Here we are at session number 83 , and I’m going to be asking – and answering – How much is enough? Lot’s of scope to that question, and lots of meat in the answers, so stay tuned…

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But first…

Sponsor Message

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Introduction

When we’re building wealth for the future, how much is enough? When have we cracked it? When can we take the foot off the gas, take a deep breath, and begin enjoying the fruits of our hard work?

You’ve heard me say countless times on this show that investing must be for a reason. And also, you’ve heard me say that you need a target to aim at. Today, I’ll be giving you the tools you need to determine your own target. It’s fairly basic maths, you just need to know what the sums are and how to apply them to your personal situation.

As usual, we’ll look first at some knowledge you need to have in place; some context for the practical stuff which comes in the second half.

Are you ready to find out your magic number for investing success? Let’s dive in…

Everything you need to KNOW

1 – All financial planning comes down to income and outgoings

There are many truisms in financial planning, but this is definitely one of my favourites. Income and outgoings is what it is all about, at every stage of life.

When you’re accumulating, you need to spend less than you earn in order to build wealth; it simply won’t happen otherwise. When you come to retirement, and determining how much is enough, you need to start with income and outgoings and work back from there. We’ll get to the practical bit in a minute, but for now, lets remember the immortal words of Mr Micawber on this subject:

“Annual income twenty pounds, annual expenditure nineteen [pounds] nineteen [shillings] and six [pence], result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”

Or in other words – spend less than you earn. It really is the foundation stone of financial success and the first of my three steps to financial freedom.

When you are determining how much is enough, you’ll need to get pretty granular in detail with how much is coming in and when, plus what your outgoings are going to be and how much they are going to increase by. Again, practical steps are coming, but for now, understand that it is not investing success, inheritances or lottery wins that are the path to success, but income and outgoings are the start and end of it all.

2 – It’s OK to erode your capital

In the course of my day job as a Certified Financial Planner^CM There are a few conversations I find myself having repeatedly with clients across the board. A key topic that keeps on going up is that it is OK to erode your capital.

Reluctance to do this is understandable. Those clients in a position to take advice from me have usually built up wealth over time by being careful, and not giving in to every purchasing whim that crosses their mind. Most of my clients are retired or are approaching retirement, and so they are beginning to think about decumulating, that is, drawing an income from their accumulated wealth. Most of them think in terms of income. So, they have a lump sum of money, what interest or dividends can it generate? That way, they live off the income, but the capital remains untouched.

At this point I usually ask why the capital needs to remain untouched. The answers I hear back are often very similar. They don’t want to run out of money in their later years; they want to leave something to the kids, but often they have no answer.

Let me make it clear right now, just as I have done countless times on this show. Money is for spending. Listen back to Session 32 for my only three acceptable uses of money. In short they are:

• Spending on having fun
• Investing towards a specified goal
• Giving away to others

My clients tend to be very good at the second of these – investing towards a specified goal – and in their latter years (often too late) they get better at giving money away, but they often struggle to spend money on themselves. It requires a mindset shift and often times they need to be given permission, as daft as it sounds, to spend their own money.

A financial forecast of the kind that Andy Hart and I discussed back in Session 79 helps here, and that’s where we’re coming to, but for now, please take it from me that spending money is OK, and indeed for most of us will be a necessary part of feeling well-off in retirement.

3 – Inflation is the enemy

Way back in session 15, I explained all about inflation and opened that session with a quote form Todd Tressider of FinancialMentor.com:

“Inflation is an incredibly dangerous three-headed monster: it can’t be forecast accurately and it multiplies your spending, while reducing average investment return”

Never is inflation a more insidious beastie than in retirement. While we’re earning, our wages usually rise above the rate of inflation so it never really feels like a thing. (By the way, for everyone listening to this show who works in the public sector, I know that your wages haven’t risen in excess of inflation for a few years now, and I agree it’s a travesty). Once you arrive at the retirement finish line and you have a finite sum of money in the bank or investments, and you know what your income is going to be, then inflation is a big factor indeed.

