Pensions and retirement are words that do not resonate for young adults - or many of their parents for that matter. In fact, what most investors both young and old are aiming for is financial freedom. That is the freedom to choose to work or not, to change career or drop your working hours to take up an interesting hobby, rather than the dated idea of a cliff edge of retirement which you jump off and then settle down to an uninterrupted life of leisure. In fact, research by the Institute of Economic Affairs recently found that retirement is bad for your physical and mental health.
Most investors ideally want financial freedom to come as early as possible, preferably by 50. But how much do you need to put aside to 'retire' rich and young? And do you really need to use a pension?
Many people have lost faith in pensions, sometimes with good reason - poorly performing investments or the government's relentless fiddling with pensions policy. However, the simple truth is that most people have no idea how much they need to save to fund a comfortable retirement. In many cases, this is self-denial - you may think the figures will simply be too scary. However, it is not enough to just buy a few investments and hope for the best. There is a big difference between buying an investment product and putting together a financial plan that will enable you to achieve your dream.
Your starting point should be a simple cash flow forecast of how much you will need to live comfortably and how much you might expect to receive from your various investment sources each year.
"It is often said that we should spend what we need and invest the rest," says Alan Dick, a chartered financial planner at Forty Two Wealth Management. "However, the best way to start your financial planning is to work out how much you need to save then spend what's left. A proper spending plan is invaluable - unless we make a conscious decision what to spend money on it just slips through our fingers like sand. Much of this wasted money could be used to help fund a comfortable retirement with very little pain today."
An analysis of your cash flow can be done using your own spreadsheet. Alternatively, you could pay £49 (or £59 for couples) and RetireEasy has a service that will let you input all your assets and investments and model as many different scenarios as you want according to different tax rates and investment returns.
If you are willing to part with significantly more money you can go to a certified financial planner who will model this on a yearly basis for you for a set fee.
But you need to invest from the beginning with a target figure in mind.
Last year, I worked out that £400,000 is needed for a retirement that meets the Joseph Rowntree Foundation's minimum income standards for retirement of £12,000 a year. That's not rich by anyone's assessment. If you want to feel even comfortably well off then you will need to put aside much more than this, say £500,000. Add in the 'bonus' that you may get from your state pension (which may come at a later date than your financial freedom age) and you may start to feel rich.
This month, Towry, the wealth adviser, came up with a higher figure for a comfortable standard of living. Its survey found that British adults said that the average amount needed to maintain a comfortable standard of living during their retirement is £25,783.87 per year net of taxes. In order to achieve an annuity paying out £25,783.87 after tax, a non-smoking male looking to take his annuity from age 65, would need to have a retirement fund of £616,400. However, this example does not take into account any additional income they would receive through the state pension.
So you want to retire young?
Anyone born after 6 April 1978 has a state retirement age of 68 and the state pension age is expected to rise to 70 within the next 20 years, so 60 is increasingly looking like the new 50.
But the main vehicle for saving for retirement is a pension - and you can access your money from this at age 55. So let's go for age 55 as a 'young' retirement.
So for a comfortable level of financial freedom you will need (at minimum) £500,000 by age 55. Impossible? Let's see.
Starting at age 25, you would have to put aside £528.51 a month, every month to get this, according to the target lump sum calculator from Radcliffe IFA, which assumes 6 per cent annual investment returns and the same charges as L&G Equity UK 100 Index Fund.
Of course there will be lots of unknowns along your investment journey and this is too simplistic a model. You are unlikely to be able to set aside £528.51 a month at 25, whereas at age 40 you may be able to set aside more than double that amount.
Also, as much as you may want to have full control of your money and may dislike the rules surrounding investing in pensions, you're probably not going to reach your target of £500,000 without the help of upfront income tax relief via pensions. This instantly turns a £100 investment into £125 for a basic-rate taxpayer and into £166 for a higher-rate taxpayer. However, income from the pension in retirement is subject to tax. Pensions work out best for people who are higher-rate taxpayers when they are investing and basic-rate taxpayers then they retire.
