For most people in their 40s, the prospect of retiring may have started to appear over the horizon but is still decades away.
But the good news is that retiring could be a lot closer than many think, given careful planning and a strategic investment. The even better news is that there is no need for very high-risk investments. A relatively cautious approach will get the job done just as effectively.
So what exactly do those in their 40s need to do to retire early, and how much do you need to do it?
Telegraph Money has devised a plan for retiring at 55, the earliest you can access a private pension, with a portfolio capable of delivering £15,000 in dividend income a year, in today’s money.
We have been conservative in our estimates, so this plan is realistic. However, this is not something all will be able to achieve, although the same plan could be used to get lower – but still decent – returns.
We assume anyone adopting this plan also has a company pension and a state pension. Together, these add up to a healthy retirement income.
At present, someone with a company pension pot of £752,445 could buy an inflation-protected annuity (or £449,943 without inflation protection) paying out £20,000 annually from 55.
Add in the state pension, currently a maximum of £8,767 a year, and you get an annual income of around £30,000.
Here, we focus on how to build up an additional portfolio for a target extra income of £15,000, giving you a total of around £45,000 a year from age 55.
But don’t neglect your company pension: take full advantage of your employer's contributions, maximise what you can put in to benefit from the upfront tax relief, and check how it is being invested. Read more about this here.
Where to build it
There are numerous “wrappers” you can use to hold the portfolio you build. The main options are a stocks and shares Isa, or a self invested personal pension (Sipp) – or a combination.
The advantage of a Sipp is upfront tax relief, so you will have a greater amount of money invested to start with. When you want to withdraw the money, the first 25pc can be taken tax-free, but the rest will be subject to income tax at your regular rate (after the tax-free allowance, currently £12,500 a year). This money will also be locked away until your mid-50s.
Philippa Gee, of Philippa Gee Wealth Management, said: “Usually a personal pension, such as a Sipp, is accessible from 55, but this will soon rise to 56 and then eventually 57. That is typically only different if someone has major health issues or a particular career that enables an earlier retirement.”
With an Isa – where you can put in up to £20,000 a year– you get no tax relief upfront, but don’t have to pay any tax on the money you take from it. You can also choose to start taking income from it at any time, so it gives far greater flexibility.
Another advantage of Isas is that they help avoid the lifetime allowance on pensions, currently set at £1.05m, which applies to all of an individual's pension pots. Pots that breach that limit will incur hefty tax charges.
With money invested in both Isas and Sipps, there is no tax to pay on capital gains or dividends earned within the account.
Mrs Gee said: “It is about creating maximum wealth over time, using the initial tax efficiency of pensions, compared to the lifetime tax efficiency of the Isa.”
She also pointed out that pension pots are more inheritance tax friendly, meaning if you expect to have money left over to pass on, you should use up money in an Isa before a pension pot.
How to build it
We have made a number of assumptions. To reach £15,000 of annual dividend income, we’ve assumed the eventual portfolio will yield 4pc at retirement, without eroding capital value.
This means that if you had £1,000 invested in funds or shares, the portfolio would be able to pay you £40 through dividends, and the £1,000 would remain invested.
Next, we’ve assumed inflation will be 3pc a year – meaning the amount required to meet the goal increases over time.
Today, to deliver £15,000 in dividend payouts would require a portfolio of £375,000. To retire in 10 years from now a 45-year-old will need £20,000 from a £500,000 portfolio.
Jonathan Moyes of wealth manager Whitechurch Securities, has provided a sample portfolio to help you reach a large enough pot by retirement, with potential returns of 5.7pc. These are not guaranteed.
To achieve the required portfolio size by 55, a 45-year-old would need to invest £3,157 a month. These figures don’t account for the differences in tax relief between an Isa and a Sipp.
The latter two scenarios are unrealistic for most, given that a very large pot has to be built rapidly.
Overall, the 45-year-old would end up paying £378,840 by the age of 55. Expected returns are based on the average return achieved over the previous 25 years for a portfolio of a similar level of risk.
In the growth phase ahead of retirement you should invest in the “accumulation” version of each fund, where dividends are automatically reinvested. As you approach retirement, the risk level will need to be reduced, and at retirement, the portfolio will need to be switched so it delivers income rather than growth.
You may need to consult a financial adviser before investing.
Lower-risk portfolio, 10-year time horizon
UK stocks: 30pc (Miton UK Multi Cap Income 8pc, MAM GLG Income 11pc, Evenlode Income 11pc)
Global stocks: 40pc (Evenlode Global Income 12pc, Newton Global Income 12pc, Schroder US Equity Income Maximiser 8pc, JPM Emerging Market Income 8pc)
Bonds: 20pc (Jupiter Strategic Bond 10pc, Vanguard US Government Bond Index 10pc)
Property: 10pc (BMO Property Growth & Income 10pc)
Mr Moyes said: "This portfolio initially has around 70pc in stock market funds, counterbalanced with select bonds and commercial property. The stocks investment strategy is focused on income, reinvesting dividends to boost overall returns.
"My active funds picks are where I believe the managers can give the greatest returns over the long-term. I have blended this with funds that take an index tracking approach in American shares and Government bonds (Schroder US Equity Income Maximiser and Vanguard US Govt Bond Index).
"The portfolio should be actively managed and not just treated as a buy and hold strategy. Risk is reduced as the investor approaches retirement."
The above assumes an annualised total return of 5.7pc. This is the average return achieve by the IA Mixed Investment 40-85pc sector (a peer group of multi asset funds investing up to 85pc in stockmarkets) over the previous 25 years.
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