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How much should I put in my pension?

A warning sign image indicates it’s time to think about how much I can put in my pension pot

The answer to the question “How much should I put in my pension?” is surprisingly simple.

You need enough in your pot to sustainably generate a comfortable retirement income that will last you the rest of your life.

This post enables you to estimate how much pension pot you need to deliver that income.

Once you hit your target number, you can fire your job, and start a brand new life doing whatever you please.

Your pension pot target number depends on knowing how much income you can live on in retirement.

That might sound like an impossible ask. But you can arrive at an estimate using the method explained in our How much do I need retire? post.

With that retirement income target in hand, you need only complete one more step to calculate how much you should put in your pension.

The ‘How much should I put in my pension?’ calculation

Here’s a quick example that’ll show you how much you need in your pension pot.

Imagine that you want a retirement income of £15,000 on top of your State Pension.

The size of pension pot you need to retire is:

£15,000 divided by 0.03 = £500,000

Where:

  • Your required annual income = £15,000 (not including other income sources such as the State Pension.)
  • Your sustainable withdrawal rate = 3% (or 0.03)

In this example, you can retire once your pension pot hits £500,000.

That target amount should generate £15,000 in inflation-adjusted income for your entire retirement – assuming your pension is invested in global equities and government bonds. More on this below.

  • Substitute the £15,000 above with the retirement income you need from your pot.
  • Divide your income figure by 0.03 to discover how big your pension pot should be.
  • Add your State Pension and any other reliable income sources to tally your total retirement income.

Run this calculation twice if you’re part of a couple.

Account for tax using the tips in last week’s post.

Is that all I need to know?

The calculation really is that simple.

What’s more complicated is explaining why this approach is the best way to estimate how much pension pot you need.

You also need to adjust your numbers for inflation and the tax-free status of your Stocks and Shares ISAs, but that’s mercifully straightforward.

Keeping up with inflation

The example above produces £15,000 income from a pension pot of £500,000 at today’s prices.

If you’re retiring years from now – rather than today – then your numbers must be updated for inflation. Otherwise, you’ll lose purchasing power as prices rise.

All you need do is adjust your number once a year by the UK’s CPIH annual rate of inflation.

For example: let’s say inflation is 2.5% one year from now.

Just multiply your pension pot target figure by 2.5%:

£500,000 x 1.025 = £512,500

You need £512,500 in your pension pot to generate enough retirement income after 2.5% inflation.

Let’s double-check that pot will produce enough inflation-adjusted income:

£512,500 x 0.03 = £15,375

Your 3% withdrawal rate now delivers £15,375 in retirement income.

If you multiply our original £15,000 income figure by the inflation rate of 2.5% you get £15,375.

Hallelujah! The calculation checks out.

Do this once a year and your target number and retirement income will keep pace with CPIH inflation.

Stocks and Shares ISAs

Many people retire with a mix of pensions plus Stocks and Shares ISAs.

Calculate the target figure for your ISAs in exactly the same way as for pension pots.

If you want £5,000 of annual retirement income from your ISAs then divide that figure by the 3% sustainable withdrawal rate to work out your ISA target number:

£5,000 / 0.03 = £166,667

To gauge how much retirement income your ISAs will generate…

Multiply your ISA’s value by the sustainable withdrawal rate:

£166,667 x 0.03 = £5,000

This calculation applies to invested Lifetime ISAs and Stocks and Shares ISAs, but not to cash ISAs.

While we’re here, usually pensions beat ISAs for retirement saving, but not absolutely always.

Our pensions vs ISAs piece illustrates why tax relief and employer contributions mean most people will be better off favouring pensions.

However a clear-cut case for using ISAs in retirement is to shelter your pension’s 25% tax-free lump sum.

By getting your tax-free lump sum reinvested within ISAs as quickly as you can – subject to the ISA annual allowance – you can generate a tax-free income for the rest of your days.

The 25% tax-free lump sum – Incidentally, our 3% withdrawal rate assumes you will reinvest any 25% tax-free lump sum you take from your pension. If you take that money and reinvest it (whether in ISAs or in taxable investment accounts) then it still counts towards your overall retirement income. Money isn’t withdrawn unless you intend to spend it. Apply the 3% sustainable withdrawal rate to all your investments to understand how much annual retirement income they can deliver.

The sustainable withdrawal rate

We’ve used a 3% withdrawal rate to calculate the income your retirement pot can sustain.

