Wednesday, October 5, 2011

Retirement Planning Series - Where will the money come from?

In the previous two posts, we saw the following:
1. Why plan for Retirement? and
2. How much money will I need?

Now that we know why to plan for retirement and how much money we need, the next logical step would be to calculate or rather figure out, where that money will come from. Isn’t it?

Where will the Money Come From?

Though employment income seems to be the most obvious answer, there are actually many sources of funds you can potentially access to build your retirement nest egg. Once you plan them all out clearly, you can then determine how much money you'll need to save every month in order to reach your retirement goals.

The typical sources of funds for retirement savings for an average individual are:

1. Employment Income

As you progress through your working life, your annual employment income will probably be the largest source of incoming funds you will receive and probably the largest component of your contributions to your retirement fund.

For your retirement plan, simply write down what your after-tax annual income is. Then subtract your annual living expenses. The amount left over represents the discretionary savings you have at your disposal.

Depending upon how the numbers work out, you may be able to save a large portion of your employment income toward your retirement, or you may only be able to save a little. Be sure to use a budget and include all your recurring expenses.

Figure out the maximum amount of your employment income that you can contribute to your retirement fund each year. Also, if you are able to work part time during your retirement years, include this information in your retirement income calculations.

For Example: Lets assume Mr. Ramesh has an after tax earnings of Rs. 5,00,000 per annum (5 lakhs). His expenses per month are around Rs. 33,000/- per month which works out to nearly 4 lakhs per year. To add on, Ramesh isn’t planning to work post retirement.

So, Mr. Ramesh has an available savings of Rs. 1 lakh every year towards his retirement plan. He can choose to invest it for retirement or take a vacation or whatever he wants. But the point here is that, if Ramesh wants, he can invest this 1 lakh every year towards his retirement corpus.

2. Employer-Sponsored Retirement Plan

This option isn’t available for a majority of us. We are all private sector employees and our employers don't usually pay us post retirement. However for people who are Government employees and have a steady pension payment post retirement, this source of income is very useful.

You should be able to calculate an estimated value (in today's rupees) of your retirement funds in terms of a monthly allowance. Obtain this number and add it to your list of retirement income sources.

For Ex: Mr. Ramesh will get a pension of Rs. 10,000 every month if he retires at his current grade of Technical Supervisor in Indian Railways. So, this 10,000 rupees is going to be a steady income for Ramesh every month after he retires.

Note: We are only considering what pension Ramesh will get if he retires at his current designation and the amount that people of his grade are getting currently. The number might vary at his actual retirement time either due to governmental policy decisions on pension or his own designation. But the point here is that, keeping this number in mind for calculation purposes will be very useful.

3. Current Savings and Investments

The next thing to consider is your current Savings and Investments. If you have a decent investment portfolio, it may be sufficient to cover your retirement needs all by itself. For more details on Investment Portfolio Click Here.

If you have yet to begin saving for your retirement or are coming into the retirement planning game only now, you will need to compensate for your lack of current savings with greater contributions in the current timeframe.

Again, going back to Mr. Ramesh as our example, let us say he has a savings/investment portfolio of Rs. 2 lakhs now at his current age of 40. Assuming a reasonable real rate of return of 6% per year until he is 65, he will have roughly 8.5 lakhs of money by the time he retires at 65 years.

Depending on other sources of income he may have, this could be enough to fund his retirement so that Ramesh does not have to contribute large amounts of his ongoing employment income.

4. Other Sources of Funds

You may have other sources that will be available to fund your retirement needs. Perhaps you will receive an inheritance from your parents before you reach retirement age or have assets, such as real estate, that you plan to sell before or after retiring.

Whatever additional sources of funds you do happen to have, be sure to include them in your retirement projections only if they are certain to be available.
You may be expecting to realize a large inheritance from your parents, but they may have other plans like leaving a larger share to your brother or donating them to charity.

Another point to note is that, you may also get some extra funds like bonuses or lottery winnings, gifts etc. Though they are not certain to happen, you need to remember to consider them for your retirement fund if they do happen.

If you do happen to get a bonus it would be a good idea to park at least 75% of the sum for your retirement corpus and avoid the impulse to spend it all out.

Next - Adding Up Your Income Sources

After you have clearly defined all the available income sources with which to fund your retirement, make a list and add them up.

Let's continue with Ramesh’s sample retirement plan. Remember, all figures are in today's dollars.

Ramesh’s retirement income sources are:

1 lakh maximum annual retirement contributions from his 5 lakh after-tax earnings.

Ramesh will get a monthly pension of Rs. 10000 post retirement from his company.

Ramesh has Rs. 2 lakhs of current savings and investments. At a reasonable 6% real rate of return for 25 years, his savings should grow to 8.5 lakhs.

Ramesh does not have any other sources of funds he can conservatively expect to add to his retirement funds. He might win the lottery, but he's not counting on it.

As mentioned in the previous chapter, Ramesh will need 40 lakhs in today’s money to fully and properly fund his retirement goals.

Since, his current investments will only provide 8.5 lakhs from his 40 lakhs of retirement corpus expected, he will need to accumulate the remaining money.

This means, he will need to save up an additional 31.5 lakhs (in today’s money) by the time he is 65 years old (which is 25 years).

To calculate this, let's track his progress over the 25-year period:

Assuming a 6% annual growth rate and constant monthly/yearly contributions, we can find that Ramesh will need to contribute Rs. 42,500/- every year to save the required corpus of 31.5 lakhs.

This works out to roughly Rs. 3500 per month for his retirement corpus.

However, let us say his parents leave him their land in their home town that is worth Rs. 10 lakhs today as Ramesh’s share of the family property, that will bring down his amount required for the corpus by an equivalent amount. If that happens, his monthly contribution towards his retirement savings will come down to Rs. 2500 per month.

Alternately, Ramesh may wish to re-think his retirement amount and bring it down to 30 lakhs which again will bring down his monthly contribution to his retirement corpus.

Nonetheless, it is the individual’s decision to decide his/her retirement amount.

The most important point while doing these calculations is to remain conservative in your financial estimates (i.e., don't assume 20% annual investment returns or hitting the lottery) and settle on a plan that is realistic, sufficient and most importantly feasible.

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