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January is when many of us review our personal finances. How painful can a little extra misery be? We are back at work after a break just long enough to make the transition irksome. We owe money to credit card companies and have a health debt repayable in exercise and dieting.
The answer is that a financial review can be excruciating. This is particularly acute if you expect to retire on an income close to your current earnings. Few of us will possess funds to cover this.
The good news is that you may be pricing happiness too dearly. You have more flexibility in how you think about your retirement than in the numbers on a spreadsheet. Behavioural finance, the subject of these columns, provides insights useful for aligning the two.
Most of us initially hope for retirement income just a little lower than full-time earnings. Hardly surprising. Our self-worth is often closely linked to earnings. It is difficult to accept that retirement income may be significantly lower.
We then depend on our own cold realism, or gentle nudging from an adviser, to moderate our expectations.
We can put this in context with some numbers. Consider two single people looking to retire at 64 on savings of £250,000 and £500,000. These figures are chosen for a reason. Last year, old fossils like me were assailed by pop-up internet ads from a savings company promising to tell us “how you can retire on £250,000 (or £500,000)”. An accompanying booklet provided no direct answers.
This annoyed a friend who had retired after a successful City career. He was indignant that anyone could suggest £250,000 was a viable sum. I heartily agreed. We were at the opera at the time, so our connection to reality was more than usually tenuous.
In reality, a £250,000 pension pot is an asset only a fortunate minority can aspire to. The median for a defined contribution saver in the 60-64 age bracket is around £36,000, according to the Pensions Policy Institute (disclosure: I am a trustee of this organisation).
I calculate that a £250,000 pot could pay for a plain vanilla annuity of about £11,500 a year after tax-free cash, which a state pension would double at age 67. The higher figure of £500,000 would be worth just under £23,000 in yearly income, with an uplift of a half from the state pension. Drawdown products could produce roughly similar yields, albeit with quite different risks.
These income levels would only give recipients living standards defined as “minimum” to “moderate” by the Pensions and Lifetime Savings Association.
Even the PLSA’s “comfortable” retirement category does not sound exactly luxurious. The threshold here is £43,100 per year, bringing with it such sybaritic delights as an annual fortnight in The Med. It equates to a fund size of about £700,000, close to median pensions wealth for the top decile of Britons as calculated by the Office for National Statistics.
A couple of factors should make it easier to tolerate pensions that are significantly lower than full-time earnings. First, as pointed out by Tim Pike, the PPI’s head of modelling, retirees can generally maintain pre-retirement living standards at much lower cost. Tax liabilities fall. Commutes are done with. Mortgages may have been paid off. For middling earners, the expected saving is around 50 per cent.
Second, there is a respectable theory that the wellbeing we derive from additional wealth diminishes the more we have of it. The idea is that money becomes less useful after we have met such essential needs as food, clothing and accommodation.
Of late, behavioural researchers have challenged this orthodoxy. Last year, Matthew Killingsworth of the Wharton School in the US published a study suggesting that life satisfaction continues rising steadily with wealth.
My main takeaway was something else: serious money does not give a massive fillip to reported happiness. The study suggested that the typical difference in life satisfaction between people on tiny incomes and folk earning $500,000 a year accounted for less than a fifth of the range of possible responses.
My conclusion is two-fold. First, money can buy you some happiness, but less than you might think. There is plenty of scope to give it a leg up by other means: yoga, fly-fishing, relationships, whatever. Second, if you want to make yourself pointlessly anxious, anchor your retirement aspirations firmly to what you earn as a full-time toiler.
Behavioural researchers at data company Morningstar therefore encourage private investors and their advisers to follow a different approach. The first step is to understand that numeric savings targets are a means to an end, not an end in themselves. The next stage is to define broad goals, such as buying a holiday home that kids and grandkids can use. The final task is to identify core emotional needs, for example: “connection to loved ones”.
Morningstar’s Samantha Lamas, a behavioural researcher, says: “An investor may realise their real objective is to spend more time with family. Buying a shared vacation property is a just a frame for that. They may then aim to buy an apartment close to relatives instead. That could be more affordable, while still meeting underlying objectives.”
Such thinking does not permit us to skimp on pension saving in the expectation that living in a shoe box will bring us Pollyanna-like joy in later years. But financial planning should be an adjunct to life, liberty and the pursuit of happiness, rather than a constraint on it.
Jonathan Guthrie is a journalist, adviser and former head of Lex. [email protected]
https://www.ft.com/content/d3772bec-3996-4074-b439-e056718d919c
