When you are 25, retirement is a long way away! You are very likely to have other more pressing commitments, like buying a car or a house, raising a young family or repaying student loans. This is why most people don’t get around to thinking about retirement until they are in their 40s.
But the more you can stash away for retirement early in life, the better retirement outcome you are likely to enjoy.
Why? Because of the maths of compounding. Albert Einstein famously said that compound interest is the most powerful force in the universe. He said, “Compound interest is the 8th wonder of the world. He who understands it earns it; he who doesn’t pay it.”
Let’s look at numbers.
If you invest $10,000 at an annual rate of 5% when you are 25, you will have $70,400 when you turn 65. That $70,400 is made of $10,000 from your investment, $20,000 from earning 5% on it for 40 years, and $40,400 on earning a 5% return on the accumulated 5% returns. These compounded returns make the majority of the final balance.
If you invest the same $10,000 at 45, you will have $26,533 at 65, with $10,000 from earning 5% on the $10,000 for 20 years and only $6,533 from the compounded returns.
This makes a huge difference!
This is why you need to join KiwiSaver as soon as you can and put as much as you can afford into it, particularly if your employer makes a contribution.
International research shows that you need 70 – 100% of your current income to maintain your lifestyle in retirement, depending on whether you own or rent your home.
Research from Massey University shows that you need anywhere between $700 and $1,400 weekly for a 2 person household, depending on where you live and the lifestyle you want to enjoy in retirement.
This means that you will want to have accumulated savings at retirement age which are sufficient to fund your expenses over the next 25 to 30 years. You can use our Kōura calculator to find out what different KiwiSaver contribution rates will give you in retirement.
For example, if you are 40 and you want to have $1,000 a week at age 65 (in today's dollars and excluding NZ Super) you will need to have accumulated savings of $1.6 million when reaching 65.
See our blog here for a lot more information and advice on retirement planning.
After decades of saving, it's time to start spending once you enter retirement. But how much can you safely withdraw each year without needing to worry about running out of money? How much you can safely spend depends on many things, including some you can't control—like how long you live, inflation, and the long-term risk and return of the markets—and others you can control—like your retirement age and the investments you choose.
A sustainable withdrawal rate
A sustainable withdrawal rate is a rate at which you can draw on your savings every year and be highly confident that you won’t run out of money. Because it is a “worst-case” rate, it is conservative and, in most cases, you would have been able to draw from your pension at a higher rate. But you will only know this in hindsight.
However, it is a good place to start.
Financial planners looking at historical data in the US have calculated that if you keep your savings in a balanced portfolio, draw 4.5% of your savings in the first year of retirement, and then adjust the amount every year for inflation, you are unlikely to run out of money over a 30 year period. Historical date in the UK has put the number a bit lower, around 3.8%-4%.
Your situation could be different. For example, you might want to withdraw more in the early years of retirement when you may plan to travel, and less in the later years. But this 4%- 5% rule of thumb offers a handy guideline for planning.
Let's look at a hypothetical example. John retires at age 67 with $500,000 in his retirement account. He decides to withdraw 4%, or $20,000, each year to supplement his NZ Super. Since John plans on withdrawing an equivalent inflation-adjusted amount from savings throughout his retirement, this $20,000 serves as his baseline for the years ahead. Each year, he increases that amount by inflation—regardless of what happens to the market and the value of his investments.
Other financial planners, namely Guyton and Klinger, have calculated that you can draw higher amounts if you are prepared to cut back spending in the years when investments perform badly. They have developed a set of rules which set the safe drawdown rates in various situations. A description of these rules is beyond the scope of this FAQ but ask us and we’ll send you more information. Alternately, you can speak to a financial adviser.
History also suggests that the prevailing market environment at the time of your retirement may be particularly important. Weak investment results early in retirement can significantly diminish your nest egg, especially if you don't reduce your withdrawals with declining markets. On the other hand, strong returns early in retirement can put the wind at your back—financially speaking—for decades.
Investment management fees will also reduce the net amount you will have available. It is therefore important that you remain invested at low fees.
Take your timeline into account
One of the biggest factors that affects how much you can withdraw is how many years of retirement you plan to fund from your savings. The longer your retirement lasts, the lower the sustainable withdrawal rate.
- As mentioned above, a 4.5% withdrawal rate over a horizon of 30 years makes it unlikely you will run out of money.
- But if you work longer—say you expect to retire at age 70—or if you have health issues that affect your life expectancy, you may want to plan on a shorter retirement period—say, 25 years. The historical analysis shows that, over a 25-year retirement period, a 4.9% withdrawal rate has worked 90% of the time.
- On the other hand, if you are retiring at age 60 or have a family history of longevity, you may want to plan for a 35-year retirement. In that case, 4.3% was the most you could withdraw for a plan that worked in 90% of the time.
These may sound like small differences, but they could equate to thousands of dollars in annual retirement income.
The good news is that even with the market's historical ups and downs, these withdrawal amounts worked most of the time—assuming that investors stuck to a balanced investment portfolio.
For people whose retirement planning includes a spouse or partner, it's important to consider not only the life expectancy of each person but also the likelihood that one or the other will still be living (referred to as joint life expectancy).
How you invest can be important too
The mix of investments you choose is another key to how much you can withdraw without running out of money. Portfolios with more shares have historically provided more growth over the long term—but have also experienced bigger price swings.
If you want a high degree of confidence that your money will last, you will be better off with a balanced portfolio, even if it grows at a slower rate, because it will be less exposed to a large fall. At a 90% confidence level, the sustainable withdrawal rate for the balanced portfolio is 4.8%, versus 4.5% for the growth portfolio.
Consider the role of guaranteed income
Choosing the right withdrawal rate can improve your odds of success, but it won't guarantee that you won't run out of money. Some products, like annuities, do offer that guarantee but they have unfavourable tax treatment in New Zealand. There are guaranteed income funds offered in New Zealand which will provide certainty if you live longer, but they are more expensive because you are paying an insurance premium.
Bottom line
Planning for withdrawals in retirement can be challenging. And no wonder, given the range of uncertainties, from how long you will live, to market performance, inflation, taxes, and more. The rules of thumb described above provides a starting point, but every individual needs to consider these uncertainties and their personal situation when evaluating how much they can sustainably spend in retirement. If you worry about this when you are retiring, it is best to ask for advice.
Kōura intends to develop advice on this important area in the future.
Note: the withdrawal rates mentioned in this FAQ are quoted from research by Fidelity Investments