This is the percentage you can withdraw from your pension (and other investments) in the first year of retirement.

That amount is your baseline retirement income figure.

You then increase your income figure for annual inflation every year thereafter to pay yourself a consistent retirement salary.

(That means the 3% element is only used in year one.)

But why a 3% withdrawal rate?

Leading retirement researchers have concluded this is the amount you can withdraw while minimising the risk of running out of money during a retirement lasting 40 years or more.

You’ll often hear that higher withdrawal rates than 3% are achievable. Usually that’s because people gloss over the problems of unpredictable future investment returns on retirements.

Happily, the State Pension – and any defined benefit pensions you’re lucky enough to have – don’t suffer from unpredictability to the same degree.

They should both deliver a reliable stream of inflation-proof income throughout your retirement, so long as UK PLC doesn’t go bust.

But few of us can live comfortably on the State Pension. Fewer still are lucky enough to enjoy defined benefit pensions these days.

The problem with pension pots

Most people in the UK now have defined contribution pensions. These do not offer a guaranteed income.

Instead you own a pot of investments in assets such as equities and bonds.

You generate an income from the pot by selling off these assets and spending the proceeds, along with the dividends and interest they pay.

However the income level you can safely spend depends on the investment returns of your assets. Those returns are inherently unpredictable.

If you withdraw too much too soon from your pot, your money could run out before you die.

Yet if future investment returns are strong, you’ll be positioned to withdraw a higher income than the 3% sustainable withdrawal rate suggests.

The retirement dilemma is you could spend too little (bad) or too much (really bad).

Running out of money is worse than not knowing what to do with it all.

Therefore, it’s best to use a lower withdrawal rate which drastically reduces that possibility, without setting you an impossible retirement savings target.

The 3% rate is derived from the worst investment return sequences world markets have suffered in the past 120-odd years.

It further depends on you holding a pretty aggressive asset allocation of 70% global equities and 30% UK government bonds.

If you’ve previously come across ‘the 4% rule’ then it’s worth you understanding why a 4% withdrawal rate may be too optimistic.

To find out more about the sustainable withdrawal rate check out:

Beware simplistic assumptions

Watch out for media sources or pension income calculators that base your retirement on assumptions like: “Your investments will grow by 5% a year.”

Such simplifications are too risky because they assume your pension pot will grow every year.

But everyone knows that investments can go down, as well as up.

The big mistake the standard calculations make is to use a simple average growth number that ignores losses.

Let’s detour through a quick illustration of the problem.

Constant growth scenario

This scenario assumes positive returns every year:

  • Year 1 return: 25%
  • Year 2 return: 25%

Simple average return: 25+25 = 50 / 2 years = 25%

A £10,000 investment would grow to £15,625 at 25% per year. Very healthy.

Volatile return scenario

This scenario includes losses, just like real investment returns:

  • Year 1 return: 100% growth
  • Year 2 return: -50% growth

Simple average return: 100-50 = 50 / 2 years = 25%

£10,000 grows to £20,000, but falls back again to £10,000 in year 2. We made no gain.

Both scenarios showed a 25% simple average return, but one is much worse than the other.

Unfortunately for us, our world looks more like scenario two.

What makes things even worse for retirees is that you’re drawing down your portfolio by spending it over time.

And in fancy terms, as a spender you’re subject to sequence of returns risk.

In simple English – the stock market could slump early in your retirement, meaning you need to withdraw a bigger chunk of an already-dwindling pot. You’d then have less money invested to benefit from any market rebound.

There’s no escaping the fact that sometimes investments inflict large losses. 

Major downturns can permanently damage your retirement prospects, even if declines in the market prove temporary.

Don’t keep it simple

This all makes it dangerous to use simple average investment growth numbers when judging how much pension you need.

The next example reinforces this warning.

Assume you start retirement with a heady £1,000,000 in your pension pot.

You withdraw 5% or £50,000 in income every year:

This table shows why constant growth assumptions are too simplistic.

A constant annual return of 5% means that your pension pot’s growth exactly covers your spending every year. Your wealth never drops below £1,000,000.

This portfolio’s simple average return is 5% over four years.

But as we’ve noted, in the real world investments are volatile. We take losses as well as gains.

The next table shows how losses can knock a big hole in a pension pot early in retirement.

We start with the same £1,000,000 pension pot. But a 50% loss in the first year cuts our pot to £500,000.

