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Sunday, August 26, 2007

The Retirement Number

From reader "bullbear"

"Seng, I am wondering, for a modest lifestyle requiring 3 to 5 k per month, how much savings should one have at ages of 50s, 60s and 70s to retire comfortably. Base the figures on your projection that one may "unfortunately" have to plan for a life of 100 years. : )"

My Dearest Bullbear,

This is a popular financial question. I have received similar questions several times before. There are many free resources on the web, and I encourage you to explore the topic fully elsewhere too. For example, MSN (and others like it) has a whole section on Retirement Planning- see http://moneycentral.msn.com/retire/home.asp. Locally, there are many forums discussing similar questions. Some calls it "The Number" since the question is always "how much do I need to retire comfortably?"

I believe the Number varies with individuals. Even for a specific individual like you bullbear, the number will also be a range since it depends on the future which is inherently uncertain. Conceptually, you are not wrong if you noticed similarities between valuing a stock and valuing this number, since both depends on projecting future cashflows, and then discounting them to today's value in order to derive a number. So, there is no single right figure, but a range of possibly right figures.

However, valuing this number (unlike trying to put a value to stock) has great practical importance - if you put too low a figure, you could end up living poorly and that's not much fun :-) So, you probably want to be prudent, and prefer a large number with a large margin of safety rather than a small number. You don't want to be broke, suffer and then die - much better to die first with a lot of money left :-).

A disclaimer first. You already know I am not a licensed financial planner. Everyone is different in so many ways, so, my view is only mine. If in doubt, always consult a licensed professional. And always exercise a large dose of common sense.

Ok. Let's tackle the problem of determining this Number from a conceptual manner first. What does this number depends on? What are some of the obvious factors and less obvious factors?

The Obvious Factors

1. Planned Retirement Age. At what age do you plan to retire? Retire early, and you have two problems compared to your imaginary "twin" who retires later. First problem is you have shorter period to save. Second problem is you have a longer retirement spending period. So, you must save a lot faster (since shorter period to save) and a lot more (since longer spending period) if you plan to retire early.

To illustrate, let's compare a Retirement Age of 50 vs 70. Let's say you are 35 years old today. To retire at 50, you only have 15 years "savings period", versus 35 years to retire at 70. In short, less than half the period.

Then, as a 50 year old, there is a longer period to spend. If you and your twin dies at age 100, then, your savings must last 50 years, versus only 30 years for your twin who retire at 70. So, you need a much larger amount than your twin.

2. Your Life Expectancy. Life irony is that to live longer, you need a bigger Number, making it even harder to achieve. MSN above has a life expectancy calculator, although they are for Americans and not necessarily the same for Malaysians. Perhaps your parents and grandparents age of death might provide a guide, although even then, there are potential problems. I guess you just need to be prudent and assume a big number just to be safe.

3. Your planned Spending Amount. Smaller spending, smaller Number, other things equal. In practice, tough to estimate, since so many "hidden expenses". Important to both keep track of past actual expenses (to provides accurate data) as well as think ahead carefully. Need to differentiate between regular expenses and once off expenses like a new house, a new car, etc. I believe large expenses like replacing a new car every 10 years needs amortization. Similarly with large overseas holiday expenses every few years, etc. MSN above provide some tools and checklists to determine this.

4. At zero interest (not realistic) and zero inflation (not realistic), anybody can calculate the Number. E.g. If Retirement Age = 50, Life Expectancy = 100, Monthly Spending = $3,000. Then, the Number is simply
= (100 - 50) x (3,000 x 12)
= 50 x 36,000
= $1.8 million.
Maybe too large for most people intending to spend $3,000 per month.

5. Interest helps reduce the Number. Higher interest on capital means you can do with less capital to fund your retirement lifestyle.

6. Inflation means you need a bigger Number to maintain the same quality of life.

7. More obligations means more spending, and so, a bigger Number. E.g. if you are also saving for your spouse, and she is expected to outlive you by another 10 years, you then have a longer spending period (although possibly lower spending after you die). If you want to leave something behind for your children or grandchildren, the Number gets bigger. Etc. you get the idea.

