retirement planning – two contrasting ways to achieve your dreams

Retirement is not a fun topic for many of us to think about. However, I believe, that it is a really important topic to consider. And the earlier you start with your retirement planning, the better the results in the end.

Retirement as a topic has a lot to be considered. I will write more on this topic over time. Today however, I want to start with sharing about how do you actually understand how much money you need to retire.

There are two different ways of looking at your retirement. The first is called top down. Unsurprisingly, the second is bottom up. I will give more explanation to both of these below. It’s a really good exercise for each and every single one of us to do.

top down retirement planning

Top down approach is really simple. It is also the one most people start with. This is a way to look at how you can withdraw from your retirement fund that should hopefully allow for it to never run out.

There is a rule of thumb formula to this. You are allowed to take 4% out of your savings. This figure can be adjusted by the inflation rate each year. 

There are a few assumptions behind this rule of thumb approach. The first one, your investments keep working for you. This means that you remain invested during your retirement years. This will generate extra growth in your portfolio and you should receive some dividends.

The second assumption is that your retirement is 30 years long. You have to be prepared to be flexible and adjust your spendings as the time progresses. This assumption is more in place to make sure that people don’t retire in their 40s and believe they can withdraw 4% each year.

You might say that some of the returns on the investments are way above 4%. While this is true, you need to shift your portfolio towards more defensive options. This will help you be confident that there are funds left in there for you to enjoy as time progresses. One other thing to keep in mind – the market returns are above 4% in the good years. A couple of bad years in a row early into retirement can really dent the future size of your portfolio.

Based on the above, once you know your total investment portfolio value you can easily calculate what sort of pension you can afford.

vs bottom up retirement planning

This in my view is a significantly better way to look at your retirement planning. The earlier you do the calculations in life, the more chances there are for you to succeed. 

Bottom up approach is in a way a calculation of what your retirement fund target should be. This will allow you to understand the retirement fund size you need to live the life you want.

I will break the calculations into three simple steps for you. I personally wouldn’t overcomplicate the numbers and just go with what you know right now. 

The further away you are from your retirement the less likely it is that you would be able to estimate these correctly anyways. You simply don’t know yet what sort of life you might want to have at that age. It gives your target to aim for. However reviewing it and readjusting every now and then could be a good practice.

Step 1 – know your expenses

To start the process you’ll need to understand what your spendings look like. This is a process that is extremely important in order to get the end results right. You’ll need to account for many things and I’ll mention some of these below.

Start off by calculating the expenses you can’t live without. This should include things like housing, food, transportation, utilities and many others. I would include some of the one-off charges into here as well. 

These could be things like repair bills that hit you unexpectedly. This could be linked to your car or your potential home. If you don’t really know these, as a rule of thumb for your home for example you can use 1-2% of the value of the property. 

For your car I’d maybe recommend going with a higher figure. Something like 10% should be nearer to the true expenses you’ll have. You will probably have a better understanding of some of these based on your personal experience. And keep in mind – if these expenses don’t actually hit you, there is more left for you to enjoy your life with.

In here I would also try to consider where and how are you likely to live when you will retire. Are you going to live in a different country? Do you want to downsize from your house to a flat? Do you actually want a bigger house in the countryside?

On top of the above try to understand what luxuries you might want in life. How many holidays would you like to go on each year? Would you like to get yourself a holiday home? Have you dreamed of owning a yacht or a small plane?

This will massively vary for each one of us. As I said before, don’t overthink it. Try to do your best using the assumptions you have right now. As time progresses you can always return to this exercise and readjust your original figures. This will be based on the new things you discover about yourself and things he would like to enjoy later in life.

Doing the above exercise will also help you understand – if markets turn against you and your retirement portfolio, what is the absolute minimum you can’t live without.

step 2 – convert it into total savings needed

When the above calculations are all done the next step is really easy. We are going to use the 4% rule once again. However this time around we are going to calculate it backwards.

If you take the annual figure you expect you need for a comfortable retirement and you simply multiply it by 25. This overall figure should be what you require roughly in your investments to retire and live the life you would like to.

As an example, if you got to £25,000 annually in step 1 – your total retirement fund should be equal to £625,000. If you take 4% of this figure it will actually get you back to the £25,000.

step 3 – start braking it down into monthly savings

The last step in the process is to calculate how much do you need to save monthly in order to achieve your goals. This isn’t as simple as dividing the total retirement fund you need by the number of years you have left to save. 

If you do the above the figure that you get will really scare you. This is due to the fact that you didn’t take into account the compounding effect. There is a point where your investments actually start making you more money than the additional investments you make.

When calculating the monthly savings you should take into account average returns you expect to make on these investments. You can learn a bit more on how to start investing and how to benefit from compounding here.

Summary

In conclusion, retirement is something that many of us don’t start planning early enough. However, it is worth doing a bit of number crunching sooner rather than later.

Firstly, the above should really help put you in control of the quality of life at the retirement age. It is absolutely up to you if you want to go and live of the savings you have or plan and build your investments to allow for a life you really want.

Secondly, I would strongly encourage you to do the bottom up exercise. It will be really helpful for you to understand what sort of annual expenses you might need. This can also be a part of your budgeting. You never know, you might actually start enjoying it.