Given the seriousness of the topic I must give the following Wealth Warning before we move on. I’m just an average person on a DIY Investment journey to Financial Independence and am certainly not a Financial Planner. The content of this post is for educational purposes only and is not a recommendation of any type.
For this post I am going to use a fictitious Average Joe who is in a similar position to me and is planning for Retirement. This means he:
- doesn’t intend to purchase an annuity but instead intends to only use Income Drawdown to Generate Gross Earnings (Earnings before Tax) from the portfolio;
- doesn’t have the benefit of a Defined Benefit Pension or other income streams. Therefore all of his Gross Earnings must come from the interest, dividends and capital growth of his portfolio;
- doesn’t have rich parents who are going to leave him an inheritance; and
- wants to maintain the same standard of living throughout retirement so will increase his Gross Earnings in line with inflation every year.
The actual calculation of the Retirement Number (how big a portfolio is required to retire) is actually very trivial and depends on only two numbers. It’s getting those two numbers that is the difficult bit and where all the risk is. The first number is what Gross Earnings do you want in retirement and the second number is what Initial Withdrawal Rate do you intend to start with. The maths is simply Retirement Number = Gross Earnings / Initial Withdrawal Rate.
Let’s look at both of those numbers in detail.
What Gross Earnings do you want in retirement?This is just a matter of sitting down and thinking about what expenditures you intend to have in retirement that will give you the standard of living you desire. Here is a short inconclusive list of possible considerations:
- You’re no longer saving for retirement so don’t need that portion of your current salary;
- You’re possibly no longer working so may not need to be paying for transport to and from work plus other costs such as work clothes;
- You’re hopefully tax efficiently invested in wrappers like ISA’s meaning you need a lower Gross Earnings than Gross Salary to give the same amount of money in your hand each month.
- If you’re in the UK then the assets in your portfolio are taxed in a more friendly way than your current Salary meaning you also need lower Gross Earnings; and
- You possibly own your home by now meaning you won’t be making those current mortgage payments.
I calculated my retirement Gross Earnings back when I was in my mid thirties and first started on my journey towards financial independence. Every year I have then up rated this amount by inflation to ensure my standard of living will be maintained as the pound is devalued. When I hit retirement I intend to continue with this strategy.
On Retirement Investing Today I never reveal my Gross Earnings target because it’s just irrelevant. Everybody has different needs, wants, risk tolerance and portfolio type meaning we all have a different Gross Earnings requirement. To enable us to run an example let’s assume that our Average Joe requires Gross Earnings of £25,000 when measured in today’s £’s.
What Initial Withdrawal Rate do you intend to start with in retirement?The Initial Withdrawal Rate is critical. Take too much risk and you could deplete your portfolio within your lifetime. Taking too little may result in you working far longer than you need to and thus ending up with savings left at the end of your life (which might actually be part of your strategy if you want to pass wealth on to friends, family or charity).
A logical starting point for determining the Initial Withdrawal Rate is the Rule of Thumb commonly known as the 4% Rule or 4% Safe Withdrawal Rate (SWR). A quick Google will reveal that this Rule of Thumb crudely means that if in the first year of retirement you withdraw 4% of your portfolio, then yearly up rate your withdrawals (your Gross Earnings) by inflation, the end result will be that you won’t exhaust your portfolio in your lifetime. What this Rule of Thumb is actually based on is a famous paper written by William Bengen in 1994 entitled “Determining Withdrawal Rates Using Historical Data”. Briefly the actual conclusion was that for a person who is 60-65 years old and possesses a 50:50 Stock : Bond Allocation then the highest withdrawal rate in the first year (which can then be adjusted for inflation every year) will be about 4% if they want their portfolio to outlive them.
One thing that I feel is forgotten about in the Personal Finance world when this Rule of Thumb is mentioned is that it doesn’t allow for portfolio expenses which must be also accounted for. So if our Average Joe was going to use this Rule of Thumb and his annual portfolio expenses were 0.36% like mine currently are then his Retirement Number would be £25,000 / (4%-0.36%) = £686,813. Invest in a 50:50 Stock:Bond portfolio of innovative products that have expenses like this and his Retirement Number could be £25,000 / (4%-1.59%) = £1,037,344 unless his chosen Active Fund Managers really can outperform the market.
If our Average Joe is looking for a more detailed approach, which I hope he is given the importance of this number, then his next stop might by what has become known as the Trinity Study. This was a paper published in 1998 by Philip Cooley, Carl Hubbard and Daniel Walz entitled “Retirement Savings : Choosing a Withdrawal Rate That Is Sustainable”. The content of this paper has been subsequently updated and now includes datasets up to December 2009. It is by the same Authors and is entitled “Portfolio Success Rates : Where to Draw the Line”. For our Average Joe who intends to up rate his Gross Earnings by inflation every year then Table 2 (shown below) is critical. This Table enables Average Joe to choose an Asset Allocation, a Withdrawal Rate and a Payout period (how much longer does he intend to live). It then let’s him know what the probability of him exhausting his portfolio is. If after reading this paper he stayed with the Rule of Thumb of a 4% SWR, 50:50 Stocks : Bonds and decides he’ll live for another 30 years then he has a 96% chance of success. So Bengen’s approach looks sound (thus it still being a common rule of thumb) but does not “guarantee” (of course nothing is actually guaranteed because the past is not necessarily an indicator of the future) success. For that he needs to drop his SWR to 3% which means with expenses of 0.36% his Retirement Number could be £25,000 / (3%-0.36%) = £946,969. Start paying 1.59% for Active Funds that only give market returns and the numbers start getting scary at £25,000 / (3%-1.59%) = £1,773,049. That is 2.6 times the number our Average Joe needed under the Rule of Thumb Low Expenses example above.
Click to enlarge
Again there is no value in me giving my selected Withdrawal Rate but what I will say is that I am not assuming a 100% chance of success with my chosen SWR. I have made this decision for a few reasons which include:
- In all of my calculations I have assumed that I receive £0 in UK State Pension. If it isn’t means tested by the time I arrive at the UK Government’s chosen date of when they’ll allow people to retire, then that will represent upside, meaning I have to take less from the portfolio each year;
- My Gross Earnings target was calculated a few years ago and was not calculated using the bare minimum I could live off but instead also included some fun money. As the years have gone by and I’ve also learnt the power of frugality then I’ve ended up in the situation where my Gross Earnings target is now more than I live off today. This combined with the fact that I believe I will maintain an interest in Personal Finance would mean that in times of Financial Armageddon (which I believe will happen many times over the next 50 or so years that I intend to live) I could hunker down and spend well less than my Gross Earnings. This would mean I wouldn’t be forced to sell capital when it’s devalued and instead could likely live off interest and dividends.
- While in my early days of retirement I expect to be very active I can see that as I become an “old” person I will spend far less than the Gross Earnings I’ve given myself.
Have you used a similar method to calculate your Retirement Number or are you on a different journey?