With the State Pension currently being £8,767 per year, it is likely to be inadequate for most retirees. Although inflation has moderated somewhat in recent months, and the State Pension has an appealing ‘triple-lock’ to ensure it grows at a brisk pace in future, living off the current payout seems to be extremely difficult.
As such, it may be worth building a nest egg during an individual’s working life in order to have a second income in retirement. The challenge for many people, though, is working out how much they will need to save in order to obtain the financial freedom they want in retirement.
Saving for retirement
While it is difficult to know how much income an individual will need in retirement, a good starting point may be the average annual wage. It currently stands at around £28,677 for full-time employees. Deducting the current State Pension from that figure leaves a total of £19,910 to make up. Obtaining this amount as a second income may provide a retiree with the same standard of living as an ‘average’ worker in the UK.
Investing in retirement
While it is always a challenge to know how much money to withdraw from a pension in retirement, the ‘4% rule’ is generally considered to be a worthwhile amount. It means that an individual withdraws 4% of their portfolio each year, with this amount being used as an income. The idea behind the ‘4% rule’ is that an individual will withdraw enough to live off, but not so much that they will eat into their capital too quickly.
For investments in the FTSE 100, withdrawing 4% per year would mean that dividends are used for income, with capital not being used to fund withdrawals. However, some investors may wish to take more or less risk in older age, depending upon their own personal circumstances.
Building a nest egg
In order to obtain an annual income of £19,910 when withdrawing 4% of a portfolio each year, a person needs to have a nest egg of around £500,000 when they retire. Although this is clearly a very large sum of money, it may be possible to achieve from a lower savings rate than many people imagine.
The FTSE 250, for example, has delivered a total return of around 9% per annum over the last 20 years. For someone who has a 40-year investment period during their working life, they could accumulate a nest egg by the end of the period of £500,000 by investing £125 per month in the FTSE 250.
Clearly, this calculation does not factor in the impact of inflation. However, it serves to show that it may be possible for a range of individuals to obtain their desired level of income in retirement by investing regularly in a diverse portfolio of shares. At a time when the State Pension continues to be inadequate, starting to plan for retirement early and working backwards from the amount that may be required in retirement could be shrewd moves for people to make.