How to save enough for retirement

Since the beginning of 2020, economic inactivity has spiked. And while rising long-term sickness has played a big role, a 2022 House of Lords report found that the leading cause of falling worker numbers has been the early retirement of those aged between 50 and 64.

At the same time, the imaginations of a younger generation have been captured by the FIRE (financial independence, retire early) movement. By cutting spending to the bone, and investing as effectively, as early, and as much as possible, FIRE advocates seek to accumulate enough wealth to survive on passive income as soon as they can, thereby allowing them to take an ‘opt in’ approach to work.

Clearly, an early and financially secure retirement is out of reach for most. If it were otherwise, the definition of ‘early’ would have to change, as would the shape and size of our economy. But the existence of FIRE fans signals an attempt to fully engage with a question most of us will ask eventually: at what stage of my life can I afford to retire?

The sad reality is that for some early work leavers, this question may not have been adequately addressed, and has instead morphed into a much more fearful one: will I run out of cash in retirement?

Given this uncertainty is also the first spark for many investing careers, it is a big one to try to tackle in a single article. But try we will. To Rob Schwarz, founder and financial planner at Finova Money, “the unifying goal of every client” he encounters is to answer that imponderable: “‘How can I live my best life with the certainty that cash won’t run out?’”

 

Goal, meet process

Doing so requires breaking the question into two parts: what is my goal, and how do I get there?

In recent years, there has been considerable interest in the idea that the latter should supersede the former. It’s easy to see the appeal of this philosophy, popularised by the writer James Clear in his bestseller Atomic Habits. While everyone aspires to financial independence or a worry-free retirement, there is nothing about having this goal that separates those who succeed in attaining it from those who don’t.

Far better to instil the many small changes in habit and identify what will get you to your target, than to obsess over a goal and risk abandoning it whenever it feels out of reach, as it undoubtedly will at points. This advice – on the virtues of incremental steps above all – is smart and practical.

But financial goals matter. ‘Independence’ is meaningless if your investments and savings don’t cover your outgoings. This is why defining your goal – be it FIRE, giving your children the financial leg-up you never had, setting aside enough cash for long-term care, settling into a life as a year-round cruiseliner passenger, or some combination of the above – is critical to working out what you’ll need to do ahead of retirement.

The first step then is to recognise that the destination is determined by the journey, and that planning can only begin with some idea of where you want to get to. “The reality is that every single one of us could retire tomorrow, if we gave up a certain level of lifestyle and were happy to make sacrifices for it,” suggests Schwarz.

Having a financial plan is a way to identify, spread and minimise the sacrifices required in a more sensible manner.

 

A plan needs a model

For many people concerned with having enough once they stop working, the moment it all becomes real is when they see their future in a cash flow forecast.

This is a little bit like a business plan, but built around the ‘before and after’ of an expected retirement. By looking at current levels of income, spending, investing and accumulated wealth, and plotting these against expected returns, inflation and interest rates, a retirement cash flow model aims to build a picture of an individual’s future wealth, and what income this can generate. These models are one of the most important tools that professional financial planners and wealth managers use, but something that can be easily overlooked by individuals who might struggle to put it together.

In its simplest form, this can be done in a few columns and rows in a spreadsheet. But even if you detest or struggle to use Microsoft Excel, there are several very good (and free) DIY modelling tools available online, such as the IC’s own newly launched pension calculator service. Others include Guiide and My NetWealth, and all either provide tables or nifty graphic depictions of projected surpluses or deficits, as well as the timing and drawdown of various income sources in retirement.

Financial advisers and coaches report that having a clear visualisation can instantly relieve some of the stress and complications of retirement planning. Being able to see whether you’re on track or might soon have decisions to make can help to inject purpose or clarify your current efforts to build wealth.

To build a model, you first need inputs. Unfortunately, making sensible forecasts for what your future will look like sounds more straightforward than it often is.

For example, one of the first pieces of information that pension calculators ask for is your target income in retirement. But if your retirement is decades away, this might feel like an impossible ask. The average 25-year-old won’t (and arguably shouldn’t) spend too much time pondering their precise needs as a 65-year-old grandparent. Better instead, argues Schwarz, for younger people to focus on 10-year horizons, as this has a more tangible impact and is more likely to “lead to better outcomes because it’s much more relatable”.

