In an earlier post I wrote about the so-called 4% rule. This tries to determine the safe annual level of withdrawal from a retirement fund. My conclusion was that it’s okay as a rough-and-ready rule of thumb. But that there are many factors that could make it highly unreliable. There’s another frequently cited rule of thumb, known as the 80% rule. This rule assumes that a worker would have a cash‑flow plan replacing 80% of pre‑retirement pre‑tax income. There’s no doubt that this is a very attractive prospect, if it’s achievable. In my view, it’s much less useful even than the 4% rule.
Does The 80% Retirement Rule Ever Make Sense?
Of course, if you’re on a defined benefit pension scheme things may be different. If it guarantees to pay out at this level, the question of income replacement becomes largely predetermined. However the majority of us will not have this financial cushion, even taking into account the state pension.
Perhaps paradoxically, such high income replacement rates are more achievable to lower paid earners. The main reason is that, the lower your income, the greater the proportion of it that can be replaced by the state pension.
Example 1: Low Paid Earner
As an example, consider someone earning only £12,000 per year. 80% of this is £9,600. The new state pension is around £8,000 per year in today’s money. This leaves just £1,600 per year to replace. This would require total retirement savings in the region of £40,000 available upon retirement (I’ve used the dreaded 4% rule here, just as an example: 4% of £40,000 is £1,600). Depending on the age of the person, this might be achievable within a typical working lifetime. If they put £2,400 per year into a personal pension scheme, then even with no real growth it would reach £40,000 in less than 17 years, and there would still be £9,600 (pre-tax) left to live on pre-retirement, which is the same as the target retirement income.
Example 2: High Paid Earner
Now let’s look at a second example, this time of someone earning £100,000 per year. 80% of this is £80,000. After deducting £8,000 state pension, that leaves £72,000 per year to replace. The savings needed to generate this are in the region of £1.8 million. Assuming the person does not want a lower standard of living before retirement than after, they might allocate up to £20,000 per year to savings. They’d require an eye-watering 90 years (again assuming no real growth) to reach the savings target of £1.8 million! Of course, they could probably do it in less than 90 years with prudent investment, but the number of years will still be large. Unless the person started saving at this level very young, an 80% replacement rate will be unachievable. In this case, the 80% rule offers little insight compared with a detailed cash‑flow model.
A Better Cash Flow Plan
Where does this leave us? My view is that focusing on income replacement is often unhelpful, except perhaps for someone on a very generous defined‑benefit scheme. A more informative approach can be to model a sustainable level of spending based on current circumstances. It can then be adjusted if and when circumstances change. At any given point in time, it is the first day of the rest of your life (or lives if you have a partner). A tool that estimates a sustainable level of spending can help frame the discussion, after which an independent financial adviser can advise on how to invest what is not spent. That is why we created our own calculator, which is designed to support that type of modelling.