How much is enough?Posted: 2020-02-23
The title of this blog is that fundamental question: how much is enough? Much of the thinking around FIRE boils down to answering this question.
And as with so many good questions, the answer depends on perspective. And perspective itself depends, among other things, on height. And I think height is a useful metaphor for explaining how much is enough for me.
Ceilings vs floors
I remember my scorn about twenty years ago for my friend W, who was my most earnings-focused mate, when he told me that “I couldn’t live on a salary less than £100k”. At that point I earnt less than half that and very much saw £100k as a ceiling, not a floor.
In any case, these days I’m afraid I would now regard £100k p.a. as definitely a floor. And I mean £100k post tax, of actual money that I could spend. It would fund my ‘needs’: groceries, utilities, transport, medical bills, household cleaning and maintenance, and such like. It would also pay for my investment expenses, though obviously there is a ‘circular reference’ here (as the more that is ‘enough’, the higher the expenses that ‘enough’ needs to fund!).
My ‘needs’ are based on relatively low housing costs. I don’t have a mortgage on my home. I am also ignoring my house as an asset – so it is not part of the ‘enough’ calculation either.
Based on a 4% Safe Withdrawal Rate (a.k.a. the 25x rule), £100k p.a. needs a pot of £2.5m. Tax would complicate that somewhat, but assuming I remain married, and that the current allowances remain in place, I am prepared to ignore tax, for the moment. Certainly I know people earning almost £90k who have <10% tax, and I think as a couple we could make the tax at £100k p.a. relatively minimal.
Or perhaps one should think of the tax liability as roughly equivalent to the state pension/benefits which, in other respects, I am ignoring for the purposes of ‘enough’ calculations.
In actual fact, whether £2.5m turns out to be enough depends on two key questions:
- What return does the portfolio deliver in the long term, and
- In what order (or sequence) – i.e. if it alternates 15% and -5% every year, you do much better if you begin with a +15 and not a -5.
I’m using the Flexible Retirement Planner to see how confident I can be that £2.5m is ‘enough’. I am assuming £100k of spending, starting ‘from now, with a £2.5m windfall’. This assumes the £2.5m windfall is fully unsheltered. I also assume that henceforth we will plough £40k per year into tax sheltered savings (i.e. maxxing the UK’s ISA allowance as a married couple), which will slowly improve the after-tax returns and income. We are investing with ‘above average risk’ (roughly 65% equities).
My annualised returns have been 11% per year over 7 years. Let’s call that about 8% per year above inflation. The Planner’s stats tell me that there is a 98.9% probability of having ‘enough’ – this box is a bright green. On the heatmap, green signifies over 90% probability that there is ‘enough’. Red signifies only a 50% probability.
But my 11% figure is only 7 years’ track record, and it doesn’t include a market bust; over the last 20 years my returns are, I think, closer to around 7%, or only 4-5% above inflation. The highlighted amber box shows the scenario where returns average 4.9% (above inflation, say), and my income remains (inflation adjusted) at £100k for 50 years. In that case I have only a 87% probability of having enough – or a one in seven chance of running out of money. The ‘Safe’ Withdrawal Rate is, rightly, not called the ‘Bulletproof’ Withdrawal Rate.
Climbing off the floor
While £100k would more than cover my ‘needs‘, but it would not cover very many of my ‘wants’. I’d have to eat out less, travel less, and be less charitable.
In point of fact the majority of my spending is on ‘wants’, not ‘needs’. I want to eat out, regularly, and check out some of London’s better restaurants. I want to travel, carbon taxes permitting, using London’s excellent airport/rail links. And I want to ‘pay it forward and back’, and continue to support philanthrophic causes. And of course with a bigger pot I will have bigger investment expenses; at least £10k if I spent only 40bps, in total, on a £2.5m pot.
I haven’t mentioned medical / care expenses but I want to be able to handle those too – though I suspect that the moment I have hefty health-related costs my eating out / travel / etc costs would drop in mitigation.
I think my annual income, that would leave me comfortably able to afford more than enough ‘wants’, would need to be around £200k p.a. This is twice the height of the ‘floor’. This sounds like a vast amount relative to the UK national average of around £30k per household. On the other hand I have written before about gilded Londoners who believe £500k of (gross) income a year is the minimum required to live properly.
And at £200k of annual income, the question of tax is unavoidable. Assuming I (Buffett style!) sold assets and paid Capital Gains Tax (at 20%), instead of taking dividends and paying Income Tax (at almost 40%), this suggests I’d need £250k of pre-tax income, and the pot is actually just over £6m.
Don’t touch the capital!
