So you’re planning for retirement. You’ve made sure you’ll get the full State Pension of £164.35 per week, and you’re building a retirement fund to boost your income to a more comfortable level.
The only problem is that you’re not sure how much you’ll be able to spend each year without running out. Today, I want to explain three simple approaches you can follow to make sure you can spend freely without running short later in life.
A guaranteed income
If you have a lump sum to invest, the traditional option is to buy an annuity. This means you hand over your lump sum to an insurance firm, in exchange for a guaranteed income for the rest of your life. The advantage of this approach is that you’ll always know what you’re getting and will receive the money in manageable, regular payments. The downside is that your money is gone forever.
The latest best buy figures from fund supermarket Hargreaves Lansdown show that a 65 year-old would receive an annual income of £5,475 for each £100,000 invested in an annuity. That’s a return of about 5.5% per year. If you want your annuity income to be linked to inflation, this figure drops to just £3,290, or 3.3%.
With an annuity income of £5,475 each year, it would take 18 years to receive back the £100,000 you paid for your annuity. With an income of £3,290, this payback period increases to 30 years. These payback periods don’t include the income the insurance company will have generated by investing your cash during this period.
An annuity is a good, safe option for many people. But if you’re prepared to manage your own finances, I think there’s a better option.
The 4% rule
At the time of writing, the FTSE 100 offers a dividend yield of 4.5%. By investing your cash in a cheap FTSE 100 index tracker fund, you should receive most of this — at least 4% — each year.
If you’ve got a £100,000 lump sum, that’s an income of about £4,000. And while this isn’t guaranteed like an annuity, history suggests that the collective dividend paid by FTSE 100 companies usually keeps pace with inflation.
This 4% figure is also important for another reason. A general rule of thumb used by financial advisers is that you can withdraw 4% from your savings each year if you want to make sure that you won’t run out for at least 30 years.
You’ve probably spotted the opportunity here — if the FTSE 100 will pay you a yield of more than 4%, you may never need to touch your capital. That means it will be available for lump sum spending during your retirement, or to leave as an inheritance for your loved ones.
In my view, the FTSE 100 is attractively valued at the moment. If I wanted to generate a reliable long-term income, this is where I’d put my money.
The third option
I promised you three options for a sustainable income. So what’s the third choice? I’m afraid this is the least attractive. Without a retirement fund that’s been invested to provide a reliable income, your only choice is to rely on the State Pension and — if necessary — to carry on working.