We won’t be giving you a specific number here, but we can show you how to work out the right number for yourself.
To start with, think about the lifestyle you want to have – will you be in one place or still travelling lots, what will your day-to-day life look and feel like, what fixed expenses will you have, and what variable (discretionary) spending power do you want to have? Then work out how much it will cost, starting with “todays money”, i.e. what would it cost to do that today?
Next, think about any large purchases you will want to make at the point of retirement – will you want to buy a property to settle down into, or will you already own one by then, or will you want to keep travelling and renting as you move around? Is your dream to have a boat and go fishing every day? Do you want to run your own bar somewhere? Think about the things you want which require one-off purchases, and how much they cost – and whether or not you have a separate plan to acquire those things before you reach retirement.
You will now have two numbers – one monthly or yearly income requirement, and one lump-sum requirement to kick-off the retirement of your dreams. That’s the easy bit :-) The next step is to turn that monthly or yearly income requirement into one number, and there are several different ways of doing this, each with their own positives and negatives, and have more to do with your personal preferences than finance specifically. Let’s run through them.
When you’ve reached the end of your pension plan duration and are about to retire, you will have a large amount of money saved up in your pension, and you need to decide how best to manage it in line with your preferences. Lets ignore any withdrawals you make for your one-off purchases at the start of retirement for now, and just focus on how you generate that all-important regular income.
Your first option, which used to be the most popular option in many “western” economies, is to purchase an annuity from an insurance company. An annuity works on the basis that you give the insurance company one large payment, and in return they guarantee a fixed regular income until you die. It is specifically linked to your life – so what you get back in return depends on how long you live. If you die three months after buying an annuity, the insurance company makes a massive profit because it has fulfilled its contractual obligations after just three monthly payments, and keeps the rest. If you live until 140 years old, the insurance company still has to keep paying you every month until you die. There are usually options to link it to the life of a spouse/partner also, but every extra feature/benefit you add either increases the amount of money you have to give to the insurance company at the start, or decreases the amount you receive on a monthly/yearly basis.
The exact cost/benefit will depend on your specific personal circumstances; the insurance company will take into account your life expectancy based on your specific situation and data for the population in general and calculate a set of numbers where it believes it can still make a profit whilst fulfilling its contractual obligations. Because the commitments of the insurance company are spread across thousands or even millions of people, their concern is the average price, the average risk, and the average profit, but each different person will receive a slightly different quote – which can be based on how much you need to give them to receive a specific income, or how much income you will receive in exchange for a specific up-front payment.
The main advantage of this option is that your income is guaranteed until death, so you never have to worry about running out of money. The main disadvantages of this option are firstly that once you’ve bought it, you usually can’t change it – your income is fixed for life (it could be inflation-linked and therefore gradually increase by a tiny amount each year to keep up with increases in the cost of living, but nothing more than that) – and therefore you don’t have the option to make random ad-hoc withdrawals or take more or less money one month to adapt to some short-term change in circumstances. It’s not very flexible.
The second main disadvantage of an annuity is the cost – it certainly is not cheap. The actuarial calculations that insurance companies make when assessing what they will be willing to pay you for life are usually very conservative and assume very low rates of return on investment for the insurance company holding the money, which results in a very low regular pay-out to you – think VERY low.
As an example, here are the best (highest) annual incomes available in the UK in 2020, based on a pension value of £100,000, at a selection of different ages (the younger you retire, the lower income you receive, because you are expected to live longer):
An annuity linked to a single life, with no increases in future payments (not inflation-protected), with regular pay-outs which stop at the point of death, would get you approximately £3,650 per year if you are retiring at age 55, £4,650 if retiring at age 65, and £6,750 if you are retiring at age 75(!). That’s per year, in exchange for a one-off payment of £100,000.
If you want to be sensible with an annuity purchase and make sure that the regular payments you receive are linked to increases in the cost of living (inflation), and add a 5-year guarantee (meaning that if you die in the first 5 years after purchasing the annuity, you at least get 5-years-worth paid to your beneficiaries), the numbers change to roughly £1,600 per year if retiring at age 55, £2,650 at age 65, and £4,750 at age 75. These are the incomes PER YEAR, not per month – in exchange for £100,000. So to receive a modest income of £1,000 per month which keeps up with inflation – which won’t buy you very much, especially in the UK, that certainly wouldn’t be a dream retirement – it will cost you roughly £750,000 if retiring at age 55, £450,000 at age 65, or £250,000 at age 75. Absolute f*****g madness.
Which brings us on to the third major disadvantage – when you die, so does your annuity. Yes there are options where your spouse or partner could receive between 10-50% of your yearly annuity income if you die, but by adding on a “second life” linked to the annuity, you can basically cut the above income rates in half (or double the purchase prices). All that hard work saving up a big pension value is gone, there is nothing left to pass on to your children or anyone else, and for what? Enough money to scrape by and just about survive? In the vast majority of cases, buying an annuity is a terrible financial decision and is best avoided. There are circumstances where it may be advisable to buy an annuity – for example if you have zero financial knowledge, no inclination to learn about finance, are scared of anything containing numbers, have no partner or children to take care of, enjoy buying rubbish financial products from people wearing shiny suits, and are crazy enough to think that the equivalent of 1-3% per year is worth paying for IN ADVANCE without any substantial guarantees, it might be perfect for you. For everyone else – it might be the financial equivalent of punching yourself in the face. Repeatedly. Until you die.
