We often get asked the fated question, how much do I need for retirement? Time and tide wait for no (wo)man, inevitably there will come a time in your life where the salary dries up and sustaining a particular lifestyle will depend much upon the size of your pension pot, and how much income it is generating for you.
Income can come in many forms, rent from additional property, government and corporate pensions, generous children, but one steady stream of income will come from your equity portfolio in the form of dividends.
When working out how much you will need it is good to start from today and work forward. Ask yourself the question – based on today’s cost of living, how much do we/I need to survive per year when we retire?
Let’s say that this figure is £50,000 per year, and we assume that you have already paid off your mortgage and own your property. Additionally let’s assume you have no major financial obligations (i.e. any loans over £50,000 outstanding), so this £50,000 is roughly disposable income.
Thanks to economic progress, purchasing power today is not going to be what it will be in 10, 20, 50 years time, so we need to adjust this figure to take into account inflation. This does require a little bit of gut feeling but we can use current and historical data to estimate inflation levels going forward.
This is a snapshot of the current inflation rates, taken from the Welcome page at Robur. However we are at a time of almost historically low interest rates, so for a more reasonable estimate of historical inflation rates I would recommend a quick Google search. “UK inflation rate past 20 years” directed me here for example. We can see that it is roughly around 2% (1.9% mean with a 1.05% standard deviation – for those who want to be accurate).
Taking this value of 2% we can say that going forward the cost of living will rise on average 2% every year. We now need to factor this in to the £50,000. At 2% inflation every year, what does my £50,000 need to look like in 30 years?
This takes a little bit of maths but there are plenty of websites with built in calculators to help. Here is one good example.
We need to plug in 4 simple values
N = the number of years (in this case 30)
Start amount is our £50,000
Interest rate is what we believe the average inflation rate is going to be over that period – 2% here
Period deposit (PMT) is £0
Inputting these bits of data, the value is £50,000 in 30 years will be £90,568. This is what we need to generate in income per year when we retire.
You have been working hard all your life, so this amount will be augmented by your pension. Average pension income in 2016 was £17,700, so assuming average pensions stay inline with inflation this will be £32,061 in 20 years time. These are just average figures, you can adjust them to meet your own income/expectation levels.
We now get the simple formula:
Required income – pension income = 90,568 – 32,061, which leaves us with a shortfall of £58,507.
So this £58,507 needs to be generated outside of the work pension. As we previously mentioned this could come from rental properties or other assets, but since we are a stock picking site let’s say we need to generate this from dividends.
Dividend portfolios do fluctuate, and we often have to sacrifice stability for yield levels – a company that has been paying a 3% for the past 20 years is likely to keep on doing this unless the company really comes into financial trouble. 3% of net income distributed to shareholders is a sustainable amount, 10%+ isn’t.
How you balance this portfolio is up to you, but remember to include dividend withholding tax. Below is an example of a portfolio I put together at the beginning of 2017. You can see that it has a net income of 6.5% (i.e. dividends after withholding taxes).
6.5% is quite high – as I have taken on additional risk in this portfolio. For a more defensive portfolio, over the long term I would average this out at around 4%.
So to generate £58,507 a year from a portfolio that pays 4% in cash is simply £58,507 divided by 0.04 =
£1,462,675 – this is the size of the required stock portfolio in 30 years.
This may seem like a stomach churning amount, but remember we have a few decades to generate this. Let’s use a different calculator here, to see how much we need to invest each year to retire with £1,462,675.
Click on the PMT tab below the word modify.
FV is the future value we need the amount to be = £1,462,675
N = 30
Start principal = 0 (adjust this if you already have savings or have started a portfolio
Interest is the average return you can make each year from the stock market – let’s take 10% here
We would need to contribute £8,891 a year, or roughly £750 a month – not so scary.
30 years is a long time, and the amount you will have to save/invest will fluctuate. It may be only £200 a month to begin with, and this may wise to £2,000 as you progress in your career.
Either way you need something to aim for, and hopefully this article can help start you off on the right track.