Here we are at session number 73 , and we’re going to be continuing our thread from last week about how to retire early. Last time we covered all the things you need to know to get your head in the right place to even think about retiring early, and I gave you some homework to do before this session. Did you do it? No? Right, see me after class…

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But first…

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Introduction

So we covered off what retirement does and doesn’t mean, plus some other things last week. Here are the main bullet points:

#1 – Know what retire means

#2 – Know what early means

#3 – Understand that retirement is basically a numbers game

#4 – Cashflow is king

#5 – Inflation is a bigger issue in retirement than it is before

#6 – Know the detail of your current provision

We now need to apply this information in a useful way so that we can can have a stab at setting a plan for getting to retirement in a timescale which makes sense, and which is affordable to us now.

Everything you need to DO to retire early

1 – Establish a Timeline

One of your homework tasks last time was to identify your current position. To my mind this takes two forms:

• If you have defined benefit pensions, which pay out a guaranteed income at some point in time, you should be able to identify how much they will pay you, and when.
• Any other funds, such as ISAs, deposit accounts, you should know what they are worth.

We need to start building a timeline for the defined contribution and state pension elements of your income. Maybe you could draw this on a piece of paper, or mock it up on a spreadsheet or something. Start the line at ‘now’ on the left,  and highlight the key points along the line.

For example: Deferred company pension kicks in at age 60. State pension age at age 67. These are known quantities so put them in.

The example above shows what I mean. It might just be me that thinks visually, you might prefer a spreadsheet (I like those too), but bear with me for now. If you are in a couple, your pensions may kick in at different times. Make life easy for yourself and deal in household income – lump it all together.

IMPORTANT: The figures should be in today’s money, so be careful. Double check the numbers on your pension forecasts – do they take inflation into account, They should, but you must be sure. The only kind of money that counts is today’s money – anything else is pie in the sky.

ALSO IMPORTANT: Remember to keep in mind income tax. It’s impossible to know what the income tax regime will be in twenty years’ time, if that’s how long you have till retirement, only today’s money counts. So use today’s rules for income tax.

There's an easy rule of thumb for calculating income tax in retirement. Take the gross income and take off £10,000. Whatever is left, take 20% off it. Then add the £10,000 back.

Example:

£25,000 total gross income

Take off £10,000 to get £15,000.

Take 20% off that to get £12,000.

Add the £10,000 back to get £22,000 and this, near as makes no difference, will be your net income for the year.

Now we have added to our timeline the income that we know will be coming in and when – see figure 2 below

Now we need to work out if there is a shortfall. You should know what your likely expenditure is going to be. Listen back to last week for more on this, but chances are there will be just one or two of you in the house – no kids. You won’t (hopefully) have a mortgage and you won’t be saving, you’ll be spending. Establish a monthly expenditure needed to live, and multiply it by 12 to get an annual figure.

Then apply this to the timeline, as in figure 3. This figure will need to increase in real terms of course as inflation means the cost of everything will rise. As we are taking inflation into account on our timeline, assume that the amount you settle on will stay the same forever.

If you look at my example, you can see that these people have a shortfall, right until age 67 when his state pension kicks in.

If the people in my example want to retire at his age 60, they have some work to do to cover the shortfall of £10,000 per year at that point.

2 – Consider phasing into retirement

Our example people have a shortfall. They have two options:

• They can phase into retirement. Perhaps they could reduce their hours a little once he reaches age 60. They would still receive a salary to make up the difference between their pension income and their desired expenditure level. When the wife’s company pension begins, they could reduce further, or maybe one of them could stop work altogether
• If they really want to flat-out retire at age 60, the shortfall is going to have to be funded from somewhere

This will, I think be a major option for a lot of people. If a shortfall needs to be filled, this might enable one or both partners to retire from their ‘main’ jobs, and take on something relatively menial and stress-free.

I have an example of this fairly close to home right now. A chap is coming to work for me which has worked for a bank for many years. His pension is in payment but he isn’t ready to stop work yet. His job responsibilities, and therefore his salary are significantly less than he has been used to, but that’s just fine with him. He doesn’t carry the can for everything like he is used to doing. He can come to work and leave it there at 5:30. No responsibility, no stress, but still an income with which to top up his pension.