The Less Obvious Factors

1. Your spending pattern is not necessarily fixed, but varies over time and age. Overall, it is prudent to assume one's spending inflation gets higher as one gets older, since medical and health-related expenses rise faster. It is prudent to assume rising inflation that exceeds reported CPI, as one gets older. Unfortunately, most retirement planning tools on the web do not model this.

2. Your investing ability and results (assuming you invest in stocks and cash equivalents) are also not necessarily fixed over time. I believe once you are over say 70-80 (this is arbitrary), you can reasonably expect declining returns % over time. Again, most retirement planning tools on the web do not model this.

3. Before and after you retire, you need to regularly review your Number to make sure it is still adequate. This is very important in practice.

The Spreadsheet

Here is a simple spreadsheet model that you can consider developing on your own, which incorporates all of the above factors. There is no complex maths involved. Like all financial models, they are only as good as the assumptions that goes into it, as well as the wisdom and conclusions that one takes out of the model results. So, treat this as merely a starting point for further consideration, and always rereview to see if it makes sense.



Some quick observations:

1. The spreadsheet above suggests that a 50 year old retiree today with $4,000 per month spending needs to have $1.4 million, assuming initial interest rate of 7% on capital and initial spending inflation of 3% p.a. This suggests a multiple of 29 times initial annual spending. But this number alone is useless.

2. His number ($1.4 million) is heavily dependent on the interest rate assumed. E.g. increase his interest rate to 8% instead of 7%, and his Number reduced to $1.15 million. This has important implications on the Investment Objective and the Investment Plan.

3. His number ($1.4 million) is heavily dependent on the inflation assumed. E.g. increase his inflation to 4% instead of 3%, and his Number increases to $1.75 million. Unfortunately, sometimes, the rate of future inflation is outside your control.

4. For practical purposes, it is critical to ensure that every year, one's actual spending remains lower than interest earned over the same period. E.g. in the above number, Interest remains higher than Spending for most years from Age 50 to Age 81.

Then, at Age 82, Spending first exceeded Interest. I call this the Critical Year. It is at this point when the Capital starts to shrink. And they shrink fast.

To ensure financial peace of mind during retirement, you should adhere strictly to this important principle - never spend more than what you earn in interest. Preferably spend less than half the interest. And if your spending has risen, then, you need to make sure that your interest earns rises. This gets riskier, since the opportunity for higher returns don't always come around, and they tend to come with higher risks, especially for the vast majority of investors.


Conclusion

I believe there is no single magic Number that is the same for everyone. We are all unique, and our Numbers will be very different for various reasons mentioned above.

I am reluctant to give a magic number, because prudence varies by individual, and more prudence requires too large a number that is not realistic for the vast majority of people looking to retire, especially retire early.

Furthermore, those who invests in stocks know that their returns fluctuate from year to year. Furthermore, the rate of inflation varies over time, and is never fully within your control in the long-term. If your returns are poor in one year, then, you need to immediately review your situation to make sure you still have enough to live on. With a large margin of safety, probably you can retain your lifestyle and monthly spending. However, without a large margin of safety, then, your spending must come down immediately. Else, you will not have enough to live on in future years.

The above table assumes someone who retires at age 50, which is considered early by most people's standards. Unfortunately, not everyone can do so, and some might not want to do so. Some do keep on working on their own business and continue to earn income. Some are very traditional, and expect their son/grandsons to not only take over the family business, but to take care of them in their old age. But not all of us can be that lucky too. From a financial planning and perspective, the safest is to assume self-dependency (for both you and your spouse), and plan accordingly.

At retirement, expect to live modestly below your means (e.g. spend less preferably only half of what you earn). If you have them, teach your children and grandchildren to be financially independent, so that they don't have to be financially dependent on you later in life :-) And should your children and grandchildren later support you in life, consider yourself blessed.

In my experience, determining the Number is only one step, albeit a very important step. To put the Number into context, there are many other important implications to consider before deciding whether to retire early or not, but this would be well outside the scope of this article. But don't forget them, as they have great practical importance too. And they would be outside the scope of this blog to discuss them.