But really you're looking at getting £500,000 over an investment career of 30 years. Is this possible?
Here's one way of looking at it. Each year of your investing career has to generate £16,666 at the end. So if you invest a lump sum of £2,768 and it grows at 6 per cent after charges then in 30 years it will be worth £16,670. That is the magic of compounding. The following year you need to work out the amount that will get you to the same figure in 29 years. So in the final 30th year you will have to put in the full £16,666 from your income.
Unfortunately, you also have to factor in inflation. To achieve the equivalent of £500,000 if inflation averages 3 per cent over the 30 year period you will need to aim for an eye-watering £1,214,000. That means each year of your investing career has to generate £40,466 of the final sum.
The initial lump sum needed for the first year of your investment plan is higher - £6,720 (this will grow to £40,471 at 6 per cent after charges over 30 years). Click here for the calculator that I have used.
That starting lump sum of £6,720 may look impossible against the average gross salary for full-time employees of £26,200 (source: Annual Survey of Hours and Earnings from the Office for National Statistics).
But if you are employed, bear in mind that employers contribute an average of 7.7 per cent of your salary to a workplace pension (source: National Association of Pension Funds), which would be £2,017 on top of that average gross salary, a very good starting point.
You then have to find the rest, bearing in mind that you are probably already doing some of it – employees' payments to workplace pensions average 4 per cent of gross salary (source: NAPF), that’s £1,048 from that average national salary. So even on an average salary, you may be contributing almost half of what you need for early financial freedom.
Young adults on top graduate starting salaries – now averaging £29,000 (source: High Fliers research) - or people who expect to become higher earners in later life should be able to achieve this dream.
State pension increases already planned for 2019 and 2026, followed by increases every five years thereafter
| State pension age | When rise starts | Affecting people born after | State pension age guide for people aged between |
|---|---|---|---|
| 66 | 2019 | 1953 | 53-59 |
| 67 | 2026 | 1959 | 49-53 |
| 68 | 2031 | 1963 | 45-49 |
| 69 | 2036 | 1967 | 41-45 |
| 70 | 2041 | 1971 | 37-41 |
| 71 | 2046 | 1975 | 33-37 |
| 72 | 2051 | 1979 | 29-33 |
| 73 | 2056 | 1983 | 25-29 |
| 74 | 2061 | 1987 | Feb-25 |
| 75 | 2066 | 1991 | 17-21 |
| 76 | 2071 | 1995 | up to 17 |
| Source: Standard Life | |||
THE ISA ROUTE
To retain more flexibility over their money most people use a combination of pensions and individual savings accounts (Isas). Isas allow your income and capital to grow free of tax and you can take the money out (whenever you want) free of tax too. Isas could comfortably be used for the first 10 years of the plan above. In fact, to make sure that you do not breach the lifetime savings limit for pensions (of £1.25m after 6 April 2014) you will need to spread your savings between the wrappers.
Alternatively, save the full amount into an Isa for 30 years. £11,280 invested every year (divided into 12 equal monthly payments of £940) for 30 years averaging 6 per cent a year after fees would get a lump sum of £916,042 (according to the calculator). Draw 5 per cent income from this and you will live comfortably on a tax-free income of £45,802. Note this does not account for inflation and may be less than you need at the time.
Even if you could only do this for 20 years, you would still have a retirement fund of £426,232, which at 5 per cent withdrawal would produce a tax-free income of £21,211.
INVESTMENT STRATEGY
Although I have talked about the tax wrappers that can be used to achieve financial freedom, I haven't yet addressed the investments that you need to hold in them. Along the way you will have to invest cheaply and to achieve 6 per cent returns you will have to take on risk in the form of investing in stock markets. You will have to reinvest your dividends to benefit from the effects of compounding over the years.
