4 Uncomfortable Truths of Retirement

Not knowing how much is enough to retire

One issue we find with those at or approaching retirement is that they haven’t really considered how much they will need to retire and are retiring on a hope and a prayer and are relying on the state pension. Well for most people, the state pension at around £11,500 for the full amount is simply not going to be enough for a half decent retirement.

With the state pension age currently 66 and rising to 67, in my experience many people I talk to of varying means wish to retire much earlier than this and anecdotally for you at home I imagine your family and friends share the same ambition. Whilst there is nothing wrong with and it is a noble pursuit, retiring early or before the state pension naturally demands having a larger nest egg particularly if you plan to bridge more income from your savings or private pensions before the state pension kicks in.

Now if you don’t want to pay someone like me to run a cashflow, or you don’t want to do a DIY one on excel or something similar, how can you come with up with a more simplistic approach to working out how much you need to retire?  Well I like to call this the 4 step process. 

Step 1 – Calculate expected expenditure in retirement

So how much do I need to have saved then? Hold your horses the first step in the calculation is to try and estimate or budget how much income you think you will need when you retire.   

This could involve increasing or removing the expenses that you will no longer have to pay. Perhaps you are planning more holidays when you retire. If that’s the case, then increase your likely expenses for holidays.       

I’d always suggest sitting down and coming up with an individual and bespoke budget as you may like to vacation in St Tropez whilst for others they are content with a camping holiday in Wales. If it’s hard to come up with a figure for retirement or it’s a long way away, then you could simply use a rule of thumb to try and estimate how much income you think you will need. One of which is to take 50-70% of your current income. The Retirement Living Standards also carry out a study which looks at how much retirees should need for a Basic, Moderate or Comfortable retirement and you could you these figures. However, I often hear in the comments that these figures are way inflated.

If you are married or live with your partner, I’d always suggest doing this exercise together and combing your retirement assets and incomes. After all you probably split the bills now and likely will do so in retirement.   

Step 2 – Deduct other sources of income from expected expenditure

So you have arrived at the figure of how much income you think you will need, the next step is to deduct any other forms of income you may have in retirement such as state pensions, rental income and final salary pensions.

Step 3 – Use a Safe Withdrawal Rate to estimate fund value required

Once you have deducted your other sources of income from the amount of income you need, you then need to calculate what fund or pension value you would need to address this shortfall. 

One rough and ready way to do this is to use the concept of a safe withdrawal rate, such as the 4% rule. We won’t get into the merits of what withdrawal rate  to use, at a high level the 4% rule is based on a study which suggested that a starting withdrawal rate of 4% of a portfolio wouldn’t exhaust the retirement portfolio over a retirement of 30 years or less.   

Example calculation

Let’s see an example. Just to warn you, it can produce quite large numbers so don’t be put off if you think you have no chance of reaching these figures. As I’ll demonstrate later, they can be very much achievable.  

So, Brad and Angelina are 66 and are about to retire. They require a combined retirement income of £35,000. Aside from their private pensions, they have no other retirement income except for the full state pensions which combined come to £23,000 per annum. This means there is a shortfall of £12,000 that will have to be met from their private pensions.  

If we take £12,000 and divide this by 4%, this would mean Brad and Angelina should be aiming for a combined retirement fund of £300,000. You can flip this on its head and simply take the shortfall amount and multiply this by 25 and you will get the same answer.  If you feel comfortable taking a higher withdrawal rate such as 5 or even 6%, then this mean you will need a lower amount, although this increases the chance you will run out of money as its places a greater strain on your retirement fund as you can see on the screen now. 

This rough and ready calculation works well if you plan on retiring at your state pension age or when you receive all your income but works less well if you plan on retiring early. A simple fix may to simply add the amount you need for each year you plan on retiring early.

Not understanding investment risk and volatility

The second uncomfortable truth is around understanding how your investment portfolio or asset allocation works. The reality is that if your guaranteed income, such as final salary pensions or state pension is less than your expenses, then you are likely to need to invest your pension in a portfolio to help the sustainability of the fund in future years.

In my experience many retirees just don’t have an appreciation or understanding of how investments work and what their expected returns and drawdowns could be  – drawdowns being how much their portfolio could  go down in a bear market or times of stress such as during the banking crisis in 2008 or more recently during covid in March 2020.

if your portfolio or asset allocation has gone down by 20%, 30% or even 40% or more in the past, although past performance is not a guide to the future, it is reasonable to expect your portfolio could see similar losses in the future if not even greater losses. What I find is that many retirees just don’t appreciate their investments could see this volatility and so when their portfolio inevitably drops in value, they panic and throw in the towel. 

