How much should you save?

A common question, especially for ‘normal’ people in their rare moments where they ever think about saving, pensions, or their financial planning, is ‘how much should I save’? It is a key question. Unfortunately, a lot of the typical answers you’ll hear/read are misguided or even wrong. Instead, I think anybody asking this question must be told three things.

For example, I was riled recently by something that the (normally sensible) Wealth Dad posted on Twitter:

I don't know who needs to hear this…

Investing only 5-10% of your income isn't going to provide you the retirement you keep telling yourself it will

— The Wealth Dad (@thewealthdad) June 14, 2020

I don’t mean to pick on the Wealth Dad because he is far from alone. A quick Google search of ‘how much should I save rules of thumb’ yields the following:

It’s not surprising that investment firms like Fidelity advocate fairly chunky savings rates. But it isn’t just them.

Elisabeth Warren, notable bloggers, financial gurus, everybody seems to agree: saving 10% of income is on the low end. All the ‘smarts’ are exhorting us to save more. That’s the message.

I think these rules of thumb are missing three key points, three ‘Must Knows’ that anybody thinking their financial future Must Know.

I am not talking about how us FIRE types should think about saving. I am talking about how ‘ordinary folk’ should consider the question of ‘how much should I save’. And for ordinary folk the main savings vehicle is a pension, so that is the focus of this post.

Must Know #1: The earlier you start, the better

Picture the scene. A financial naif is having his/her first proper sit-down conversation with a financial planner / adviser / similar. Bracing himself/herself to hear some inconvenient truths, rein in their retirement aspirations, tighten their spending belts.

How old is the financial naif, in your mental image? I’ll wager he/she is in their mid/late 30s, or 40s.

If your first proper ‘sit down’ is after the age of 40, then I take back almost everything I’ve just said. I exhort you to save more – you will almost certainly need to, if you haven’t been thinking about this stuff properly before. If, God forbid, you first get serious about your financial planning in your 50s, then time is your enemy. You simply haven’t got enough time left before retirement age for your money to work hard enough for you, and you will have to work hard enough to save sufficient money.

But if you start saving in your 20s, then time is your friend. Compounding is time’s language of love. Money you put aside now can be working for you for decades, ensuring you won’t have to work hard in your 60s/70s to have sufficient money.

Consider these six scenarios. Let’s start saving (e.g. via a pension contribution) at three ages – 25, 35 and 45. And let’s consider what happens, starting at each of these ages, experiencing two different rates of average return: 3% and 7% per annum (after taxes/fees).

This graph has that old exponential optical illusion. All the thick knobbly curves are the same! The salmon and red ones are the same as the green one, just shifted right, and cropped earlier. And all the thin lines are the same too, similarly.

What you can see from this graph is that your 45 year old self has no chance, if starting now, of beating your 25 year old self. The 35 year old self does have a chance but only if they end up with high returns and the early starter doesn’t. But if you start 20 years late, you have a problem and you need to own it: you will need to save considerably more, and expect less in your dotage, than if you had started earlier in your career.

Must Know #2: Early on, you must embrace risk

The other implication from the graph above that stares you in the face is the difference between investments growing at 7% annually, rather than 3% annually. Obviously the graph is simplistic – it assumes constant returns annually, for instance.

Obviously, we’d all prefer to be on the 7% annual growth than the 3% annual growth. But far too many people end up closer to 3% than 7%. The reason for this is that, I believe, the way we talk about risk in this country is flawed, and it starts at the top – even with the regulator itself.

The FCA, the regulator in this case, imposes strict requirements on anybody providing financial advice to ensure that investments are “suitable” and “appropriate”. And as part of this process they expect retail investors to be screened for their appetite for risk, among other things.

The first problem with this approach is that it treats a consumer’s appetite for risk as a personal preference. A fixed personal preference. I think this is misguided. Preference is context sensitive, and can be altered by persuasion, trickery, etc.

Another problem with the FCA’s approach is that appetite for risk is a very hard thing to measure. What somebody tells you is not what they will actually do. Everything depends on the context, how the question is asked, and what answer options you give somebody.

I see this in myself. I say “I am investing for the long term”; I know I can afford a significant drop in portfolio value; I tell myself “I will not mind if stock markets plummet – this represents buying opportunities”; my self-image is of a rational, thoughtful, strategic investor, not an emotional impulsive panicker. How I actually feel when I see markets drop >10% is a different thing entirely – holy cow I have just lost over £100k in the last hour! I am more disciplined than most, have planned my actions, constrained my trading flexibility, made public commitments, and in fact do behave more like my self image than most – but I know how wide the gulf is between how I want to behave when trouble strikes and how I am tempted to behave on the day.

