How much is enough for retirement?

This is a question I get asked in almost every initial meeting I have with clients, so I am going to try and provide some guidance by answer a few simple questions.

What is the 4% rule?

The 4% Rule is a practical rule of thumb that may be used by retirees to decide how much they should withdraw from their retirement funds each year, with the aim to keep a steady income stream while maintaining a sufficient overall balance for future years. The withdrawals will consist primarily of interest and dividends on savings, but also the sale of capital investments.

Until very recently interest rates have been at historic lows, and it has therefore been harder to generate a natural income of 4% a year after charges. This means that investment managers or DIY investors have to work harder to make the 4% rule work. However, for a balanced risk investment profile a target sustainable return should be in the region of 5% per annum although you may have years that significantly detract from this.

The key is that if you are able to generate a 5% rate of return, you can sustainably draw 4% per annum, effectively forever! The additional one percentage point is a contingency that allows for changes in costs, requirements and of course fluctuating investment returns and inflation.

The key here is that your 4% income may preserve capital which can be relied on for later life, including long term care, gifting and additional inheritance planning, or large one-off purchases. For example, as your income needs change later in retirement, the amount of capital needed to generate a lower income at 4% may mean there is excess capital which can be removed from the overall estate.

What are the pros and cons for selling capital in retirement?

The biggest pro is that tax-free capital can be a lot more efficient than taxable income. How many higher rate taxpayers do not use their annual capital gains tax (CGT) allowance? If you can provide the income you need from natural income in retirement, that is a great place to be because it allows you to ride out the falls in markets. However, there is never anything wrong with taking profits, especially if it means you can reinvest the proceeds to generate a higher income. Of course, if you have to sell capital, then it can be a different matter as it can start a vicious cycle of capital sales being needed to maintain income, while the overall value of a portfolio is falling. The more capital you sell, the less is invested and therefore the less income you are generating.

In what situation is it better to sell capital than simply own high yielding stocks or income funds?

High yielding stocks rarely stay high yielding forever. Investors need to watch out for high yielders where the dividend is in jeopardy and be prepared to sell the capital. If a yield is sustainable, then the high yielder will become a lower yielder purely by virtue of the share price rising. Eventually, it makes sense to sell out of that share and reinvest in something else that will deliver a higher income. It is a bit more work but can reap high rewards.

When you sell capital, will capital gains tax kick in? Is there any way to avoid this?

If the gains are large enough, CGT will kick in. If the time is right to sell capital, it should be sold – do not let the tax tail control the investment dog. However, if timing is not critical, waiting until the new tax year, or transferring the capital between spouses before sale, can reduce or eradicate a tax charge. Making sure that the right assets are held in tax wrappers such as pensions and ISAs can be a great help. For investors with surplus capital, Enterprise Investment Schemes (EIS) can be a great way of kicking the CGT can down the road and getting income tax relief as well. But do not get too hung up about avoiding CGT. After all, it is only there because your portfolio has done well and tax is charged only on any gains in excess of any available CGT annual allowance.

Are there certain assets you should look to sell first?

The bad ones. The ones that have failed to live up to expectations and are unlikely to recover. And the good ones. The assets that have done so well that the yield has fallen to a level where a higher yield can be obtained elsewhere.