Tuesday, September 13, 2011

Retirement Planning Series - How much money will I need?


In the previous article in our Retirement Planning series, we learnt how important it is to plan for retirement and have a sizeable retirement corpus.

The next big question anyone would have is "How much money do I need to retire?"

The answer to this question contains both good news and bad news.

As always, lets look at the bad news:

There really is no single number that would guarantee everyone an adequate retirement. It depends on many factors, including your desired standard of living, your expenses (including any medical costs) and your target retirement age.

That being said, lets get to the good news part.

It's entirely possible to determine a reasonable number for your own retirement needs.

All it involves is answering a few questions and doing some calculations. As long as you plan ahead and estimate conservatively, it's entirely possible for you to accumulate a nest egg sufficient to last you through your retirement years.

There are several key tasks you need to complete before you can determine how much money you'll need in order to fund your retirement. That includes:
1. Decide the age at which you want to retire.

2. Decide the annual income you'll need for your retirement years. It may be wise to estimate on the high end for this number. Generally speaking, it's reasonable to assume you'll need about 80% of your current annual salary in order to maintain your standard of living. (We are talking about value in todays money value without considering Inflation)

3. Add up the current market value of all your savings and investments.

4. Determine a realistic annualized real rate of return (net of inflation) on your investments. A realistic rate of return would be 6-10%.

5. If you have a company pension plan, obtain an estimate of its value from your plan provider.

A Sample Calculation

Let us consider the hypothetical case of Mr. Ramesh a 40 year old man earning Rs. 6 lakhs per year after taxes. Let us take a look at his key factors:
1. He wants to retire at 65 years
2. He will need around 5 lacs or more of annual income post retirement
3. He currently has Rs. 10 lacs in investment & savings
4. He will receive company pension of Rs. 20,000 per month (Assuming he retires at one grade higher than his current grade, which we will assume he will do so in the next 25 years)

Now, we determined that Ramesh needs around 5 lacs per year which comes to roughly 40,000 rupees per month. If we subtract his company pension, he will need to fund Rs. 20,000 from his own pocket to retain his current standard of living.

Additional Consideration: Ramesh is in good health and has a family history of longevity. He also wants to make sure he can pass along a sizable portion of wealth to his children. As a result, Ramesh wants to establish a nest egg large enough to enable him to live off of its investment returns - and not eat into his principal amount - during his retirement years.

We will assume that Ramesh should be able to earn 6% annualized returns (after considering inflation), he will need a nest egg of at least 41 lacs or more (2.5 lacs / 0.06).

As you can see – Ramesh needs to accumulate around 40 lacs before he retires in order to be able to fund the Rs. 20,000 he will need every month after retiring.

Note: We haven’t considered any taxes he would have to pay on the income he will earn. We will come to it later.

The Big Problem – Inflation:

Now, remember that all these numbers are in today's rupees. Since we're talking about a time period spanning several decades in future, we'll need to consider the effects of inflation.

In India the current Inflation is running above the 10% mark but is has been around the 8% range over the past many years. So, for our calculation we are going to keep inflation at 8%.

In Ramesh’s case he needs 40 lacs as of todays money 25 years from now. So to include inflation, we will multiply that number by 1.08, 25 times.

Inflation Adjusted Value = 40 lacs * (1.08 ^ 25) = 273 lacs or 2.7 crores


As you can see, the nest egg of 2.7 crores is a much much higher number than the 40 lacs we saw just in the previous paragraph. . This is because of the effects of inflation, which causes purchasing power to erode over time and wage rates to increase each year. Twenty-five years from now, Ramesh won't be spending 5 lacs per year - he'll be spending 17 lacs per year

Trivia:
If we consider Inflation @ 6%, then the nest egg required will be only 1.71 crores. A 2% increase in inflation every year has increased the nest egg requirement by 1 crore.

To explain in other words, a 40 lac nest egg and a yearly budget of 5 lacs in todays rupees is the same as 2.7 crore nest egg and a yearly budget of 17 lacs 25 years from now, assuming that inflation will run amock at 8% per year for 25 years.

The key is that we assume that savings will grow at a real rate of return of 6% annually. The numbers would actually be growing at 14% annually, but inflation would be running at 8%, so the growth in purchasing power would actually be 6% per year.

You don't need to worry about this too much for your retirement plan, but just keep inflation in mind when you determine how much you want to save for your nest egg every month.

Trivia:
Saving 2000 rupees every month now might look like a breeze now, but 25 years from now, your grandson will probably have more pocket money per week than 2000 rupees.

As you continue with your retirement plan year after year, simply check the inflation number each year and revise your contributions accordingly. Provided you do this, you should be able to grow your capital at your estimated real rate of return and reach your target nest egg.

Other Factors:

There are other factors that might affect your retirement plan for example:

1. You may choose to work part-time and make a smaller amount of money (when compared to what you are earning now) and that could help you maintain a better standard of living
2. You may purchase a residential or commercial property and rent it out to generate a steady source of income every month
3. You may decide to retire a few years early. In that case you may have to increase your monthly contribution to your nest egg (while you are working) to accumulate the same amount you wanted to do so as per the original plan
4. Best of all – The Government may come up with a scheme similar to Social Security to help the millions of Indians as a whole…


Happy Retirement Folks!!!

