In 2019 I wrote ‘Rules Rule OK’ that looked at useful investment-based rules of thumb to help us plan and track investment progress. Some of it is my own work, but mostly collected over many years in financial services.
The 25 rule
I’m asked all the time: how much do I need to have saved to retire? Well the times by 25 rule can help. All you need to know is how much you will spend (or plan to spend) over a year in retirement and multiply by 25.
For example, and I’m using some nice round numbers, I think I’ll spend £20,000 a year so I’m going to need 20,000 x 25 = £500,000 in my retirement pot (eek!).
It’s important to note that it’s not 25 times your annual income, but rather 25 times your annual expenditure. Working out how much you expect to spend in retirement can be tricky; some big expenses such as mortgage, pension saving, kids (hopefully) will disappear, but new expenses (holidays, travel, grandchildren) may arise.
Start with your monthly spending on bills, food, council tax and leisure. It depends on what you want to do, but if it still looks like a horrifyingly big number then get saving now, yes right now, change jobs or get realistic about your plans.
The 25 rule is starting to be used by DIY investors, but what is especially appealing is that every pound that comes off the retirement income spend brings the required retirement pot threshold down by £25.
It’s become the mantra of the FIRE movement (Financial Independence Retire Early) to motivate cuts in unnecessary spend.
The 25 rule assumes no other income, though in the UK a state pension will eventually kick in at the moving goalposts of state retirement age.
Thanks to Kirsty and Phil you may have some rental income from property to factor in too.
If we assume no other income, the rule has about 80% accuracy compared to the type of full drawdown modelling done by a professional adviser, who may do a rule of 25 check to make sure that the expensive plan looks ballpark right (and you never know their clients may just have read this article too).
The 25 rule (and full cash-flow modelling) can be repeated every year to see if your plan is on track. It’s the year-on-year direction of travel that is more important.
Like similar rules it makes assumptions: namely an annual average investment return of 4% after inflation and investment costs.
Over a long-term period of 20+ years, investment returns of 7% can be achieved. Inflation erodes this at around 3% a year, so 7%-3% produces a real return of around 4%.
This sort of thing has been backtested using reliable sources such as the Barclays Gilt Equity Study with UK data going back hundreds of years. Post Coronavirus pandemic, there is a possibility that inflation and returns will change, but the long-term averages have held up through worse global crises.
How to achieve 7% returns
In the 10, 5, 3 rule we state that the expected long-term return from equities is 10%, bonds 5% and cash 3%.
Using simple proportions a portfolio of at least 40% equities and 60% bonds would be needed. It can’t be done without equities and that brings investment risk with it. Cash is safe but won’t deliver.
100% cash would push the 25 rule out to almost any number since the retirement pot would never show any real return and how long the pot lasts would then depend on how long you live.
Some investors say the 25 rule should accompany equity content of 60 to 75%. Equities are needed but it should never be a fixed number.
Equity content depends on your appetite for investment risk, which will change over time anyway. But what really matters is how long you have to reach that retirement target amount.
Some financial advisers recommend that as you near the target you glide into it gradually by switching the equity content to lower-risk bonds in phases, a technique known as life-styling.
Nowadays, given how long people spend in retirement, current thinking is that you should divvy your pot up into short, medium and long-term pots, with the medium and long-term pots maintaining a higher equity content for longer. But that’s a more complicated strategy that we’ll save for another time.
How much can I withdraw from my pension pot?
The 4% rule is intertwined with the rule of 25, so worth covering again. The 4% relates to the retirement income level that can be taken from the retirement pot.
The theory goes that if you take no more than 4% of your portfolio as income then it will last at least 30 years. The origins of this rule are based on equity and bond returns in a 60% equity 40% bond portfolio.
If we go back to our nice round example, the £500,000 portfolio can at retirement support an annual income of 4%, which happens to be £20,000. (£500,000 x 0.04 = £20,000)
For the second year of retirement the same amount can be withdrawn but adjusted for actual inflation. Let’s say it’s 2% so you should take £20,000 x 1.02 = £20,400.
Depending on how your investments did the £20,400 could be more or less than 4% of your remaining pot. You only need to withdraw what you need so if £20,400 is too much then reduce what you take.
Pros and cons
The relationship between the 25 rule and 4% rules are the first estimates of how much you’ll need to have in your retirement pot to meet your spend level — if all goes to plan this will be the same pot from which 4% can be safely taken.
Financial advisers consider the 4% rule too simple and use sophisticated cash-flow modelling tools, and blend income from different sources to prevent depletion as well as using the tax-free element of pensions to minimise taxation impact.
The safe 4% rate also makes assumptions about interest rates and investment returns. If this pot is the only source of income, it may result in forced selling of assets from the fund when markets are down.
Sometimes too much income is taken early on in retirement. If a portfolio is ravaged early in this way, it can be to the point where it cannot recover to sustain the desired income.
Critics of the 4% rule (and there are many) say it’s too risky; the assumed 7% return requires too much volatile equity for older investors with a lower appetite for risk. But this is more a criticism of the assumptions.
What’s the answer? Step forward the times 33 and 3% rules.
The 33 and 3 rules
The same principles apply but using 33 assumes a return of 6% with inflation still at 3% making for a real return of 3%. The 3% income rule works in the same way as before.
Let’s do the same maths for both. I still think I will spend £20,000 a year but now I will need 20,000 x 33 = £660,000 in my retirement pot (ie a pot that is £160,000 bigger than before so an even bigger EEK!!).
Using that £660,000 pot I can take 3% by multiplying by 0.03 = £19,800, ensuring the pot size will not become depleted.
The 33 and 3% rule might be too cautious, that, and fear in general, can result in holding back from doing things early on in retirement.
It’s not a rule but the saying ‘enjoy things while you can’ is also true and the octogenarian retiree that has grown their retirement pot has maybe missed out on opportunities for fear of running out of capital — ‘not all treasure’s silver and gold, mate’.
Those who would like to be able to stop work very young in their 30s and 40s should remember the rules of 25/33% and 4/3% work for retirement periods of up to 30 years.
Today we expect to live into our 80s and beyond. If you are planning for 50 years of retirement, then 25 or 33 is not going to be enough, though financial independence at age 30 and retirement is not quite the same thing.
The techy code stuff
There is a modification to the 25 rule to adjust the income for inflation. Let’s take assumed inflation rate which we set at 3%, and if you are ten years away from retirement then do the calculation 1.03 ^ 10 = 1.34 and use this as a factor on the required retirement income. So our £20,000 x 1.34 becomes £26,800. (Note 1.03 ^ means 1.03 to the power of 10 or use the buttons on your calculator.
If we go back to our first example of needing £20,000 a year and plan to retire in ten years’ time, I’m going to need 20,000 x 1.34 x 25 = £670,000 in my retirement pot.
Retirement in 10 years’ time, 3% inflation multiply by 1.34
Retirement in 20 years’ time, 3% inflation multiply by 1.80
Retirement in 30 years’ time, 3% inflation multiply by 2.42
Retirement in 10 years’ time, 4% inflation multiply by 1.48
Retirement in 20 years’ time, 4% inflation multiply by 2.19
Retirement in 30 years’ time, 4% inflation multiply by 3.24
Or use your own assumptions. ‘Aye, that’ll about do it.’
‘I thought you were supposed to keep to the code.’
‘We figured they were more actual guidelines.’
You’re pirates. Hang the code, and hang the rules. They’re more like guidelines anyway.
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