3 – Identify the shortfall

If our example couple want to retire at age 60, and never work again they will have to meet the shortfall from their liquid capital. This capital can provide an income and they can also drawdown from the capital if they need to.

So how much is enough?

There are quite a few variables here, so remember what I said last week about planning for the future being, at best, educated guessing. Unless you are working with an adviser who has access to cashflow modelling software, or unless you are an Excel ninja yourself, we’re going to be working with rules of thumb here.

We can work backwards to get our desired lump sum level by starting with a safe withdrawal rate or SWR

For more info on the SWR, check out my video episode 276 where I explain it and give example via a screencast.

For now though, we need to use the SWR to ‘convert’ a lump sum of money into an income which can cover this shortfall.

Easy example. If our shortfall is £4,000 per year, and we assume a SWR of 4%, then we need £100,000 to cover this withdrawal rate – make sense?

Take a look at the shortfall in your situation, or use my example. My couple have a shortfall of £10,000 at age 60. If they assume a SWR of 4%, they need a pot of money of £250,000 to fund this.

The SWR needs to be conservative enough to cope with making withdrawals for the rest of your life. Advisers have for many years used 4% as a rule of thumb. Some recent research shows that this is probably too simplistic, and that a big factor is the price of markets at the point at which you begin withdrawing. If markets are high when you begin, you may need to assume a lower SWR to give scope for markets to drop off. Conversely if you are retiring at a low point in the stock markets, yo may be able to afford a higher SWR.

I’m pretty sure no-one listening to this knows what the markets are going to be doing 20 years from now, so we can’t get too hung up on this. Best just to be conservative in our estimate. This can make a big difference though – in my example, switching from an assumed 4% SWR to a 3% SWR means our couple have to save an extra £83,000 – no mean feat.

What’s the maths for working out the lump sum needed to fund a given level of income? Just divide the income required by the SWR as a percentage.

Example:

£10,000 shortfall and SWR of 4% – Divide 10,000 by 0.04, or hit 10000 divided by 4 and hit the % key on your calculator.

4 – Build the fund

The last thing to do then is the hard bit – we need to amass the funds needed to cover our shortfall, and this requires some good old fashioned saving.

We have established how much we need in the previous step, let’s say £250,000. We know how much we have in personal pensions and investments right now, let’s say £50,000. We need to save up £200,000 over the next X number of years.

The markets all hopefully help us by growing our funds asa we add to them.

To make the maths easier, I’m going to refer you to a fantastic little calculator on the website of a friend of mine called Andy Hart. He goes by the name of the Voyantist, because he is a master user of some cash-flow modelling software called Voyant.

His calculator has as start age and anticipated retirement age, which he calls Financial Independence age. Then you need to enter your income shortfall and the amount of money you are starting with.

The final two variables are the Safe Withdrawal Rate and the expected growth rate above inflation. The calculator will then provide you with a sum of money you need to amass to fund the income shortfall and the level of annual savings you need to make to get there.

Huge thanks to Andy for steering me towards his calculator – it will make all our lives easier.

Summarise the steps

#1 – Establish a timeline

#2 – Consider phasing into retirement

#3 – Identify the shortfall

#4 – Build the fund

There is nothing more complex to retirement planning than this, not really. Once you know what income sources are going to pay out and when, including maybe part time work, it is simply a case of identifying the shortfall, if any, and then amassing enough other funds in pensions and ISAs to fill the gap. Simple, but not easy, as at some point the realisation sets in that the only way to do this is to knuckle down and save.

Retiring early 

Retiring early is a matter of accelerating one or more of these factors:

• Save more aggressively so that you can fund your shortfall more quickly
• Invest more aggressively, i.e. take more risk, with the hope that markets will help you get to your goals more quickly
• Phase into retirement by taking part time work, enabling you to retire form your current full-time position, or by dipping into your private pensions or liquid investments early

I’d love to give you a magic formula, but there isn’t one – sorry to burst the bubble! Retiring early means hard graft while the earned income is coming in, so that you’ll be fine when the income stops.

Again I’ll quote Dave Ramsey, author of the Total Money Makeover who says you need to “live like no one else, so that later, you can live like no-one else.”

Will you make the sacrifices needed no to achieve your goals? No-one else is going to do it for you…

Questions

Let me take a minute to address what I think will be the most obvious questions

1 – How do I decide a target income for me?

