Do you have any idea how much you need for a comfortable retirement? Here’s a clue.
Can you picture your dream retirement? Island hopping on a yacht? Hanging out at coffee shops in one of the world’s great cities? Pottering about in the garden?
Whichever grabs you, retirement will be a lot more fun if you have saved enough to make the most of it.
We can all dream, but we also have to do some hard sums to make them come true.
There are two great unknowns when saving for retirement. First, how much do you need in your pension pot? And second, how much should you invest to achieve it?
Until you have answered these two questions, you are flying blind and won't know what kind of retirement you are heading towards.
Think of a number
The answer to how much you need partly depends on you, although it is probably more than you think.
A nice round figure like $1 million, £1 million or €1 million sounds promising but it won't stretch as far as you hope.
A financial rule of thumb states that if you draw 4% of your portfolio as income each year, your investment pot will never run dry. That assumes you leave your money invested, mostly in shares, and generate an average annual total return of 7% a year, while inflation averages 3%.
The 4% rule, as it’s known, suggests that a cool million would safely generate income of just $40,000 a year (or £40,000, €40,000, depending on your currency).
That’s not enough to fund a luxury retirement, unless you have other sources of income, or loads of property, a juicy inheritance or wealthy partner.
Another rule of thumb suggests we should be aiming for two thirds of our working income in retirement. So if you want $120,000 a year, you should be aiming for $80,000, and will need $2 million in your pot.
That sounds daunting, but at least you know your target.
The next big question is how much you need to save to hit that target. Again, there are variables.
The more important is your age. The younger you are, the longer you have to invest and let your wealth build.
Unfortunately, many young people start too late and squander this advantage. This is understandable, retirement seems a long way off when you are young, and you typically have more immediate demands on your wallet.
However, each year of delay makes it harder to build the wealth you need to live your retirement dream.
You might be surprised how hard.
Time is your best friend
Your early pension or investment payments are the most important you will ever make, as they have so much longer to grow in value.
Let's say you invest $500 – or £500 or €500 – a month from age 30. If you invest it mostly in shares and your portfolio rises at an average rate of 7% a year after charges, then you will have $887,481 by age 65.
You will have contributed $210,000 and compound interest would have made up a whopping $677,481 of your balance.
However, if you don't start saving until you are 40, and put away the same $500 a month, you will have just $406,059. That 10-year delay has halved the value of your pension pot.
This has happened for two reasons. First, you have paid in less money. In this case, your contributions totalled $150,000 (rather than $210,000).
The second reason is that your money has 10 years less to grow in value. Over 35 years, compound interest makes up 76% of your total pot, or $677,481, but over 25 years that falls to 63%, or just $256,059. Your money isn't as working as hard, because it isn't invested for as long.
If that doesn't convince you, this figure might. To build a million from a standing start at 40 you will need to invest $1,250 a month rather than $500.
At age 50, when you are just 15 years away from age 65, you would have to save a thumping £3,250 a month.
Whatever your age, the underlying message is clear. Save as much as you can, as early as you can.
Don't worry about overdoing it. Have you ever heard anyone complain they saved too much in their pension pot?
Invest more over time
Here’s something else you should do: increase your contributions every year as your income (hopefully) rises.
As we’ve seen, saving a flat $500 a month from age 30 gives you $887,481 at age 65. But if you increased your contribution by 3% every year, you would have $1.26million.
If you hiked your contributions by 5% every year, you would have $1.66million. That is roughly double the amount compared to paying a flat rate.
So wherever you invest, increase your contributions regularly (and especially after you get a pay rise).
This will help the value of your money keep pace with inflation, which eats into the real value of your portfolio over time.
Start by investing in shares
Naturally, you will not generate 7% a year if you leave money in cash, especially these days.
You need to build a balanced portfolio with plenty of equity exposure, which you can do easily and cheaply by investing in exchange traded funds (ETFs).
If you’re not sure what to buy but want your money to start compounding right away, here’s a simple way of getting started. A global equity ETF such as the Vanguard FTSE All-World UCITS ETF or iShares Core MSCI World UCITS will give you a diversified spread of thousands of companies around the world.
Then you can do some research, and created a balanced spread of shares (mostly), bonds, gold, property and possibly even some cash and cryptos, over time.
Everybody has a different idea of what makes up a perfect retirement, but we have one thing in common. We all have to work and save hard to achieve it.
Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.
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