Congratulations—you have landed your first job and are just settling into the working world. One part of this is obviously pensions and savings for retirement. "Booooring," as the great Homer Simpson might say, and retirement might seem 50 years away for you, but there are some valuable lessons to be learned.
The Power of Starting Early
The most important lesson: whatever you do, start early—as early as possible. Albert Einstein apparently once said that “compound interest is the most powerful force in the universe.” Play around with a calculator https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator or on Excel, and you can see the difference a couple of years can make. Just to give you an example: for an investment of $10,000 and an interest rate of 5%, the difference between a 30- and a 40-year period is a whopping £2,718. If you invest a regular sum per month (let’s say £100, same interest rate), the difference will be a whopping £46,884.
Set Up a Rainy Day Fund
So, when and where to start? By all means, reward yourself after receiving your first salary—be it going on a nice trip, buying that gadget you always wanted, having a big night out with your friends, or inviting your loved ones for a nice meal out. After that, you should build up a rainy day fund of 2–3 monthly salaries and put this sum into a separate (sub)account from the account you use for daily expenses to avoid any temptation to use this sum for regular payments. This rainy day fund is strictly for emergencies (e.g., a broken washing machine or fridge). Should you take money out of this account, pay the same sum back before spending money on anything else.
Pension and Savings for Retirement
Ten to fifteen percent of your gross income should go into pensions and savings for retirement—this is not exclusively your active investments but will also include (mandatory) state pensions, quite often some sort of voluntary pension contributions offered by your employer, and last but not least, savings/investments of your own. The details are different from country to country—quite often there are tax incentives either for payments/contributions or when receiving your pension later on. The HR department of your company will be able to give you more information. In some countries, this information is mandatory. I will give an overview of the situation in the UK a little later (see below).
Managing Student Loans
As a fresh graduate, you might carry a student loan with you, so there is a valid question of whether you should pay off this loan first or start investing in a pension. This depends on the interest rates, the tax situation, and the payment terms—it is usually better to pay off debt before starting to save or invest. However, the situation is slightly more complex. You want to benefit from compound interest, so start investing early, even if there is still some debt outstanding. Repaying a student loan is sometimes coupled to your income or tax payments, so you might not have much choice. I would encourage you to pay back student debt as quickly as possible (the faster you reduce the principal, the less interest you will be charged), with the only exception being your pension payments/retirement savings. Should your loan have a lower interest rate than the expected rate of your investment, the answer to the question above is clear: you can invest more. If there is a favourable tax position in repaying your student loan compared to pension contributions, go for this. Have a look at the payment terms for student debt: is there the option to make lump-sum payments (if so, how often?), and when (and how) are interest payments calculated?
Understanding State Pensions
State pension: In most countries, there are mandatory payments towards a state pension, often by both employer and employee. In some countries, the payments you can expect can be quite generous; in others, e.g., the UK, they only cover a basic standard of living. The payments you can expect to receive will definitely be less than your last income. Educate yourself on the payments (what goes in) and potential payments (what you can get out of it). Demographic shifts (fewer active employees supporting more pensioners) will mean a lot of pressure on these pensions, so you should not rely solely on them. On the plus side, payments are usually guaranteed by the state and there is some protection against inflation.
Company PensionsCompany pension: In some countries (like the UK), this is mandatory; in other countries (like Germany), it is a voluntary benefit as part of a payment package. These pensions are quite interesting because there is usually a tax benefit either when paying in or taking money out. Should there be an option to top up payments voluntarily, I would strongly recommend looking into it, not least because having your regular contribution deducted from your pay cheque helps you to be disciplined about regular contributions.
Making Your Own InvestmentsOwn investments: First of all, this is about your retirement savings, so be risk-averse and look at an investment horizon of decades. If you want to invest and engage in picking companies (it is a lot of fun), you are free to do this as well, but do this from a separate budget and ring-fence your longer-term investments. While working in a demanding job, you might not have time to do much research or react quickly should the share price fall. I would thus recommend monthly payments in very broad ETFs like the MSCI World, Eurostoxx 50, FTSE 100, and so on. Fewer bragging rights at parties, but this approach gives you peace of mind. Compare the costs of ETFs and regular investments, as you might be able to save some money. For the UK (see also below), a stocks and shares ISA will be the best option. Granted, you might forego some exciting upside returns, but you will also have to worry a lot less about downside risks.
Planning Your Monthly BudgetIn your first couple of years in the working world, I would now recommend thinking in monthly budgets (this will also help with a mortgage application in a couple of years—I have worked in mortgages, so I roughly know what budgets these banks will look at):
- Max 30% of your income should go towards your rent—this is probably your biggest regular spend, so do not overspend on it; if you want to spend more on a nicer/more central place, take the money out of the fun budget.
- Ten to fifteen percent of your gross income overall should go into retirement savings/investments—this is all three parts combined.
- Five to ten percent on long-term savings, e.g., to build up capital to buy property in a couple of years; you can make very safe investments with half of that (e.g., a broad ETF), but nothing risky. If you get close to spending this money, e.g., for a mortgage down payment, hold it as cash.
- Five percent—invest in yourself (or rather, career progress): this could be books, newspaper subscriptions, training, or certifications like a CFA; your employer will quite often have a budget for this as long as it is relevant for your job.
- Rainy day fund—every now and then, top it up, e.g., if you get a salary increase or a promotion.
And last but not least, have a budget for fun of 5–10% which you spend on something that you enjoy, be it an especially nice gym, travel, fine dining—life is not only about saving.
Everything that is left in your monthly budget, split it between long-term savings and the fun budget. Should you regularly spend more than you have, adjust your spending, but never your saving. It might seem like a lot of saving as a share of your income, but as long as you are young, have very limited regular spending, and no dependants, build up funds. You might need them later in life and then thank your younger self.
Other Things to Know for the UK
As promised, some more details on the UK, especially for those planning to come from abroad. The state pension is comparatively low relative to other countries https://www.citizensadvice.org.uk/debt-and-money/pensions/types-of-pension/state-pension/—not more than £600 per week after full contributions (on the other hand, these contributions are also lower), so there are workplace pension schemes to top this up https://www.citizensadvice.org.uk/debt-and-money/pensions/types-of-pension/workplace-pensions/. You will be automatically enrolled by your employer, usually cooperating with a large fund company, and they will guide you through the process. You are free to choose funds, but keep an eye out for the risk profile and cost of individual funds. Last but not least, your own investment, which you are free to choose unless your employer has compliance rules (which they will tell you about), so you are not betting against clients or using insider knowledge, etc. Use a stocks and shares ISA https://www.moneysavingexpert.com/savings/stocks-shares-isas/, which allows you to pay in up to £20,000 per year and enjoy any gains tax-free. There are also cash ISAs for savings—the annual contributions over all ISAs should not exceed £20,000 per year. And to bust the jargon—ISA stands for Individual Savings Account.
A lot to take in, so feel free to ask any questions.