target retirement income..
3. Pay attention to “asset location.” For people who have tax-favoured retirement accounts like personal pensions and ISAs, aswell as unwrapped investments, it can be challenging to figure out in which accounts to put which investments. It makes sense that you should put a higher percentage of shares into your taxable accounts, while taxable bonds are better off in your ISA or pension plan as tax paid on the interest from these investments can be reclaimed, whereas the tax paid on company dividends cannot.
4. Focus on asset allocation. Many studies show that a very high proportion of a portfolio’s performance is determined by allocation of assets, not individual investments or market timing.
- Age ‘rules’. Some financial advisers recommend stock market or equity exposure equal to about 120 minus your age. If you’re 55, at least 65% of your portfolio should be in stocks, regardless of which types of accounts you are using to invest for retirement.
- Risk. In reality, a personal approach linked to an assessment of several aspects of risk is important, such as: Emotional attitude to risk – can you sleep at night? Capacity for risk, how much can you take before the wheels fall off! Importantly, how much risk do you need to take? There is little point setting out to make a return of 5% in excess of inflation, if all you need to do to reach your goals it to match inflation. Why would you expose your money to the additional risk?
- Fixed income matters. The remainder of your portfolio, once you’ve decided on the allocation to ‘real’ assets should be in fixed-income investments like Government bonds, corporate bonds or bond funds, which generate annual interest income.
5. Pick the right investments. Misguided investment choices can cost you tens of thousands of pounds over a lifetime.
- Fees add up. Investment fees come in many forms, including expense ratios on funds, commissions for share trades, and account fees from advisers. Fees should be minimised so that your return is maximised. hands-out-of-my-pockets-please
- Diversify. For the share element of your portfolio, consider index funds and and get exposure to domestic and international markets, as well as small, medium and large company shares; for the fixed income portion of your portfolio consider bonds, bond funds and property.
- Ask for help. A financial adviser can help you pick low-cost investments to help you meet your retirement goals. Be mindful, however, of how that adviser gets paid.
6. What not to do. Think rationally, not emotionally.
- Don’t try to time the markets. A recent study by Morningstar found that people who try to time the markets end up with significantly lower returns than those who buy and hold.
- Don’t tinker too much. Don’t change your investments on a whim; instead, once a year, make review your portfolio, either on your own or with an adviser. Investors who rebalanced their $100,000 portfolios once a year ended up with roughly $31,000 more over a 20-year period than those who didn’t re-balance and nearly $20,000 more than those who rebalanced monthly, according to a study by T Rowe Price .
- Don’t assume you can make up for lost time. Many people delay maximising their pension contributions, assuming they can make up for lost time later on. It’s not easy to do as money invested early into a pension plan has many more years of growth ahead of it – saving-for-retirement-the-time-is-now
- It pays to be prepared as retirement nears – be prepared for change and the inevitable decision-making. The Money Advice Service recommends that from about two years out, you should start thinking about your options and planning for the choices you’ll need to make. Consider getting professional advice because there are decisions that will shape your income and lifestyle for the rest of your life.
7. Work out your likely retirement income. Your annual pension statements, or pre-retirement information from your pension provider or providers, will give you an estimate of the kind of pension income you can expect in retirement. You’ll need to request a forecast of your likely State Pension entitlement, and you should also take account of any income you might have from other savings, investments or assets.
8. Shop around to get the best pension income for you. The most important thing you can do in the run-up to retirement is to shop around to find the best pension income – both the right kind of income, and the highest income of that type that’s available on the market. Most people buy a lifetime annuity with their pension savings, which means it’s a decision that affects their income for the rest of their life. It pays to get it right – shopping around can boost your income by 20% or more, and once you’ve bought a lifetime annuity you generally can’t change it. If you have health problems or an unhealthy lifestyle, you may be entitled to a higher pension income. Many people who are entitled miss out, so make sure to check your position!
9. Be ready for changes in your day-to-day budgeting. You’ll probably need to get used to a different pattern of income and spending when you retire. You’re likely to have less money to live on. Work-related costs will fall, and you may have paid off many of your debts. But your spending may go up in other areas, such as leisure, healthcare and, if you’ll be at home more, things like heating. To prepare yourself for these changes, it’s a good idea to draw up a budget – a record of where your income comes from and how you spend it – and to think ahead to how it might change in the years ahead.
10. Seek professional advice. The whole area of pension income options and choices is complex. Making mistakes with your own pension arrangements can turn out to be very costly in the long term and life-changing in unwelcome ways. Seeking reliable independent advice should be an early move in your pre-retirement planning.