As a result of these, and other, problems, I think that basing long term investment plans on agreement with statements like ‘I don’t like to lose money’ is downright idiotic.

However in reality, when we are talking about pension savings in particular, the policy framework has got one important thing right – it makes it almost impossible to access your pension until you are ‘old’. This forces a long term perspective. And removes from reach many of the dangerous buttons/levers that could cause short term damage and loss.

So, when it comes to pensions in particular, asking investors anything about appetite for risk is not just a waste of time, but actually dangerous, for any investor under the age of about 40. Their pension is an investment over such a long time period that their opinion on risk preferences/appetite is practically irrelevant.

What matters more than risk appetite is actually the likelihood of maintaining contributions. This is a function of many things – employment prospects, childcare arrangements, the economy, local school arrangements, etc – which are themselves very hard to answer reliably. It would be more sensible to try to unpick somebody’s chance of stopping/reducing future contributions rather than to try distinguish between two youngsters base on how they answer questions like ‘I don’t like losing money’ or ‘I am prepared to risk a loss in order to achieve a higher gain’ differently.

In any case, if you are a ‘youngster’ (under 35 years old, I mean!) then I have one very clear steer for you: dial your pension / long term investment arrangements up to ‘maximum risk’.

By ‘maximum risk’, I don’t mean cryptocurrencies, 10x leveraged spread bets, penny stocks, or anything crazy. I just mean: go for more equities/stocks, and less cash. If your robo advised pension has a 10 point scale, choose 10. If your financial planner asks about your appetite to risk – remember to ask whether he is talking about your long term investments like your pension, or your short term buffer against surprises. And if you are given choices like ‘conservative vs adventurous’, ‘growth vs income’, ‘higher risk vs lower risk’, seriously consider the riskier variant.

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Once you are within 15-20 years of needing to use an investment, even as a possibility, then ‘maximum risk’ may not be the best posture – especially if your pot is already sizeable. Beyond that point you may want to consider rules of thumb like ‘allocate your age, as a percentage of your portfolio, into bonds’ – to protect against short term falls clobbering your pot too close to your retirement to have time to recover.

If anything, the FCA’s framework here actually adds risk, by reinforcing an inbuilt risk-aversion in many people. When you are in your twenties, you should not risk anything less than maximum exposure to equities for your pension-like investments. Any plausible stockmarket fall will have time to recover before you are in your 70s – especially if you continue to make contributions during the down periods. Cash is portrayed as risk free, but in fact carries the enormous risk of not generating adequate resources for your retirement.

Must Know #3: Minimise taxes and fees

Anybody first pondering their savings/investment strategy will quickly ask themselves, when looking at my graph above, “how realistic is it to get 7% returns”?

And the short answer is that if you save money in an instant access savings account, outside a tax wrapper, then you would be very lucky to be netting even 1% returns.

Many people fuss about avoiding taxes, but don’t pay much attention to fees. Yet mathematically taxes and fees are identical. If you pay 1% of assets, plus VAT, as fees to an adviser / similar, and your investments grow by 5% a year, then those fees alone are a 24% ‘tax’ on your growth. That’s more than the government would tax most people on dividends or capital gains.

The good news is that pensions, from the point of view of building your first £1m, are tax free. Which makes 7% returns feasible, albeit far from guaranteed.

The other good news is that most pension providers fees are well under 1%.

The bad news is that pensions are exempt from the transparency requirements of MIFID so it is not easy to see your full fees paid but reputable providers will usually have options that are closer to 0.5% than 1%. This is worth checking.

If you have moved your pension into a SIPP that some nice St James Place fellow has helped you with, perhaps picking a bunch of ‘beat the market’ funds, some income funds, a gold tracker, a share in a wind farm, and some units of that fascinating Israeli Cyber Defence Fund, then you will find the fee load damages your returns far more than any taxes would have been.

On the other hand, if you have your money in a tax-free pot (i.e. a pension or an ISA), you have index trackers, and your fees are under 1% a year, then you have a good chance of returns of 7% per year. A very good chance, if history is any guide.

Here’s the table reproduced in Monevator. It shows real returns – i.e. after inflation. You can see that over long term timeframes, UK equities have delivered almost 5% after inflation. That is over 7% per year, before inflation. US returns are even better.

My own portfolio has delivered annualised returns of around 10% over a 7 1/2 year period. This arguably doesn’t include a full stock market cycle (depending on how you interpret the crash / rebound of earlier this year), so it is probably going to drop a bit over time. But it would have to see a pretty torrid drop to fall below 7% per year. My returns are not exceptional – anybody who has had a basket of world equities (such as Vanguard’s VWRL) would have experienced very similar returns.

