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
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.
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.
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!!!