One of the first steps in planning your financial independence, your escape from being a Finance Zombie, is estimating how much you will need in retirement.
But how do you estimate this? I asked some friends, one thought for a couple of minutes and then said confidently at least two million. Another £500k. Another £250k. Pretty wide ranging bunch of guesstimates right there. Based on nothing other than a couple of pints of beer and some hot wings.
One way to try and estimate how much of a financial nugget you need to accumulate for Financial Independence is look at how much you would spend after you are FI. So we are looking at how much we need accumulate, based on our expected expenditure in FI.
Your current spending is possibly, maybe, perhaps, the place to start. If you can start cutting you expenses now you win two fold, one you can save more and two you will need to accumulate less.
I put together some theoretical numbers (assuming you have been a bit a FI wizard you would have no tax to pay and your mortgage would be paid off in full). Using a bit of currently accepted wisdom around Safe Withdrawal Rates we can estimate the size of the financial nugget we need to build.
4% is accepted (at the moment) as being a pretty safe withdrawal rate for 30 years of spending, so I will use this and a more prudent 3% to try and give some context to what a reduction in this rate of 1% will do. The withdrawal rate is how much you will be getting your grubby paws on each year, it is these withdrawals that will cover our expenditure in FI or retirement. For example, if you had a fund of £100,000 then at a 4% withdrawal rate you would be allowed to withdraw £4,000 each year.
Some studies have shown that at a 4% withdrawal rate our fund is pretty safe, so we shouldn’t run our savings into the dust and have to resort to robbing a bank as an OAP. It figures that if we increase our withdrawal rate we run a higher risk of money running dry, if we reduce the withdrawal rate then the risk of running out of savings reduces. It’s a simple way to look at it and should be taken with a pinch of salt, but it at least gives us some kind of base to estimate how much we will need. Obviously it is based on historic data, in this case of the S&P500 index. But it looks to be a fairly prudent study, it takes into account expense inflation (meaning we can play around with numbers at today’s value) and assumes that there will be no other sources of income or social security, to name a few assumptions.
I tend to think that if we are looking at aiming for a fund defined by this method, then we are implicitly assuming that we will be using “drawdown” to fund retirement. But I guess there is nothing to say you can’t use part of the fund to by an annuity, it’s your money right. An annuity, especially at the moment, is likely to provide less income each year but we pass all of that investment and longevity risk to the insurer (and inflation risk if we buy an inflation linked product). But I digress.
I pulled together some expenses quickly for a couple living together (as I said assuming no tax or rent/mortgage payments and I’m sure I have missed things).
A real basic budget that gives each person £200 a month for discretionary spending, £1,500 a year to spend on holidays, a couple of mobiles at £30 a month each and enough to a run a small car. Nothing there for one off large expenses etc.
So, a pretty small budget and we need approximately £365k to survive on at 4% or £486k on a smaller withdrawal rate of 3%.
This drives it home for me, how even on a modest budget we need a fairly substantial nugget of wealth to live off.
But it also highlights how reducing our expenditure has a massive effect on how much we need to save (an obvious link really but not one many people seem to make). Every £10 you can reduce your monthly expenditure by you reduce the size of required savings by £3,000 (£10 x 12 x 25 at a 4% withdrawal rate). So cutting back now is so powerful in bringing forwards FI and making it easier to achieve.
It’s taken a while for it to click in my lead lined skull that by getting used to spend less now not only allows you to save more but also reduces the amount you need to save in total as your expenditure in FI also decreases. HAPPY DAYS.
Also, by splitting it out line by line, it highlights how much things will cost. Do we really need £30 a month on a nice phone each? Maybe, but that accounts for £24,000 of our required savings! Better be a fucking good phone. Splitting out our budget and projecting the required fund for each certainly helps to bring in perspective. Cutting back on Sky and a mobile phone to reduce the fund by £34.5k and bring FI a bit closer? Hell yes please.
You may look at the budget and think it’s excessive? Lucky you, you can reduce the amount you should aim for. You may think it looks tiny, if so better get saving!
The normal response to how much would you like in retirement seems to be £25,000 a year, or in financial nugget terms, we would need a fund of £625,000.
The other way round, assuming that we need a nice round £1,000,000 to fund retirement would leave us with £40,000 a year to live off. Not too shabby, but that’s going to take a shedload of saving which I can’t believe many people are doing.
Perhaps it’s dangerous to place too much reliance on the 4% Safe Withdrawal Rate, but it does give you a target to aim for.
I would use something a bit more prudent, 3% or maybe even 2.5% (which would give us £583k to aim for in the above example). Always good to be prudent, right?
Aiming for a nugget of £1million shows dedication, but I wonder if it’s more that we need.