My bar is however higher still. I want to be funding spending (and taxes) from investment income, without any need to sell ‘capital’. And my income yield is somewhat lower than the 4% SWR I’d used above; it’s closer in fact to 3.5%. This also pushes my tax rates up, to about 30%. So now my £200k spending money needs almost £300k of gross income, which requires a pot of £8.5m (at 3.5% yield) to deliver.
Two more storeys to climb
Psychologically I have two more storeys to climb.
First of all, I want my lifestyle to be relatively unaffected even by a severe market drop. How severely can the market drop? I reckon on a blended fall of about 25% – taking into account my diversified asset allocation. In effect, therefore, my pot of £8.5m needs to be ‘post crash’ – suggesting I only really have ‘enough’ once the pot reaches £11m. At that point I can cope with a market crash, and still have enough to live a very ‘wanty’ life, and pay my taxes, without touching my nest egg, and on an indefinite basis.
I’m close to the top of my ‘enough’ definition at this point. But in fact I aim for one layer higher still. Arguably the most toppy layer of all – perhaps the penthouse floor? And this layer exists because I want to maximise my ISA/SIPP tax incentives.
The ISA maxing double whammy
To maximise my ISA/SIPP tax incentives, I need to ‘max out’ my contributions. My SIPP is already on track to hit the Lifetime Allowance, so this doesn’t really alter my calculations so far. But ISAs have a £20k annual contribution allowance, on a ‘use it or lose it’ basis. So for me and Mrs FvL to maximise this, I need to move £40k a year from unsheltered funds into an ISA.
But aiming to maximise my ISA benefits also has a further implication. To maximise the benefits, no money must be withdrawn. Any withdrawal represents opportunity lost; £1000 withdrawn in 2020, could have been left in to compound up tax-free for, touch wood, 50 years. If I sustain 7% returns in the ISA, in 50 years that £1000 would miss five ‘doubles’. In 50 years time the ISA would be £64k smaller.
Aiming to maximise my ISAs means effectively ignoring the ISA pots from all these calculations. I’m really redefining the question as ‘how much is enough, ignoring (but contributing to) a fully-maxed out ISA’?
If I/Mrs FvL worked to earn that £40k ISA allowance, we’d need to earn over £70k per tax to fund it. In practice I don’t think of these funds coming from income, but rather being unwrapped assets that I sell to fund the ISA topup. Conceptually, I need to ‘ringfence’ a pot of unwrapped assets, just to fund the annual ISA allowance. How much ‘ringfence’ is required? At a 4% yield, I’d have to ringfence £1m. At my 7 year annualised return of 11%, and assuming 20% capital gains tax, I’d only need to ringfence just over £400k. Let’s take the mid point – about £750k of assets are required to fund the ISA topup without disrupting the ‘nest egg’ or my spending profile.
So, that leaves my ideal ‘enough’ figure as over £12m, excluding the ISA and excluding my home. That includes a £750k ‘funding the ISA’ pot, a cushion to allow for a nasty (but not the worst possible) market drop, enough to allow me to take dividends, and pay my taxes.
Surely I can’t be serious?
£12m certainly seems like a lot of money. I do not have an absurdly opulent lifestyle; I only have one home, I don’t have to pay for school fees / nannies, nor do I have armies of staff or very expensive hobbies. How can I possibly need so much money to have enough to calmly embrace financial independence at my current spending level?
Of course a pot of £5m, less than half my ideal figure, would certainly be a fine thing to have – particularly if it is in addition to my home. I could live a decent life, in London. I could probably do so indefinitely. I’d be able to build my ISA for some time yet. But there is a >5% chance I’d have to cut back; allowing for inflation, there could be as much as a 30% chance of running out of money. I’m young enough not to like those ‘in extremis’ scenarios much.
And it is those ‘extremis’ scenarios that are bumping my pot up so much. Let’s just doublecheck how my Flexible Retirement Planner models my penthouse-floor pot of £12m. I’m going to come down a storey, because my approach has built in a buffer to allow for a 25% market fall – something which, in effect, the statistical modelling of the Flexible Retirement Planner does for me. So if my £12m took a 25% bath right at the outset, leaving me with £9.0m, here’s the heatmap:
I’m not quite 100% guaranteed that £12m is enough. The key risk is, effectively, taxes going up – which would make me seek higher gross income to maintain my lifestyle. The equivalent risk is my spending levels increasing, something that is certainly possible. But these risks only prove serious if portfolio returns are below 4% on average. Assuming my analysis is all after inflation, that is a real possibility (apologies for obscure economist pun!). But the chances of low returns, just after the 25% bath, as well as taxes going up, is a chance I will take. For me, a pot of £12m (excluding housing and ISAs) would definitely be enough.