How much should I pay into my pension to retire early?

Here’s a question I hear every now and then: “How much should I pay into my pension?”. A pension is a great tool to have in your investing arsenal because it gives you the option to invest your pre-tax money!

By doing that you can build your wealth as soon as possible rather than take a tax hit and then invest in an ISA or company investments.

The general rule of thumb is that you should put 10% of your salary in your pension every year. But similar to how conventional 10% “saving rates” don’t apply to Foxy Monkey radical finance readers, 10% of pension contributions is just another random number worth investigating. Can be a lot higher (or a lot lower depending on your circumstances).

From a pure maths point of view, a pension is the best investment you can make. You’re simply getting free money now and deferring your income tax for later in life when you will be unemployed or in a lower tax bracket. Therefore, it makes a great sense to contribute to a pension. It’s even better if you’re a higher-income taxpayer because you’re investing 40% more money vs when investing after-tax. How awesome is that?

Also, employers usually offer an option to match your pension contributions up to a point (5-10%). If you have this option, take it without second questions!!! Not only you’re not taxed on your gross income going towards your pension but you’re getting FREE MONEY from your employer on top of that. That is my first rule. Always take matching contributions from employers. But can we do better than that?

First, the bad: Despite the pension being an amazing wealth-building tool, it comes with some significant constraints. The main drawback is the pension age which is not controlled by us but by government rules.

In the UK, the current pension age for Self-invested Personal Pensions (SIPP) is 55 years of age, 10 years behind the state pension age of 65. By 2027 this will increase to 58 years of age. As a result, we have no control over our money and not even some sort of a guarantee really, unless you’re really close to it.

The other drawback is the future unknowns in terms of income tax. When we start taking out money from our pensions, we will have to pay income tax on it. Will a future government introduce a 50% income tax? Will they reduce the maximum amount we can contribute (lifetime allowance) and penalise us? Who knows!

How much we put into our pensions forces us to think in bets while not having all the facts.

Therefore, it’s no surprise people, including myself, are confused. There is no magic number. Nobody can plan everything and what we really want is a ballpark figure not an exact amount to the penny. In investing and tax planning the perfect plan can only be done in hindsight.

If you implement a good pension game plan, then you can benefit from thousands of £££ of extra wealth in life! If there is only one article in Foxy Monkey you’ll need to read, it’s this one!!!

Out of all the options, the pension gives you the most rewards but with the least control over your money. So how much should you put into your pension?

To arrive at a good answer, you need to ask yourself 4 hard questions first.

1. When do you want to retire?
2. What are some pre-pension big plans that need a lot of money?
3. How much trust do you have in the government
4. How big is your pension pot already?

1. When do you want to retire?

From a maths point of view, what you really want is to be able to fund your pre-pension lifestyle while stashing everything else into your pension. If you plan on working til pension age, then you can “afford” to make smaller contributions over a longer horizon.

Put too much into your pension and you’re risking locking too much of your wealth and limiting your options. Put too little right now and you’re not building your wealth as fast as you could.

Some people like me, plan to stop working earlier in life.

Assuming you can start withdrawing when you’re 58 years old, then you need to build a bridge to cover your cost of living until you have access to your retirement pot. Let’s run some numbers to find how much our bridge will cost.

A real-world pension example for the early retiree

Say you want to become financially independent at 43 years old and never work again a day in your life. Then you want to make sure you have enough accessible cash/investments out of your pension to carry you until pension age.

We have to assume an annual cost of living that includes not only essential spending but discretionary too like holidays and gifts. Let’s say £40,000, which is about £3300 per month.

In pure cash, we would need 15 years x £40,000 = £600,000 (not adjusted for inflation). But we can do better than that by investing our lump sum and generate some income while withdrawing.

For example, if we put most of our money in long-term bonds and some equity into the mix, we have a good chance of entering retirement without depleting our initial amount. Alternatively, we can just take advantage of the investment returns in order to start with a smaller amount or simply become FIRE earlier. But how much can we stretch it?

Since 15 years horizon is not a very long time, let’s invest defensively by putting 70% of our money in bonds and 30% in equities. Investing $600,000 across all possible 15 years in history leaves us with a $255,544 sum on average (sorry folks, US data only here). This plan has a 98.5% chance of succeeding – not running out of money before pension kicks in. Pretty good if you ask me.

Our bridge can cost even less if we’re happy to accept a lower probability of success, are flexible with spending or can find extra income on demand. After all, there are things we can do to improve our plan’s success such as cutting on non-essential spending or help our pot with a side income. It’s up to you to decide how risky you want to play it. For me, anything above 90% is acceptable.

Play with the FIREcalc and run different scenarios. How to optimize your withdrawals for a fixed period of time is a huge topic that I’ll tackle in a different post. If you like this stuff, I highly recommend the Living Off Your Money book by McClung. It’s not written for the beginner investor, it’s boring, it’s expensive but it’s totally worth it 🙂.

If you, on the other hand, have a more steady income, let’s say from your property portfolio, then you may be in an even better position. What we’re looking for here is to avoid getting hit by a big portfolio downturn just after retirement. In other words, to minimise your sequence of returns risk. Therefore, if your income portfolio can provide a steady 5% return without losing capital, a £480,000 sum should be good to go for 15 years, adjusted for inflation.

Play with the numbers at the interest calculator to find out how much you really need.

So overall, the year you want to retire is probably the most important factor for choosing your pension contributions. The earlier you want, the harder it gets. This is because you’re not taking advantage of the tax breaks and need accessible (taxed) cash.

2. What are some pre-pension big plans that need a lot of money?

Life is not only numbers and spreadsheets. We better keep some accessible cash because who knows, we may want to start a business in 10 years time, have a health issue that requires money, help a family member and generally, planned or unplanned events – you get the idea.