Then we withdraw our £50,000 retirement income. Our pot is down to £450,000 by the end of the year:

This table shows the impact of volatile investment returns on how much you should put in your pension pot

Our bad luck continues with another 50% loss in year two.

Thankfully the losses are temporary. The market bounces back strongly in the next two years.

Overall, we’ve experienced the same simple average return of 5%.

But our pot looks very different compared to the sunny constant growth scenario.

It’s shrunk to £318,000 instead of sitting pretty at £1,000,000.

The volatility of returns has left us in a far more precarious situation.

Recovering from losses

A major issue is that large losses require much greater gains to recover the lost money:

  • A 10% loss is recovered by an 11% gain.
  • But you need a 100% gain to recover from a 50% loss.

The 60% gains in the previous example were nowhere near enough to make us whole after that nightmare two years.

And a steep hill becomes a mountain to climb when you’re forced to sell your investments at low prices to pay your bills in retirement.

This inescapable truth is why the best retirement researchers advocate using a 3% sustainable withdrawal rate.

A 3% rate keeps withdrawals low enough – especially early on – to enable you to ride out historically bad investment returns, should you be unlucky enough to experience them.

Many happy returns

I’ve focused on the downside to show you why it’s important to use a cautious and sustainable withdrawal rate.

But investment volatility can work in your favour, too. A brilliant sequence of returns can boost your portfolio to giddy heights. Here’s hoping!

Ultimately, navigating the “How much should I put in my pension?” dilemma does involve an element of luck. As in poker, you can be dealt a terrible hand or a Royal Flush.

The important thing is to play your cards well and avoid being wiped out.

That’s what a 3% sustainable withdrawal rate helps you to do.

Take it steady,

The Accumulator

PS – If your State Pension and/or defined benefit pensions arrive later in your retirement, then you can increase your sustainable withdrawal rate a little.

This means you’ll work your pension pot harder at the outset, until your other pensions arrive to relieve the pressure later.

This is a complex area but if you want to follow one researcher’s solution then follow the walkthrough in this post. See the ‘Investment fees and the State Pension SWR bonus‘ section.

PPS – If you’re close to retirement, here’s the decumulation strategy I put in place to help me manage my volatile retirement funds.

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Why you should think about your legacy and write a will

Write a will for those you leave behind as much as for yourself

This article on why you should write a will is by The Mr & Mrs from Team Monevator. Check back every Monday for more fresh perspectives from the Team.

Although The Mr & I only stumbled across the Financial Independence movement (FI) as we advanced into middle age, in general we’ve been a pair of early birds. We were quick off the blocks in terms of marriage, mortgage, and starting a family.

Yet as the offspring of older parents, we’ve also been at the coalface of ageing earlier than many friends.

Their parents are still in their 70s. Of our six collective parents and step-parents, only one – a spry 89-year-old – remains alive.

I’m certain that having elderly parents endowed me with melancholy tendencies. In fact I’ve probably given more headspace to contemplating death than I have to my post-FI goals.

And I’m not alone in this morbidity: The Mr regularly updates his funeral playlist!

The Mr: My funeral will be awesome. I’m just sorry I won’t be there.

The Mr & I wrote our first wills at 24 and 23 respectively. Even though back then we’d barely an asset between us.

Planner or pantser?

Planning for death is unusual for a pair of twenty-somethings. The Mr & Mrs are statistical outliers – early birds, again.

Yet I’m still surprised whenever someone I know tells me they know they ‘ought’ to get round to writing a will.

Flying by the seat of your pants – doing things in the nick of time – looks exciting. But it raises the risk of failure.

During the coronavirus pandemic, however, the UK experienced a rise in people writing wills. Forbes reports that the average age for someone writing a will has fallen from 50 in 2019, to just 47 in 2020.

My hunch is that Monevator readers (being a money-savvy lot) are more likely than average to have drawn up a will. Wealth begins to amass even in the early stages of pursuing FI, and pursuing freedom requires planning.

And given the energy and effort we invest into accumulating for our future selves, it’s odd not to pay attention to what happens once you’ve no further need of your funds.

Is there no place, organisation, or person that you would like to benefit?

The Mr: Apparently charities receive over £3bn a year from legacies, so that is something you may want to think about.

Of course, there’s a legal process to wind up the estates of those who die intestate (that is without a will). The Citizen’s Advice Bureau has a breakdown of likely outcomes in different situations.