The closer you are to retirement, however, the clearer your likely desired income will be. Tom Kimche, a client adviser at NetWealth, says the starting point should then be your current levels of spending.

“There might be one-off expenses like round-the-world trips or renovations, but, beyond that, assume that general day-to-day costs will stay as they are,” he argues. “Often, people spend less than they think in retirement, but by not lowering the assumed level of cash needs, it builds in a buffer.”

Indeed, many retirees find that with debts paid off and children out of the nest, their day-to-day cash needs fall well below the average gross salary they were used to in their final years of work. Circumstances of course vary. But Kimche’s advice to set a higher income bar for those early retirement years is also important because it helps instil the confidence and self-permission to spend without guilt or worry.

 

Getting there

As well as timeframes, a few more inputs – namely projected returns, risk tolerance and current outgoings and savings – are needed to map the path ahead. Fortunately, assuming retirement is still ahead of you, you should have a clearer idea of each.

Because you have the greatest control over your own earnings (and therefore investing) power, this invariably becomes the big focus.

But it also needs to be approached with balance. People in the FIRE movement, for example, spend a lot of time seeking to build multiple income streams and working out ways to minimise unneeded or status-driven consumption. If your job is to put away as much cash as possible today, then this makes sense. It may even make sense to instil this discipline for those decades of passive income in retirement, too.

At its most extreme, however, this drive can include delaying most gratification, prioritising wealth accumulation over starting a family, or engaging in ‘geographic arbitrage’: where you seek a high-paying job that can be done anywhere in the world. To some, such privations will defeat the point of a secure retirement.

Whatever your approach, it is important to be realistic and happy with the trade-offs required to sustain it. For most people, this needn’t require total sacrifice. “For us, it’s about getting good behaviours in place early on – saving and investing regularly, utilising tax-efficient Isas and pensions, protecting your earning ability – and not worrying too much about the end destination,” says Schwarz.

Those good behaviours include budgeting, and understanding your likely near-term spending. But a financial plan needn’t overcomplicate things or account for every outgoing. Even debt repayments (often an individual’s largest cost, if it takes the shape of a mortgage) can be simply factored into an average headline monthly expenditure figure.

After determining how much you can set aside, you have two options. The first is to work backwards from a certain level of desired income and then make adjustments to make reaching that goal more likely. The second is to stay consistent while leaving most of the work to compounding.

Assumptions around returns and inflation rates are where things get less personal, and a lot more subjective.

Financial planners tend to rely on an evidence-based approach, pegging long-term asset return forecasts to historical averages. For example, many calculators and advisers assume that inflation will average between 2.5 and 3 per cent over the long term, above the Bank of England’s target of 2 per cent. If you take a more active or non-consensus view, then you should pursue it, while staying alert to the possibility that you may be wrong or that things may change.

Nor do you really need to take a view on inflation for the purposes of modelling future wealth. Some investors believe that for simplicity – and because it is a good discipline – forecast models should only focus on real returns (that is, asset returns less inflation), and we already have decades’ worth of data on which to base those assumptions. While this approach is likely to result in lower projected wealth, it has the advantage of pricing your future income in today’s money, which is usually better rooted in your understanding of spending.

Ultimately, the question of risk and return is about investing judgment, the subject of 90 per cent of the pages in this magazine. What we know is that over time, equities should outperform other asset classes, even if estimating risk and volatility ahead of time is often guesswork. What you can control, however, is the way you invest. In the long run, over-trading or using products and funds with chunky annual fees will hurt returns.

The final consideration is an even tougher call than predicting long-term inflation: how long do you expect to live? The simple answer is that you can’t know, and that actuarial tables should be seen for what they are, which is a de-personalised collection of averages about large groups of individuals. “We don’t tend to look at the actuarial tables,” says Kimche. “We default to 95, to build in some prudence.” Schwarz, by contrast, uses 100 as a guide.

If that seems too prudent, then a plan that assumes you outlive four-fifths of your demographic might strike a better balance between quality of life and the risk of running dry.

Although a financial plan can feel like the project of a lifetime, it is important to remember that it cannot be perfected. Equally, while the future is unpredictable, having a clear idea of what is financially viable in retirement can serve as its own safety net.

That’s because, for most people, retirement also heralds the approach of the final chapters of their life, and a time when more important matters than money come to the fore. Anticipating that reality, ideally as far ahead as you can, will never be a bad idea.