How To Retire Early

Do you ever daydream about the perfect retirement? Picture this: living each day on your own terms, travelling the world, indulging in mouthwatering cuisine… and, miraculously, not a single ache or pain!

Now, let’s face it – you’re probably too wrapped up in the hustle and bustle of daily life to give retirement much thought. It seems light years away. But the idea of being financially free is sure to grab your attention.

My goal here is to give you a framework so you can craft your own plan to reach financial independence.

The Three Must-Have Tools

To be financially free, you need to use three investment tools:

• Your State Pension

• Your Personal Pension

• Your ISA

Your State Pension. This is what you’re paid by the state once you reach the state retirement age – assuming you’ve put in your fair share of years in the workforce. Work for 10 to 35 years and you’ll receive a partial state pension. Work for 35 years or more and you’ll receive the full state pension, worth about £11,000 / year. The catch? You’ll have to wait until the state retirement age, which, for most of us, will likely be age 70.

Your Personal Pension. This is the money you accumulate through a mix of your personal contributions, and those of your employer. If you’ve changed jobs, you might have ended up with a collection of personal pensions. The good news? You can bundle them together for a neater setup.

Your ISA. These are your tax-efficient savings outside your pension. It’s best to withdraw as little as possible from your ISA, and to keep investing. But in case you need to withdraw, there are no penalties. And the best part? You can contribute up to £20k/year.

Champagne & Caviar?

The next step is to find out how much you need in retirement for the lifestyle you want. Some people might be happy on £20,000/year, others on £60,000/year. The longer you work, the larger your retirement pot will be. But you might prefer a lighter wallet and more leisure time. That’s a personal choice.

Many readers of this blog have asked me ‘how much do I need for a comfortable retirement?’

So, let’s sketch out a rough idea. After accounting for remaining mortgage payments - or rent if you’re not a homeowner - a £15,000/year income for a single person would give a humble retirement. This means very few restaurant meals, no holidays, and the odd leisure activity.

Bump that up to £25,000/year and you’re in moderate territory. Perhaps you can treat yourself to a budget-friendly holiday and some more fun. At £40,000 income you have much more margin. And £60,000? Well – that’s quite a fancy retirement.

Now, brace yourself, because even in retirement the taxman is waiting to nibble away at your income. But retirement taxes are a topic for another day.

For now, remember that these income figures and the corresponding lifestyle assume you own a house with no mortgage. If you still have outstanding mortgage payments, or are renting, you’ll need to budget extra income to pay for that cost.

The 3%, 4% and 5% Rule

Now you know the income you need, let’s crunch the numbers to work out the value of assets you need to generate that income. To do this, we use the 3%, 4% and 5% Rules.

These rules state that you can withdraw 3%, 4% or 5% each year from your investments, without running out of money.

Imagine you have a retirement pot of £500,000.

Using the 3% Rule, you could withdraw 3% of your £500,000 (£15,000) each year to fund your retirement. With the 4% Rule, that would be £20,000/year. And with the 5% Rule, it would be £25,000/year.

The 3% Rule is the safest – you’re unlikely to run out of money in your retirement pot. The 4% Rule is more risky – there’s a small chance of running out of money, especially if you retire early. You might be better off increasing the value of your pot to build up a buffer, before retiring. Otherwise, you could be forced to reduce your income later.

The 5% Rule is riskier still. Unless you retire later in life, there’s a real risk of running out of money, especially with today’s longer lifespans.

If I were you, I’d set up camp somewhere between the 3% and 4% Rule. That way, you can make a 3% to 4% withdrawal each year, and sleep soundly at night, knowing your finances are secure. (Assuming your money is sensibly invested – but we’ll chat about this another time.)

So, if you decide you need £30,000 income to fund your retirement, then the 3% Rule requires a pot of £1,000,000 (3% of £1,000,000 is £30,000). If you want to risk the 4% Rule, you’d need £750,000 (4% of £750,000 is £30,000).

THE 3-STAGE FRAMEWORK FOR RETIRING EARLY

Alright. We’ve got many of the puzzle pieces lined up. We’ve figured out roughly how much we need each year to bankroll our dream retirement, and we can work out the size of the investment pot to make that happen.

The next step is to picture the three stages of retirement:

Stage 1 is from today until ten years before retirement. This is where you can only access your ISA funds (the red arrow). The personal pension and state pension remain locked up.

Stage 2 is the ten years before the state retirement age (between age 60 and 70). In this phase, you can access funds from your ISA and from your personal pension (the green arrow) which you’ve built up over the years.

Stage 3 includes the years after your 70th birthday. In this phase, you can access all three tools – the ISA, the personal pension and the state pension (the blue arrow).

Now work back from the end. To retire in stage 3, your state pension plus personal pension plus ISA need to provide enough income. In our example that was £30,000/year.

If you were eligible for the full state pension of £11,000, you’d need an additional £19,000 from your personal pension and ISA. Using the 3% Rule, a pot of £633,000 would generate £19,000 income. So, ignoring taxes for now, your personal pension plus ISA would together need to be £633,000 for you to retire.

To retire in stage 2, your personal pension plus ISA would need to provide £30,000/year. Using the 3% Rule, you’d need a combined pension and ISA pot of £1,000,000 to retire earlier than age 70.

Finally, to retire in stage 1 (before age 60), your ISA alone would need to provide £30,000 income. That means you’d need a £1,000,000 ISA.

This is the framework for early retirement. First you need to be on track for the Stage 3 box, then for Stage 2, then for Stage 1. Then – when you’re happy to lock in a lifestyle you can afford – you can stop working.

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The next step is to work out how to grow your assets. But that’s for another article!

Looking at early retirement this way is a slight simplification to make the examples easier. But follow this framework and you won’t go far wrong. With financial frameworks like this, you can spend less time working for money, and more time doing what you enjoy, while your money works for you.

Early retirement is very possible – if you start planning for it now.