What is less obvious is the additional time – and money – it can take to track down assets or even beneficiaries in the absence of a clear directive. This adds an extra dollop of uncertainty for the bereaved, and at a time when they may be struggling to cope, both mentally and practically

According to Unbiased, an association for financial advisors, in 2017 up to 31 million UK adults were at risk of dying without leaving a will.

If you’re one of those 31 million, then I would urge you to put ‘write a will’ at the top of your To Do list. (Or else ‘review will’ if it’s been a while since you last revisited it and your circumstances have changed.)

Write a will wherever you are on the path to FI. Get it done regardless of current age, state of health, and life expectancy. Write a will irrespective of whether you live with others, or alone, and with no known relatives.

The Mr: The reality is that none of us know what the future holds. Think of writing a will as reducing the gamble that something happens to your possessions after death that you wouldn’t want.

Too young to die?

We’re all gamblers at heart. We’re betting on living long enough to hit our financial independence numbers and to then reap the benefits.

Why else would we sacrifice present resources for the promise of future rewards?

Pandemic aside, the odds are good. Figures from the Office of National Statistics show that:

  • UK life expectancy at birth (2017-2019) was 79.4 years (males) and 83.1 years (females).
  • Life expectancy for those already aged 65 years rises to 83.8 years (males) and 86.1 years (females).

But any deck of cards contains jokers.

For example, the same statisticians calculated that 1% of children born in England and Wales in 2019 will lose their mother before reaching their sixteenth birthday. Figures for fathers were harder to extrapolate, but were estimated to be even higher, at around 2%.

Long-ish odds, and yet I shouldn’t want to call them.

My mother died before I left school or met The Mr. For all her dreams of traveling on the Trans-Siberian Express or learning to play the piano, she never got close to retirement.

Anyone in their 40s or upwards will have some contemporaries who, sadly, did not live out the usual lifespan.

The Mr & I plan to end our days in a tidy manner. We don’t want to burden our kids or the state. Our financial planning assumes that we reach a ripe old age – let’s go for an aspirational 90 years – without a marriage bust-up, dependent adult children, or more than three years of expensive end-of-life care each.

Future forward

Drafting a will is not just a mechanism for disbursing your assets once you no longer need them. It is a part of your legacy to a world without you.

Even though life has a habit of disrupting the best-laid plans, The Mr & I hope to leave behind a positive legacy.

Something that doesn’t seem unfair, sow discord or cause distress. Instead, something that reflects our lives and lived values.

Something that looks to the future.

The final chapter

Neither The Mr nor I are qualified to give legal advice. But we have seen several wills that have proven distressing.

The Mr: One relative left a will that seemed to be saying they didn’t much care what happened after they died. That was hurtful for their children.

One tip when writing that first will is to set aside time to consider what you’d want to happen to your belongings should you die in the next week, month, or year.

Use the time to consider what end of life treatment you’d undergo, and whether to consent to being an organ donor. (Among the rash of recently published medical memoirs, there’s an excellent account that guides readers through the sorts of decisions they will need to make, somewhere towards the end: 33 Meditations on Death by David Jarrett.)

You would do well too to adopt the medical maxim: first, do no harm.

More tips for when you write a will

1. Last words

Your will is likely to be your final communication with family and others who knew you. Try to avoid it leaving an unpleasant aftertaste.

Think about the tone and language adopted. Whilst some technical terms are required, there’s nothing to stop you adopting a warm tone or plain English where possible. Even if the will says exactly what has been anticipated, it’s unsettling to read an overly-formal, fussy legal document when the deceased was an untidy, fun-loving friend.

If you don’t want to deviate from standard wording, here’s a suggestion: write a letter of farewell.

Write short positive letters to children or significant others that recall good times spent together and thoughts for their future. Try to be magnanimous. Most kids (even middle-aged ones) want reassurance in the wake of death.

Keep these letters with your will. Update them as and when needed.

2. Transparency

One of the advantages of planning your legacy earlier rather than later is that time is on your side. You are not making decisions under the duress of a terminal illness. Your thinking is not impaired by dementia and other age-related diseases.

Use the opportunity of drafting your will to discuss its implications with anyone who might reasonably expect to be a beneficiary.

