How Much Money Do You Need to Be Financially Independent?
This is a big, complex question. No two individuals and their lives are exactly the same, so neither are the answers; there are many factors and moving parts which come into play.
The purpose of this blog is to share with you some of the conversations and processes we go through with our clients, to help you start answering this important question. We’ll also share some risks and issues to look out for.
This blog goes into some detail of how to calculate “Your Number”. For a shorter easier-reading summary of the process please see our earlier blog here.
How to Calculate
A. Spending
The biggest single factor – every £1 you want to spend when you are no longer working will need to be funded. We think it’s helpful to consider 3 main types of spending:
1. Normal day-to-day living costs
2. Lifestyle spending
3. One-offs
With 1.) think in terms of your current spending. Then adjust for changes in retirement – for example, any mortgages/debts paid off, commuting or childcare costs that will end.
With 2.) think what you want your life in retirement to look like – what will you do, how will you occupy yourself. It’s likely that discretionary lifestyle spending will increase when you are no longer working and have more time to fill.
With 3.) these can be initial items on retirement or further down the line e.g. that round-the-world trip you always wanted or helping children with house deposits. We find clients often have some sort of ‘one-off’ expense most years, such as car replacements, property maintenance etc.
Inflation: remember your normal expenditure will increase as prices in general rise. Just think what things used to cost 20/30 years ago to get an idea of the impact. The spending you plan on making now will be in today’s terms and will increase with inflation.
Spending over time: people often plan to spend more in their younger retirement years whilst in good health. This makes some sense but note it is far easier to increase spending than decrease it. In our experience clients don’t suddenly get to an age and happily slash their expenditure and many travel well into later life. There is also the risk of incurring care costs. In our view a sensible and sustainable financial plan should rarely rely on heavily reducing expenditure in later life.
B – Income
What if any (secure) income will you still have after you finish work, other than from your capital? Think of state pensions and salary-related (e.g. public sector) pension schemes in particular.
When and for how long will they be payable? How will they be taxed – it’s the net of tax amount that matters.
Most people will have some state pension provision, which can be a very valuable resource. The current full (flat rate) state pension is over £9,000 p.a. increasing by (at least) inflation each year.
If a couple planned to spend £5,000 p.m. / £60,000 p.a. then £1,500 p.m. / £18,000 p.a. could be funded by their state pensions (from state pension age), reducing the amount to be funded to £3,500 p.m. / £42,000 p.a. (ignoring any additional tax). This drastically reduces capital needed.
Rental Income: a note of caution here in that rental income is not entirely secure – void periods, property damage/structural issues, weak rental market etc – can reduce or stop income. The alternative is to treat the (equity) value of properties as part of your capital sum.
Initial, Rough Estimate
Once you’ve planned spending and deducted income, you can estimate how much capital you will need. This will be determined by the rate at which you draw from those assets (from both income and capital).
A quick note on that capital; you should only include assets that you can spend. Your main residence wouldn’t count; you’re living in it and can’t spend it. If you were planning on downsizing or using equity release in the future, this could provide additional capital at that point. A trading business is also often a ‘used’ asset until it is sold / liquidated. However, planning with businesses is more complex and specific circumstances may lend themselves to different treatments.
Historically many experts viewed 4% as a ‘safe withdrawal rate’ i.e. you could spend 4% of your (well invested) capital each year (increasing with inflation) without risking running out of money.
If we consider the example of a couple wanting to spend £3,500 p.m. / £42,000 p.a. in addition to their monthly state pensions, this equates to a required capital sum of £1,050,000 (£1,050,000 x 4% = £42,000) to be financially independent.
This simple rule of thumb was based on returns from decades ago. Over the last 10 or so years we’ve seen global interest rates slashed and expected returns on assets reduce. As such, the 4% rule currently looks a little ambitious, particularly for younger people and/or those unwilling/unable to take much investment risk.
A recent version is the ‘rule of 375’. Here you take monthly spending plans, in this example £3,500, and multiply it by 375. This would give a capital requirement of £1,312,500 – more conservative than the 4% withdrawal rate.
More Detailed Analysis
The above can give you an indication of the scale, but it would be advisable to undertake more detailed analysis before making major life changes. The actual rate at which you can safely draw assets will be dependent on how long those drawings last and the expected return (and risk) on your capital.
The younger you are, the longer your spending will need to be funded and the more capital you’ll need. Also, the younger you are, the greater the uncertainty of outcomes; there is more time for reality to deviate from plans, increasing the margin for error required.
The higher the return on your capital, the less you will need to fund a given level of expenditure. Obviously, you cannot know the return you will receive decades in the future, you will have to make an assumption.
For a more detailed analysis you will need to plan cashflows for every year of your life … for which you will also need to make a (financially) conservative assumption (we usually plan to age 100).
You can use a spreadsheet to do this. For the first year you aim to be financially independent, take a starting level of capital (e.g. estimated amount required) and:
· Deduct planned spending
· Add in expected net income
· Add in expected return
· Giving an end capital value, which is the starting value for the next year
Then repeat for every year. You can try different rates of return and spending amounts to see the differing levels of assets needed.
Inflation - don’t forget it, your spending will increase every year!
Expected Returns - Be realistic. Investment risk and return are related. You cannot gain a higher expected return without taking risk. You need to carefully consider the level of risk you are willing to take with your capital. You need to be confident that you can financially and emotionally cope with it. Also consider there will be costs and (on most assets) tax to pay out of returns – you need to use returns net of costs and tax.
Considerations
Some further thoughts highlighted issues which can represent risks to your plans.
Additional Costs / Spending – Most plans are very sensitive to spending. It’s prudent to consider scenarios where spending is higher than planned. In particular, consider what would happen if long-term care costs were required.
Investment Risk – What happens if your capital fell by a large amount in a year? A quick rule of thumb to consider is what if riskier assets (e.g. equities) fell by 50% and safer assets (e.g. cash) maintained their value.
Ongoing Review – The famous quote “no battle plan survives first contact with the enemy” (1) springs to mind, or as Mike Tyson put it “everyone has a plan until they get punched in the mouth”. The future obviously will not unfold exactly as planned. Things will change, both within your control (priorities, aims) and particularly those without (market conditions, illness, family circumstances etc) and you will need to adapt your plans to ensure they maintain on track.
How Collingbourne helps achieve Financial Independence
We expertly guide our clients through a structured process. We start with why, to work out what it is all for and to help you (and your partner) explore the life you want to live.
Through our Financial Forecast process, we can model financial independence requirements, bringing all the elements together to provide a visual presentation of your future financial life, giving new insights and perspectives into the possibilities ahead.
We explore the long-term financial impacts of different decisions, the options and trade-offs available, showing what is possible. This allows you to make informed decisions and be confident the future has been planned out and your financial lives are secure.
Through sophisticated tools we expertly model investment risk and its impacts, guiding clients to a level or risk that is appropriate for them and their requirements. This allows us to construct an investment plan that can efficiently power financial plans. You can then choose whether you want to Collingbourne to execute these plans for you.
(1) Apparently from nineteenth-century Prussian military commander Helmuth van Moltke
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