I sincerely hope you and other readers here will find this article useful.

Cheers,
Seng.

4 comments:

tinyDust said...

Hi Seng, indeed this is a very useful article. After readign this, i realised that everyone should have plan for their retirement. Self-dependency is very important. Seng, how I hope my parents will be like you, plan their retirement properly. However, very unfartunate to say, they don't. Especially my mother, she gave all her savings to her son to start a business, but then when the business failed, she lost her money. I actually feel unfair to me, where she gave her savings to her son, but now she has to depend on me for her expenses. This article really enlighten me to plan for my own retirement, so that I won't be a burden for my future generation. Thanks Seng.

bullbear said...

There are various phases in one's financial life, namely:

1. The early accumulation phase
2. Consolidation phase
3. Spending phase
4. Gifting phase

Sadly for many Malaysians, life is a struggle. With little financial knowledge and/or financial planning, they may not accumulate enough for their retirement; even for those with a reasonable income/asset. Many may need to depend on their children to take care of them during their retirement.

jasonred79 said...

I've come up with (IMHO) the most stress free, risk free and effort free effective retirement strategy.

For an income of around 5k a month, you would need around 1,000,000 capital.

Invest into GOOD RENTAL RETURN property. The most important consideration here is that you are projected to get pretty stable income from these properties for the rest of your lifetime. And 2nd, that it pretty much runs itself. You can only consider yourself retired if you at most have to make 1-2 phone calls regarding your rental collections a month. you don't want to be having a hard time collecting your money or dealing with difficult tenants.

With decent shoplots or apartments, you should be getting at LEAST 6% returns on capital per annum, which is 60k, which is 5k per month. MOST IMPORTANTLY, this amount should (more or less) track inflation.

Furthermore, the value of the properties itself should appreciate over the course of your remaining life. So, if you have beneficiaries, at the end of your life, they will have something for them.

OR (and this is VERY likely assuming you live that long), in the case of medical or other emergencies, you should be able to dispose of one of these properties to obtain a chunk of immediate spending money.

Alternatively, you can always get a loan using these properties as collateral. (loans on stocks are relatively unfavourable)

Overall, stock market would give better returns. However, there is so much stress, time and effort involved in stock market, you could not consider yourself REALLY retired. Anyhow, imagine if you start to go senile or are hospitalised on a regular basis and can no longer perform so well in the market. You will be in trouble!

Anyhow, currently, this is the best I came up with. Maybe some others can come up with even more attractive plans.

bullbear said...

Jason, There are many asset portfolios one may devise for retirement. Some will put real estate as the main item in their portfolio. Others, may prefer equities or others as the main portion of their portfolio.

Here are some model portfolios for the various phases of one's financial life, adopted from a book I read. You may wish to use this as a guide.

For early accumulators:
Equities: 50 - 80%
Fixed-income: 10 - 40%
Cash & Equivalent: 5%
Alternative Assets: 5%

For Mid-Life Consolidators:
Equities: 30 - 60%
Fixed-income: 25 - 55%
Cash & Equivalent: 5 - 10%
Alternative Assets: 5 - 10%

For Retired Spenders and Gifters:
Equities: 25 - 50%
Fixed-income: 30 - 40%
Cash & Equivalent: 10 - 30%
Alternative Assets: 5 - 10%


1. Equity investments: higher returns, but higher risk assets
(Large, middle, small, micromarket capitalization, growth style, value style, master limited partnerships, venture capital, developed international markets, emerging international markets).

2. Fixed-Income investments: lower risk, but lower return assets
(US treasury notes and bonds, State securities, Municipal securities, Government agency securities, Corporate bonds, Mortgage backed securities, Asset-backed securities, Coins, ills and related, Bank holdings, US treasury bills, Money market funds, Certificate of deposit. For Malaysians, essentially, only fixed deposits.)

3. Alternative investments: assets to amplify your portfolio
(Real estates, commodities, private equity, hedge funds, collectibles).