Planning for retirement: how do I hit my target?
The amount that any person needs for their retirement is on the increase thanks to rising life expectancy. And in a pensions revolution, the UK government is encouraging everybody to take much more responsibility for their own retirement. That means taking the time to understand your future needs and ensuring you invest to hit your targets.
Retirement is one of the most daunting prospects that an investor faces during his or her lifetime. Income usually declines substantially and you’re left to rely on your pensions and savings. While your costs may also decline if the mortgage is paid off and the kids have left home, life expectancy is on the increase and that means one needs having a bigger pot than ever before.
A common figure that’s quoted is that you need about two-thirds of your working-life income to live comfortably in retirement. So if you earn £30,000 a year, then you’ll need £20,000 a year for your retirement. Now, consider that Public Health England says men can now expect to live for a further 19 years at age 65. That means a man would need at least £380,000 for their retirement. A woman can expect to live a further 21 years at 65, meaning they would need at least £420,000.
These are very general figures that can be used as a rough guideline. How much you will personally need depends on the lifestyle you want to maintain.
What’s clear though is that our pensions and savings pots need to be substantial, and with careful financial planning and discipline you can build a solid asset base that would pay off during retirement. Let’s look at this in more detail.
Planning for retirement — your checklist
1. What are my investment return objectives?
It’s very important that you set objectives and targets when investing. We can either look at income and growth separately, or use the total return ignoring taxes for the sake of simplicity. We will use total return when calculating the required rate of return. Let’s also assume you have retired or are nearing your retirement. This simplifies matters for this discussion since it’s most likely you are able to estimate your outgoings more accurately.
Let us assume the following:
- Your expenditure each year during retirement is going to be £75,000
- Your investable assets (excluding the property that you live in and cash set aside for emergencies) are worth £2,000,000
- Inflation is expected to run at 3% for the next year
- Management fees are often overlooked when trying to work out one’s return objectives. Sometimes these can be as high as 3 or 4% and therefore cannot be ignored. Let’s assume management fees on the portfolio are 1.5% in this case.
Given the facts above, the real return objective should be 3.75% net of taxes. Once you consider inflation and the management fees, the nominal rate of return should be 3.75% +3% +1.5% = 8.25% net of taxes.
2. What are my risk objectives?
Since our example assumes you are at or near retirement, we should also assume your risk tolerance is below average, both in terms of willingness and ability to take risk. Your investment time horizons are shorter and therefore your ability to recover losses so late on in the investment phase are lower. The earlier an investor is in the investment cycle, the higher their ability to take risk tends to be.
Having worked out the return objectives above, you would need to ensure that this is achievable given the risk parameters. As you move through the investment cycle, you would - or at least should be - more invested in bonds than riskier equities. The question then is whether an 80/20 or a 60/40 bond portfolio can achieve an 8.25% nominal return per year?
If not, can I increase my investable assets? Can I increase my risk parameters without increasing the volatility of my returns significantly?
3. What are my constraints?
Am I expecting a negative or positive liquidity event in the near future? How would this affect my investable asset base in terms of return and risk objectives? A negative event would include a large piece of expenditure, while a positive event could include a windfall from inheritance, for example.
- Time horizon
What is my time horizon? Remember it tends to follow that the longer the time horizon, the higher the ability to take risk since more time allows the investor to recover any losses.
Am I maximising tax wrappers like stocks and shares ISAs and SIPPs? And do I have the right investments within each of them? Read more about how to make the most out of your ISAs.
You should always keep track of changing law and the investing environment, and react to changes to ensure you are achieving your required (not desired) returns and managing your risk.
6. Other unique circumstances
There are a number of unique circumstances that could affect your return and risk objectives, and you should regularly be managing and rebalancing your portfolio.
In the example we’ve used, the investment pot is extremely large — mainly because you are close to, or have reached, retirement. It’s often said, but worth repeating, that the earlier you start saving for your retirement, the easier it becomes to achieve your targets. The later you leave it, the more you are going to have to set aside per month. That’s because you have less time to achieve growth on the capital you are investing.
For example, if you start saving £500 per month at the age of 20 towards your pension pot, either via a SIPP or an ISA, and you expect an annual rate of return of 5% a year, then by the age of 65 you would have accumulated £958,000. If you start saving or contributing at 40 the same amount, you would only have accumulated £286,000. To achieve £2,000,000 in your pension pot, you would likely have needed to save or contribute £1,041 per month for 45 years.