Transparency is easier in straightforward situations. When The Mr & I updated our wills in 2018, we showed our kids the documents. It sounds a bit ghoulish, but they were reassured that we’d named guardians in the event of both of us dying, understood that we intended to leave bequests to charity and, most importantly as far as they were concerned, that there was adequate provision for re-homing any family pets (not named).

But what if your situation is complicated?

Perhaps you consider your adult step-children to be more deserving than your own children? Or you’ve decided to leave everything to your oldest son because he has a disabled child? Or your relatives are all sufficiently well-off and there are better causes you’d prefer to help?

If you want to do something off the beaten track, communicate and start to manage expectations. You may discover that things are not as you supposed or that your relatives approve of your chosen charities.

In these situations, seek legal advice in drawing up your will. Any one of the scenarios sketched above could lead to a contested will and, according to a recent Financial Times report, inheritance disputes are on the rise.

Don’t risk your legacy festering into a family rift.

3. Stuff matters

I wish my mother had known about a Letter of Wishes. At my mother’s funeral, a number of her relatives asked me for a meaningful memento. A few roamed around the house until my father put a stop to it.

A Letter of Wishes does not have the legal force of a will. At its simplest, if you think Auntie Jean should have that vase then note it down. The publication Which? has clear advice on drawing up a Letter of Wishes

Another alternative is a Living Will. This distributes cherished items to relatives, friends, or organisations who could use them while you are alive.

When an elderly relative of The Mr – let’s call her Doris – downsized, she asked children, grandchildren, nephews, and nieces what items of hers they would like. There was astonishingly little overlap.

Everyone got at least one thing they actually wanted and Doris herself got to see many of her things appreciated in new homes.

Just do it: write a will!

Despite dealing with death, your will is a living document. It needs drafting and, once drafted, needs revisiting.

There are costs to consider. There are free templates online and some will writing services are very inexpensive. However, for most of us it’s worth a few hundred pounds to get it drawn up by a qualified, regulated solicitor.

The Law Society recommends using someone carrying its ‘Wills & Inheritance Quality’ accreditation. A solicitor will generally also deal with storing the will with the government’s HM Courts and Tribunals Service, which is a handy backup in case it goes missing or there is a dispute about the final version.

The Mr: They can also help with inheritance tax planning, but that’s a subject for another post, written by someone with the right expertise.

Last words: plan for death so that you can get on with the business of living.

See all The Mr & Mrs’ articles in their dedicated archive.

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Weekend reading: The cheerful way out of debt

Weekend Reading logo

What caught my eye this week.

While I’ve made the case for running a big interest-only mortgage in recent years, overall I still loathe debt.

The first thing I tell almost anyone who asks me about their finances? Get rid of the non-mortgage debt.

It’s always surprising to me how much debt some people have. Especially those earning a reasonable salary.

Sure, you can make a case for not paying off student loans, or even for financing a car versus buying new. (But better not to buy new!1)

Generally though, debt drags you down. It turns compound interest into your enemy. Debt is mentally dispiriting, too.

Celebrate good – and bad – times

Perhaps my perma-downer on the Big D is why an article celebrating being in debt at The Money Principle caught my attention.

Of course the author, Maria Nevada, urges you to ‘demolish’ debt ASAP.

But rather than bemoaning the state of your finances that made such emergency action necessary, Maria suggests you think positively about how this episode will enhance your life story:

Things started to happen once I pulled away from the misery debt brings and found reasons to celebrate it.

I felt empowered, not downtrodden.

I felt hope, not despair.

Paying off our debt became the meaning of my life, not its destroyer.

Do you wish to pay off your debt and live the life you want?

You can do it. But you must resist the pull of negativity and focus on the reasons to celebrate your debt. Learn to celebrate your debt, not in the new age ‘I love everything about me and my life’ way, but as a set of opportunities you may never get again.

Do read the full article – especially if you’re facing a debt challenge.

The only way out of debt is up

After 14 years writing Monevator I’m finally appreciating how big a role stories play in motivating most people about money – and everything else for that matter.

I came to financial independence via a compound interest calculator. This anonymous site was partly founded on the back of that.

But I’m unusual. Most people want to see a human face, and to hear a story. They want abstract concepts about money turned into a narrative, and an arc.

For an example, look no further than the great job my co-blogger has done on charting his path to early retirement and beyond.

I’ve a close friend who has long struggled to turn monthly budgeting and half-arsed saving into a financial plan.

That’s despite – or maybe because of – plenty of lectures from me over the years.

But recently I happened to tell her about how I met The Accumulator, and how different he was in those days.

