How do I calculate the amount of annual income I need in retirement?

Adam is 51 and has just started a new job with a salary of £85,000 a year. For two years before this he was self employed, and over the past year had paid himself about £70,000 after tax. Adam’s wife is 47, self-employed and earns less than £12,000 a year.

They have two children.

Their home is worth around £500,000 and has an interest-only offset mortgage of £200,000 which has nine years to run.

“We would like to pay off our mortgage,” says Adam. “I had intended to do this by cashing in my individual savings account (Isa) which is worth about £136,000, and drawing on my savings. However, until now my investments have been earning more than the mortgage is costing. But I plan to build up savings over the next few years as a fund for over payments that leaves the monies available, if we need them. 

"We would like to send our children to a private school. We estimate that this will cost £190,000 in total and will spend this sum between 2024 and 2032. I plan to work until the children have left school although I may have to continue working while they are at university. But, ideally, I'd like to reduce my working hours and responsibilities from when I'm 60, or retire around then, so my salary may start to reduce from that point.

"When I retire I would like to have an income of over £40,000 a year, although I am not sure if that will be enough. I struggle to work out how much I will need from my investments when I retire as there are quite a few variables. I assume that as we get older our spending will reduce but then there's inflation. And going from £85,000 plus a year to £40,000 seems like a massive drop. I have heard it said that in retirement you need two-thirds of what your salary was. But I should receive the full state pension from age 67. Basically, I want as much income as possible without running out too soon.

"In my new job, I will pay 10 per cent of my salary a year into my pension and my employer will match that amount. This is likely to take my total pensions' value near to the lifetime allowance by the time I am age 60. I also have a final salary pension that I can begin to take from age 55 in 2025. This will either pay out £30,700 a year, or a lump sum of £161,000 and income of £24,000 a year. Should I take the tax-free lump sum or the higher taxable income? I thought of taking the tax-free cash, putting it into my Isa and using the pension income to pay school fees.

"I have stopped paying into my self-invested personal pension (Sipp), which is worth about £273,000, and instead been making contributions to my wife's Sipp. I was concerned that my pensions' total value may get close to the lifetime allowance limit. But in the 2022/23 tax year I'll probably not contribute to her Sipp as I'm contributing to my own workplace pension.  

"My wife is likely to work beyond age 60 and has a pension from her previous employment as a teacher although this is unlikely to be significant. She also has various pensions from other jobs, but we need to check exactly what these will provide. And I want to buy National Insurance credits towards her state pension as she does not fully qualify for it, if that is possible.

"I am reasonably speculative regarding my Sipp's risk level because I also have a defined benefit (DB) pension. But when I need to withdraw from the Sipp I'll switch the holdings into more income-focused funds.

"I manage the Sipp myself and have been fairly successful in terms of market trends I’ve picked. But I'm concerned that I hold too many funds."

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Chris Dillow, Investors' Chronicle's economist, says:

How much you need in retirement is a question central to financial planning. To estimate this, first look at how much you are spending now. And include irregular spending such as home maintenance or buying a new car. For example, if you buy a buy car every five years, an estimate of your annual spending should include one-fifth of your spending on cars. But you can exclude work-related spending such as commuting. However, don't assume that you'll be able to live more frugally in retirement than now – if you can’t cut spending now, you may not be able to in 10 years’ time.

Then consider how much wealth you will need to cover this spending. One rule of thumb used to be 25 times as much, so for £40,000 annual outgoings you would need £1m. This, however, is uncertain. It depends on interest rates and investment returns which are uncertain – even over longer periods. If you are willing to let your wealth fall in retirement, however, 25 times your outgoings should be sufficient, even if investment returns are poor.

Inflation doesn’t features in this. Although it will increase your outgoings it will also increase your salary and asset prices, so it nets out. What you should  worry about is moves in relative prices – the danger that shares will fall relative to consumer prices. One solution to this risk is to continue saving so that you can top up your income if the market falls.

