My name’s Linda. I would like to have a comfortable retirement but I am not sure how much money I need to have saved up in order to achieve this goal. I am not particularly extravagant but I do want to be able to afford at least two holidays a year. I additionally don’t have access to a fixed workplace pension so I need to live within the means of my own investments and the state pension. How should I go about working this out?
Thanks for this question Linda.
There are a few ways to think about this.
Firstly, when do you want to retire? The reason that this matters is that your state pension will only kick in at the state retirement age so if you retire earlier than this you will need to make up the difference from your own investments.
You also need to consider your living situation during retirement. If you are likely to be married or in a relationship then you would have two state pensions coming into the household but not double the costs – for instance, utility bills don’t double with double the number of occupants in a home.
You would also need to factor in that, even if you are in a relationship, one person will probably outlive the other and at that point one source of pension income may be lost.
TWO WAYS TO GET AN INCOME IN RETIREMENT FROM A SAVED LUMP SUM
There are two ways that your savings and investments can be used to secure your income in retirement:
The first way is to buy what is called an annuity. The second way is to just draw down your income slowly over time.
An annuity is a financial product that provides a guaranteed income for life. Essentially, you take a lump sum of money, give it to a financial provider and they tell you how much they can pay you for life depending on the features you want. For example they can give you a fixed amount every month for life, or they can increase that amount every year by inflation, if you want an annuity that grows with inflation the starting amount will be smaller than if you go for the fixed amount. You can also buy an annuity that covers one person’s life or two people’s lives, that is, once the first person dies the annuity continues to pay out until the second person named on the annuity also dies.
Annuities used to be popular in the past but because interest rates have fallen drastically since the 2008 financial crisis they have not been so attractive.
How much would you need if you were planning on retiring today, were getting a state pension and were planning on buying an annuity?
According to this is money who in turn source a report by Royal London, you would need £260,000.
“Royal London’s sums were based on the amount needed to bridge the gap between an £8,500 state pension and two-thirds of the £26,700 average salary.”
Two-thirds of £26,700 is £17,800. This means Royal London are assuming that you would live on £17,800 every year: £8,500 of this would be coming from the state pension and £9,300 would be coming from the purchase of the annuity. These figures suggest the annuity is giving a return of just 3.6%.
In my opinion, that’s a very poor return and not even worth getting the annuity.
This is money also confirm in their article that if you plan to retire in 30 years’ time rather than today, this £260,000 becomes £400,000 and this further assumes that annuity rates improve by then.
If interest rates are just as low in 30 years’ time as they are now and if we assume average inflation of 3% per year (which is what it has been historically), then instead of £260,000 you would need £630,000.
Personally, I do not recommend the annuity route AT ALL. If you are happy to take a little risk then you would be FAR better off just drawing on the invested money.
The most popularized rule for drawing down on your invested pot is the 4% rule. The 4% rule essentially says that if you drawdown 4% of an invested pot every year, you are unlikely to run out of money over a 30 year period. While the study that came up with the 4% rule used 30 years as the period during which a person would be retired, the general conclusion is that even at the end of that 30 years the money invested will have grown because the average drawdown rate of 4% is lower than the average growth rate of your investments.
So, for example, if your investments grew by 7% in the last year then taking 4% means you are still ahead.
The beauty of drawing down rather than buying an annuity is that whatever is left when you die can be passed on to children, charities or whatever you choose. With an annuity, the payments die with you. For example, if you bought the annuity of £9,300/year today and died next month, tata £260,000 – that’s it. The full benefit of your early demise goes to the financial institution that sold you the annuity in the first place. Rubbish, right, well that’s what you get for playing it too safe!
If we take the £260,000 lump sum we have been using and continue with it for example purposes, then a 4% drawdown would produce £10,400/year in the first year which is better than the £9,300 you were getting from the annuity that ‘this is money’ talked about. Not only that, in the following year it could be that you will base the drawdown on a bigger number than £260,000 because the investments will have grown in value. The average growth rate of the stock market over the last few decades has been 10% before accounting for inflation. Of course, this says nothing about the future as stock market returns in the future could be better than or worse than this.
