How much money do I require to retire? This question will elicit various emotions from different people,
Negative emotions like uncertainty, fear, guilt, anxiety, or positive emotions such as joy, certainty, and relaxation.
Research shows that over 70% of people in the UK have no idea how much they will need in retirement
There are many reasons why we should know the answer to this question; personally, with this number, I have a goal that will make 9 to 5 optional.
This number is part of the few personal finance metrics you need to know. This blog post will empower you to answer this question
The further away from retirement you are the more uncertain this question will be
Going forward, the amount required to retire or be financially independent will be referred to as your Financial Independence (FI) number.
Calculating your FI number requires a combination of personal and societal factors. Let’s walk through the steps for you to calculate your FI number.
The most important question to answer is how much will you spend in a year in retirement?
Depending on how close or far you are to retirement, there are a few thoughts accompanied with this question, such as “what type of retirement do I want?”
For example, do you want to live a modest, average, or lavish retirement life?
To get a close enough answer to how much you will spend in a year in retirement, you need to answer a few questions.
In other words, what are your current expenses because you can’t determine how much you’ll spend in retirement unless you know what they are today.
If you use a budget and track your expenses, congratulations; everything you need to answer this question is in your budget.
If not audit your expenses for the past 3 months and create a budget
How to Make a Budget in 6 Easy Steps
Then multiply your monthly expense by 12 to get your annual expense or how much it costs to live your current lifestyle in a year.
For example, Josephine spends £3,000 monthly that equates to £36,000 in a year,
This is difficult, but the goal is not to obtain exact figures, but rather an estimate based on your current lifestyle on the expense you will most likely incur when you retire
You can also skip this and just use your current expense going forward
Depending on your circumstances, here are some examples of expenses that you might stop or start paying in retirement.
This is just good practice that I recommend, you want to know
The UK pension age currently begins at 67 but you can retire before this age.
To calculate your pension income regardless of your current age, approach this as if you were retiring today.
What I mean is that if you want to retire at 50 and you are currently 30, you must imagine that you are 50 and calculate what your pension income will be for a year based on current information if you continue working until 50.
Get the figures in today’s money
Your pension income will vary depending on a variety of factors. The first is what kind of pension do you have? There are various types of pensions.
The state pension: When you reach State Pension age, you will receive a regular income from the government.
The amount you receive is determined by your National Insurance record. You can get an estimate of your state income here
Defined Benefit plan pays a retirement income based on your salary and the length of time you’ve been a member of the plan.
They are only available in the public sector or in older workplace pension schemes.
Defined Contribution: The most common type of workplace pension, it uses a defined contribution scheme to build up a pot of money.
You’ll use this to give yourself an income when you retire
For example, when Josephine retires, it is estimated that she will be eligible for the state pension, which currently pays £9,308 per year.
She also contributes to a pot from her gross income, and it is estimated that when she retires, her pot will provide her with an annual income of $6,500. (You can get an estimate from your pension provider)
Total pension income £15,800, also assuming she doesnt have other sources of income like rental etc
Josephine will have a £20,200 gap using these scenarios if her annual expense is 36,000.
£36,000 – £15,800 = £20,200
Your SWR is the percentage of your investments that you pay yourself in retirement by withdrawing.
The higher the percentage, the smaller the nest egg you’ll need, but you risk running out of money.
Josephine, for example, will require £1,200,000 if her withdrawal rate is 3%
36,000 / 3% = 36,000 / 0.03 = 1,200,000.
With a 5% withdrawal rate, she will need a pot of £720,000.
The goal is to select an SWR that almost guarantees Josephine will not run out of money.
The 4% rule states that if you accumulate enough wealth that your annual expenses are 4% or less of your total portfolio, you can retire.
This means that in order for Josephine to live on £36,000 per year, she needs a portfolio worth £900,000 from which she can withdraw 4% annually and live happily ever after.
This rule of thumb was popularised by three professors from Trinity College in Texas in the February 1998 issue of AAII, who based their work on William Bengen’s SAFEMAX study (1994).
For this study, some assumptions were made.
Some conclusions from the study
If you go down the rabbit hole of the Trinity study and the 4 percent rule, you will find a range of opinions and points of view, from the optimistic (who believe that a 5% SWR is sufficient) to the pessimistic (3.5% or less)
I believe
For example, if the previous year’s stock market return is greater than your SWR, you withdraw the SWR; if it is lower or equal, you reduce your spending.
You now know your annual expenses, annual income from state and pension and your safe withdrawal rate
Your FI number will be (annual expense – annual income) / Safe withdrawal rate
What does this mean for Josephine (£36,000 – £15,800) / 4% = £20,200 / 4% = £20,200 / 0.04 = £505,000
If you already have savings and investments, you must subtract them from the FI number to determine your gap.
How big should your emergency fund be when you retire? I believe that having a year’s worth of emergency funds in cash is a good idea so if the market crashes, you will have the option of not drawing from your investments for at least a year.
Recalculate your FI number. Your FI number is bound to change over time, especially after major life changes, such as having a baby. Recalculate this number yearly.
What if i already have enough to retire: You can do whatever you want, you have options
What if at my current pace i won’t have enough for retirement? You can
There are numerous options available so please do something
Where do I invest my saving? I believe a good index fund like the S&P 500 or the total stock market index is the best. I use vanguard to invest in index funds.
This FI number serves as a starting point for retirement planning.
The steps are