So, how much do I need to save?

Let’s look at that graph again.

Starting age 25. Putting £4k a year into a pension, and getting an average of 7% a year. For 45 years, until the age 70. This ignores inflation (but also the chance of salary increases, bonuses, or for that matter periods out of work). But it lands on £1.23m at age 70, enough (under the 4% rule) for £50k of income a year.

So, what does contributing £4k a year require? What do you need to be earning (as a 25 year old – hold that thought), to be a) paying £4k a year into a pension, and b) happy with £50k income a year? Well, I’d certainly suggest it is doable if you are earning £50k. At £50k (gross) earnings, £4k a year is 8%. That’s the minimum contribution under auto-enrolment. So it turns out that a 25 year old, doing the minimum contributions, would be able to retire on a 100% pension, if they averaged 7% a year.

Before you say ‘not many 25 year olds earn £50k’, please note that this argument is independent of salary. All it relies on is 45 years of contributions, at 7% growth a year. This delivers, after 45 years, a pot big enough to generate income of over 12x your annual contribution. And it says that at the minimum contribution (of 8%), 45 years at 7%, delivers a pot that can fund 100% of your earnings aged 70.

The key point here is that if he/she can plausibly expect 7% returns after fees, a 25 year old doing the default (minimum) pension in the UK, should be fine. The nub of the issue is getting 7% returns – which needs a ‘maximum risk’ approach to the asset allocation as mentioned above.

Most ‘ordinary’ folk are not expecting 100% of salary in retirement. They would usually be pretty happy with 66%, or 70%. That says you don’t need to start at age 25, or you don’t need 7%, or (most likely) your earnings will rise significantly after the age of 25. But this lot certainly suggests that the rules of thumb to save 10, 15, 20% of earnings are far too simplistic.

In fact if the pension averages a lower return of only 5% a year, the default pension grows to only 55% the size it would at 7% returns. But that’s still enough to provide about 55% of that salary you’ve been earning. That’s not far off the 66%/70% most people aim for. Dialling the savings rate up to 10%, the absolute bare minimum according to those gurus/bloggers/etc, gets the 25 year old’s pension, after 45 years at 5% returns, to a level that it should safely provide 67% salary in retirement.

Of course, if you’re older than 25, things look tougher. If you start from scratch at 35 (from scratch? That’s a very pessimistic starting point in the auto enrolment world), even with 7% returns you’ll only have a pot capable of providing about 46% of salary at the age of 70. You’ll need to contribute 12% of earnings henceforth, to get even 70% salary. And if your returns are 5%, not 7%, well you’ll need to be putting 17.5% away. This sounds much closer to those rules of thumb we kicked off with.

So maybe I’ve been a bit harsh on those rules of thumb. Maybe I should have said ‘hey, if you’re 35 (and not significantly older), and really don’t like equity investing, then these rules of thumb are great’.

But I think a far more useful perspective is ‘before you worry about how much to save, make sure you have a tax-free pension and that your contributions are invested in the right thing – which for anybody under the age of 45 means largely/entirely equities’. Specifically that means ‘head for adventurous / aggressive / growth / whatever your provider calls it’. If you get that right, and start early enough, then you can stick to the standard auto enrolment contribution levels and you’re done – without any additional investing/savings. That message isn’t one you’ll find when you google ‘how much should I save’.

What about us FIRE types?

Of course most readers of this Financial Independence Retire Early blog are not ‘ordinary folk’ – broadly hoping to have 66-70% of their (final) salary when they retire, without crimping their lifestyle on the way up.

I did a (very unscientific) survey of my blogosphere recently, and 74% of my respondents save 25%+ of their earnings. At, say, a 30% savings rate, they’ll have enough saved to provide 100% of their income within 27 years. This is definitely not normal (hence the ‘Early’ in the FIRE moniker!). Even the 12 respondents who are under aged 25 are uber savers; these 12 people included 8 people saving 25%+ of their earnings! 40% of my respondents have earnings of over £100k, which puts them in the top 1m or so earners in the country.

I took some heat from my survey respondents for the question about savings rate not going high enough (capping out at 25%+). These respondents are a long way from the rest of the country, for whom a 10% contribution level seems arduous, and for whom the state pension is an important topup to whatever the pension pot has delivered.

For regular readers of my blog / twitter profile , we’ve had this lot sussed a long time ago. But you don’t need to be a high saving FIRE type to be well provided for, in the auto enrolment world, provided you dial into equities, avoid cash/low return asset classes, and keep your fees low. It’s a pretty simple message, but it’s not one taught in schools, or indeed on any the blog posts I found when researching this piece. Let this be the first!