Thursday, September 21, 2006

How Much is Enough?

--- continuing from the last post on Financial Freedom ---

Stage 2 is a tough nut to crack.

First, you need to know what you want out of life and how you expect to be spending your retirement. And this is a question that is really, really tough to answer for two reasons:

  1. You've never thought about it
  2. Can one really reliably predict what one will be doing 10, 15, 20 years ahead?

Yet this is important, because your entire well-being in retirement depends on it.

Your Provident Fund Alone Will Not Cut It

Till a few years back, it was OK to think that your Provident Fund would take care of your retirement. But things have changed dramatically of late and there is a pretty clear indication of how our retirement options will be a few years hence. In my opinion, the writing is on the wall:

  • interest rates on capital protected investments like PF will continue to fall, eventually aligning themselves with market rates. This may not happen now or even in a few years, but definitely soon enough to demolish your PF strategy
  • the responsibility for maintaining and managing retirement funds will move away from the government and into your hands
  • inflation will eat away into your savings
  • your kids may no longer be willing to take on responsibility for your well-being (God forbid, but one never knows)
Given this horror-story setting, it is definitely important for you to know how much money you need to set aside for a happy and fulfilling retirement.

So, How Much Is Enough?

To answer this, at least in a broad sense, try the following:

  1. Figure out when you'd like to retire (Be realistic! Chances are, if you are reading this, you ain't gonna be quitting next year!!)
  2. Write down your annual budget as determined from your Stage 1 analysis
  3. Add in any additional regular payouts you think you might be incuring when you retire and increase the overall budget by, say, 20-30% since you'll probably want to live in better style than you are accustomed to right now. This is how much you would need if you were to retire today. This needs to be adjusted for increases due to inflation till your retirement date
  4. Make a guesstimate on how inflation will remain till your retirement, it's better to aim high than low, so perhaps you could take a figure of 6%
  5. Calculate the value of your annual payout at the time of retirement by multiplying your retirement payout (from step 3) with (100+inflation)% to the power 'n', where 'n' is the number of years left to retirement
  6. This figure is the annual payout you need to keep you retired and happy and should be generated entirely out of investment income. Based on investment returns of, say, 5% you need to have saved about 20 times of your retirement annual payout (from step 5) in order to be comfortable

Example:

You want to retire 15 years from now and your current annual payout is, say, Rs. 200,000. You expect to be spending an additional Rs. 100,000 for annual vacations when you retire and you anticipate inflation to remain at a level of 6% from now till you retire.

Hence, your annual retirement payout in today's money would be about Rs. 390,000 (200,000 + 100,000 increased by 30%). Adjusting it to 15 years from now for 6% inflation would yield an anticipated annual payout of Rs. 934,657 at retirement. (390,000*1.06^15)

This needs to be generated entirely out of investment income and hence you need to save about Rs. 1.87 crores by the time you retire.

Further

Inflation will not end just because you have retired. Hence, the expenses will continue to rise even post-retirement. To account for that, you need to know how long you expect to live (!) post retirement and save even more to accommodate the increasing costs for that period.

But let's not get into that - it's too complicated!

The point of this entire article was that, while retirement planning is an inexact science, it is something you must do so prepare now rather than being taken by surprise when it's too late.

1 comment:

pkapte said...

dear amit,
I have read your blog with great interest. I am an army officer with about 15 years of service. I have made some investment to back up for my post-retirement. however, thanks for putting things in the correct perspective.
also, please guide me to a correct child investment plan. My son is 3 yrs old and I am 36 yrs. I am planning to invest in some long-term plan so as to get some lumpsum when he attains the age of 18 yrs. I have tried a few of the funds but am left confused.
Please guide.
thanks
pkapte