Also consider what to do with your mortgage. Investment returns have recently exceeded mortgage rates so it has been sensible to maintain the mortgage and put money into equity investments. But this may not remain the case. In principle, interest rates should only rise if the UK and world economies strengthen, in which case equities should do well enough to offset your higher mortgage costs. But if higher rates cause investors to fear for the health of the economy equities could suffer. Personally, I would reduce the mortgage a little and then the higher rates go, the more I would reduce it. In particular, if the Bank of England rate rises above 10-year gilt yields it would be a signal to significantly cut your equity exposure.

You might be holding too many funds. What matters is your portfolio as a whole, and any basket of funds can quickly become like a tracker fund – except with higher fees. And management charges compound horribly over time – even a half percentage point extra in fees compounds to over £700 for a £10,000 investment over 10 years. So think about replacing higher charging funds with similar ones with lower fees – especially if they are investment trusts trading on bigger discounts to net asset value than usual. And there's also nothing wrong with tracker funds which should be your default equity holdings.

Andy Baker, chartered financial planner at Equilibrium Financial Planning, says:

Your plans are dependent on your income, so consider taking out income protection because if you pass away or become unable to work it would change things completely. Protection is particularly important when children are dependent on you, and there are school fees and a mortgage to pay. It's also very important to have an up-to-date will and Power of Attorney in place. And ensure that you have an expression of wishes document for your pension so the scheme administrator knows who you would like its beneficiaries to be.

Based on your income, and assuming £40,000 annual expenditure in addition to mortgage payments and pension contributions, your family appears to have surplus income of £2,000 per month. If this is not the case, your target expenditure in retirement may be less than what your actual spending will be. It’s important to consider whether this estimated expenditure includes costs such as home maintenance, cars and holidays.

When estimating what school fees will cost, take inflation into account. School fee inflation has outstripped standard inflation over the long term so this cost may be higher than your estimate. Also take into account other child-related expenses such as university costs and deposits to buy homes.

A DB pension is a really good base line income. But there are a number of variables. When is this pension's normal retirement age? What is the scheme funding position? And what would it pay out if you passed away before retirement and following retirement? Find out these details to help you plan effectively.

Also take account of your state pension and any potential changes in your financial circumstances. For example, might you receive an inheritance? This can significantly change your financial position.

You will mostly need the liquid assets in your pensions and Isa between ages of 60 and 68 – the beginning of your retirement and when you start to receive state pension. And you will need a lump sum in nine years’ time if you pay off the mortgage then.

Although having almost all of your investment portfolio in equities may work well, as you might need to draw from the liquid assets in nine years, it could be worth starting to mitigate the equity investments' high volatility by introducing some alternative asset classes. You have plenty of time to manage this carefully so can avoid selling anything at relative market lows.

If you are receiving a full state pension and DB pension by your late 60s, you should have sufficient liquid assets and not need a real investment return to achieve your stated objectives. This means that you could be quite aggressive with an element of your investments as you might not need all of them to support your plan, so some could remain invested for decades.

It looks like the value of your pensions will grow to near the lifetime allowance limit so you have been right to fund your wife’s rather than your own pension. But if your salary plus any bonus grows to about £100,000, your marginal rate of tax on the top tranche of earnings could be around 60 per cent as you could lose your personal allowance. So a pension contribution to offset this could be beneficial, even if it means you breach the lifetime allowance as the income tax gain may exceed the lifetime allowance charge.

You could also manage your lifetime allowance by making drawdown withdrawals up to the higher rate band between when you retire and the normal retirement age for the DB pension or when you start to receive the state pension. You could further mitigate any lifetime allowance liability when you retire by taking tax-free cash and a reduced pension in retirement, and three withdrawals of £10,000 as small pots.

Your wife has limited pension savings but could contribute up to the value of the amount she earns, so around £12,000 a year, into pensions and get tax relief, even if she is not a tax payer. If she does this every year until retiring at, for example, age 60, she could build a significant pot over the next 13 years.