What’s my required rate of return?

One of the biggest questions we face as we head towards retirement is: ‘how much is enough?’

It is a surprisingly difficult question to answer.

Unfortunately, for many of us, who will not enjoy an inflation-linked final salary pension, it is a question that we can’t avoid.

Going forward, most people are likely to end their working lives with a pot of money and a daunting task - working out how to make it last.

To do that we have to take stock of where we stand financially, and to make a few assumptions. Some of the things we have to take a view on simply don’t have an answer - like how long we are going to live or how much the value of our money will be eroded over the years by inflation. But we can’t ignore these questions just because they are difficult.

One of the big unknowns is how hard we will have to make our savings work for us in order to achieve our financial goals.

To put it another way: what is our required rate of return?

We need this figure in order to decide where and how to invest our money. It could determine whether we need to chase the stock market’s historically higher returns or can sit back and relax with our money safe and sound in a deposit account - or somewhere in between.

We may need to take a few calculated risks along the way to get where we’d like to go. But, equally, we may be in the fortunate position of being able to follow a less risky path than we thought. Either way, it’s good to know where we stand.

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Meet Peter

To illustrate this retirement challenge, we have mapped the pre- and post-retirement plans of a group of imaginary but realistic personas, and we plan to tell their stories over the next few weeks.

Our first case study is a 52-year-old man, Peter. He has enjoyed a generous company pension over his 30-year career with a financial services company. Over that time, he has built up a useful pension pot, worth £500,000. He earns £4,000 a month after tax, but he has probably peaked in terms of promotions. Nevertheless, he expects his salary to rise in line with inflation for the eight years that he wants to continue working full time.

From the age of 60, Peter anticipates adjusting his work/life balance significantly. He enjoys his job but knows he will have no problem filling his time with charity work and hobbies when he cuts down from five days a week to two and a half. He plans to work part-time until his state pension kicks in at the age of 67.

Peter is in good health and is planning on the assumption that he will live until the age of 90. But he recognises that he may have a longer life, so he wants to ensure that at this age he still has sufficient funds for an even longer retirement - his target is somewhere around £600,000 at this age.

Peter’s assumptions:

• He starts with a pension pot worth £500,000 at the age of 52.
• His starting salary of £4,000 a month, after tax, will rise in line with inflation throughout the remainder of his working life.
• Peter’s salary will halve at the age of 60 and then stop completely at the age of 67.
• He assumes that the Bank of England will achieve its target of 2% inflation over the whole period. Just as his salary rises by this figure while he is working, he plans to increase the amount of income he takes from his pension pot by the same percentage amount once he starts to draw down his savings.
• He will start to receive the state pension at 67. It will have risen in value by then in line with the 2.5% minimum growth rate stipulated in the government’s ‘triple lock’ guarantee. This means that by the time he starts to receive the state pension it will have risen from £800 a month (after a notional 20% tax charge) today to about £1,150 and it will continue to rise by 2.5% annually for the rest of his life.
• While he is still working full time, he will pay 12.5% of his net salary into his pension pot. His contributions are paid out of gross income so they are increased by 25% in our model. He stops contributions at the age of 60.
• He plans to draw down just enough money from his pension pot from the date of his semi-retirement until full retirement to maintain the income he enjoyed while working full time, after adjusting for the amount he was paying into his pension.
• Because the income he takes from his pension is taxable, he takes out 25% more from his pot than he needs, in order to be able to meet his tax liability each year. This is a simplification - it takes no account of tax-free allowances.
• At full retirement, Peter is prepared to reduce his take-home pay by another 20%.

What is Peter’s required rate of return?

Peter is pleasantly surprised to learn that, on the basis of these assumptions, his required rate of return is a manageable 5% a year for the next 15 years until he starts to receive his state pension. Thereafter, he only has to earn 4% a year in order to receive the income he requires and to still end up with a pot worth £580,000 at the age of 90.

There are a few reasons for this surprisingly good outcome:

• Peter started saving early and had built up a significant pension pot by his early 50s. Building capital as early as possible is an essential ingredient of planning for a comfortable retirement.
• He avoids being wholly reliant on drawing an income from his pension pot by staying in part time work until his state pension kicks in. Extending the period in which he earns at least part of his required income makes a big difference to the rate at which he needs to deplete his pension pot.
• He continues to contribute to his pension while he still can. Keeping his pension topped up ensures that when he starts to draw money down from his pot, it is in a healthy state.
• He is realistic about the income he can afford to pay himself once he stops earning. Peter knows that he needs to cut his cloth to match his reduced means once he reaches retirement.
• Inflation is benign.

Peter’s reasonable required rate of return means he is able to rethink his investment strategy. Having spent many years chasing the best returns he can and accepting the volatility this entails, he moves some of his pension pot into a low-risk cash fund. His reward for saving hard through his working life and living within his means is being able to get on with his life and worry less about what’s happening in the financial markets.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Before investing into a fund, please read the relevant key information document which contains important information about the fund. Eligibility to invest in a SIPP and tax treatment depends on personal circumstances and all tax rules may change in the future. Withdrawals from a SIPP will not normally be possible until you reach age 55 (57 from 2028). An investment in a money market fund is different from an investment in deposits, as the principal invested in a money market fund is capable of fluctuation. Fidelity’s money market funds do not rely on external support for guaranteeing the liquidity of the money market funds or stabilising the NAV per unit or share. An investment in a money market fund is not guaranteed. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.