The pension fallacy (Part 2)

By Slow Dad - March 26, 2017

Adequately funded, tax advantaged, pension funds can be great investment vehicles. Beware the age constraints governing their access however.
This is the second in a series of posts about the fallacy of relying on pensions for early retirement.

In many countries the government is now making pension contributions mandatory.

In Australia for example it is compulsory to contribute 9.5% of salary into a pension, rising to 12% by 2025. The United Kingdom is starting to venture down this same path, making it mandatory to contribute 1% of salary.

In an ideal world everyone would be financially self sufficient, and no require the safety net provided by the government pension.

However anyone with a passing interesting Financial Independence, or even a basic grasp of high school math, can quickly spot that such a low savings rate just isn’t going to get the job done.

Even with the magic of compounding returns, and a stock market on a generally upward trajectory, for many people saving such a small proportion of their incomes isn’t going to amount to a large enough pile of wealth to support them in their elder years.

Ok, if mandatory pension contributions aren't enough then what is the answer?

Well to put it bluntly, people need to fend for themselves.

Financial Independence dogma will tell you that the “4% rule” will see you safely through retirement without running out of money. Except when they say “retirement” they mean 30 years, and when they say “without running out of money” they mean you will have at least £1 left at the end of the 30th year.

Given the retirement age is 65, and the average life expectancy is around 80, then it is not unreasonable to assume that a reasonable number of folks will make it to retirement age + 30 years.

To briefly recap the logic behind the 4% rule, you are supposed to multiply your current cost of living by 25. The result is (in theory) how much of a nest egg you need in order to “safely” retire without running out of money over the subsequent 30 years.

While the 4% rule sounds conveniently simple, many commentators believe (just like those clichéd financial services product health warnings) that “past performance may not be an accurate indicator of future returns”, and that your mileage may vary considerably if you're investing outside the US.

Early Retirement Now has produced an excellent series of analytical posts that tend to support this position. As a lapsed accountant, who was schooled in the Doctrine of Conservatism, I personally have doubts about whether any withdrawal rate over 2.5% to 3% could be considered “safe”.

It is no coincidence that the lower end of my range is roughly the same as the dividend yield on a low cost global tracker. Millennial Revolution would call this living within the “yield shield”, which to me is a prudent approach that should mean I haven’t an infinitely renewable stream of funds as opposed to a diminishing bucket of wealth.

I need to save how much to retire?

Let’s briefly consider what that actually means in practice.

Not too long ago I wrote a post about the average cost of living for a household in the United Kingdom being roughly £25,000 plus housing costs. If you live in an owner occupied property that you own outright then housing costs are relatively low, whereas if you live in rental accommodation or have a large mortgage then they could be vast.

The 4% rule crowd would say you need £25,000 / 4% = £625,000 + housing costs to retire.

By my measure you would actually need between £833,333 and £1,000,000 + housing costs to safely retire without running a significant risk of outlasting your money.

Safely retire without running a significant risk of outlasting your money.

Whatever your risk tolerance, that is a hell of a lot of money when you consider the average UK wage is currently only £27,000 per year before tax.

Yay for private pensions, but so what?

Private pensions are a wonderful thing, and I would definitely encourage readers to rely upon themselves rather than the government to provide for their retirement.

However private pensions come with strings attached. Not least of which is there are government imposed limitations on the age at which you can start receiving a pension from them.

As recently as 2010 this was age 50.

Currently that age is 55.

In 2028 it is looking like it will increase to 57.

It is highly likely this number will continue to rise, for many reasons not least of which is the demographic challenges the government faces in paying for all those government pension!

Moving goal posts make long term decision making tricky
If you are reading this pension fallacy post series and have made it this far then you deserve a medal. The fact that you are reading this blog at all suggests that you possess an above average interest in retiring early, and are clearly a great looking intelligent person with exceedingly good taste your reading materials.

That being the case, then none of this talk about private pensions is going to make you feel all warm and fuzzy inside. Waiting until 55, or 57, or whenever to retire “early”? Bollocks to that!

Myth busters: it is possible to withdraw money early from a UK pension

The good news is actually possible to extract money from your pension pot before the age of 55.

However for your trouble the government will tax you 55% of the amounts you withdraw, plus another 15% penalty if you don’t tell the tax man about the withdrawal.

The 55% represents the amount of PAYE and National Insurance (both employer and employee shares) taxes you avoided when you placed this money in your pension. If nothing else this number shows you just how heavily taxed earned income actually is before it lands in your bank account. Ouch!

On top of those taxes according to the regulator your pension platform is allowed to charge you up a fee of up to 30% of the amount withdrawn.

Note to self: Don’t ever withdraw money early from a pension.

So what?

Back when I was completing my Financial Planning qualification this arrangement was described as feeling like you were being screwed with your trousers on... expensive and ultimately unsatisfying.

Where does that leave you if you want to retire early?

For the answer to that question you'll need to wait for the next post in this series.

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  1. An excellent post about the issues with the pension. I would however like to point out that the increase to 57 by 2028 has not been legislated yet so that is still subject to change (One hope!). I will look forward to next post in the series.

  2. Thanks JoeCrystal.

    I've amended my wording regarding the 2028 increase, though I must admit I'm not too optimistic. The last couple of Chancellors seem to be searching down the back of the couch for spare change to plug the gaps in funding commitments, eventually they'll need to pick on a broader range of targets than those presented by buy-to-let investors and freelancers.