House, Degree, Life or Pension?

Nigel Williams, 10 October 2011

This is the last of a short series on the subject of pensions. In an earlier post, I considered the situation of a low-wage earner saving in order to preserve a constant income after retirement. I now present a final example to illustrate the retirement planning of someone further up the income scale.

Consider  a middle earner, who gets a job on graduation. The job has a salary of £30,000 and our example retains it for 45 years until retirement, with no fallow periods but no change in salary either. This is the starting point for the illustration. Optimists may foresee a pattern of rising salary or spells of parental leave, whereas pessimists may expect periods of unemployment or ups and downs. In planning terms, the constant, regular salary is an ideal situation, giving our example every chance of planning properly. I have left out inflation.  The illustration has more chance of being understood without it but of course any increase in prices needs budgeting adjustments throughout.

Our subject intends to borrow for a degree and buy a house in the south-east, where job prospects are reasonable and prices lower than in London. Having paid off the mortgage and the student loan, a retirement income of £10,000 seems adequate, similar to a worker on the minimum wage. Two particular circumstances may add to this. The basic state pension may still be in existence and paying its current level of a little over £5,000 each year. Then our subject’s parents may die and boost his income in retirement with the proceeds of the family home. Neither is certain.

Pensions work by paying now and receiving the benefits later. For our aspiring graduate homeowner, two major costs work the other way round. A student loan and a mortgage both defray expenses incurred early on. The student loan may come to £50,000; the house in the south east, £210,000. For this example, I have ignored the interest. Do not try this in reality, because it upsets the lenders. For illustration, the cost of house and degree are greater than the pension pot needed for fourteen years of retirement income, but the payments are spread over a slightly shorter time. Saving and borrowing at the same time seldom work to advantage, so our example middle-earner must choose either to keep a larger mortgage while putting money aside for a pension or to pay off the mortgage and do without years of growth in the pension fund. Simply adding up the totals required will not be far wrong.

Forty-five years of earning, aged 21 (no gap years here) to 66 provides lifetime earnings of £1,350,000. Basic-rate tax and NI reduce that to £1,050,000. Taking out a student loan and a house purchase leave £790,000, effectively £17,500 a year to spend on other things, including saving. Setting aside a little over £3,000 each year will provide a pension fund that provides fourteen years of income at £10,000. The residual income is £14,500. Our middle-earner has a house and a degree and will be able to maintain a standard of living in retirement, but at the cost of having only half a headline salary to spend on anything besides housing.

In “You’re On the Own” by Alasdair Palmer and Peter Morris, a major cause cited for low income in retirement is inadequate savings, where people have been discouraged from putting enough aside, whatever the other drains on their funds. This simplified illustration shows how that can come about. Even someone employed continuously from graduation to retirement can only regard less than half a salary as his or her own. Augmenting disposable income by not saving may be foolish but is very tempting.