Four retirement planning rules of thumb that mislead you

If you ask ten people how they plan to have enough money to stop or slow down from work, you’ll probably get several blank stares and a few tentative ‘Rules of Thumb’—which don’t actually work!

This Insight is about exposing those Rules of Thumb for the ROT they are. And pointing you to a sound approach to retirement planning that you can start mapping out on one sheet of paper at home.

This is a 5 to 10 minute read – depending on your speed.

What’s coming up?

Here, we’ll outline four quite common but misleading rules of thumb (ROT) you might find if you look for guidance on retirement income planning.

We’ll show you exactly how each ROT fails, using worked examples and point you to our Rough Guide to Retirement, which shows you how to build a plan that works — and is personal to YOU.

For the first 3 of these examples, we’ll use ‘Sam’ as our case study.

Sam is 35, has no retirement savings yet, earns £39,000 a year (the median level of full-time earnings in the UK) and wants to target a gross retirement income of £20,000 a year from private pensions (or £33,000 a year, including the New State Pension), from age 68.

Sam has done her homework and knows that in today’s terms, £33,000 a year should provide a ‘moderate’ standard of living in retirement – assuming her mortgage is repaid by that time.

Sam would love to stop or slow down from work before age 68, but knows her State Pension of around £13,000 p.a. (2027-28 figures) will not start until age 68.

So, Sam is happy to make an initial plan on this basis and fund any earlier retirement ambitions later if she can afford it.

Let’s get into these misleading Rules of Thumb now.

ROT #1: Use very cautious assumptions

This ‘Rule of Thumb’ error is less common now – but it used to appear constantly in the money pages of newspapers, including the better-quality ones.

What’s the problem?

A journalist, looking for a table on “the cost of funding retirement,” would ask a financial planner for the numbers.

And in many cases (perhaps to deter criticisms that they were making over-optimistic assumptions) the planner would be excessively cautious – on both the assumed growth rate of the pension pot and the ‘pot to income’ conversion rate.

Sadly, the resulting tables published in some papers frighten many people off from saving anything at all!

This table shows the problem.

To be clear, the assumptions for both rows could be reasonable depending on prevailing interest rates and the pension planner’s age and attitude to investment risk.

However, in Sam’s case, the double caution on two assumptions has resulted in a cost estimate in the top row that is nearly three times that in the second!

Stacking caution on caution makes even modest retirement goals look unaffordable. And that defeats the purpose of this exercise, which was to encourage Sam to save something rather than give up on her plan.

ROT #2: The 300 times target income rule

On the face of it, the assumptions of this Rule of Thumb are broadly OK.

The idea is to:

1. Multiply your target monthly retirement income by 12 for an annual figure.
2. Multiply that number by 25 to find the pot you need to generate that income — assuming a 4% pot-to-income conversion rate.

4% is 1/25.

And 12 x 25 = 300.

We could argue for a factor of 240 (which assumes a 5% income withdrawal rate) in some cases, but 300 is also acceptable.

So, the problem with this ‘Rule’ is not the Maths.

The problem is that those who promote it often overlook the State Pension in their calculations, which introduces a major error in your plan, as this table shows.

Ignoring the State Pension has added more than £300,000 to Sam’s target pension pot – which has added over £260 a month (nearly £3,200 a year) to what Sam is told she needs to save.

And that is the cost of two reasonable holidays a year.

(Double those unnecessary pension contribution amounts if you’re planning as a couple!)

To be fair, the rule of 300 (or 240) can give you a feel for the scale of your fund target.

You just need to take care to deduct your forecast monthly State Pension from your monthly target income before you multiply it by any big number!

ROT #3: The fixed-percentage savings rule

The next two misleading rules of thumb come from the world of (somewhat gold-plated) Defined Benefit (DB) Pensions.

DB pensions, as their name suggests, define your benefits!

So, you don’t need to worry about investment growth rates or pot-to-income conversion rates.

DB pensions promise you a future income based on your pay and years in the scheme. The employer deals with the underlying investments.

And these schemes can be horribly expensive for employers. So, they’ve been almost entirely phased out (for new joiners and future benefit accrual) in the private sector, but they remain the norm in the public sector – in both central and local government departments.

Estimates of the ‘average’ cost (across all employees) to provide these DB pension benefits range from 20% to 30% of PayRoll, depending on the precise design of the benefits.

So, that’s where the 20% number comes from – but that’s an average cost for an entire pension scheme. So, it includes people who are close to retirement, for whom the cost to provide each additional year of DB pension may be 50% or more of their earnings in that year!

In other words, the average cost of such schemes is not relevant to you.