Spending in retirement tends to be on a greater proportion of things which rise faster than the headline rate of inflation, food and fuel for example, so this needs to be factored in. But factoring inflation into our plans, as Tressider’s quote says is difficult because it cannot be forecast accurately, so we need to make assumptions. It means we need to spend more each passing year in order to stand still, and it erodes the returns on our investments – all pretty nasty.

Suffice to say we need to do our best to take into account the effect of this nasty beastie when determining how much is enough.

Summarise KNOW

#1 – All financial planning comes down to income and outgoings

#2 – It’s OK to erode your capital and spend your money

#3 – Inflation is the enemy

With those things in mind, let’s get stuck in to determining your magic number, your ‘enough’ figure:

Everything you need to DO

1 – Summarise known income and DESIRED outgoings in today’s money

If everything comes down to income and outgoings, then we need to know what both of those figures are before we can work out our magic number.

Let’s start with income. This is like to be coming from different sources at different stages of your life in retirement. Your state pension will  come in at a set age, barring any more surprise legislation changes. You can find out your state pension age using the calculator on the Gov.uk website. The state pension will be a fixed amount from April 2016, and if you qualify for the full amount, this will be a little over £7,700 per year. It will also be indexed, that is, it will rise by an amount each year to try and keep pace with inflation.

Remember that if you are in a long term relationship, both partners will have a state pension most likely. It is definitely easier to do this exercise together than apart, but I understand that every household is different. Maybe you can work together when it comes to each other’s contribution to the household expenses, but otherwise you want to keep things apart. Whatever works for you…

Remember company pensions too. Be careful here if you are planning any distance into the future. You ideally want to express each of the income amounts in today’s money, because that’s the only kind of money we understand. So ask your pension providers for projections, or do your own projections taking into account assumed growth rates and the amount you are contributing, and try to find out what level of income you will get from each pension plan.

Do you have rental properties? – these are an income source and so need to be added to our list.

Remember, you want all sources of income written down and crucially, you want to know whether each source is going to be level or indexed, in other words, will it go up each year, or will it stay the same.

When it comes to money purchase pensions such as stakeholder pensions, personal pensions or money purchase pension schemes at work, then express these as a lump sum fund value. This will form part of our magic number. What we need to know are guaranteed sources of income first, everything else can be expressed as a lump sum figure – more on this in a minute.

When we know what income sources we have, we need to look at outgoings next. Divide this into two areas: necessary and discretionary.

How much do you need to run your household and pay all your bills, including eating well and maybe changing the car every five years? Express this as an annual figure. This figure will need to increase each year of course, but work out that figure based on today’s needs.

Then come up with a discretionary figure. If you want to take two foreign holidays a year, eat out twice a month and change the car more regularly, what will you need each year to have these things?

Two figures then, necessary and discretionary outgoings. We’ll be working on the sum of the two, as no-one wants just to get by in retirement.

2 – Determine your likely available lump sum at the point of retirement.

So we have income and outgoings; now we need to work out how much cash you’re going to have at the point of retirement. This will be made up of all kinds of assets:

• Cash in the bank
• Investments such as ISAs and bonds
• Shares
• Lumps sums from pensions
• Possible inheritances

It should not include your home as you can’t eat this. We’re talking liquid, spendable assets.

It should definitely include your pension fund . Time was I would have said the opposite of this, but the new pensions rules allowing pretty much unlimited access to pensions form next April mean that I would now include them as part of your lump sums.

Now, add all those lumps sums of readily available cash together. How much does it come to? Once you have a figure, we need to know how long that is going to last if you are dipping into it each month or each year to fund your lifestyle.

3 – Will you be eroding capital? Then determine how much you will need

Take your outgoings from your income. Is there any income left or are you left with a minus figure?

If your income is £30,000 and your outgoings are £40,000 then you’re login to have to find £10,000 every year, rising by inflation to bridge the gap. This will need to be from the capital sum we worked out in the last step.

So if you need £10,000 per year, and you have £100,000 in lump sum, it’ll last you ten years, right?