If you’re wondering why we didn’t simply say “don’t buy an annuity”, it’s because we’re not here to tell you what to do, we’re here to give you the knowledge and information you need to make your own good decisions so you can optimise your finances as a nomad. And the single best piece of advice we can give is this: Do not make stupid mistakes with your personal finances! Or as Warren Buffett puts it: “Rule number one: Don’t lose.”. Avoiding mistakes is a lot easier than making exceptional investment returns, so focus on that – continually educate yourself and develop your own financial skillset, so that you know what you’re doing and stay in control of your finances and your life.
So now that we’ve thoroughly trashed the idea of buying an annuity, lets move on to the other two main options that you should be thinking about, which are similar in nature but have different approaches. Both start in the same way – instead of handing over your pension value to somebody else in exchange for a tiny payout until you die, invest that money wisely and use it to fund your life in retirement.
The second option (buying an annuity was the first option) is to calculate your own expected lifetime needs and set up regular withdrawals from your pension, which leaves everything you haven’t yet withdrawn still invested and growing. We’ll leave out what you could invest the money into for now (pretty much anything, just be careful and make sensible decisions), and focus on how to do the calculation. Firstly, be very conservative. Not necessarily as conservative as an annuity provider, but close to it. The difference here is that you’re being conservative with yourself – you retain the ownership of the pension value, you’re not selling it cheaply – so the more conservative you are, the more flexibility you’re giving yourself to give yourself a pay rise or make occasional one-off withdrawals in addition to your regular monthly withdrawal.
Take the monthly/yearly income requirement you calculated at the start, get it into an annual figure, and firstly multiply it by the number of years you can reasonably expect to live. Note – this is obviously a guess, unless you somehow know exactly what the future holds, but we’re not finished yet so bear with us, it will make more sense soon :-) This is a similar approach to how insurance companies calculate annuity rates, and has other benefits that we’ll come on to shortly. How many years you can reasonably expect to live will depend on two things – firstly, what age you plan to retire at (the starting age), and secondly, the average life expectancy for your demographic (the ending age – note that there is usually some variance between men and women, different countries/regions, and even things like your lifestyle, and also consider your family history in this regard). Lots of information is available online for this, from credible sources, so do some research and come up with a number.
Whilst you are doing that research, take some “alone time” to consider your own mortality. It’s not a nice topic – and is often avoided by people generally – but by doing so it can really help you focus on what you want from your life, and what you want to leave behind as your legacy (not your financial legacy – your personal legacy). How long have you got left on this planet, realistically? What to you want to spend that time doing? What do you want to achieve on this planet before you leave? How does your current life fit in with what you really want? Are you currently pursuing a path which will result in you achieving the things you want to achieve? If today was your last day, what regrets would you have – that you still currently have time to fix; what dreams and ambitions do you have, that you still have time to fulfil? Don’t fit your life around your finances – fit your finances around your life, by firstly having clear aims in life that truly make you happy, and then secondly having a clear financial plan to make sure you can turn your dreams into reality rather than stressing about money.
Got that “number of years between retirement and death” number? Multiply that by your annual income needs, add on any one-off retirement set-up expenses, and you’ve got a target for how big your pension needs to be at the time you start retirement. Note that this approach does not include calculating the investment growth on the money you haven’t yet withdrawn – that’s your buffer. This approach has its risks – particularly if you live longer than you could reasonably expect, and especially if you are withdrawing money at a faster rate than your invested pension is growing – as you are gradually depleting your pension through retirement, the amount left in it will gradually reduce, and therefore the investment returns on what’s left in will gradually reduce also.
On the plus side, this option usually results in the lowest required pension value at the point of retirement out of all three options, and is fully flexible – you can always change how much you regularly withdraw if you need to, or even top up (add to) your pension value if you come into some money, or find yourself spending less than you thought you would. It also lets you withdraw random one-off amounts when needed, and makes a lot more sense than purchasing an annuity in most cases.
The third and final option is similar to the second option above, except that it is designed to maintain your pension value rather than gradually deplete it over the course of retirement. This means that not only do you have a very comfortable and large buffer if you ever need to change anything, but you can also expect to be able to leave a large inheritance behind when you draw your last breath. To do this, you’ll need to save up a bit more than needed for the second option above, but that’s perfectly doable if you have a good financial plan, stick to it, and start paying into your pension plan with plenty of time to spare – the earlier you start, the more money you’ll have, AND the earlier you can retire. It’s known as the “4% rule” – it’s used widely across the financial planning industry as a conservative estimate for how much you can withdraw from your pension value each year, without depleting the value of your pension. It’s the simplest of the three options – simply multiply your annual income requirements that we talked about earlier by 25, add on any retirement set-up costs, and you’ve got your target pension plan value.