TA was a high-spender, and in hock. Extremely different from today.

My friend was visibly intrigued. A couple of days later she emailed me about online investing platforms.

I’ve never found a way out of debt

Some readers will feel that ‘celebrating’ debt is at best a mental delusion, and at worst a cop-out.

I hear you. But then I’ve never been in debt, and I’ve always had savings – right back from when I took my first paper round as an 11-year old.

Yeah – go me!

But really, who is more likely to inspire somebody who is up against it right now?

A person who could save without ever really thinking about it? Or someone who strove and found ways to turn their finances around?

I think the answer is obvious.

So three cheers for wherever you start your journey to being good with money!

And have a great weekend everyone.

[continue reading…]

  1. At least that’s usually true, when a global pandemic hasn’t sent secondhand prices soaring. []
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How much do I need to retire?

How much do I need to retire? post image

Just “How much do I need to retire?” The answer to that question tells you whether your pension is on track, and when you can finally call it a day.

Everybody’s circumstances are different, so we’ll guide you through a straightforward process to find your number.

The two retirement riddles we need to solve are:

  • How much retirement income do you need to fund the lifestyle you want? (We’ll cover that in this post).
  • What size pension pot will deliver that income? (That’s in the next post).

Your response to the first question unlocks the answer to the second.

How much do you need to retire?

The amount you need to retire is the annual income that can comfortably pay your bills and life’s extras – once you’re no longer earning.

Thankfully that figure needn’t match your current pay.

Many expenses fall away in retirement. You’ll probably pay less in taxes too, and you won’t need to fund your pension anymore.

How much you need to retire is obviously a personal number. Inevitably it takes a bit of guesswork to visualise the life you’ll lead in the future.

Step one: track your expenses

The best place to start is with your current expenses. They already include many of the expenditures you’ll pay for in retirement. We’ll delete the costs that won’t apply later.

If you already track your expenses then most of the work is done.

If not, tot up your current spending using a budget planner. This tool helps you remember all the expenses you’d prefer to forget – dentist’s bills and the like.

Do this step as accurately as you can. Excavate your credit card and bank statements to fill in the budget planner.

It’s good practice to record your monthly expenses for a year at least.

If you’re happy with a lower resolution snapshot that’s fine. It’s better for your numbers to be mostly right than to skip this stage entirely.

Step two: remove pre-retirement lifestyle expenses

Now for the fun bit: offloading all the expenses that won’t bother your budget in retirement.

Create a retirement duplicate of your expenses’ planner. Then strike out all the costs you won’t have to pay later in life.

For example you can nix:

  • Commuting costs, such as petrol, train fares, et cetera
  • Work clothes
  • Professional fees
  • Networking lunches and drinks
  • Other work expenses – Costa Coffee pick-me-ups, baby shower gifts, billionaire shortbread buckets to get the team through another Wednesday.
  • Mortgage payments (assuming the mortgage will be paid off when you retire. Sadly becoming less common in the UK.)
  • Insurance bought to replace your employment earnings, such as income protection, critical illness, life cover, and mortgage payment protection.
  • Child-related expenditures – namely the cost of bringing up the kids before they fly the nest.

Other expenditures won’t disappear but they will change.

You’ll still want clothes and haircuts. But you can save a packet when you don’t need them to be office glam standard.

Perhaps you’ll replace your car less often – or spend less on repairs and servicing – when you’re not piling on the work miles.

Discount these sorts of expenses in blocks such as 25% or even 50%. You only need a rough estimate.

Make conservative reductions to be on the safe side.

Step three: add retirement lifestyle expenses

A fresh stage of life means new spending priorities. You may want to increase your outlay on:

  • Holidays
  • Hobbies
  • Heating
  • Health

Have fun dreaming about how you’ll live when your time is your own.

If you’re really struggling, the Pensions And Lifetime Savings Association has funded research that visualises a trio of retirement budgets using a bronze, silver, and gold framework.

For example, the ‘moderate’ £30,600 couple’s budget includes two weeks holiday in Europe and a long weekend staycation per year.

Your own parents will be a good reference point for health. After all, they’re more like us than we might care to admit. (A temperamental early model, naturally. You 1.0 before the kinks were ironed out.)

Insurance companies inquire about our family history for a reason. Try asking your parents what they spend on health per year.

Elsewhere, your social and entertainment spend may well include lines for retirement pleasures like spoiling the grandkids and catching up with friends.