6 comments:

  1. It is a very simple calculation.

    The moment you think of retirement, just check for two things.

    1. Your current annual expenses. This is the amount required by you to live comfortably (or rather luxuriously) in the current year. It is the amount you spend in one year to maintain your current standard of living which includes money required to pay for house rent, food, electricity, water, transport, clothing, insurance, taxes etc.

    2. The number of years you plan to live. For example, if you are 40 years old and you plan to live till the age of 90, then you must take this figure as 50 years. Your current age does not matter. Only how many years you expect to live matters.

    Now multiply the two figures and you get the corpus fund required in your bank account as of today to retire.

    For example, in India if a person's current annual expense is Rs. 12 Lakh. and if he plans to live for 50 more years from today, then the corpus fund required by him in his bank account today is Rs. 12 Lakh * 50 years = Rs. 6 Crore.

    If he has Rs. 6 Crore in his bank account today, he can retire with immediate effect irrespective of his age. All his expenses including medical expenses incurred in old age can be taken care of with this money.

    This calculation will work globally and can never go wrong irrespective of which currency you use. This is because the bank interest rate on fixed deposit will always be higher than inflation rate of any country at any point of time.

    Here we are assuming that post retirement, the person would do the following.

    a. Continue with same standard of living and not increase the expenditure unnecessarily. For example if a person is currently travelling in economy class of an airline and staying in budget hotels, he must continue doing the same post retirement. If he suddenly starts travelling in business class or accommodating himself in 5 star hotel rooms, the above corpus fund might not be enough.

    b. The corpus fund calculated above is for mere survival without compromising on standard of living. Any other expense such as purchasing a new house or a luxury car, paying for children's education/marriage or planning a vacation abroad need to a accounted separately. The corpus fund would not be utilized for such expenses.

    c. The corpus fund would be invested in a guaranteed, risk free fixed deposit scheme of a reputed bank yielding minimum 7% quarterly interest. The money would not be invested in equity, debt, gold or any other quick money schemes that cannot guarantee fixed returns or involves a certain amount of risk. Even investing in real estate is not entirely risk free though it yields much higher returns than fixed deposits.

    d. The retired person wants to utilize the entire corpus fund during his lifetime and does not intend to leave any inheritance for family members after his death. If the person wants his wife to maintain the same standard of living after his death, he must account for the number of years his wife would live after his death while doing the calculation. For example, if a person intends to live for 50 years but his wife is expected to survive for additional 10 years then the calculation must be done for 60 years.

    e. The person does not survive beyond the expected number of years. It is not a good idea to become bankrupt at an old age. Hence it is always safer to assume that the person would live till the age of 90 years or more which doing the calculations.

    ReplyDelete
  2. Dear Anand

    I am 60 years old and my children settled overseas. Me and my wife live in India in our family home in Chandigarh. We have one investment property of value 1,10,00,000 giving us return of about 3 lakhs annually but I am finding it little hard to maintain. My son is also helping me financially specially with our medical insurances and mortgage.
    There is a mortgage of about 10 lakhs with monthly EMI of Rs 15,000.

    I am looking to sell the property and pay off mortgage so that I will be left with 1 crore of corpus. please let me know where to invest this money (diversified investment) to get a monthly payments of about Rs 30,000 and capital growth to beatup the inflation at the same time for next 20 years.

    My son suggested a plan i.e.
    A. 10 Lakhs - Liquid funds with monthly SWP @ Rs 30,000 for 3 years
    B. 40 Lakhs - Debt Fund - Grow to 50 Lakhs in 3 years - Withdraw 10 lakhs profit (8% return) and use to get monthly payments
    C. 50 Lakhs- Equity Fund (12%-15% return & tax free) - Grow to 1 crore in 6 year

    Please let me know if that's a right approach or if you can suggest the best option
    I would also like to know about the risk involved in this plan and your plan as I don't want to end up loosing money in just 5-10 years.

    Your reply will be highly appreciated

    Thanks

    ReplyDelete
    Replies
    1. Hello Uncle, what you are asking for is almost a detailed financial planning type of query. I would be more than happy to help but that type of advise is usually chargeable.

      Please let me know if you are willing to proceed that route.

      Thank you
      Anand

      Delete
  3. Hi Anand

    I would like to know what are the charges for getting statement of advise and I would also like to know the annual charges for maintaining the portfolio to achieve the desired goals.

    Please send all information on my son's e-mail: "manoj.kumar81@hotmail.com"

    I would also like to know more about your business and how can you manage my portfolio being far away from my place of residence.

    Thanks

    ReplyDelete
    Replies
    1. Uncle - I am a personal finance blogger & advisor but do not provide portfolio management services. If you want investment advise I can provide the same but implementing the advise is entirely up to your discretion. You can follow-up with me after 6 months or 1 year to assess your portfolio position and we can review your investment advise as required.

      Have emailed your son with details of the fees. Do let me know if you are interested.

      Thanks
      Anand

      Delete

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