College education for your kids. Downpayment for their first house. An idea to start a business that may require a lump sum (say £100k to start a restaurant at your FIRE destination!). You name it.

Whatever it is, you need to add an extra buffer to your bridge cost from above.

3. How much have you contributed already?

The good thing is that your past employers should have put some money in your pension already. How much is that? In my case, the answer is “not much” which means that I have a lot of room to cover and can, therefore, reduce my taxes as well.

I can now max out my pension contributions because I know I will need some money after age 55 and I’m getting a 40% tax break for doing so.

Your pension will be a lot larger at pension age than it is now, so account for that.

The rule of thumb I’m using is “double every 10 years”, which means roughly 7% growth per year. So if you have £250k in your pension and you’re 20 years away, you’re looking at £1m at pension age. Now £1m in 20 years time will not buy you the same stuff as it does today, thanks to the silent wealth killer called inflation. But it’ll give you a rough estimate.

We humans are not good at grasping the power of compounding! Do not underestimate it!

If you don’t know how much you’ve got in your pension already, don’t worry, you’re not alone. Usually, that’s because people switch workplaces often and have pension pots scattered here and there. Part of the reason is employees don’t really know how much employers put in their pensions because this process is pretty much on auto-pilot.

A good strategy to simplify and manage your pension is to combine all your pensions in one place. I’ve heard PensionBee is a startup that does just that, you may want to check it out.

There’s also a lifetime pension allowance set at £1,030,000 for 2018/19, which caps how much you can pay into your pension before exceeding the tax threshold. So don’t go crazy there.

4. How much trust do you have in the government?

Government trust is my major concern when contributing to a pension. Is the minimum pension age fixed or am I chasing a moving target?

Currently, the pension age is 55, but by 2027 this will be 57. You can, in fact, check your pension age on this gov link.

What’s worse is that the SIPP access is set to 10 years before the state pension age. But government liabilities, people living longer and the NHS mess mean that there is a good chance this number will go up. I would have a lot more trust if there was some sort of a guarantee.

For example, for the money I have contributed already, I should be able to access it at a certain age. But there isn’t. So we have to make trade-offs between saving tax now and not knowing when we can access them. Obviously, the younger you are the higher the uncertainty.

How to pay money into your pension

If you’re an employee (PAYE), you can either tell your employer you want to contribute straight from your gross salary or open a personal pension account (SIPP) to start contributing your after-tax money.

Some workplaces allow you to just contribute more without having to file a self-assessment return in order to get the tax breaks. But this comes with some constraints because they usually pay into the workplace pension which, funnily enough, can be riskier or more expensive than doing it yourself. If your workplace pension fund charges 1% or more, that’s just too high and it’s worth DIYing your pension.

If you’re a permanent employee (PAYE) your employer will take 80% of your pension contribution from your salary (also known as ‘net of basic rate tax relief’). Your employer will tell the government to top up your contributions by 20%. So for every £100 into your pension you only need to pay £80.

To contribute to your pension yourself, you need to open a Self-Invested Personal Pension (SIPP) which is very easy to do. This way you pay into the SIPP after paying tax first, and then the government automatically tops up your contributions by 25%. If you’re a higher rate taxpayer, you can file a self-assessment return to claim back more tax which is great.

The good thing about contributing your money into a SIPP is that you’re the one to choose what to do with it. I’ve had people telling me they bought commercial property with their SIPP money, and yes it’s allowed! The other benefit is that you don’t have to deal with paperwork and company bureaucracy that usually is the case with big organisations.

I’m with BestInvest which charges 0.30% a year. But I know the Vanguard SIPP is coming early in 2020 (0.15% fee) and plan to move there once ready.

If you’re a higher rate taxpayer, then you can claim the full 40% in total by filing a self-assessment tax return. It’s really a great deal, especially for higher rate taxpayers.

If you run a company and are self-employed, then a SIPP is probably the option you’ll go with. You can either contribute straight from your company or can invest “personally” (after-tax). The simplest option is for your company to pay money straight into your pension. You don’t need to do anything else plus the company won’t pay corporation tax on your pension contributions.

Final Thoughts

How much should you pay into your pension to retire early? I’d say you should put more than 10% of your salary if you can afford it. If your employer matches your contributions, definitely take this up to the max amount. It’s essentially free money.

Then work out how much money you will need to cover all your living costs until you can start withdrawing. I know, that’s the million-dollar question. But you don’t need an exact amount, just a rough estimate. Once you have this amount add some buffer to that and stash everything else into your pension. This will be the most tax-efficient way to grow your wealth long term.

In other words, if someone asks you How much I should pay into my pension, the ultimate answer should be this:

Put as much as possible into your pension but not more than needed so that you bridge the gap between current age and pension age. In other words, you need an amount large enough to carry you to the pension age. This amount should include a buffer for unexpected events and leisure spending too.

After all, we can’t have everything. As Mariano, a reader said:

SIPPs and Lifetime ISAs are very good on tax but constrained on time. Investment ISAs are also great on tax and are not constrained on time, but are capped to £20k a year. Corporate investing account (through an investing company), unlocks some money in the business account, it isn’t capped and doesn’t have a time constraint, but is not tax-efficient as the others.

Hope you found it useful. How much are you contributing to your pension? Do you plan to retire early?

Disclaimer: This is not financial advice, just general education only. You are liable for any losses. Always seek professional advice and do your own research!

P.S. What’s also great about pensions is that you can contribute up to 3 years in retrospect. This means you don’t lose your annual allowance (£40,000) if you missed some past contributions.