Target income is decided by target expenditure. Work our first what a desired lifestyle looks like. Take the bills you know you will need to pay and then add on play money.

So if £1,500 a month is enough to live on, assuming you are mortgage free etc, then add on to that how much you want to be able to live well. No-one wants to just get by in retirement, but most people will have to.

If you establish that £2,500 per month is a nice level, that’s £30,000 per year, but you’ll need to gross that up to account for income tax. Assume that, if you’re a couple you can earn £10,000 each tax free. The rest will be taxed. So if you need to £30,000 net, you can assume that £20,000 of that is tax free, the other £10,000 net income you need will have have had tax paid on it. Divide the £10,000 by 0.8 and you’ll get £12,500 – add that to the £20,000 you can receive tax free and you have your pre tax total income figure of £32,500. You can then work out how much of that will be covered by pensions and fund the shortfall

Your target income is unique to you. It’s your retirement and no-one else’s

2 – How should I fund the shortfall? Pensions or ISAs?

For most of us, these are the two types of tax wrappers which we will use to fund our retirement. The difference between the two is quite simple:

Pensions: Tax relief (free money) when you pay in, but income is taxed on the way out

ISAs: No tax relief going in, but tax free coming out

They both grow in exactly the same way. It used to be that pensions were much more inaccessible than ISAs but this is changing form next April 2015. Do be aware of the taxation of pension income though.

I like my clients to have both strings to their bow. It gives choice of where and how the income can be taken

3 – How do I invest to build the money I need?

Usual answer from me here – I like risk-managed, multi-asset, passive funds. I like them because they’re mostly hands off and should largely look after themselves. Listen back to Session 41 for detail about how I think investing should be done.

4 – How can I consider different scenarios to see which works best for me?

The maths behind all this would be easy if it weren’t for the annoyance of inflation and its compounding effects over time. This is why advisers use software to do the heavy lifting for them! If you want clarity on this, I can’t recommend enough that you see a competent adviser, preferably a Certified Financial Planner or CFP. They can help you model scenarios using software. There isn’t to my knowledge a tool online which helps people do this easily. Andy Hart’s calculator mentioned earlier will help.

If there is a ‘best time’ to seek advice from a quality financial planner, it is when you’re thinking about this stuff. I’ve been working with a couple of podcast listeners recently – hi to John, Penny, Damian & Jacky – and they will say that the clarity they have received from working with me so far has been worth the fee.

5- Once I have retired, have I set out my stall and can’t change the path I’m on?

The great thing these days is that pensions particularly are far more flexible that they have ever been. After next April, you can take pretty much what you want from a personal pension, when you want. Whatever you take is taxable at your marginal rate of income tax, but you can take out your whole pension pot if you want to.

Defined benefit or final salary pensions are more set in stone, and all the better for it. They are usually very attractive schemes with incomes which are indexed, but once they are in payment, the terms are pretty much set.

Flexibility will come from personal pension provision and your non-pension portfolio such as ISAs and the flexibility you have to top up your income with earnings. I think this is going to be a huge part of many people’s retirement in future. Most of us will be working to some degree for as long as we are able to.

Summary

While writing this I have tried to constantly ask myself – have I fulfilled the brief? Have I covered how to retire early?

Fact is most of us won’t retire early because most of us won’t save enough to do so. Again retiring early is about accelerating some of the factors we’ve covered. The alternative is to lower our expectations. Yes, you can retire early, but not on the level of income you would like. If  you can live with that, then yes, you can retire early.

I’d love to hear you questions or comments on this. But one final point from me: I may be able to work with you to help with your retirement planning, but I am approaching capacity for taking on new clients. There is a button at the top of the website to Work with Pete. Just be aware that when this session is released, I will be on annual leave, so may not respond for a couple of weeks…

This week’s reviews

No reviews this week because I am recording this in advance of being on holiday.

If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/or pressing the big red button! This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.

Next Session Announcement

Next time we'll be starting a new occasional series called How I Invest. I’ll be talking with investing experts about their views on investing and kicking things off for us next week will be Abraham Okusanya of Finalytiq. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete

Outro

That's it for this session of the MM podcast, I hope it was helpful. If I missed anything or if you have any questions, please leave them comments section below.

I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.