During our 20s and 30s, retirement can seem like a very distant prospect. It’s hardly surprising we’d rather focus our financial planning on building the lives we want to lead by investing in our career, our homes, and our family. Fast-forward a decade or two, however, and the reality suddenly hits us: we need to put the financial arrangements in place to make sure we can enjoy the later years of our life without sleepless nights. By our 40s, at the latest, we should already be setting aside a regular amount to grow our retirement capital. 

The good news is that, even if you can only save a small amount, your capital has a long time to grow, given the power of compounding. And remember: the earlier you start saving for retirement, the greater chance you give yourself of achieving higher returns and greater prosperity during your later years. Investors with a long horizon can take on more risk – and thereby open up the possibility for higher reward – because the market has a longer time to recover in the event of a pullback. 

If you only have a few years to invest in the run up to your retirement, on the other hand, it’s unlikely you would be willing to take on as much risk. Our retirement planners generally advise that you reduce your exposure to riskier asset classes such as stocks as you near the end of your working life and progress through your retirement.

The 4% rule

For many investors mulling over their financial wellbeing in later life, peace of mind comes from applying the 4% rule. This formula involves accumulating a large enough portfolio of assets that you could withdraw roughly 4% of it each year to replace your annual salary, with small increases in the amount that you withdraw year by year to account for the rising cost of living due to inflation. If you follow this rule of thumb, you stand a high chance of not running out of money during a 30-year retirement. 

Let’s say, for example, your investments and savings at retirement total CHF 1 million. If you apply the 4% rule, you would withdraw CHF 40,000 in your first year of retirement (see the chart below). If the cost of living increases 2% that year, you would give yourself a 2% raise the following year, withdrawing CHF 40,800, and so on for the next 30 years.

Many different variables 

While the 4% rule provides a useful rule of thumb for calculating your overall spending during retirement, it’s rather rigid. For example, it assumes a specific portfolio composition at the time of your retirement and doesn’t account for the fact that your investments may change over time during your retirement. So, it’s important to treat it as a guideline, rather than following it to the letter.

Moreover, each person’s financial needs during their retirement vary based on a number of factors. These factors include your current age; the age at which you plan to retire or may have to retire on health grounds; how long you expect to live based on your family history; how much you plan to spend in retirement; and what your sources of retirement income will be.

Keep you smiling into later life

Importantly, your individual readiness for retirement should also factor in the substantial variations in spending rates that occur during most people’s retirement years. 

Most of us are likely to spend a larger fraction of our income in the early years of retirement when we are healthy and energetic, whether it be on travelling the world, entertaining friends and family, or remodelling our homes. Then, as we transition into the years of mid-retirement, our outgoings are likely to slow, before rising again towards the latter part of our retirement years with the possibility of medical and long-term care needs. Some investors refer to this as the ‘retirement spending smile’, reflecting the shape of the chart as costs start high, bottom out in the middle, and pick up again. 

By factoring this pattern into your calculations and creating a well-structured plan that matches your individual expectations, you can help to ensure you’re wearing your own retirement smile later in life, no matter how you plan to spend it. And it can even help you sleep better now…