Knowing how much to save for retirement can appear a difficult question to answer. It is a life event that requires careful financial planning and smart decision making from a young age. You can and should start calculating your retirement funds today to get a better picture of what your life in retirement will look like.
The money you should save for retirement in the UK is 25 times your annual expenses for a comfortable retirement by the age of 66. There are many ways to do this including passive income or state pension earnings but the safest option here is an investment in a pension pot.
This article discusses the right age for retirement and the amount of money required to live comfortably during your years of senior citizenship. Pension pots, annuities, the 4% rule and the power of seven are also explained in detail. The recent changes in the policies about pension pots have also been mentioned to help the reader make informed choices for their financial future.
When Can I Afford Retirement?
With the recent changes in employment patterns and the increased frequency of individual ventures, retirement no longer seems like a distant endpoint as it has done in the past.
Historically, people tended to toil at their jobs until they hit the age of retirement defined by the state and then they were content with the comfortable, slow pace of life that retirement brings. But that’s not necessarily the case today.
Now an individual can choose to work for as long as they are interested in working if they are able to understand and implement the simple math that underpins retirement or more specifically – early retirement.
If you are one of those individuals who would like to escape the 9-5 life before the typical retirement age, then you must consider how you will be able to afford your monthly expenses without the income your job provides.
The key here is to ensure you have sufficient funds saved to last for your entire retirement and avoid the desperate situation of running out of money late in life when the chances to earn more are difficult to come by.
How Much Do I Need to save for Retirement?
Economic surveys have revealed that the average monthly expenditure of a retiree’s household in the UK adds up to £2,100. However, this figure is clearly not a one-size-fits-all result. If you take a moment to calculate where your money goes today, then you can calculate the expenditures you may have in the future as well.
For example, if you currently spend £3,000 per month but know some of these costs relate to commuting or buying clothes for work that you would no longer need once retired, you can adjust your monthly expenses to predict a likely future figure.
Naturally, this number fluctuates based on your planned lifestyle during retirement. If, for example, you plan to live a life of relative luxury with two new cars per decade and a foreign holiday every year, then your annual expenses may look something like £50,000 per year.
While saving £50,000 for each year of retirement may seem like a difficult feat, you must keep in mind that priorities change as you age. The ageing population pays less on food, housing and recreation because most of their spending is redirected to utility, insurance, health and bills.
How do I Amass a Sufficient Pension Pot for Retirement?
Your pension income can be thought of as the building blocks that begins with the state pension, expands with pension savings and then includes any other additional/passive income you might receive for example rent from an owned property.
State pensions in the UK are stipulated for men and women above the age of sixty-six. The government provides a large chunk of the post-retirement funds every week, where couples receive £175.20 each if they are eligible by the legal standards depending on the individual’s national insurance record. This equates to £9,110 a year, which whilst not enough to live on, is a helpful starting point.
The figures from 2019 reveal that men, on average, qualified for £160 and women for £152 weekly, which leaves £16,260 annually for a married couple. With this in mind, it is clear that you will need to supplement your state pension earnings (if eligible) with your private pension income.
Generally speaking, the earliest you can withdraw money from a pension in the UK is age 55 but it is up to the individual when to start taking an income. You can receive money from your pension and still be earning money from work at the same time.
For most pensions, you will have a few options for taking money out from your pension. Broadly speaking they are:
- Leave it invested in your pension at retirement date and just take what you want when you want. 25% of each withdrawal will be free of tax, but the rest is liable to income tax at whatever your applicable rate is.
- Take 25% of your pension pot as a tax-free lump sum on retirement and buy a flexible income drawdown product with the rest. This then works the same as option a), except the whole withdrawal is liable to income tax as you have already used your 25% tax-free allowance.
- Take 25% of your pension pot as a tax-free lump sum and buy an annuity with the balance (see below).
What Is an Annuity?
An annuity is basically a product where you pay a lump sum up-front and the annuity provider will pay you a guaranteed amount (possibly adjusted for inflation) for the rest of your life.
An annuity is an insurance product that provides you with a regular income post-purchase of a pension fund. The current economic standards have raised the prices for annuities due to rising life expectancies and lower interest rates. But they remain a popular choice for retirees in the United Kingdom. Your income from an annuity is taxable at your prevailing income tax rate.
How To Save For Your Retirement in the UK?
The first thing to consider is when you start saving for retirement. Few people in their 20’s are thinking about retirement but beginning to save at this age has several benefits which can’t be underestimated.
Firstly, your savings will benefit from many years of compounding (a powerful phenomenon I wrote about in detail here).
