Why you need to save 20% of your salary for retirement

If you are relying on your employer to help fund your retirement, beware that generous workplace pension schemes are in decline and that the onus will be on you to pay for your old age.

In the UK there are two types of workplace pension schemes: defined benefit (DB) and defined contribution (DC).

DB used to be the norm until everybody started living longer. The schemes provide a retirement income based on a multiple of years worked and a proportion of your final salary. In the job-for-life culture of previous generations, this amounted to generous incomes.

The end of defined benefit

But the schemes became unsustainable for companies as retired employees' lifespans increased, meaning they could no longer afford to pay out.

So employers replaced these schemes with DC pensions, where the income paid out is dependent on the contributions paid in. In 2009, the average DB employer contribution was 16.5% of a worker’s salary, compared with just 6.5% of a worker’s salary for a DC scheme.

Figures from a report by the Pensions Policy Institute and insurer MetLife show that in 1950 the level of combined employer and employee contribution needed to fund retirement was 11% of salary, but by 2004 that had jumped to a staggering 25%.

It has since come down slightly owing to a change in the measure of inflation used for indexation, from the retail price index to the consumer price index, which doesn’t increase as quickly. However, in 2012 the contribution must still hit 21% of salary.

How much to save

For those in DB, the employer will pick up the majority of the bill, but those in DC scheme should also take note. DB contribution levels are a good measure of how much those in DC schemes should be saving for a comfortable retirement, and at the moment most UK workers are not saving nearly enough.

Figures show a decline in DB pensions: there are just 1.2 million workers in an active DB scheme today compared with 8 million in the 1960s. But members of DC schemes are expected to rise from the current 6.6 million members to 16 million as workers are automatically enrolled in workplace pensions from October this year.

This shows that more employees will be forced to save more for their own, potentially very long, retirement.

What’s the solution?

The most obvious solution is that we all save more to try to reach the elusive 21% of salary mark – although that may seem unsustainable in today’s tough economic climate.

But there may be another solution in the form of defined ambition (DA) schemes. Pensions minister Steve Webb coined the phrase ‘defined ambition’ to try to describe a new type of workplace pension that shares the risk of retirement between employer and employee. The problem we currently have is that DB is risky for the employer and DC is risky for the employee.