Retirement planning, or financial planning, is a critical first step in preparing for the day an individual stops working. It involves identifying long-term retirement goals and building up sufficient wealth to live in comfort.

For most newly employed individuals in their early 20s building, a pension pot isn’t usually at the top of the priority list. Yet, starting this early can yield enormous dividends in the long term. After all, compounding returns from savings and investments get significantly amplified for each additional year left to run.

What’s more, younger individuals investing for retirement have a much longer time horizon, enabling them to take on additional risk in pursuing higher returns.

On average, most people have a retirement age of 65. But how much money is actually needed to retire comfortably? What are some of the retirement accounts available to build up this capital? And is investing with an ISA smarter than sticking to the classic pension fund?

How much money should I save for retirement?

Figuring out how much money is needed for retirement isn’t always straightforward. Why? Because there are a lot of moving parts that go into this calculation, most of which are specific to individuals. After all, everyone has different investment goals, lifestyles, and timelines.

As a general rule of thumb, most financial planners suggest saving around 10% to 15% of gross annual income for a retirement plan. The aim is to establish sufficient capital to generate a passive income stream that’s roughly equal to 80% of the income earned while working.

For example, under these guidelines, an individual earning £45,000 today will want to aim for a retirement income of £36,000. A relatively low-risk investment portfolio of £900,000 yielding a 4% annual return would be enough to meet this goal without slowly diminishing its value each year.

Of course, this may not always be sufficient. Some retirement savers may need to put aside more or less than others depending on certain factors.

Time Horizon

A young worker starting retirement planning early may have as much as 40 years to get their pension pot in order. As such, they may not need to set aside as much money each month versus someone only a decade away from retirement.

But time horizon considerations also apply after retirement has begun. Not everyone is in perfect health. And those expecting to pass away earlier may not need as much as an athlete in excellent health.

Retirement Lifestyle

Calculating how much is needed in a pension pot is also driven by the intended level of spending. Those seeking a luxurious lifestyle of super yachts, seven-star spa hotels, and skiing excursions will need significantly more than those content with living modestly.

Retirement planners often recommend planning an ideal year of activities such as travelling and holidays to land at a rough estimate of likely annual expenses. That way, it’s easier to establish a retirement goal to aim for.

Risk Tolerance

Not every investor has the same level of risk tolerance. Even younger individuals with the flexibility to take on additional risk may not feel comfortable doing so.

There are plenty of asset classes and investment instruments designed to cater to different risk profiles. Yet, as with anything in finance, the lower the risk, the lower the potential return. Therefore investors sticking solely to high-grade bonds will likely need to save more for retirement to compensate for the lower level of returns.

Having said that, taking on additional risk may also backfire. The FTSE 100 has historically provided annual returns of around 8% over long time horizons. And by investing in an index fund, these returns can be replicated with minimal effort. However, the stock market can be volatile. Should a crash or correction rear its ugly head, investors could have significantly less than expected in the pension pot when the time comes to retire.

Fortunately, asset allocation and diversification strategies can help mitigate this impact.

Tax Considerations

One of the ultimate banes for investors is taxes. And when it comes to financial planning, these need to be considered. Capital gains, dividends, and interest earned on retirement savings are not tax-free. Therefore, the previously highlighted £900,000 portfolio example may need to be worth considerably more after taxes are considered.

Luckily, several tax-efficient investment and savings accounts are available to reduce or outright eliminate this unpleasant expense.

How much does the average person retire with?

The cost of living varies wildly from country to country. And the average level of retirement savings and income goes with it.

Pension-building vehicles for retirement

There are multiple retirement plans available for individuals. Here are the most popular:

• State Pension – National Insurance is an additional tax earners pay in the United Kingdom. These contributions go towards the state pension, which can provide some extra weekly income, with payouts mainly proportional to the amount contributed. However, relying solely on the state pension may not be sufficient, depending on a lifestyle retirement goal.
• Stocks and Shares ISA – This is a special type of tax-efficient investment account for British investors only. All capital gains and dividends from investments within a Stocks and Shares ISA are tax-free. However, investors are limited to depositing a maximum of £20,000 per year.
• Lifetime ISA – This special type of account enables individuals to deposit up to £4,000 a year and receive a 25% bonus from the government on any deposits. In other words, individuals can receive up to £1,000 a year by depositing money into this account. However, funds can only be withdrawn to either buy a property within the UK or as a pension after the age of 60.
• Self-Invested Personal Pension (SIPP) Account – This is a special type of tax-deferred investment account for British investors only. Capital gains and dividends received from investments are protected from tax. Furthermore, any deposits made are tax-deductible, with refunds issued into the SIPP shortly after each deposit. However, investors cannot withdraw any money until reaching the age of 55 (57 from 2028). And when funds are taken out, only 25% of the portfolio can be withdrawn tax-free. The rest is taxed as regular income.
• Employer-Sponsored Retirement Account – This is a special investment account with certain tax benefits. However, withdrawals from this account are limited until investors reach a certain age. They are designed to be a pension-saving instrument for retirement. The most common type of employer-sponsored retirement account in the United States is a 401k plan.

Should I invest with an ISA or a pension fund?

A common question among British retirement savers is whether to invest using a Stocks and Shares ISA or through a pension fund. The answer ultimately depends on the individual and what they’re trying to achieve.

Investing through a Stocks and Shares ISA means all capital gains and dividends are tax-free. There is much more freedom and control in the hands of the investor regarding where their capital gets invested. And best of all, the money can be accessed at any time, including before retirement.

By comparison, pension funds can be significantly more restrictive as to when money can be withdrawn. And the level of investment returns may not be as impressive as what a successful stock-picking portfolio can achieve. What’s more, only 25% of the total pension pot can be withdrawn tax-free. The rest is taxed as regular income.

So far, pension funds don’t sound as promising as an ISA. However, they do come with some distinct advantages. Firstly any contributions made into a pension fund benefit from tax relief of up to 40% (20% for basic taxpayers, an additional 20% for higher taxpayers). In other words, providing an investor meets the requirements, a £100 pension contribution could become £140 after tax relief.

Furthermore, workplace pension schemes mean that employers will also contribute to a pension fund, granting even more savings for individuals. As such, a retirement fund receives far greater contributions overall than an ISA despite the same amount being inputted by the individual.

So, while pension funds may not provide the greatest flexibility before retirement age, they typically serve as better investment vehicles for building a pension pot.

The bottom line

The burden of financial planning is increasingly falling on individuals rather than employers or the state. Getting started early can be enormously advantageous. And increase the odds of achieving a desired retirement lifestyle while eliminating long-term stress.

However, for individuals that need additional help with retirement planning, it may be prudent to seek pension advice from an independent qualified financial planner.

[1] Pensioners’ Incomes Series: financial year 2020 to 2021, Department for Work & Pensions

[2] Household Income in 2021, United States Census Bureau

[3] Canadian Income Survey 2020, Statistics Canada

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.