Secondly, beginning to save early in your working life solidifies the habit. If you fail to begin retirement saving when you’re young, you may continue to avoid it as you age until it’s too late.
Finally, saving for retirement is a great way to practice delayed gratification. In the modern world, we are driven by instant gratification (think social media, high-calorie food in abundance, Netflix binges). Saving for retirement allows us to develop the muscle which allows us to put off benefits now, for greater benefits later.
Many people put off retirement savings due to the belief that their high future incomes will enable them to save more than enough than will be required. To me, this seems problematic in several ways. What if your future high income never materialises? What if health concerns or childcare responsibilities prevent you from earning what you expected?
Research into the ‘the power of seven’ has revealed that households who save seven times their peak annual income by the age of 66 can live a calm and comfortable retirement.
The road to saving this much money may seem like an insurmountable challenge, but it is less of a race and more of a marathon. If you prepare and start saving at an early age, you can stay on track with your saving milestones and let compounding help you.
A good financial marker is whether you have managed to save your annual income at least once by the time you turn thirty. Once you meet this goal, you can consider yourself on the right track for your retirement plans.
How the 4% rule can be used to calculate how much money you need to be able to retire
The 4% rule (derived from the Trinity Study, 1998) is a rule of thumb that determines the safe withdrawal rate a portfolio can withstand without running out of money in a given time period. For example, a portfolio of £1 million could safely withdraw £40,000 annually.
The 4% rule has become a key concept within modern personal finance circles, however, we have to go back to 1998 to understand its origins. The Trinity Study (1998) was a paper published by the Trinity University, Texas which essentially aimed to determine a safe withdrawal rate (SWR) for future retirees.
The SWR can be defined as the maximum rate at which you can withdraw money from your portfolio every year without running out later down the line. For example, a 5% withdrawal rate on a £500,000 portfolio would mean £25,000 could be withdrawn annually (adjusted for inflation each year).
So how is this helpful for you?
Step 1 – work out your predicted monthly expenses once retired (e.g. £3,000 per month).
Step 2 – annualise this amount by multiplying by 12 months (e.g. £3,000 * 12 months = £36,000)
Step 3 – Multiply your annual expenses figure by 25 to find your portfolio value number which allows you to retire. (£36,000 * 25 = £900,000)
This suggests if you save up a pension portfolio of £900,000, you can safely retire knowing it will produce investment returns that are enough to cover your monthly expenses forever with a reasonable degree of certainty.
If £900,000 sounds impossible, consider this – if you started saving at age 20 and retired at age 50, you would need to save around £8,000 a year or £666 per month during that period assuming average investment returns of 8% a year.
That £666 a month can contain your employer’s pension match. So if your employer matches your pension contributions at a 1:1 ratio, you would only need to contribute £333 per month to your pension which is doable for many people.
How Helpful Are the Recent Laws for Retirees in the UK?
In 2015, new rules about retirement savings were announced by the government. These rulings were generally positive for those approaching retirement age. A few changes include:
- The total pension amount can be withdrawn at the age of 55.
- The first 25% of your pension is not taxed.
- The remaining amount is taxed according to salaried incomes.
These changes are beneficial for retirees and given how difficult future regulatory changes are to predict, the prudent thing to do is to save as much for retirement as you can afford
What Is the Future of Retirement in the UK?
While sensationalism surrounding the increase of the retirement age in the developed world is at its peak, a closer inspection suggests that insufficient retirement savings are only one reason.
Many people are working longer into their lives because they can work jobs they like which provide them with a purpose that otherwise may be missing. Similarly, improvements in healthcare allow the population to continue working to a later age for those who choose to.
The point is, whilst many people choose to continue working past the ages traditionally used for retirement, it is entirely possible to retire by this age or before if you take the right steps.
Final Thoughts
Retirement is an inevitable part of life. Whether you start saving at the age of 25 or wait until 55 to plan something is your own choice but my suggestion is that you begin financial planning for the future as soon as you start in full-time employment. This does not need to be a major time commitment and can be as simple as making sure you are investing in your employer pension on a monthly basis and securing the optimal employer match.
As always, please remember I am an Accountant, but not your Accountant. In this post (and all of my others) I share information and oftentimes give anecdotes about what has worked well for me. However, I do not know your personal financial situation and so do not offer individual financial advice. If you are unsure of a particular financial subject, please hire a qualified financial advisor to guide you.
This article has been written by Luke Girling, ACA – a qualified Accountant and personal finance enthusiast in the UK. Please visit my ‘About‘ page for more information. To verify my ACA credentials – please search for my name at the ICAEW member finder. To get in touch with questions or ideas for future posts, please comment below or contact me here.