If you're short of ideas then you can take a look at Investors Chronicle's Top 100 Funds (see a selection below). Alternatively, we have a range of portfolios that you can take inspiration from, including real reader portfolios.
Learning from the experience of other investors is crucial. One Investors Chronicle reader is well on his way to financial freedom at just 37. In the next part of this article we will take a close look at the investments he is holding to achieve his goals, which will hopefully give you some ideas for putting together a strategy.
How much to invest over 30-year investment career to get equivalent of £500,000 lump sum
Assumes 3 per cent average annual inflation. (Results in final retirement lump sum of £1,214,000.) Each segment has to reach £40,466 at end of year 30.
| Start of year | Lump sum invested | Basic-rate taxpayer pension contribution | Higher-rate taxpayer pension contribution |
|---|---|---|---|
| Year 1 | £6,720 | £5,376 | £4,032 |
| Year 2 | £7,130 | £5,704 | £4,278 |
| Year 3 | £7,570 | £6,056 | £4,542 |
| Year 4 | £8,037 | £6,429 | £4,822 |
| Year 5 | £8,533 | £6,826 | £5,119 |
| Year 6 | £9,059 | £7,247 | £5,435 |
| Year 7 | £9,618 | £7,694 | £5,770 |
| Year 8 | £10,211 | £8,168 | £6,126 |
| Year 9 | £10,841 | £8,672 | £6,504 |
| Year 10 | £11,509 | £9,207 | £6,905 |
| Year 11 | £12,219 | £9,775 | £7,331 |
| Year 12 | £12,973 | £10,378 | £7,783 |
| Year 13 | £13,773 | £11,018 | £8,263 |
| Year 14 | £14,622 | £11,697 | £8,773 |
| Year 15 | £15,524 | £12,419 | £9,314 |
| Year 16 | £16,482 | £13,185 | £9,889 |
| Year 17 | £17,498 | £13,998 | £10,498 |
| Year 18 | £18,577 | £14,861 | £11,146 |
| Year 19 | £19,723 | £15,778 | £11,833 |
| Year 20 | £20,939 | £16,751 | £12,563 |
| Year 21 | £22,231 | £17,784 | £13,338 |
| Year 22 | £23,602 | £18,881 | £14,161 |
| Year 23 | £25,058 | £20,046 | £15,034 |
| Year 24 | £26,603 | £21,282 | £15,961 |
| Year 25 | £28,244 | £22,595 | £16,946 |
| Year 26 | £29,986 | £23,988 | £17,991 |
| Year 27 | £31,835 | £25,468 | £19,101 |
| Year 28 | £33,799 | £27,039 | £20,279 |
| Year 29 | £35,884 | £28,707 | £21,530 |
| Year 30 | £38,097 | £30,477 | £22,858 |
| Click here for the calculator. Note that this table is a very simplistic version of a financial plan. Investment and inflation rates will change over the period so you’ll need to review your plan every year. | |||
INVESTORS CHRONICLE READER AIMS FOR FINANCIAL FREEDOM AT AGE 44
Simon is 37, has a good job and has put together an impressive extra-early retirement portfolio, currently worth £325,000. His investment discipline combined with his frugal living means he is well on his way to achieving his dream. He wants to retire from his current job in seven years' time when he will be aged 44 in order to concentrate on writing.
It's a pretty inspirational portfolio and strategy. But can he do it?
How Simon got to this position
■ He avoided student debt.
■ He had an academic career followed by a well-paid middle-ranking career in a FTSE 100 company.
■ He controls his living expenses.
■ He rents a property with spouse and child.
■ He has always invested fully in individual savings accounts (Isas) and his company share scheme.
■ His savings rate is an impressive £35,000 a year.
■ He has had fortunate investment timing: When his company share scheme matured at a good price, he sold it. He then used the cash to invest into a basket of investments after the financial crash in first half of 2009. Some did exceptionally well.
