Simply take the expected nominal long-term return. Historically, it has been somewhere in the 8%-10% range. Thus, I often use 8% in my calculations. You may want to err on the side of caution and use a lower number, let’s say 6%.
Then, back out the fees which are hopefully no more than 0.2% in a low-cost index tracker plus whatever your platform charges you. This simple act of subtraction gets you to your expected long-term nominal return.
Finally, you’ve got to take a view on inflation. I like to think in nominal terms. That is, I know that ending up with £1m in 20 years simply isn’t the same as getting £1m today. Prices will certainly rise, some faster than others.
That being said, I also know that my circumstances and spending habits are also going to be vastly different in 20 years.
I don’t like to waste time anticipating my life in retirement a decade or two before it actually happens. Instead, I set the bar at an approximate level and look to re-calibrate closer to hitting the eject button.
Me, looking for the magic button in 2030!
Others prefer to think in real terms (i.e. in today’s dollars / pounds / euros).
If you are in this camp, you also need to make an assumption on what inflation will look like going forward. Long-term inflation runs about 3%, but it has certainly been lower than that in the recent past.
Once again, us FIRE folks tend to be a conservative bunch. Thus, if you assume 3% inflation eating away at your 8% nominal return, you get to a 5% real return. Slightly less, once you factor in those pesky fees.
It’s all fine and dandy – as long as you are investing in regular, tax-sheltered vehicles – i.e. an ISA or a LISA.
Where it gets a bit more complicated is when you’ve got the wonderful option of contributing to a workplace pension. All of a sudden, you’ve got multiple additional factors to consider:
- Your current income tax bracket
- Your expected income tax bracket at withdrawal
- The quantum of your employer match
- Whether your contributions are made through a salary sacrifice scheme
- The investment return you get in your pension plan (some really crappy plans out there but thankfully you can always hack it with a SIPP)
- Government’s rules around tax-free lump sum withdrawals
There are others, but the above items are critical.
All of a sudden, there’s a multitude of factors impacting your returns. In other words, you no longer have any idea how much money your money is making.
Apples And Oranges
This question of returns is far from an esoteric one. In the finance world, the rate of return (sometimes known as the IRR) is by far the #1 decision that impacts capital allocation strategy at the enterprise level.
The logic applies to personal finance as well. To accelerate your wealth-building journey, you should allocate your savings to the investment vehicle that has the best risk-adjusted rate of return.
Tough to do that, if you don’t know what the actual rate of return is.
For example, you find a real estate deal that yields 11% – but will likely come with a baggage of admin and hassle. Should you pull the trigger?
Your brother-in-law offers to go into some kind of a business venture together. You reckon you can make 15% on your money. Leaving aside the practicalities of doing business with family, is it worth the effort?
There’s an investment that you are quite confident will yield 10% over a long period of time. The challenge is that you will have to hold it in an ISA. Should you proceed?
If your alternative investment opportunity is putting money to work in your workplace pension, you cannot answer any of the questions until you figure out the actual return on your money.
The Real Deal
Assume you are a basic rate (i.e. 20%) taxpayer, contributing into a workplace pension plan with a minimum employer match*, and generating a long-term nominal return of 8%.
Let’s also assume your withdrawals will be taxed at the same 20% rate in retirement – and that the government won’t kill the 25% tax-free lump sum option. Finally, let’s say your contributions are not done via salary sacrifice.
Running the numbers shows that the actual return you can expect is actually 12.3%.
The tax break and employer match combine to juice your returns by an extra 50%. Not too shabby!
If you happen to be a higher rate (i.e. 40%) taxpayer, and keeping everything else constant, the returns go up to 13.8%.
Finally, if you were to make your contributions via salary sacrifice, the returns would have gone up further still to 14.2% (but check the disclaimer at the bottom of the post).
Given the number of variables involved, the quantum of permutations is endless. Thus, I would encourage everyone to play around with the spreadsheet and plug in their own assumptions.
For those who just don’t feel like it, the tables below may just come in handy. All assume an 8% nominal return and no salary sacrifice.
Implied Returns (Assuming A 75% Employer Match)
Scroll horizontally to find your current tax bracket. Then scroll down to find your anticipated tax bracket at withdrawal time.
The number you get is the effective return on your workplace pension, assuming your employer matches 75% of your contributions.
Thus, if you expect to be in the 20% tax bracket in retirement (as most people will) you could well realize a return somewhere between 12.3% and 14.3% on the money you contribute into your workplace pension.
Implied Returns (Assuming A 20% Tax Rate At Withdrawal)
Some employers are more generous than others. The table below shows you how much extra oomph you can get from a more generous employer match.
In a world starved for yield, fortunes are made by people who manage to generate an extra few basis points of return on the money they manage. And yet, you can get to the same place by simply working for a company that goes beyond the bare minimum when it comes to the employer match.
In other words, it pays to do the pension plan diligence when looking to switch jobs.
One For The Pessimists Purists
Even though the 8% return assumption is rooted in history, you may want to assume a lower number. If so, this table is for you.
The key assumptions here are a 75% employer match and a 20% tax bracket at withdrawal.
Even with a conservative assumption of a 6% nominal return, the actual return you can realize goes well into double digits.
A few things to point out before you ask.
First, employers typically cap their match at a specific level. Just because you are contributing 20% of your salary doesn’t mean your employer will do the same.
Second, keep in mind your annual contribution allowance, the pensions taper, and the Lifetime Allowance. When it comes to pensions, the sky is NOT the limit. That being said, you can still go pretty high before you hit those caps.
Third, you may end up moving between tax brackets while you are making the contributions.
Also, you may well end up with a zero tax rate in retirement if your taxable income (including pension withdrawals) falls below the personal allowance. If you expect that to be the case, simply put “0” in cell C6.
Fourth, given your National Insurance contributions are based on your salary, the “salary sacrifice” option in the spreadsheet may be slightly imprecise. If you are in a salary sacrifice scheme, it might be best to leave it off and be surprised on the upside.
All of the above clearly add to the complexity. If one of these circumstances applies to you, you can still count on the tables above to get you very close to the right answer.
To zero in on a precise number, you’ll have to make some minor tweaks to the spreadsheet that reflect your own set of circumstances, which you are of course welcome to do.
Happy modelling – and investing!
*Minimum employer match defined as 3% of your salary (whereby you contribute 4% and the tax break adds up to another 1% for basic rate taxpayers)