Indeed, for Sam, the estimated total required contribution to reach her target pension might be closer to 10% of earnings – if we use the optimistic assumptions from the first table above.

And, on similar assumptions, that rate might be closer to 7% of earnings for those who start contributing in their 20s, which most people now do through auto-enrolment into their workplace pension.

Most employers then pay a minimum of 3% (of your qualifying earnings) towards that. So, the estimated cost for an employee to build a reasonable pension fund (based on sensible assumptions) can be much lower than many think.

Yes, a total (employee plus employer) pension contribution rate of 20% might be the right amount for a handful of people of a certain age, depending on what they’ve already built up and how their pension pot is invested.

But for most people in their 20s and 30s, juggling other financial demands, a 20% savings target is a heavy and unnecessary burden.

And it’s one that can put people off saving altogether.

The clue to the secret of personal financial planning is in the name.

It’s personal.

The right amount to save or invest towards any financial life goal depends on how much you want to have at the end, what you’ve already built up, and, in the case of pensions, what your employer contributes.

There is no useful rule of thumb about how much you should pay in.

ROT #4: The two-thirds-of-income rule

The idea that you need ‘two-thirds of your earnings’ as retirement income is the final misleading Rule of Thumb in our list.

And again, it dates back to the days when Defined Benefit (DB) pensions were more common.

A typical DB scheme would offer a pension of 1/60th of your (final or career average) earnings for each year you were an active member of the scheme.

So, if you stayed with the same employer for 40 years (which was more common than you might think), you’d receive 40/60 (two-thirds) of your earnings as a pension at retirement.

And two thirds might sound like a sensible target – esp. if roughly a third of your income today goes on a mortgage that you expect to have cleared by then.

Indeed, for those on lower incomes, a modest private pension when added to the New State Pension of c. £13,000 a year (2027/28) could deliver a total pension income of two-thirds (or more) of final earnings.

But the two-thirds target is a trap for higher earners.

Take Sam’s friend Phil, who is also 35 years old, has two young children and is a high-flying professional earning £180,000 a year.

Phil wants to stop work at age 60 – at the latest – and the two-thirds rule would set him a target pension income of £120,000 a year.

This is around £107,000 p.a. from private pensions – with the State Pension on top.

Now, try this question.

What (total) contribution to pensions do you think would be required to deliver a private pension of £107,000 a year by age 60?

The answer, of course, will depend on how much Phil has built up in his pension and other investment pots so far, and on the assumptions about the growth on that pot and the rate at which he converts it to pension income later on.

Let’s say Phil already has £100,000 in his pension pots, and let’s use ‘reasonable’ assumptions of 4.5% for both the income withdrawal rate and the real (above-inflation) growth rate on Phil’s accumulating pension pot.

Then, if we run the numbers, we find that Phil needs around £45,000 a year going into his pension pot now – and that figure would need to rise with inflation and continue to be paid in for the next 25 years.

So, even if Phil’s employer paid in one third of that amount, Phil would still need to pay in c. £30,000 a year. And while he might enjoy significant income tax relief on those contributions, this is still an enormous commitment to long-term pension savings to hit an arbitrary target.

And that’s where the error sits.

The two-thirds-of-earnings rule assumes you’ll need something close to your current income level to be happy in retirement.

Yet your current earnings are a poor guide to that number.

Most of us make huge errors in forecasting what we’ll need to be happy in the future – as psychology professor Daniel Gilbert lays out in his book Stumbling on Happiness.

And if this happiness forecasting challenge interests you, we’ve explored it in more detail in this other Insight on ‘How many ways are you unique?’

How could you start your retirement income plan?

Well, you don’t need a fifth rule of thumb!

Hopefully, you can now see that retirement planning rules of thumb fail because they ignore your personal circumstances and goals.

• What’s your personal retirement income target?
• How much have you built up already – and what are you on target to build up in Private and State Pensions?
• What’s the most your employer will pay in?
• What rate of tax relief could you obtain on your personal contributions?
• How many years do you have to build the fund you want?
• What’s your attitude to (and Capacity for) Investment Risk?
• What non-pension investments (inc. employer-sponsored share schemes) could also help you achieve your goals?

These are all unique factors for you.

And that’s why I’m developing the Rough Guide to Retirement: a four-part series to show you how to draw one vital picture of the income you want, the age at which you hope work will change, when your State and private pensions may begin, and any gaps you need to deal with.

And you’ll learn to draw this on one sheet of paper.

This guide will get you started – with an exercise that uses your numbers, not a silly rule of thumb.

So, if you’d like to start mapping out your own unique retirement income plan, you’ll want to read that guide.

Sign up for my newsletter, and I’ll let you know when it’s ready.