Rather than working backward from what income a given lump sum will give you? Let’s figure out how much you will probably need to spend in retirement, that is, let’s work out your desired retirement income.
Once we have your desired income we will subtract income from your state pension and any other pensions.
We will then divide the gap by 4% and this will give you the value of investment assets that you need.
I’ll share two sources that I have found for trying to work out how much money you will need each year in retirement.
SOURCE 1 – on how much money you need for retirement
“According to research carried out by Loughborough University and the Pensions and Lifetime Savings Association (PLSA), workers who only manage to save enough for a retirement income that provides them with £10,200 a year (£15,700 for couples) will achieve a minimum living standard, those who managed to save enough for £20,200 a year (£29,100 for couples) will be able to live a moderate lifestyle during retirement and those who are able to save enough for £33,000 a year (£47,500 for couples) will be able to enjoy a comfortable retirement.” (source: moneyfacts.co.uk)
This £33,000 a year (£47,500 for couples) includes holidays abroad, a generous clothing allowance and a car.
These are the lifestyles that the Loughborough University and PLSA study creates:
I don’t know about you but I would like to target the comfortable lifestyle or better!
Using the 4% rule, if you are targeting a comfortable lifestyle then:
Before you give up before you’ve even started because these numbers sound too hard to achieve, keep listening, I’ll give you an example at the end of how much you need to save now and it will sound much more achievable.
If you are targeting a moderate or minimum living standard, you can calculate the equivalent numbers by following this formula:
As a reminder, the full state pension is currently £8,767.20 per year but I used £8,500 in my examples for simplicity.
If you plan to retire based on the minimum standard of living at say 60, then when you start getting the state pension as well if you are a single person, you would be boosted to close the moderate living standard; and if you are in a couple, you would be boosted just beyond the moderate living standard by receiving two state pensions – assuming both people are entitled to the full state pension or close.
SOURCE 2 – on how much money you need for retirement
Using a report from the Joseph Rowntree Foundation, a respected charity, Fidelity.co.uk allows you to start of with a basic standard of living which costs £16,300 and allows you to add annual costs to this depending on the lifestyle you want.
This £16,300 accommodates basic rental accommodation, basic costs for food, alcohol, clothing, water, gas, electricity, council tax, household insurances and other housing costs, public transport costs and an occasional visit to the cinema.
The basic £16,300 cost of living assumes a single person not a couple. Within this figure you don’t run a car, you don’t eat out much at all, you don’t smoke and you don’t have internet access or paid-for film channels (I guess you would watch only free channels and have to go to the local library for the internet).
Note that this £16,300 is higher than the £10,200 suggested by the Loughborough University study for a basic standard of living but lower than the £20,200 suggested for a moderate standard of living so we can call it basic Plus.
I would guess the Loughborough study assumes you have paid your home off in their basic living assumption which could explain the difference.
So, how do we boost the £16,300 basic income to improve our life style?
If you added on every single one of these extras, you’ll be at a very comfortable £37,500/year which is not too far off the £33,000 suggested by the Loughborough University study for a comfortable retirement.
This would be equivalent to £54,000 for couple if we increase in direct proportion to the Loughborough study (37,500 * (47.5/33)).
What level of investment assets do you need to achieve this?
You need c.£940k if you are a single person or £1.35m if you are a couple before the benefit of a state pension. This £1.35m is very aligned with the £1.2m we got using the Loughborough University study. State pension income reduces your need to save and invest by about £200,000.
If you keep a budget it might be easy to calculate what your monthly spending in retirement will be; just remove all the things you spend on now that you won’t need to spend on in retirement, like travel to work or rent or a mortgage payment if you plan to own your home outright at the point of retiring.
There are a lot of numbers here but it’s more or less pretty straight forward once you have worked through it systematically. How much do you need to save now to live your ideal lifestyle and to hit your goal by retirement? You’ll need to take the next step and figure that out. If you want me to help you do this, request a call.
