Two-thirds of income rule of thumb for contributions

SlightlySmart

I've read this rule in many places - you'll need around two thirds of your income in retirement.

Seeing as a significant portion of income would need to be contributed to achieve such income (even if starting young), do you use your entire income for the purpose of calculation, or your income after taking away the contribution? If you do the former, you're actually aiming for a much higher retirement income than 2/3rds or your current available income after contributions.

In my calculation for my situation, if I aim for 2/3rds of total income instead of 2/3rds of available income after contributions, my monthly contributions need to be 27% higher, and my expected retirement income will be 90% of my current available income.

My guess is that the rule of thumb doesn't take into account the amount of current income that goes toward the contribution.

HappyMJ

It's not a fixed figure. If you pay off all of your debts such as a mortgage by the time you retire you won't need income to cover that either.

For example if your income is £3,000 a month your pension contributions £300 per month and your mortgage £1,200 a month then you only need half your net income...£1,500 per month.

You need to figure it out for yourself.

dunstonh

I've read this rule in many places - you'll need around two thirds of your income in retirement.

There is no rule. It comes down to preference. People have lifestyles they want to afford both now and future. Some locations have higher living costs than others.

Its probably better to work out what you would want, when you want it and focus on what you need to pay for that given your risk tolerance for the investments you plan to use.

ffacoffipawb

dunstonh wrote: »

There is no rule. It comes down to preference. People have lifestyles they want to afford both now and future. Some locations have higher living costs than others.

Its probably better to work out what you would want, when you want it and focus on what you need to pay for that given your risk tolerance for the investments you plan to use.

Two thirds was also the old Inland Revenue maximum of 40/60 ths so it probably emanates from there.

dunstonh

ffacoffipawb wrote: »

Two thirds was also the old Inland Revenue maximum of 40/60 ths so it probably emanates from there.

yes. The very old HMRC rule was the only time I have heard reference to two thirds.

patanne

The figure you need in retirement is totally personal. If I had retired on 2 thirds I would find it difficult to even run a car. It is my opinion that the lower your salary the less you can afford to drop in retirement. I have been fortunate enough to retire on more than the salary I was on for the last few years which goes to fund the extra I spend because I have 24/7 to spend it instead of 16/7 to spend what I earned. Why not try living on the figure you intend to rely on, that way at least you will know

jamesd

Forget two thirds. Work out what you'll want and use that instead. I've been saving and investing more than 60% of my (net pay plus gross pension contributions) and it's be daft for me to use two thirds of my total income when I've been comfortably living on much less than that for years. However, good safety margins are useful and unless your investments do badly your investment pot value for prudently taking two thirds of net income would take you to two thirds of gross income or even two thirds of gross income before contributions. Aim for at least 50% safety margin and up to 100%. Beyond that you're just working longer than you need to because the likely result is that you'll be living on more than your after tax working income unless you have the misfortune to have bad investment results from major market drops in the early years of retirement. Unless you want to plan to retire on more than your working income, of course - some may want to do that.

It is to your advantage to start with relatively high contributions so you can get the maximum benefit from compound growth. An even better time to boost contributions to pension or S&S ISA is just after a big market drop when there's doom and gloom in the press. Think of that a big "investment sale on now" sign.

What I'm doing at the moment is working on maximising pension tax relief while also arranging to pay no income tax in retirement. The Venture Capital Trust system is one key to this if you can afford to defer using income until five years after you first receive it. Pay in, get the 30% tax relief, take ongoing dividend income, don't take out the other 70% until after five years when you can get it tax free after investment gains or losses. ISAs are another tool and the VCT approach can be used to shift money from pension to ISA tax free. Be aware of the investment risks of VCTs before using them. Of course you'll need existing capital and income to draw on during the time you're deferring the 70% of VCT purchase portion.

SlightlySmart

Thanks, very much a rule of thumb then and the reality is quite a bit more complicated.

I'm 26 now and have been using the "half starting age % of salary" rule since I was 23, so saving 11.5% of gross.

I've made a spreadsheet using today's values of what I think I'll need (based on tracked current expenses), along with multipliers for how much of each thing I'll use and how much above inflation I think it will rise in cost. For example, I'll use more energy and it'll increase in cost by more than inflation (most things at 1.25, things like energy/fuel on 1.5 or 2.0).

It works out as 93% of my current income! That's for the kind of reasonably frugal but enjoyable and active life in a country village, as my grandparents have and what I'd want. Go to the city, ditch the car and holiday and it's 66% (I'd probably die (and want to) sooner too). I realise this need will change over my working and retired life, so will need reviewing.

Both the Hargreaves Lansdown and Money Advice Service's calculators (default options) tell me I need to double my contributions to 23% of my gross income to get the 93% income level retiring at 68 with a level income. Assuming no tax-free lump sum (which I'd probably take and invest in an ISA if that option would be available), and no state pension as I expect that to be abolished or means-tested by then.

That isn't going to happen anytime soon while I'm saving up for a house as well, so I'll just have to ramp up my % contribution each year.

sandsy

The two-thirds concept is a bit dated now.
The preferred concept now is replacement ratio. In general, it's considered that people on lower incomes need to maintain a higher proportion on their income in retirement than those on higher incomes whose fixed expenses from a lower part of their outgo and have more discretionary spending.

DWP published replacement ratios for different income levels a few years back. There's a couple of pieces of research where these have been updated to allow for inflation in the interim.

System

I think it largely depends on what you want to do and where/how you are going to live.
If you have a high income, large house, mortgage paid off, and are going to downsize to a cheaper area and keep bees, then you won't need a fraction of your original income.
If you have a modest income but loads of interests you intend to pursue, and no intention of moving house, then you may need more income in retirement, not less.
If you are poor, live in a council house, modest interests, no car, then possibly you don't need any more that the state retirement pension.

patanne

There are other issues which you need to consider which are quite personal & probably difficult in your youth to even contemplate. Such as how old do you think you will be when you no longer want to be involved in the source of your income. I have decided that by the time I am eighty I just want the money to go in the bank and for me to spend what I have and not to have to file self assessment every year. So lots for you to think about & only you can provide the answers! Down sizing is fine but you need to ensure that you do not leave it too late as these things do become more stressful with age and also doing it without the support of a partner can be more stressful too.