Wrong. We need to take inflation into account and growth on the money. So, if inflation is say at 3% and you get a 3% return on the money, they should largely cancel each other out and the £100,000 will last you ten years. Get a higher return and it might last you a year or two longer. But investment returns are never uniform, so you can’t rely on assumptions. Regular review and intelligent investment are necessary if things are close to the wire.

Instead, for the purposes of working out how much is enough, we’ll use a rule of thumb for something called the Safe Withdrawal rate. I discussed this in quite a bit more detail back in Session 73 so do check that out. The SWR is simply the rate at which you can afford to withdraw money from capital and never have it run out. Extensive studies have been conducted into this, and they all conclude that there is no such thing as a rule of thumb, but I’m going to use one anyway!

I’m going to be conservative and go for 3% because we want to build in an inflation proofing element. You may want to use 4%.

The sum is as follows:

If you need £10,000 income from your lump sum and you use a 3% SWR, you need to divide £10,000 by 0.03, which gives you £333,333 lump sum required to meet that income shortfall comfortably.

Can you see where we have come to? We have identified income and expenditure. Shortfall in income has to be made up from capital, and we need to make sure we have enough capital to cover the income shortfall for the rest of our lives.

A MASSIVE CAVEAT!

This whole process is ultra-simplistic. Way too simplistic to have that much value. Certainly, I wouldn’t want to make bets based on the information this process will give you.

But it will give you something of an indication as to whether or not you’re remotely on target.

The problem with any rule of thumb, back-of-a-fag-packet calculation like this is that there are so many variable in every individual’s situation that you simply can’t cover them all. This sis where I encourage you to seek the advice of a Certified Financial Planner, but I do that in almost every episode, so I’ll say no more about that now 😉

I do believe that instinctively, most of know whether or not we have done what is necessary to achieve financial independence. I also know that most people have not done enough and many leave it too late to fix that.

The fact you’re listening to this show tells me that you’re serious about getting your finances in order and finishing the race strongly. Kudos for that, and I hope that I’ve at least given you an inkling into my thought processes here.

Comment from David8242

You may remember that a couple of weeks ago I read an iTunes review from a listener called David8242. I asked David on air if he could add some detail to his question. He has kindly done so, and I will be addressing some more of his comments in a future session. But regarding target Net Worth, he had this to say:

From a target Net Worth perspective, guidance suggests an indicative (Age x annual pre tax income / 10). Is this a good rough guide? Should pension pots be included as ‘assets'? 

Do you know of any better way of setting Net Worth goals? I'd love to hear an episode on the many facets that make up Net Worth…What you need to know and what you need to do. Also, as a married couple, do you simply pool all assets / liabilities?

Age x pre tax income / 10. If you need a pre tax income of £40,000 pa and you were age 60. That would be 40,000 x 60 = 2.4million, divided by 10 which would be £240,000. That aint enough to fund a £40,000 a year lifestyle so I think there must be more to it than that. I’ve had a quick look at NetWorthIQ, the American website which David has been using and from which he got this rule of thumb, but I haven’t found it there yet.

I’ll definitely resist Net Worth in a future episode, but let me finish here by summarising:

1. Define your income and add it all up – use after tax income
2. Define your desired outgoings
3. Take one from the other
4. If income exceeds outgoings – congrats, if not, determine the shortfall
5. Use the Safe Withdrawal Rate calculation to determine the size of lump sum you need to fund the shortfall
6. Have you got enough already? If so congrats, if not, get saving.

Let me know if you have any questions – leave me a comment below

This week’s reviews

[This is where I read the reviews]

If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/iTunes just like HazBaz2 this last week. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.

News

How to win the loser’s game – now full version released at SensibleInvesting.tv. Refer back to Session 76 for more on this excellent documentary.

Weight loss. I put on albs while I was away last week but have already taken them off again. Full on paleo diet mode again now so results will surely follow! I’m now 16st 2lb

Next Session Announcement

Next time the subject will be In Defence of The Annuity. The humble annuity has come in for some flack in leith of the pensions changes coming in next April. Will anyone need an annuity any more? I think so, and next time I’ll be covering why I think annuities will still be the right choice of most people. 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.