We’ll take a deeper dive into the spending insights revealed by retirement research in a later post.

Monevator Minefield Warning #1: Retirement research doesn’t tackle the cost of adult social care. In other words, how much might you need to cover care at home or in a home? This is a huge unknown that every government has failed to tackle for 15 years or more. Your future liability is a lottery but there is useful information out there. We’ll cover this issue in a follow-up post. In the current environment, long-term care is likely to cost you something but there are options that don’t involve the ‘leaving your spouse homeless’ nightmare.

Step four: allow for depreciation

Some big-ticket expenses only show up once in a blue moon. They can too easily be overlooked in the steps above.

Hopefully your retirement will last for decades, so your income needs to account for replacing items like the car, boiler, TV, and white goods.

There’s house maintenance, too.

You can estimate an annual allowance to cover these costs. Applying depreciation to the stuff you own is one way to do it.

Step five: subtract other retirement income like the State Pension ­

Income from other sources takes the pressure off your private pension.

The State Pension is the main alternative income stream for most retirees.

You can deduct the State Pension and any other income you can reliably expect from non-investment sources from the total spending estimate generated by steps one to four.

The remaining sum is the retirement income you need to generate from your private pension and any stocks and shares ISAs.

Subtract your significant other’s State Pension too if you’re calculating a budget for two.

(Add up your retirement income as two individuals first. Then combine your numbers as a grand total at the end. We do this because you’ll adjust for tax as individuals in step seven.)

Your State Pension forecast reveals how much money you can expect to come your way courtesy of UK PLC. The State Pension can be a solid wodge, provided you max out your National Insurance record.

Other retirement income sources may include:

  • Defined benefit pensions
  • Property rental income
  • State benefits
  • Passive income – trust payments, royalties, and so on

Only include income streams you’re confident of receiving throughout your retirement.

Part-time work or a side hustle can do a lot of heavy lifting, especially early in retirement. But it’s not reliable enough to be a key part of your plan. Such work can dry up, or you may suffer ill-health or just decide you don’t want to do it anymore.

Treat any uncertain income as a bonus or back-up instead. The same goes for inheritance money.

Only deduct the amount of income you’ll receive from other sources after tax. Otherwise, you’ll deduct an unrealistic amount of income from your total so far. See the tax section below.

What if your State Pension will only kick in later than your intended retirement date? Well, you might temporarily draw more from your private pension and other investment pots like ISAs to bridge the shortfall.

However, this approach comes with its own risks and uncertainties. It also means you’ll have less to take from your depleted investment pots after the State Pension finally arrives. I’ll point you in the right direction in my next post.

Step six: build in a safety margin

You’ve probably noticed that answering the question: “How much do I need to retire?” involves a lot of guesswork.

That doesn’t make retirement income planning pointless. It’s better to be roughly right than precisely wrong!

A better answer to the precision problem is to add a safety margin. This shock-absorber protects you against undershooting your retirement target.

There are a few ways to build such a buffer:

  • Underestimate how much you can subtract from pre-retirement expenses.
  • Overestimate how much extra you’ll need for retirement expenses.
  • Round up your total number by another 10% or 15%.

In practice, actual retirees cut their cloth just like they did when they earned.

Their pension is effectively their salary. If a bigger than expected bill comes in, they cut back in other areas for a while.

So your retirement spending needs flexibility.

If your budget includes plenty of optional extras, this automatically gives you room to tighten your belt when necessary by putting them on pause.

Downsizing, reverse mortgages, and annuities are all tools that can provide financial reinforcements later. You needn’t worry about them now.

There’s also time to adjust before retirement. Delaying hanging up your boots for a year or two can make a big difference.

The important thing is to have a number that will guide you towards retirement. This can tell if you’re on track as you get closer to your destination.

Step seven: adjust for tax

Your total number so far is net retirement income. That is to say it’s the annual amount you’ll need to retire after paying tax.

Sadly, there’s no escaping tax in retirement so we need to cover that, too.

Use a good tax calculator to work out your before-tax gross income.

Use a tax calculator to work out your gross retirement income
  • First, tick the No NIC box (National Insurance Contributions).
  • Check the calculator is set to your particular country in the UK.
  • Pop your net income total into the Gross Income Every [Year] field.
  • Increase this figure by your best guess of your annual tax bill.
  • Keep adjusting this gross amount until the Net Earnings field (circled) is close to the net income amount you want.

