How much money will you need in your pension fund to have an adequate income in retirement? Dr Edmund Cannon of the University of Bristol has worked out a handy formula:

Start with 37, subtract one third of your age, subtract one seventh of your expected retirement age and then multiply by your current salary.

Planning for a pension is one of the biggest financial decisions that we have to make. Yet there is widespread misunderstanding about even what decisions are required, let alone how to make the ‘best’ decision.

In the era of final salary pension schemes, this did not matter too much because employers made most of the decisions, providing a pension as part of their employees’ total remuneration package. In some cases, the value of the pension was quite large relative to the salary or wage that employees received. But for various reasons, final salary schemes are gradually disappearing and increasingly, people have to plan for their own pension provision.

One key question is how much a pension will cost. In this context, a ‘pension’ means a guaranteed income lasting until death. You can buy this on the open market by purchasing a life annuity from an insurance company.

Consider a single man earning £30,000 just before retirement. For him, a pension of £21,000 would probably be a good target since the cost of living is generally lower in retirement (he does not need to commute to work, for example). To buy an annuity would cost about £300,000, since the annuity rate for men aged 65 is just over 7%.

An annuity rate of 7% can be compared with the rate of return on government bonds of about 4.5%. The reason that an annuity pays a higher rate than a government bond is that it pays an income only until the man dies. By buying an annuity, the man avoids the possibility of running out of money if he lives a very long time, since that risk is borne by the insurance company.

For someone about to retire, the cost of buying a pension is straightforward to calculate, since it is just the desired pension divided by the annuity rate. The Financial Services Authority sends information on annuity rates to people who are reaching this point in their lives.

But what about someone who is going to retire in the future and needs to know roughly how much money they should attempt to save in their pension fund? Making such a calculation requires assumptions about wage growth: 25-year-olds earning £20,000 now are likely to be promoted and earn much more by the time they retire.

The need to make difficult numerical calculations involving compound interest does not make things easier. Dr Cannon’s formula provides a simpler way of calculating the likely costs of buying a pension.

“Buying a pension: How to calculate the cost” by Edmund Cannon is published in the Autumn 2005 edition of “Research in Public Policy – Bulletin of the Centre for Market and Public Organisation”.