The choice that faces people each year could be simplified as aiming for an extra 1 per cent of investment return versus saving an extra 1 per cent of salary into a pension pot. The best answer, however, likely depends on your client's age.
Starting early
When people are young, for the first few (possibly many) years of their career, the salary they receive is likely to be much larger than their pension pot, so saving hard can have a much larger impact on their pension pot later down the line.
If we take the example of someone at 20 starting out saving, with a salary of £20,000 – if they saved 5 per cent of this into their pension pot, that’s £1,000 into their pot.
If this grew at, say, 5 per cent per year that would mean £1,050 at the end of their first year of saving.
If this person instead increased their savings rate by 1 per cent, so saved 6 per cent of their salary, that would mean £1,260 at the end of the first year, with the same 5 per cent growth rate.
If this person increased their investment risk, resulting in an additional 1 per cent annualised growth each year (to 6 per cent) that would mean £1,060 at the end of the first year, with the same 5 per cent savings rate.
In other words, saving more, rather than dialling up their risk profile slightly, had the bigger impact.
In their 30s
But crucially, as people get older things change (ignoring inflation for now).
After around 13 years, our individual, now 33 years old, on a salary of £20,000 saving 5 per cent per annum and with a portfolio generating around a 5 per cent investment return per year will have a larger pension pot than their £20,000 salary.
This is the threshold at which 1 per cent of their pension pot is worth more than 1 per cent of their salary – investment returns are expected to add to their savings more for each percentage move in their plan assumptions.
Approaching their 50s
Fast forward to when the individual is 50 years old and the impact of compounded investment returns at 5 per cent per year and diligent saving has meant that the pension pot is now worth over £70,000 – around 3.5 times their £20,000 salary.
If this individual wants to grow their pension pot by saving more, they are facing an uphill struggle, as much larger sums of money would be needed to save – 1 per cent extra of their pension pot at 50 years old is much harder to find than that 1 per cent of an annual salary was. This is where dialling up risk can have a more meaningful impact.
The numbers here are based on annualised returns, leaving volatility aside, but we are considering relatively small adjustments in returns (1 per cent at a time) and find similar results in simulation models that incorporate volatility explicitly.
