Imagine an average person. We can call him Mr Grey, if you like. Mr Grey is born in an average part of the country, to average parents, lives in an average sort of house, goes to an average school, then gets an average job, with an average wife and children, earns an average wage. Mr Grey eventually retires at an average sort of age and then dies at the average life expectancy.

While Mr Grey’s life (and my clumsy telling of it) could be a convincing entry for the most boring story of the decade, Mr Grey helps illustrate a point: our economy is in real trouble.

Mr Grey can be separated into bits, like Shakespeare’s seven ages of man. An average man, he’ll live for about 80 years. Well maybe not that long, but it’ll do for the purposes of this exercise. To start with, he’s looked after by his parents, say for the first 20 years. That’s a full quarter of his life when he’s basically not earning a bean. He will retire at 65, leaving another significant slug of his life when he won’t be earning, but will be drawing down on his savings.

That leaves him 45 years to save enough to live on for the final 15 years – a 3:1 ratio. But he won’t need to save 1/3 of his take-home pay every year, because there are certain forces that will work in his favour:

• He won't need to save in retirement So, part of the income he earns during his working life is there solely to save. If we count this in his ‘post-retirement’ needs, it’s double-counting
• The magic of compound interest. It really is magic. The money he saves can earn interest and dividends, which will contribute towards his retirement pot
• Old people don’t necessarily need as much. They maybe don’t consume certain types of service (e.g. nightclubs, expensive mobile phones) or may find that some of the services they do consume are subsidised (e.g. some council-run gym memberships, TV licences).
• Housing. Mostly, by the time people come to retire, they’ve already bought their house outright, at least if they’re average, like Mr Grey. This removes another big slug of monthly outgoings from the budget – making mortgage repayments.
• State pension. Additionally, the state will pay a state pension to Mr Grey based on the number of years he has been working and paying national insurance contributions.
• Employer’s pension. Many employers contribute to their employees’ pension arrangements. This is an added benefit, on top of their annual salary.

However there are other forces that will work against him.

• Inflation. This will eat into the value of money, meaning that each pound he earns in his working life will be worth less when he comes to retire. This means he needs to save more to compensate against it.
• Political interference. Governments of all political parties can’t resist meddling with pensions. So Mr Grey might have started saving on one basis, only to find the rules have been changed. An example is the state pension – this used to be payable from 65, but is due to change in steps to 68, even though those affected have already paid for the right to receive their pension from 65. Even worse, the rights afforded by the State Second Pension (formerly SERPS) have been eroded so badly that it’s now questionable whether it was ever worth paying for them at all (although the refund from opting out was unnecessarily pitiful). Private companies would not be allowed to unilaterally change their minds in this way, but government does it often and with alacrity.
• Children. As any parent will tell you, children are expensive. Mr Grey had his parents to look after him when he was a child; now he has to look after his own children.
• Earnings profile. By and large, people earn more the longer they work. This makes sense – when you first start working you have very few skills. You gain skills and experience the longer you work, which makes you more valuable to an employer, who then pays you more. Unfortunately this means Mr Grey has less money available to save when he is young, the time when money would have the longest opportunity to earn compound interest.
• Self-discipline. People struggle with self-discipline. If they have money today they want to spend it today, even though that expenditure might commit their future, older self to penury. To a certain extent this makes sense – you want to go on exotic foreign holidays while you’re still fit enough to fly. But people tend to overspend today, at the expense of their obligations to save for their future self. Additionally, they tend to consistently underestimate the magnitude of saving that is necessary to retire comfortably.
• House prices. Depending on when Mr Grey was born, he might have been very lucky with house prices or he may not. Regardless, it’s generally accepted that mortgage repayments cost approximately a third of net income, more if a first-time buyer overextends themselves. This can reduce substantially the amount of money available to save.
• Unemployment. Unemployment is a double-whammy. Not only can Mr Grey not save while he’s not working, but he also needs to draw down on his non-pension savings, if any, to pay the bills. This reduces the funds available to him for retirement.
• Economic cycles. Even if he does everything right, Mr Grey may still come unstuck by the timing of economic cycles. His assets may get devalued by a stockmarket crash as he approaches retirement, reducing the amount of money he has to retire on. This can be mitigated to a certain extent through proper diversification, but it cannot be completely eliminated. In effect, this means an average saver needs to save additional sums to protect themselves against the possibility that it’s them (and not someone else) who is on the receiving end of a stockmarket crash.

Taken altogether, what does this mean for Mr Grey? If he saves 10% of his gross salary every year for 45 years, and makes an average return, he can expect to receive just over 20% of his gross retirement salary in retirement. This would be supplemented by his state pension entitlement.

By now, many people will have given up. Perhaps because this article is too boring for them, or because they can’t or don’t want to believe the numbers. How can 10% annually lead to such a paltry sum in retirement? And with such a long list of possible downsides, it’s easy to get disheartened and give up entirely.

Unfortunately, the cost of retirement has to be borne by somebody. Labour has sought to supplement state pension provision by introducing the means-tested pensions credit. That has the downside that it penalises those who saved and rewards those who did not. And it’s paid for through taxation on the working, which reduces their ability to save for themselves.

Given that, in practice, Mr Grey is unlikely to save 10% of his salary right from the get-go, and may find himself out of work before his 65th birthday, it’s probable that he will have only a small sum saved at retirement. This is a problem for us all. If our system doesn’t allow the average man to retire averagely well, the state – meaning the rest of us who are working – have to step in. Ultimately that suggests the system isn’t sustainable in the long term. And that means a grim retirement beckons for many millions of average people.

People who read this post also read:

• Selfish young people
• Reasons not to vote Labour #12 – letting the household savings rate plummet
• Abnormal growth
• A very strange idea indeed
• Pension accounting, Osborne style

Filed under: Economics with tags compound interest, house prices, inflation, pensions