How much should be in the pot?
He is not altogether wrong but at its core planning for your future income is based on some guesswork and assumptions. You have to make a guess as to what your expenses will be in 25 or 30 years’ time you have to assume how much your pension fund will grow by, what age you want to retire at and so on and some of these things are hard to predict and have control over.
There is a rule of thumb in the pension industry that says you need to save enough money to be able to live off about 67% of your pre-retirement income. If you earn €80,000 for example you should plan to have c. €53,600 per year when you retire. I completely disagree with this method and it amazes me how stupid this idea, something most banks and financial advisors peddle. When planning for retirement income you should plan and be guided by what your current expenses are. And you should benchmark this amount from what your current outgoings are by the way.
A client of mine (age 37) earns €65,000 per year and if he was to plan for an income to replace 67% of that i.e. €43,500 as was suggested by his bank, he would need to have saved c. €1,309,058 in his pension fund and in order to do this he would need to put away about €33,000 each year for the next 28 years which of course would not be possible. And when you hear things like this, what do you do, you do nothing, you give up because why bother when you have no chance of succeeding – when we carried out the exercise I am just about to tell you about we identified that he needed c. €2,200 per month which meant he needed a fund in his pension at 65 of €360,900 and not €1,309,058.
So rather than just pick an arbitrary number based on your salary, a figure that you will find next to impossible to replace, look at what your current monthly outgoings are and do the following:
Complete an income and outgoings budget showing what you typically spend your money on each week, month and year. You don’t have to be terribly accurate to begin with, guesstimates are fine.
Now deduct from this budget your current expenses that you will no longer be required in retirement i.e. mortgage repayments, life assurance premiums, car repayments, savings plans, costs associated with children etc.
Now don’t forget to add expenses that currently come out of your salary that you will have to pay out of pocket once you are retired. And what extra expenses do you want to budget for during retirement - these would include things like travel, or extra money for medical expenses.
Subtract other sources of income you may be in receipt of such as rental or investment income or the state contributory pension or any other pension income you may have from what you estimate your annual expenses will be. The amount left over is the amount you will need to withdraw from your pension fund so whatever this figure you are left with is, is the amount you will need to spend in a given year, and you now need to multiply it by 25.
Here is an example:
Expected Retirement Expenses
€40,000 per annum
Other pension including state contributory pension
€15,000 per annum
Rental and investment income
€7,500 per annum
€22,500 per annum
€17,500 per annum
Pension fund requirement is €437,500 (€17,500 x 25)
The reason for multiplying by 25 is based on the amount you can withdraw from your pension fund but it doesn’t factor other things in like rental or investment income, the state contributory pension etc. and this rule of thumb assumes you will be able to generate an annual return of 4% on your pension fund.
It assumes that over a 15 to 20 year term your pension fund will produce returns of 6% (Warren Buffett predicts this is what stock market indices will return over the next few decades) Inflation will erode the value of your Euro at an average long term rate of 2% meaning your real return after it is taken into account is about 4%.
Another pension rule of thumb is called the 4% rule and it is linked to the Rule of 25 but the 4% rule is based on the amount you can withdraw without depleting your fund each year.
For example you retire with €300,000 in your portfolio, you should withdraw 4% of it i.e. €12,000 per year. Of course you can withdraw a lot more but eventually and depending on how much you need, the fund could run out. If for example you were withdrawing €30,000 per year, then in 10 years your fund would eventually run out.
So, the Rule of 25 estimates how much you will need in your retirement fund and the 4% rule estimates how much you should withdraw from your fund each year after you have retired.
Do you need to adjust for inflation? And the answer is yes of course you do.
If for example you want to withdraw €30,000 from your pension fund each year and you are 25 years away from retirement then you your inflation adjusted target is €80,100.
Here is a quick summary of how you can factor in inflation:
If you are 10 years away from retirement multiply your target income by 1.48
If you are 15 years away from retirement multiply your target income by 1.80
If you are 20 years away from retirement multiply your target income by 2.19
If you are 25 years away from retirement multiply your target income by 2.67
The Rule of 25 and 4% rule are not without their draw backs and should be used as a guide only. It is hard to predict with any certainty what tax rates will be in the future, what the state contributory pension will be, what utility costs will become decades from now so the bottom line here is to at least start and aim for something and yes there are what I refer to as what we know and what we don’t i.e. the unknowns and these are things that yes you need to be aware of and be able to react to which is why it is important to build in flexibility into your plan so that you have the safety net to fall back upon i.e. don’t rely too much on the state pension, try and plan for without it or it you are planning to include it maybe take 50% from what the current rates are – this is one of the reasons I encourage people to slightly over estimate how much they will need in retirement.
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Managing Director of Harmonics Financial