What’s your magic number?

Most people dream of the day they can retire.

Even if you are lucky enough to have a job that you enjoy, the chances are that you can think of nicer ways to spend your day other than the daily grind of working life.

So, what’s stopping you?

Well, money obviously. Unless you are lucky enough to have a final-salary pension, or are old enough to draw a state pension, you are going to need a substantial pot of cash in order to be able to retire.

But how big a nest egg do you actually need, in order to be able to live off the income? In other words, what’s your magic number?

The 4% rule

Conventional investment wisdom says that you can withdraw 4% from your savings each year without running out of money in your lifetime.

This rate was suggested back in the nineties based on research done in the US. It was made on the assumption that if you invested 50% in equities and 50% in bonds, you would have a 95% chance of not running out of money.

So, simply take your desired annual income and work out your magic number based on a 4% withdrawal rate.

For example — and ignoring tax — if you calculate that you need £25k a year to live on, then your pot will need to be £625k. Easy, job done.

However, like many guidelines, it’s not really that clear cut. After all, we all have different personal circumstances and attitudes to investing.

Also, the investing environment now — especially for interest rates — is very different to the mid-nineties when the rule was proposed.

More recent studies have suggested it could be as low as 2.5%. It all depends on the markets, interest rates, longevity and your appetite for risk.

I think it’s a useful rule to get a ball park figure. But, let’s see if we can do any better.

A risk based approach

A simple rule of investing is that risk and reward go hand in hand.

So, if you want to take very little risk, you can stick your money in the bank and be pretty certain that it will still be there when you come to withdraw it.

But, of course, you will also get very little reward — in the way of interest — for your efforts.

At the other end of the spectrum you could stick the whole lot on a horse at 20/1. Your potential reward is huge, but so is your risk. It’s not a realistic strategy.

Putting your money in the bank is low risk, low reward and takes very little effort. But, running an advanced options strategy is higher risk, higher reward and more work.

So, another factor to consider is — how much effort do I want to put into this?

Ultimately, we want to take as little risk as possible to achieve the reward we require.

So ideally, we would simply stick our pot in a range of savings accounts earning a typical 1.5%. That would be great from a risk point of view. But, not so good from a reward perspective.

In fact, you would need over £1.6m to earn the £25k a year you require. And, of course that takes no account of inflation or tax. It’s a none starter.

So, we are going to have to take more risk to get the reward we crave.

Between these extremes are a host of income strategies that will allow you to generate a sensible yield whilst taking on the risk and a workload that you are comfortable with.

Then, you want to blend them into a robust portfolio of income strategies.

An example portfolio

The aim is to decide which strategies you are comfortable with and decide the percentage of your pot you will allocate to each. We can then average out the expected yields and calculate our magic number.

This approach allows us to blend different risk/reward profiles, assets and tax allowances to build a well-diversified income machine.

Let’s have a look at a typical portfolio we might put together:

Firstly, let’s put a quarter of the cash into…well, cash. It’s boring but safe and allows us to pick up bargains elsewhere if the opportunity arises. The best instant access accounts are currently paying 1.5%.

I’m also a fan of Peer-to-Peer lending. It is higher risk, but the rewards are also higher and it’s quite reasonable to expect an average yield of 7.0% if you spread your investment over several different companies. Let’s put another quarter of the pot into that.

For a little diversification, we might like to add some property. Let’s avoid the hassle of buy-to-let and go with an equity crowdfunding investment, such as those offered by Property Partner. The rental from the properties is paid out in the form of dividends and a 5.0% yield is quite achievable.

Okay, time to juice it up.

I’m a fan of selling options on shares and based on my experience, a well run covered call strategy could conservatively achieve a return of 15% per year.

Of course, you will still be subject to the vagaries of the stock market so it’s definitely at the higher risk end of the spectrum. And, it’s certainly more work than some of the passive strategies.

But, assuming we are happy with that. Let’s put the final 25% into a covered call strategy.

So, whose good at maths? We need to work out the overall average yield.

Actually, it’s pretty easy. Since we have allocated the same amount to each strategy we can just take an average of the four yields. It comes out at just over 7.1%.

Therefore, if our expected yield from the portfolio is 7.1% and we want to generate £25k a year. We would need — ignoring tax for now — a savings pot of £352k.

What about tax?

Our example portfolio is diversified across four different asset types and each has a different risk reward profile.

However, it also makes sense to make efficient use of tax allowances. Obviously, I don’t know your personal circumstances but a judicious use of the allowances available could pretty much eliminate any tax.

The interest on the cash savings could be largely swallowed up by the Personal Savings Allowance (PSA) of £1,000 per year.

Many P2P providers offer their products within an Innovative Finance ISA (IFISA) wrapper. If you plump for this option over several successive years, then the interest from these investments would be tax free.

The crowdfunded property investments pay rent in the form of dividends. Therefore, we can make use of the tax-free dividend allowance of £2k and the personal income tax allowance of £12,500 for 19/20 to swallow up that tax.

And finally, the covered call strategy makes its profits through selling option premium and that is taxed as a capital gain. Everyone has a capital gains tax exemption of £12,000 for 19/20 so that effectively deals with the majority of that income stream.

Final points

Of course, you could use different income-producing assets such as bonds, dividend shares, or commercial property and mix up the amount allocated to each. This is just a simple example.

And, remember to make the most of all the tax allowances and wrappers available. Then make a reasonable estimate of the respective yields, average them out, and work backwards to get to your magic number.

Inflation will affect how much income you need each year but also how much money your various investments generate. If you are lucky, the two sides of the coin will stay evenly matched.

So, that’s the 30,000 foot view of how you can figure out your magic number — or in other words, how much you need to save to eventually escape the daily grind. I hope you found it useful.

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