Undercover Economist

How to plan for your pension

‘The standard tool is the online pension calculator, of which countless variants exist. There’s only one problem: they leave out almost everything that matters’

Everyone seems to be talking about whether pensioners are vulnerable and poor or living gilded lifestyles. I decided to take a rather self-centred look at that question; I am an economist, after all. I’m 40. Retirement is more than half my working life away. Leaving aside the fate of today’s pensioners, what about my fate? How much cash will I enjoy in my golden years?

The standard tool for such crystal-gazing is the online pension calculator, of which countless variants exist. Type in the basics (age, income, retirement date, current pension contributions, current pension pot) and the calculator spits out the projected size of the eventual pension pot, along with the monthly income it is forecast to generate. More complex varieties allow for all sorts of tweaks – inflation, investment returns, and smoothly rising income and contributions over the years.

There’s only one problem: these calculators leave out almost everything that matters. It is useful, I suppose, to know what one’s income in retirement would be given a particular salary progression, rate of return on a portfolio, inflation rate, annual charges and the annuity rate available on retirement – although simply to list the variables gives a sense of just how uncertain that “knowledge” really is.

It is worth adding that, over the past 14 years the FTSE 100 index hasn’t risen, even in nominal terms; over the 14 years prior to that, the index roughly quintupled. Stick that in your pension calculator and smoke it. In some ways that’s an extreme case – after all, sensible investors rely on reinvesting dividends and will diversify.

Yet, in other ways, the FTSE’s fate over the past 14 years understates the uncertainty produced by long-term compounding. The relevant time horizon isn’t 14 years but more like 30 – over such a span, a modest 4 per cent rate of return would turn £100,000 into £310,000. A tastier 8 per cent return would compound into £930,000. And an optimistic-but-not-unheard-of 12 per cent return would deliver nearly £2.7m.

Those numbers will surprise some: we underestimate the value of a high rate of compound interest so predictably that behavioural economists even have a name for the condition: exponential growth bias. A reasonable forecast range for a £100,000 investment then, 30 years later, seems to be anything from several million pounds to less than you had when you started.

The uncertainties don’t end there – when we look away from the spreadsheet, at the real world, we realise they are barely beginning. Three big risks simply don’t figure in the tidy world of the calculator: one, that I lose my job and can’t find anything comparable; two, that my wife and I divorce, an expensive business; three, that anything from depression to a slipped disc to cancer renders me too ill to work. Ill health, unemployment and divorce are common and bad for your net worth. (They are also bad for measures of “subjective wellbeing”; more colloquially, they make you sad.)

Then there are the wilder possibilities – I might be defrauded by con artists; I could be sued for libel; my home, which is near a flood plain, may be rendered uninhabitable and unsellable by the weather.

I’m not planning on being sideswiped by any of these misfortunes but, then, who is? A common cause of a penurious old age is not a savings problem as such, but an insurance problem: people who are on track to save enough for a comfortable retirement but are then derailed by “events, dear boy, events”.

My plan for a gilded retirement still involves saving for a pension but I have reinforced it with a number of other tactics: buying disability insurance, keeping fit, being nice to my wife – and hoping that the fates are kind.

Also published at ft.com.