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\u2019s okay as a rough-and-ready rule of thumb. But that there are many factors that could make it highly unreliable. There\u2019s another frequently cited rule of thumb, known as the 80% rule. This rule assumes that a worker would have a cash\u2011flow plan replacing 80% of pre\u2011retirement pre\u2011tax income. There\u2019s no doubt that this is a very attractive prospect, if it’s achievable. In my view, it\u2019s much less useful even than the 4% rule.<\/p>\n\n\n\n
Of course, if you\u2019re 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.<\/p>\n\n\n\n
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.<\/p>\n\n\n\n
As an example, consider someone earning only \u00a312,000 per year. 80% of this is \u00a39,600. The new state pension is around \u00a38,000 per year in today\u2019s money. This leaves just \u00a31,600 per year to replace. This would require total retirement savings in the region of \u00a340,000 available upon retirement (I\u2019ve used the dreaded 4% rule here, just as an example: 4% of \u00a340,000 is \u00a31,600). Depending on the age of the person, this might be achievable within a typical working lifetime. If they put \u00a32,400 per year into a personal pension scheme, then even with no real growth it would reach \u00a340,000 in less than 17 years, and there would still be \u00a39,600 (pre-tax) left to live on pre-retirement, which is the same as the target retirement income.<\/p>\n\n\n\n
Now let\u2019s look at a second example, this time of someone earning \u00a3100,000 per year. 80% of this is \u00a380,000. After deducting \u00a38,000 state pension, that leaves \u00a372,000 per year to replace. The savings needed to generate this are in the region of \u00a31.8 million. Assuming the person does not want a lower standard of living before retirement than after, they might allocate up to \u00a320,000 per year to savings. They’d require an eye-watering 90 years (again assuming no real growth) to reach the savings target of \u00a31.8 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\u2011flow model.<\/p>\n\n\n\n