Hey Presto! The Gross Income figure is now the amount of total income you need when you retire.

It’s expressed as an annual retirement income at today’s prices.

We’ll deal with inflation shortly.

Customising your tax number

Do this calculation twice if you’re part of a couple.

It is pretty likely for example that your pension pots are unequal and one person will bear more of the tax burden. We’ll explain how much you can expect each pension pot to deliver in the next post.

Your State Pension and private pensions are taxable (except for the 25% tax-free lump sum).

If you deducted your gross State Pension from your net retirement income in step five then we need to adjust the Tax Free Allowances setting in the calculator.

This prevents you from double-counting your income-tax-free Personal Allowance.

(Your State Pension only counts as tax-free in step five because it uses up some of your Personal Allowance.)

Adjust your Tax Free Allowance down in the UK Tax Calculator like this:

  • Type your gross State Pension income into the Allowances/Deductions Field as a minus figure. For example: -9000.

The tax calculator deducts that amount from its Tax Free Allowances field to show you’ve already counted some of your Personal Allowance.

You can see that I’ve adjusted for a £9000 annual State Pension income in the tax calculator picture above.

What about ISAs in retirement?

ISA income isn’t taxed at all.1

We need to remove income that’ll be generated from ISAs from your tax calculation, as you don’t pay tax on that.

So temporarily deduct your ISA income estimate from your net retirement income figure. Then add the ISA income back into your total after you’ve calculated your Gross income.

This stops you inflating your gross income figure with tax you don’t have to pay.

(How much income can your ISAs produce? That’s also in the next post!)

Do the same for your 25% tax-free lump sum if you think you can tax shelter it quickly enough. That’s possibly doable with a flexible annual ISA allowance of £20,000 per person, depending on how big your pension pot is.

Incidentally, pensions beat ISAs as a retirement savings vehicle for most people. A mix of both works, with pensions doing the heavy lifting.

Monevator Minefield Warning #2: It’s fair to assume that tax rates will have changed by your retirement date. But we cannot see into the future. So our best model for the tax burden tomorrow can only be the tax burden today. Add an extra percentage if you fear things will get worse. For example, you could tick the NICs box, assume your ISAs will be taxed, or suppose that the tax-free lump sum is eliminated. This all simulates increased tax in the future without having to know the unknowable right now.

Accounting for inflation

This process all tells you how much you need to retire on at today’s prices.

That’s fine because you can easily adjust this number for inflation.

Simply check the annual inflation rate once a year or so.

The picture below shows how the official rate looks on the Office For National Statistics website:

An image of the inflation rate to illustrate the need to adjust your retirement income figure by inflation

Multiply your retirement income figure by the CPIH inflation rate every year.

For example:

  • Your retirement income number is £25,000 per year.
  • One year later, the annual CPIH inflation rate is 2.9% (as in the graphic above).
  • Your retirement income number adjusted for inflation is now:
    £25,000 x 1.029 = £25,725

In other words, your pension pot must generate £25,725 income per year to keep pace with current prices.

Next year, multiply your latest retirement figure (e.g. £25,725) by that year’s inflation rate. And so on.

Yes it’s a faff. But this annual calculation ensures your income estimate keeps up with official inflation.

You should multiply your investment contributions and target pot size by inflation every year, too.

It’s the same calculation as above and helps prevent your forecasts being boiled away by the slow pressure cooker of inflation.

You can go even further and calculate your personal inflation rate. But there comes a point when life is too short, even for retirement planning.

The State Pension is up-weighted every year by at least the annual inflation rate. Small mercies!

Can I really know how much I need to retire?

As long as you treat the process as an ongoing estimate then this method answers the nagging question: “how much do I need to retire?”

Admittedly, it all takes a fair bit of work if you’re starting from scratch. But once you’ve done it, you’ve got a target to aim for.

Complete the process and you’ll drastically reduce one of life’s big uncertainties.

Adjust your number as you go, and it will help you keep your retirement on track for years to come.

Which in turn will be an enormous tick off your To Do list.

Oh, and please don’t be put off by the unknowns.

Your best educated guess will be good enough, because retirement planning cannot be precise.

We’ll walk through how to translate the amount you need to retire into, how much should I put in my pension?in the very next post.

Take it steady,

The Accumulator

  1. You already paid tax on the money you put into your ISA. []
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