As an example, if you are a 22-year old couple now and plan to retire at 67, you only need to be saving £285/month in total into pensions (that’s only £140/each). This has to be into pensions and not into an ISA as I am assuming you get the tax benefit of saving into a pension. My calculation assumes you get an average market return over those 45 years of 7%. If returns average 10% as they have in the last 45 years, you would completely overshoot and end up with a retirement pot of £3.7m – how’s that for compound interest?!
If you are enjoying listening to my podcast, please give me a 5* rating wherever you listen to podcasts. If I don’t yet deserve your 5*, please let me know how I can earn it.
I hope this helps!
Have a money question for me?
My name’s Sam. Can you talk about financial independence and the steps one has to move through to get there?
Thanks for this question, Sam.
In the past, I used to think about financial independence in a one-dimensional way: you were financially independent if your income from passive investments exceeded what you need to maintain the lifestyle you want indefinitely.
It wasn’t until I heard JD Roth the founder of Get Rich Slowly on Paula Pant’s Afford Anything podcast that I started thinking about financial independence as something that can be broken down into stages. I like his idea so rather than re-invent the wheel, I’ll share his wisdom with you and you can decide where you are on this continuum:
Stage 0 – Dependence
In the dependence stage, your lifestyle depends on other people for financial support. Absolutely everyone starts here, we are born fully dependent on our parents and people break out of parental dependence at different stage. I dare say you can break out of being dependent from parents and fall back into dependence in your 40s and 50s because of a life incident or poor planning.
However, if even if you don’t live at home with family you would still be in the dependence stage if your spending exceeds your income.
Following the dependence stage, stage 0, there are six stages to full financial independence in JD Roth’s model. The first three stages of the journey are the “surviving” stages.
Stage 1 – Solvency
You’re solvent if you can meet your financial commitments, that is, you have enough earnings to pay your bills. You will have reached this stage when you no longer rely on anyone else or on credit for financial support.
You are a solvent person if your income exceeds expenses, and you are no longer accumulating debt. I reached this stage when I was 18 thanks to an academic scholarship. My scholarship paid for all fees and gave me a lump sum to cover accommodation, food and a plane ticket home every year. In December 2002 when my dad sent me a gift of money with my mother who was visiting me at school, I told her that from here on out I don’t need money from you and dad; I will survive within the means of my scholarship – I asked that they saved the money for my sisters’ education and I haven’t looked back since.
My dad took that thanks and ran!
While some people will reach this stage in their teens, as I did, most people reach this stage when they start the first job that allows them to leave home. Some never reach it and are dependent on others for survival from cradle to grave.
Stage 2 – Stability
You have achieved financial stability once you've repaid all your consumer debt and have some money set aside for emergencies, and continue to earn enough to save – you can think of your savings as your profits.
You may still possess some “good debt” — student loans, a mortgage — but you've eliminated other obligations and built a buffer of savings to protect you from unfortunate events. Dave Ramsey suggests a buffer of £1,000 and I would agree with that as being adequate to cover most emergencies. I would recommend buying insurance cover for things that could cost more than this, e.g. buildings and contents insurance to cover damage to your home and your personal possessions.
As I have never been in debt, again thanks to my scholarship, I could say I reached this stage at 18 as well. As a Malawian student living in Britain I had no credit history so no bank would give me access to a credit card or even an overdraft facility and no store would allow me store credit.
You know how you get to stores and they ask you if you want to get 10% off by signing up to a store card? Well, I said yes and I got rejected with the net result that I always said no after that because I felt so ashamed when she walked back to the counter to tell me I didn’t qualify in front of other customers.
Thank God for small mercies. I was an unsuspecting teenager in a foreign country and I don’t know what debt I could have landed myself in had that request for store credit gone through.
Stage 3 – Agency
The final “surviving” stage in JD Roth’s model is free agency. He describes this as the ability to work and live how and where you want. In the free agency stage, you've cleared all debt (including student loans and your home mortgage) and you have enough banked that you could quit your job at a moment's notice without hesitation. Apparently, some call this “screw-you money”.