■ He has a company pension scheme as a "backup plan" for his later years.
Simon's investment philosophy
He says: "I focus on quality for the long term and momentum/trends for the short term. All of the holdings, apart from the 'high-frequency trading' component of the portfolio are ones where I believe that the companies or funds are excellent and stand a good chance of performing well in the future (Investors Chronicle has helped me to identify several of these holdings).
"I've tried to build the long-term portfolio so that it is diversified while being relatively simple and thus easy to monitor. I hold quite a bit of cash to balance risk and have emergency funds, but also to have significant money to invest should any major potential buying opportunities arise due to a stock market crash.
"I recognise that short-term investing is very high risk. To control the risks, I limit my short-term investment pot to about 10 per cent of the overall portfolio. Any trading gains go into cash for treats or to buy more for my long-term conviction holdings."
"When I first started, I failed miserably at foreign exchange trading. But I have been quite successful at investing in small companies within the same sector in which I am employed. And over the past 18 months or so I have developed a type of momentum trading* strategy that has been doing well."
*Once a momentum trader sees acceleration in a stock's price, earnings or revenues, the trader will often take a long or short position in the stock in the hope that its momentum will continue in either an upward or downward direction.
Simon's investment worries
Simon wants to bring down the costs of investing - something that Investors Chronicle considers absolutely the right approach. His retirement may be only seven years away but he is facing a lifetime of investing over which time charges will eat away at performance.
He is reconsidering his holding in the Jupiter Merlin Worldwide Portfolio (GB0031667834), a fund that invests in a portfolio of other funds, therefore incurring relatively high charges compared with conventional funds. Even Jupiter states on its website for the fund: "Charges tend to be higher than for conventional Unit Trusts to allow for a portion of the charges applicable to underlying funds. On average this works out at around 0.7 per cent of the net asset value per annum."
He is thinking of replacing the Jupiter fund with the iShares MSCI World Monthly GBP Hedged (IGWD). This is an exchange traded fund that aims to track the performance of the MSCI World 100% Hedged to GBP Index Net as closely as possible. The ETF invests in physical index securities and is currency hedged, which enables investors to hedge currency exposure in one transaction, without having to monitor and maintain a currency hedge. The MSCI World 100% Hedged to GBP Index Net offers exposure to stocks from developed countries worldwide which comply with MSCI's size, liquidity, and free float criteria. IGWD has a total expense ratio of 0.55 per cent. This seems like a reasonable strategy.
We see a potential problem regarding his holding in First State Global Emerging Markets Leaders. This is an excellent fund but it is to 'soft close' in September to protect the interests of investors. This means that the fund will impose a mandatory 4 per cent initial charge to make it less attractive for new investors to invest in the fund. First State is doing this to try to limit the size of the fund but it will cut into your returns if you buy this strongly performing fund. As an alternative to this fund for investors who want emerging markets exposure, Investors Chronicle recommends Lazard Emerging Markets Fund (GB00B24F1P65). Alternatively, you could invest in Templeton Emerging Markets Trust (TEM).
Benchmark for Simon's portfolio
The Association of Private Client Investment Managers and Stockbrokers (APCIMS) runs a series of Private Investor Indices that can provide investors with an objective measure of performance against which to measure their investment portfolios, based upon the assumption that they are domestic investors with sterling denominated accounts. The Indices are based on average allocations across private client investment managers.
As Simon is invested for long-term growth we think he should compare his portfolio to the APCIMS Growth Portfolio.
As you can see his portfolio is very different to the APCIMS Growth portfolio. There is room for Simon to have higher investment in UK and international equities, and lower allocation to bond funds and cash.
