How much do you actually need to retire?

Start with the problem, not the portfolio

A retirement target such as £500,000 or £1 million sounds precise, but the number on its own does not tell you much.

Two people can retire with the same portfolio and need completely different amounts from it. One might own their home outright, spend £25,000 a year and receive pension income later. Another might spend £50,000, continue paying housing costs and want to stop working years before any pension begins.

Instead of starting with:

How large should my portfolio be?

start with:

What will I need the portfolio to pay for, and for how long?

Step 1: estimate the spending you want to fund

Start with annual spending in today’s money (what that spending would cost today, before allowing for future inflation).

Current spending is often a better starting point than a percentage of salary, because retirement does not automatically cost 70% or 80% of what you earned while working.

Some costs may disappear or fall:

• commuting;
• pension contributions;
• mortgage payments, if the mortgage is repaid.

Others may increase:

• travel;
• time spent at home;
• hobbies;
• healthcare, or care later in life.

Suppose you estimate that you would want £30,000 a year in today’s money. That is the starting point, not yet the portfolio requirement.

Step 2: subtract income that does not need to come from the portfolio

You may expect income from pensions, annuities, rental property or other sources. Suppose £12,000 a year of your £30,000 spending is eventually covered elsewhere. The portfolio-funded gap is:

Once that other income has started, the portfolio needs to support £18,000 a year rather than the full £30,000. If you stop working before it starts, the portfolio has to cover all £30,000 until then: the bridge period, covered below.

Step 3: estimate the long-term portfolio requirement

A common shortcut is the withdrawal-rate approach. A withdrawal rate is the share of the starting portfolio you plan to withdraw in the first year of retirement. A 4% rate means taking £4,000 in the first year for every £100,000 invested, then usually increasing that cash amount with inflation in later years.

It does not mean the portfolio earns 4% every year, or that its value never falls. The historical research behind the 4% rule assumed the money remained invested in a portfolio of shares and bonds, and asked whether it could keep funding those withdrawals through a long retirement despite market rises and falls. That result cannot simply be applied to money held in cash. The invested balance can still fall substantially along the way, and the approach is not designed to keep the original capital intact.

If the portfolio needs to provide £18,000 in the first year at a 4% withdrawal rate:

This is where the familiar 25× spending rule comes from:

so:

The calculation is straightforward. Whether 4% is a sensible assumption is a separate question.

Where does the 4% rule come from?

The number is usually traced to a 1994 study by the financial planner William Bengen. Using historical US stock and bond returns, he tested retirements starting in each year from 1926 onwards: withdraw a percentage of the portfolio in the first year, then raise that cash amount each year with inflation. Starting at about 4%, the money lasted at least 30 years in every period he tested, for portfolios holding a mix of US shares and intermediate-term US government bonds.

The study looked at roughly 30-year retirements using US market history. Its result tells us what would have survived those historical periods, not what is guaranteed to work in the future.

Source William P. Bengen, “Determining Withdrawal Rates Using Historical Data”, Journal of Financial Planning, October 1994, vol. 7, no. 4, pp. 171–180.

So it is a planning assumption. The result depends on factors including:

• how long the portfolio needs to last;
• the investment mix;
• fees and taxes;
• inflation;
• the order in which good and bad market years occur;
• whether spending can be reduced after poor returns.

A retirement beginning at 65 and one beginning at 40 are therefore not the same problem, even if annual spending is identical.

Why the order of returns matters

Average return alone does not describe a retirement portfolio.

If two portfolios experience the same set of annual returns in a different order, they can finish with very different values when withdrawals are being made.

Poor returns early in retirement are particularly damaging, because money is being withdrawn from a portfolio that has already fallen. There is then less capital left to take part in a later recovery. This is known as sequence-of-returns risk.

After 25 years one portfolio holds 460.300 £ and the other 1.042.900 £. With no withdrawals, both would end at 1.921.900 £: the same returns multiplied in a different order give exactly the same result. It is the withdrawals that make the order matter.

Early retirement adds a bridge

Suppose you want to stop working at 55, but another source of retirement income does not begin until 67. For 12 years the portfolio has to support all £30,000 of your spending; from 67, only £18,000 of it.

A simple calculation such as:

shows the scale of the spending during that period, but it is not the same as saying you need an additional £360,000 on the day you retire. The portfolio remains invested, withdrawals happen over time, and returns and inflation matter.

A year-by-year projection handles this better than multiplying one annual number by 25.

Where FIRE fits into this

FIRE stands for Financial Independence, Retire Early. It asks the same question as any retirement plan, usually with an earlier date: when could your investments and other non-work income pay for your life, so that paid work becomes optional?

Your FIRE number

Your FIRE number is the portfolio estimated to support your spending without relying on employment income. Under a simple 4% assumption, it is usually approximated as the annual spending your portfolio has to fund, multiplied by 25. With £30,000 of spending and no other income:

If £12,000 of it is covered by other income, as in the earlier example:

That £450,000 describes the long-term requirement once the other income has started. If you retire earlier, you also need enough to fund the years before then. That does not mean simply adding 12 years of spending to £450,000: the portfolio remains invested and withdrawals happen over time, so the bridge needs to be modelled as part of the projection.

Your FIRE age

Your FIRE age is the age at which your projected finances could support the spending you expect without relying on employment income, under the assumptions you are using. For a simple plan this may be the point where your portfolio reaches your FIRE number. With future pensions or other income starting later, the calculation also needs to account for the years before that income begins.

Your FIRE age moves when any of these change:

• your spending;
• your savings rate;
• what you have invested today;
• the returns you expect;
• other future income, and when it starts;
• when you want to stop working, and so how long any bridge lasts.

Full, partial and Coast FIRE

Financial independence does not have to be all or nothing:

• Full financial independence: the portfolio and other non-employment income are projected to support all planned spending.
• Partial financial independence: the portfolio covers part of your spending, reducing the amount you need to earn from work.
• Coast FIRE: you have enough invested that, under your assumptions, the portfolio could reach a later retirement target without further contributions. You still need income for today’s spending, but no longer need to contribute towards that target.

In practice, these can be treated as different stages of the same plan.

Why savings rate matters

For the FIRE age, spending affects both sides of the calculation. If you spend less:

1. more of your current income can be saved; and
2. the future portfolio has less spending to support.

So the savings rate can have a large effect on the time it takes. With a take-home pay I, a savings rate s and a real return r, starting from nothing and saving at the end of each year, the number of years n to reach 25 times annual spending satisfies:

Income appears on both sides and cancels out: only the savings rate and the return are left. Solving it for different savings rates gives the chart below.

Going from saving 10% to 20% shortens the wait by 14,6 years. Going from 50% to 60% shortens it by 4,2 years: the same ten points, taken off a much shorter wait.

So how much do you need?

There is no useful universal answer. A better retirement calculation is:

1. estimate spending;
2. identify other income and when it starts;
3. calculate what the portfolio needs to fund in each period;
4. choose and test withdrawal and return assumptions;
5. include any early-retirement bridge;
6. account for tax where relevant;
7. compare the required portfolio with what you have today;
8. rerun the plan under less favourable assumptions.

You end up with more than a single retirement number: you can see when different sources of money are expected to cover your spending.

This also makes it possible to work backwards. Define what the money eventually needs to cover, then compare that with where you are today.