I was about to disagree with the free agency stage until I saw JD’s note that: “he knows first-hand there are times when you might prefer to carry a mortgage even if you don't have to. So, for the purposes of this stage, if you have enough saved and invested to pay off your mortgage, it's the same thing as not having one.
Technically, I would say I initially reached this stage when I was about 30 because I had enough equity in a home I bought when I was 23 to pay off our home mortgage free and clear and I had enough passive income from a small business I set up at when I was 26 (but spent only 10 minutes a month on) to meet the other financial needs that I had at the time. I say technically because in practice, I would never have done that as even then, I knew I would probably want kids and I would need more money to give them the life I wanted them to have, essentially, even if you are in the agency stage but you know your future financial needs will be greater, you’re probably not fully there yet.
In JD’s six-stage model to financial independence, you move from surviving to thriving in stages 4 to 6. As you work your way through these stages, money is no longer a safety net, but a tool to help you build the life you imagined for yourself and for your family.
Each of the next series of stages assumes no debt or enough cash on hand to instantly repay all debts.
Stage 4 – Security
You have achieved financial security when your investment income can cover your basic needs. Investment income is money that you don’t need to actively work for; it arrives like clock work without any further input from you.
So, in the security stage, based on how much you have saved and invested, you could live a meagre existence for the rest of your life. Even if you never worked another day in your life, you have enough to afford simple housing, basic food, essential clothing, and insurance.
I would say we are currently working towards stage 4.
If we both quit our jobs and took our children out of a fee-paying school, rental income would cover our cost of living and we have some decent savings to cover tenancy gaps BUT our whole life would come tumbling down if interest rates rose because of the buy-to-let mortgages and our mortgage so we are not here yet.
In the security stage you should be able to cover all basics regardless what interests and other economic indicators are doing.
Stage 5 – Independence
Financial independence is the ultimate goal for most people. At this stage, your investment income is enough to fund your current standard of living for the rest of your life. You cannot only afford the basics, but you can afford some comforts such as holidays abroad too. You have “Enough” with a capital E.
Stage 6 – Abundance
In JD Roth’s sixth and final stage of financial freedom, you have “enough — and then some”. At the abundance stage your passive income from all sources not only funds your lifestyle indefinitely, but it grants you the freedom to do whatever you want. Besides sharing your wealth with others – which you should be doing whatever your stage of wealth but can really ramp up once you’re in the abundance stage – you can indulge in luxuries, explore the world.
When you see me wearing a Patek Philippe, we have arrived here. Both children will be in university at this stage (think early 50s) and I will spend a full year of school fees on one watch! Okay, so in a world with starving children, even writing that doesn’t feel quite right – I’ll downgrade that aspiration to a Rolex which I could buy now but that will be my gift to myself for getting to Abundance!
Jokes aside, the more money you can save either by clearing mortgages on your home or rental properties or by investing in stocks and shares and shares, the more your financial independence increases. As you become more financially independent your happiness levels are likely to increase because you can make decisions based on life fulfilment rather than what makes financial sense.
Being financially independent doesn’t mean you will quit working, it just means that you can if you wanted to!
Now, I can’t talk about financial independence without talking about the FIRE movement. FIRE stands for Financial Independence, Retire Early. The movement is a lifestyle movement whose goal is financial independence and retiring early. Most people agree on the financial independence bit of the equation but RE means different things to different people.
To some, retire early actually means quitting work and living a hobby life of travel and blogging, to others it’s simply a reference to reaching the ‘Abundance’ stage of financial freedom.
I am totally into the FIRE movement because I love how they’ve changed the meaning of what it means to live rich, many in the community live humble lifestyles in the secure knowledge that they are building real wealth. FIRE is not about conspicuous consumption it’s about real wealth and achieving meaning in your day to day life.
Let’s wrap up with some key takeaways on what you can do to move towards financial independence?
The philosophy is simple and as you put ‘spend less’ principles into practice, it gets easier and easier not to spend over time.
I hope this helps!
Have a money question for me?
Heather on Wealth
I enjoy helping people think through their personal finances and blog about that here. Join my personal finance community at The Money Spot™.