If you do some research online, you will find that this “4% rule” approach is both widely recommended AND widely criticised as not being high enough. The reason that it is widely recommended is that it has been proven to work over several decades, and makes sense based on the maths and data underpinning it. The reason it is often criticised is usually because as part of the criticism, two things are conflated – firstly the “4% rule” itself, and secondly the investment strategy that is often recommended to retired people. Generally, most financial planners and investment advisors (or at least the good ones) will recommend taking a higher risk approach in the early years of a pension plan (not crazy high – it refers mainly to volatility risk rather than anything else), and gradually reducing the risk (volatility) as the target retirement date nears. This is often (somewhat sloppily) reduced to a ratio of stocks to bonds, i.e. have a higher allocation to stocks (shares/equities, index/investment funds etc) and a lower allocation to corporate and government bonds at the start, and gradually change the allocation throughout the pension plan period to end up with a high allocation to bonds, and a low allocation to stocks.
The rationale for this is simple – stocks/shares/equities are growth-orientated but volatile, whereas bonds are income-orientated and not very volatile (although they do change in value, just not as much as equities). Having high volatility near the start of a pension plan is largely irrelevant – your pension value is still relatively small at this stage, needs as much growth exposure as possible, and if there’s a stock market crash for any reason, it’s got plenty of time to recover. However, towards the end of a pension plan savings period, your pension value is very high, and doesn’t have time to recover *IF* you’re going to withdraw it all at the end of the pension plan period, so a higher allocation to bonds is often recommended to make sure that it’s maintaining value rather than being volatile.
However, we have two problems with this opinion. Firstly, many of the people saying that the 4% rule is not high enough are the same people who are either assuming, or in some cases suggesting, that you purchase an annuity. Therefore, they may well be correct, because annuities are really expensive, but if you’re not cashing-in your pension plan and purchasing an annuity, and are instead keeping your pension value invested even after the pension plan savings period ends (which would be the case if you choose either option two or three above), you DO have the time to allow it to recover, and therefore don’t necessarily need to swap volatile-but-higher-return stocks/shares/equities (including index funds and managed equity funds etc) for less-volatile-and-lower-return bonds, which are often not inflation-hedged and therefore actually a lot more risky than most people believe in this era of “money printer go brrrr”.
Secondly, an average 4% return is a very conservative long-term average for something like the S&P500 Index, and therefore it’s highly unlikely that you’ll ever run out of money, whether you chose to take a fixed 4% of the value-at-retirement-date as a withdrawal for retirement income regardless of the current pension value, or whether you choose to take a variable 4% of the current value as your retirement income (roughly 0.3% of the current value per month).
Ultimately there are many things to consider when choosing what to do, and most of it will be based on personal circumstances and preferences, not a one-size-fits-all financial approach – and the larger your pension plan value is, the more flexibility you’ve got. If it’s relatively small, you really should invest more conservatively in retirement, because you need to make sure that it doesn’t run out – one or two bad years in the stock markets combined with a continuing large regular withdrawal could make a dent in your pension that is extremely difficult to fix. On the other hand, if your pension value is high, you really don’t have anything to worry about by withdrawing 4% a year and continuing to invest in a low-risk and diversified index fund that generates strong average annual returns over the medium-to-long term.
The last thing to consider is inflation – the increases in the cost of things over time. As a general rule, 3% per year is widely considered to be an accurate figure to use, but this can vary from country to country as well as from year to year. Do some research on inflation, decide what annual percentage increase you think is most appropriate for your plans and circumstances, and add that to each of your calculations. Remember that it compounds – at a 3% per year inflation rate for example, if the cost of a selection of items is $100 this year, it would be $103 next year. To calculate the next year, it’s not another $3 to add – that’s 3% of an old price ($100), and you need to calculate a 3% price increase of the new price ($103). So another 3% increase on $103 is $3.09, taking your total not to $106, but to $106.09. That’s the starting price for the next years’ calculation. It might seem like a small difference, but small differences add up over time – which is why you should be constantly optimising your finances, in every way you can. The S&P500 Index is inherently inflation-protected, as the earnings of the 500 companies comprising the Index (and the things they sell) are inflation-linked, but it’s still something to consider.
Now that you have done your calculations and have three different results based on three different approaches, go and have a play with the pension calculator (“Crunch The Numbers”) on www.PensionsForNomads.com to get an idea of what different monthly savings amounts over different durations will get you – it will show you the minimum guaranteed value, the value assuming a 7% annual investment return rate, and the value assuming a 10% annual return rate.
One thing that applies to everyone equally, regardless of your target pension value amount: The earlier you start, the less money you have to pay in to get the same amount at the start of retirement – or another way of putting it, is the earlier you start your pension plan, the more money you will have at the start of retirement.
Start planning, and then act! Future You will thank you for it :-)