If you’re like us, you’ve been dreaming about the retired life ever since the day whatshisname in accounting swiped that leftover slice of pizza you were saving in the office fridge. You’ve probably already got retirement plans (ie, sleep til 10:00 AM most days, acquire roomy sweatpants for every occasion, and become the D.B. Cooper of sneaking burritos into multiplex matinees). But in order to get there, you’re going to need a strategy to make your particular Shangri-La a financial reality.
The best-of-all strategies is a fairly predictable one: make or inherit a pile of money large enough that you can coast 20, 30, even 40 years on the income thrown off by it. If you weren’t born filthy rich, this will take some work. But there are three fundamental steps that will set you on the right path.
Start early, as in right now. Saving like a maniac is great but it’s got to happen early. You won’t accomplish a heck of a lot if at 55 you decide it’s time to start saving for retirement. Creating a comfortable retirement out of something modest will require your savings to simmer for a very long time in an investment account, experiencing the magical power of compounding year in and year out. Play around with a compounding calculator like this one to get a feel for what time can do to money. Assuming a hypothetical, though historically reasonable 5% annual rate of return on an investment, a 25 year-old who manages to put £5,000 away every year will end up with almost £675,000 by age 65. Put in that same £5,000 beginning at age 35, and she’ll only end up with about £370,000 by 65. In fact, in order for that 35 year-old to end up with the identical £675,000 by 65, she’d have to put away about £9,100 a year to catch up to the early bird who started at 25.
Invest in stocks. So what’s the best way to harness that miraculous compounding power we reference above? Why, through investing your savings somewhere that’s going to earn you some significant returns, and historically, the most reliable place for that is the stock market . One big disclosure that the compliance folks insist upon: investing in shares is speculative, and anyone who tells you otherwise is a big fat liar, so keep in mind that whenever you invest in shares, you run the risk of losing some, or even all of your money. That being said, historically, the annualized returns of UK shares over the last 50 years have been over 5%, which is a pretty solid rate of return. One particularly effective way to take advantage of the natural growth of the market is by purchasing a tracker fund that mirrors an entire economic sector or index, like the FTSE 100. With such an investment, one price could buy you a tiny sliver of the 100 most valuable companies on the UK stock market.
Beware fees, taxes. High management fees and taxes will both decimate your retirement investments, so make sure that you take advantage of all tax relief and keep your investment management fees to a minimum. Before investing, take a deeper dive into these issues with an investing guide like this one.
If you’ve been disciplined from a young age, and retire with a nice chunk of change, you may choose to retire following the famous 4% rule, a guideline introduced by a financial advisor named William Bengen, who ran the numbers and figured out that if you withdraw 4% of your well-invested retirement portfolio annually and adjust for inflation, you will never, ever run out of money. Legend has it, Dracula kept his castle rent paid for 400 years using the 4% rule; it’s also how well-to-do mortals finance their retirement and then pass on their wealth.
So what does the 4% rule mean in real numbers? When you hit retirement age, you’ll be eligible to take the state pension — which at £8,546.20 a year, won’t exactly keep your pantry stocked with truffles and caviar. Some financial advisors will suggest that in order not to feel deprived, you should be netting 70-80% of your pre-retirement income. So, if you’re used to making £75,000, you’ll want to be bringing in about £56,250 annually. If you’re going off the 4% rule, in order to make up that $47,700 your state pension won’t cover, you’d need to have a portfolio of almost £1.2 million. Used to making $150,000? Using the same calculations, you’d need to retire with a portfolio of £2.6 million.
As the saying goes, nice work if you can get it—but very few can. According to a recent study, 55-65 year-olds currently have on average £105,496 saved in their pensions. (As a rule of thumb, a pension pot of £100,000 will yield an annual £5,000 of income.) The good news is that as great as having a cool million in the bank upon retirement would be, it’s easily accomplished with a lot less. Research conducted by consumer group showed that the average couple could cover all their expenses with £18,000 a year. £26,000 would cover all expenses plus regular European holidays. The retirement pot required to cover that £26,000 annual bill? £210,000 in 2018 dollars (in addition to the proceeds from a state pension.)
Early retirement strategies
You don’t want to wait until you’re 70 to start hustling your fellow retirees at bocci? Great, why not retire at 60, or even 50? The only impediment to keep you from retiring on your 30th birthday is having enough money to keep you afloat for 60 or so years. Life’s expensive, and the earlier you retire, the less time your retirement savings will have to experience the magical power of compounding. Here are a few of the major points we’ve set out in more detail elsewhere[link to “How to Retire at 50] for those aiming to exit the rat race early.
Save like a mofo starting right now — and invest much of it in stocks. We went over the power of saving and compounding above, but you’ll need to put that into overdrive. Again assuming a hypothetical though not unreasonable return of 5%, a 25 year-old who puts away $10,000 away every year will end up with almost 741,000 by age 50. Be warned, though: Investments are speculative and it’s important to understand that past results should never be understood to be guarantees, but rather imperfect predictors of future performance. Again, you must keep your fees low, and max out all tax-advantaged accounts before investing elsewhere. A deeper dive on these issues can be found here.
Other ways to retire earlier? Eliminate credit card and other consumer debt. Live somewhere cheap. Hold your head high while giving the valet the keys to your 2005 Honda Civic. Commit to a cheapskate lifestyle like this bloke. Plan to retire in a country with a lower cost of living, ideally one with plentiful rum and coconuts.
Tax-free retirement strategies
If you’ve got even a passing interest in saving money, you probably already know that the tax relief associated with pension contributions should have made your pension the absolute primary destination for your savings over the years. But when, and how quickly, you withdraw it will have a great effect on how much tax you pay—and even how long your pension will last.
Legally gaming the HMRC is something to be planned decades before your planned retirement date, and it’s dense stuff, so we recommend consulting an accountant or financial planner to create a strategy, but for the moment here are a couple tips.
As this article point out, it’s important to be vigilant about the so-called “money purchase annual allowance.” Though you might be able to continue funding your pension until you’re 75, something tricky happens should you start withdrawing from the pension in those years you hope to keep contributing; money purchase annual allowance reduces your maximum contribution down from 100% of your earnings to £4,000 a year if you withdraw too much. (It’s designed to thwart tax cheats.) So, for the love of all that’s good and right, be cautious!
This fellow over here is all about maximizing tax allowances by withdrawing pension income and reinvesting it in other tax-efficient wrappers like ISAs—and even shows how a retired couple might effectively be able to enjoy over £66,000 in retirement income tax-free. It’s totally legal, so you won’t have spend your golden years having your meals delivered through the bars of a cell.
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