SIMON'S PORTFOLIO
UK equities (33 per cent):
| BP | £47,460 |
|---|---|
| GSK | £41,598 |
| Tesco | £18,858 |
World equity funds (21 per cent):
| Jupiter Merlin Worldwide Portfolio | £29,630 |
|---|---|
| First State Global Emerging Markets Leaders | £21,631 |
| Murray International | £16,655 |
Bond & property funds (14 per cent):
| Henderson Strategic Bond | £12,311 |
|---|---|
| M&G Corporate Bond | £10,857 |
| Invesco Perpetual Corporate Bond | £10,817 |
| M&G Property Portfolio | £10,688 |
| High frequency trading accounts (11 per cent) | £35,428 |
| Cash (21 per cent): | £68,275 |
| Total | £324,209 |
ADVICE FROM THE EXPERTS
We showed Simon's portfolio to some industry experts who had some words of advice. They think that he may not reach his target income and needs to change his investment strategy.
Income issues
Patrick Connolly, a certified financial planner with Chase de Vere Independent Financial Advisers, says: "If Simon retires early he will want to take income from this portfolio and for the underlying capital value to grow at least in line with inflation. He must ensure he doesn't deplete capital as he could easily live for another 50 years or more. "An income of around 5 per cent per annum seems reasonable, with this coming from a combination of natural income and capital withdrawals. His current portfolio would therefore give him an income of £16,250 per annum."
Ben Yearsley, head of investment research at Charles Stanley Direct, says: "Good luck with retiring at 44! If he achieved 10 per cent per annum growth over the next seven years then he will double his money, which will clearly place him in a good position. With £600,000 he could modify his investment strategy to move more into yielding investments. In this case he could get 5 per cent per annum, so maybe £30,000 at a stretch. But that means his capital growth prospects will be limited and if he is depending on that for the next 40 years his living standards will be curtailed quickly due to inflation."
Asset allocation
Mr Connolly says: "Simon's portfolio has large exposures to individual equities and to cash. These are at opposite ends of the risk spectrum. Is he looking to take big risks and hope the portfolio grows enough so he can retire or is he planning to protect what he has and look for more gradual and consistent growth? I would encourage the latter approach even if this means retiring a few years later."
APCIMS Growth Portfolio vs Simon's
| Asset allocation | APCIMS growth portfolio | Simon's portfolio |
|---|---|---|
| UK equities | 47.50% | 33% |
| International equities | 35% | 21% |
| Bonds | 7.50% | 10% |
| Cash | 2.50% | 21% |
| Commercial property | 0% | 3% |
| Hedge funds | 7.50% | 11%* |
| *High frequency trading could be viewed as the equivalent of Simon's own hedge fund | ||
Mr Yearsley says: "If he is serious about retiring in seven years, then surely he needs to go all out for growth and ditch the cash and bonds? There is nothing wrong with the portfolio per se. There are lots of good funds in there I would happily hold for the long term. However, I am not sure he has thought this through properly. Two shares are both over 10 per cent of the portfolio - it is quite a high-risk strategy."
Jason Hollands, managing director, business development and communications at Bestinvest, adds: "True, these are blue-chip companies, but as the Deepwater spill in the Gulf of Mexico demonstrated, even big companies are not immune from potential shocks and you don't want something like that blowing up on such a large slug of your portfolio on the eve you were planning to retire on the proceeds.
"The FTSE All-Share Index includes circa 650 stocks and a further 1,1000 are listed on Aim, so holding one oil company, one pharma stock and one supermarket doesn’t make sense both in terms of company specific and sector risk."
Lee Robertson, chief executive officer at Investment Quorum, says: "Any profit warnings on those three companies could really hurt the portfolio. The cash element is over 20 per cent and is a negative contributor once inflation adjusted.
"Over the next seven years it is highly likely that we will have higher interest rates and inflationary pressures. We therefore feel bonds will perform badly and with no inflation hedge the portfolio could suffer substantial capital erosion.
"We would suggest diversifying further into equity funds away from bond funds due to the issues mentioned, aiming to do more with the large cash element of the portfolio and really consider whether the high frequency trading is correct with only a seven-year investment period during this time of uncertainty."