That’s all well and good , but how do I know how much my portfolio could go down by and how long can my portfolio take to recover. Well one way to do this is to use a website called portfolio visualizer. A word of warning, this is geared to US individuals, but its still quite useful. To show how this works we are going to show to demonstrate this with a typical 50% stock portfolio and 50% bond portfolio. I am not advocating this, it is simply to show you how a weighting of these asset classes has reacted in past stock market crashes.

Alternatively, what I find that is because of this volatility, more conservative retirees with their pensions or indeed savings in general, will hoard their cash and leave it in the bank. Whilst savings rates are very attractive at the moment, this has not always been the case and indeed the return on cash historically has been lower than inflation for the most part meaning rather than being the safe haven they think cash deposits are, you are actually losing money in real terms!

So, what are the implications of this. Let’s take John. He is aged 63 and has a pension valued at £200,000 and he is planning on taking 10,000 a year from it which equates to a starting withdrawal rate of 5%. The income we will assume increases by 2.5% a year to keep up with inflation. Let’s assume he’s a really conservative investor and leaves his pension in cash based products and we will assume the returns are 2.5% a year. Under these scenarios the pension pot would run out at age 84.

How about if John had taken invested his fund in a balanced portfolio which grows at a 5% per year? How will that effect the sustainability of the pension fund? If this was the case then the pension fund would support John for a further 7 years running out at age 90. If he was to pass away at age 80, the pension fund would still be worth over £132,000 whereas in the previous example the pension fund would only be worth £42,000. This means the opportunity cost of taking no investment risk or little investment risk means the sustainability and longevity of the pension fund could be lower.

Leaving too much behind

Another uncomfortable truth I find is that retirees spending drops significantly as they move into what I like to call later retirement and they don’t do the things they used to do such as holidays. I’ll also see those newly retired, they often struggle with transitioning from the accumulation phase ie whilst they were working and saving their money, transition into the decumulation stage of their life, retirement and now taking an income from their pensions and or investments as they developed good saving habits, maybe they are naturally frugal and spending their retirement saving doesn’t seem right or fills them with worry they may run out of money further down the line or they’re scared they might have to pay for care fees in the future which is of course a great concern.     

What this either drop in expenditure later in retirement or just reluctance to spend your hard earned money means is that we’ll often see clients when they pass away leave behind rather large estates and pension funds. 

Now this is not a problem if your primary objective is to leave behind a large inheritance for your children or loved ones after you’ve gone, but this is an issue if actually your primary objective was to use your pension fund to enjoy your retirement as much as possible or do those things you had always dreamed off such as trips around the world, gifts to your family when they actually need the money when they are younger for house deposits or weddings etc.  We often hear from clients as they plan for retirement and their objectives say they wish to spend all of their retirement savings as the children can have the equity in the house for example. 

So, what can you do to address this if you fall into this camp. One option is to use a withdrawal strategy as a guide. The first approach would be to carry out a cashflow where you can model different scenarios such different ages for life expectancy, factoring in care fees and different expenditures to guide you in how much income you can take that should hopefully be sustainable. If carrying out a cashflow isn’t an option, then one option is to use the likes of the 4% rule as a guidepost. In research published in 2018 and based on the architect of the 4% rule, Bill Begen, they found from 1925-1990, the lowest safe withdrawal rate during this period was actually 4% and in some years when returns were particularly favourable, the safe withdrawal rate could increase to almost 10% as you can see below.

One option to use the 4% rule is to say that if you income falls below this target this is relatively conservative, whereas if the income you take is above 4% you are more aggressive, but not unreasonably so.   

Another consideration is to look at a variable or guardrails approach which unlike the 4% rule which  is a static amount of income each year, with the guardrails approach if your portfolio either increases or reduces by 20% in value, then you reduce the withdrawal rate by 10%. I’ve done a video on this little known strategy, but the founder of this a chap called Guyton, his thesis was that the 4% was too conservative and prevented retirees from benefitting from investment growth and actually  taking more income from their portfolio which is again the theme of this point – not living your retirement to the full. And on the other side of the coin as it forces you to reduce your spending needs when your portfolio falls in value significantly, this helps with the sustainability and protects against the sequence of returns risk. 

Bored in Retirement

In the build up to retirement, clients always focus on the financial aspects; is there enough money, how to take a tax efficient income and ensuring the investment portfolio is correct based on their risk appetite and capacity for loss.

The uncomfortable truth when it comes to retirement, which is a little bit corny, is that financial side of things isnt the sole priority in determining if someone retires successfully. Of equal importance is thinking about in the build up to retirement and before you pull the trigger what you will do with your new found freedom and time. Too often we see successful individuals when they retire lose their sense of purpose and identity and can enter an almost depression like state. So what I would urge you to do is to focus on what you want to do with your retirement and coming up with a routine to prevent you from watching Jeremy Kyle in the day. Be it hitting the golf course, hiking, volunteering, looking after the grandchildren or time to see those countries that have been on your bucket list.  

The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a guide to the future. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.