By Frank Conway
Factoring for inflation should be central to retirement planning.
With the on-again, off-again rollout of pension auto-enrollment delayed until January 2026, the focus on retirement planning is likely to remain highly topical for some time to come.
A big topic of conversation within the pension industry centres on the size of one’s personal pension pot.
When it comes to financial needs in retirement, there is one core metric that should drive behaviour. It’s the quality of life someone will require and the funds to deliver it.
What is your financial personality?
The biggest challenge when it comes to future pension needs starts today.
What is their financial personality? Are they big spenders? Are they savers. Or do they bury their head in the sand?
The other big factor is inflation.
Seeking to build the biggest pension pot should not be the objective in itself. Rather, the objective should be to build a pension pot that, when factoring for inflation can deliver a quality of life based on today’s financial needs.
And there is one other thing. Whatever the State pension entitlements will be in the future reduces the pressure to have more in that personal pension pot.
So here is how I generally approach retirement planning calculations.
First, I identify the current spending needs. In doing so, I am also exploring the financial personality type of the individual, or couple. Are they spenders, savers or a bit of both?
Next, I examine what amount of State pension they will be entitled to.
Next, the number of years to retirement is essential to those calculations.
Next, their salary, existing pension pot, wage inflation, workplace pension scheme (or not) and some other essential figures to complete their financial profile.
Next, the expectant rate of inflation. This is critical. Without factoring for inflation, the calculations cannot be fully accurate.
Why factoring for inflation is critical
The value of money in the future is extremely important when planning for retirement needs today. Having a large pension pot, and even only drawing down 4% or 5% per year will be missing the point if inflation is not factored in. Here is why.
Recently, I had a client that plans to retire in 18 years’ time when they reach the age of 66.
They earn €80,000 per year and have no private pension.
Their annual take-home pay is about €57,000. They are confident they could live on about €35,000 per year. That figure was backed up with a comprehensive personal budget plan (as a result of a recent family separation).
So, the question now is what percentage of salary is needed to deliver a pension fund in 18 years’ time that will provide for the quality of life this person can live on today.
The first part of that question is answered by the State pension. Having never worked outside of Ireland (and no plans to), they will qualify for the maximum State contributory pension, which is worth about €15,000 annually.
Subtracting this from the annual income needs, the client must come up with the equivalent of €20,000 in today’s money.
This is where the calculations become interesting and more complex and why the final pension pot, while important is not the final answer.
Using a custom pension calculator developed by MoneyWhizz, there 8 variables included in the calculations.
Because their employer does not offer a workplace pension, all the contributions will be coming from the employee’s side.
So, if they put away 17.5% of salary, by age 66, they could have a total pension pot of €504,000 (assuming for 1.5% wage growth and 5% pension investment growth along the way).
With a 4% annual drawdown, this would deliver an annual income of just over €20,000. Target met…or is it?
In this case, I have factored for 2.5% inflation so discounting for that impact on the value of the future money, the actual value of that €20,000 is €12,926 in today’s money. More needs to be done.
Because this person is in their 40’s, the maximum percentage of salary they can put into their pension presently is 25%. However, when they turn age 50 (and separately 56 and 60, they can increase their contribution to 35% and 40%).
Tweaking the figures, if they contribute an average of 27% of salary from now until age 66, they could have a final pension pot of €777,600. With a 4% drawdown every year, this would deliver an annual income of €31,104 but when discounting for inflation, the real value in today’s money is €19,943. Close enough in today’s terms when combined with the State contributory pension.
The resulting reduction in net take-home pay would be well within the living allowance tolerance of €35,000 which they are confident they could live off.
Of course, the trick is to start pension planning sooner. This way, the accumulation of funds and combined with investment growth, the pension value should continue to grow over time.
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