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Sunday, July 25, 2010

How Much Do You Need to Retire?

So, how much do you really need to retire? If you haven't figured it out, here's a simple seven step to help you.

Seven easy steps to work out how much money you need

Step 1: Determining the number of years you have until retirement:

The first thing you need to do is to determine, how long you have to achieve your retirement plans. In order words, how many more years until your retirement – this can be when you plan to retire (for instance, at age 45), or must retire (for example, age 55 in the civil service), less your current age.

Let's say that you are now 31 years old and plan to retire at age 55. The number of years to retirement would be:

Planned age to retire:            55 years
Less present age:              31 years
Equals number of years to retirement:    24 years.

Step 2: Determining your desired retirement income:

The next step would require you to ascertain how much money you would need when you retire, and no longer working. This is difficult to predict but is not impossible. You can estimate this by considering changes you plan to make to your spending patterns and how (and where) you plan to live, after you retire. Some of your expenses will probably be lower, for example, work-related expenses (like fuel or bus fare), clothing expenses and housing expenses. On the other hand, some other expenses may increase: for example, your travel expenses since you may have more free time. At the same time, your medical expenses may also increase as you get older, and become more susceptible to illnesses. It is often suggested that you would need about 60% to 70% of your last drawn annual income after you retire.

Let's assume your last drawn income is RM200,000 per year:

As such, your desired annual income upon retirement would be RM120,000 (that is, 60% of RM200,000), calculated as:

0.6 X RM200, 000 = RM120,000

Next, we will need to estimate how long this retirement income would be needed. The number of years this income is required is a function of how long you would expect to live. In Malaysia, according to the latest information from the Statistics Department, the average life expectancy is 70 years for males, and 75 for females.

Let's assume that you will live till 80 years old (which is a ripe old age!), and as such would need 25 years of retirement income (from age 55 onwards).

Step 3: Calculating your inflation-adjusted retirement income:

Inflation is one of the most important factors to consider in retirement planning. It erodes the purchasing power of our retirement savings, and thus needs to be taken into account in our planning. Here we need to determine how much your retirement income would be, adjusted for inflation.

In our example, we know that the current value of your retirement income is RM120, 000 (from Step 2), and you have 24 years before you retire (from Step 1) Let us assume that the average inflation rate over the next 24 years will be 5% per annum.

A retirement income of RM120, 000 today at an average inflation rate of 5% would mean that we need to have an inflation-adjusted income of RM387, 011 per annum in 24 years time. This can be calculated as:

 FV    = RM120, 000 x FVIF (24 yrs, 5%)
= RM120, 000 x 3.225 = RM387,000

Step 4: Calculating the total funds needed at retirement:
After we have ascertained the inflation-adjusted income needed for retirement in the future, next we will need to determine the total funds needed, so that we can plan appropriately towards achieving this goal.

Let's assume that the average rate of return (on our investments) that we can expect for the next 25 years until retirement would be 8%. As such, the 'real' rate of return from our savings (given that inflation is 5%) will therefore be 3% (that is, 8% minus 5%).

In our example, given that the inflation-adjusted income at retirement equals RM387,011 per annum (determined in Step 3), the total funds we would need can be calculated as:

PVA = RM387,000 x PVIFA (25 yrs, 3%)
    = R387,000 x 17.413
    = RM6,738,831

Hence, the total fund needed at retirement, 24 years from today would be approximately RM6,738,831.

Step 5: Estimating funds available at retirement:

The following step is to estimate the funds that will be available when we retire. Again, this amount is difficult to determine accurately and would depend on various factors such as the type of assets we have today, and those that we will accumulate in the future. Some of the sources of funds would include our EPF savings, personal 'compulsory' savings, insurance cash values, and financial assets such as stocks and unit trusts, which can be disposed of. To simplify our analysis, let's assume that in our case, the available funds amount to RM3,000,000 (accumulated from various sources) when we retire.

Step 6: Calculating the shortage (or surplus) of funds at retirement:

Once we have determined the total funds we require, and also the funds available at retirement, we can then plan for any possible shortfall.

Total funds we require (from Step 4):         RM6,738,831
Total funds available (from Step 5):        RM3,000,000
Total shortfall:                    (RM3,738,831)

Step 7: Calculating the savings required to cover shortfall:

Next, to meet the shortfall at retirement which we have identified in the previous step, we need to calculate how much we must save during our working lives.

From above, we know that:

Our total shortfall:                (RM3,738,831)
No. of years to retirement :            24 years
Average rate of return:                8%

Therefore, the amount that we need to save in order to meet the shortfall (which is equivalent to an annuity), can be calculated as:

PMT     = (RM3,738,831) / FVIFA (24 yrs, 8%)
PMT     = (RM3,738,831)/ 66.764
= RM56,000

Hence, in our example, the amount we would need to save is a total of RM56,000 per annum (or roughly RM4666.7 per month), in order to meet this shortfall target.

As demonstrated above you can easily determine how much money you really need to retire, taking into account important factors such as inflation and the rate of return on your investments. However, executing this Plan is another story altogether, as it is not easy to put aside some money every month. Let alone, an extra RM4,000 to RM5,000.

Alternatively, you may want to consider investing in rental properties as a Plan to generate your retirement income (see my earlier Blog on this).
Happy investing!

Retirement Planning Worksheet
Step 1: Determine when you plan to retire:     
Planned retirement age:             
No. of years to retirement:             
B – A = C
Step 2: Determine your desired retirement income:
Desired monthly income (RM):     
Annual income (RM):                 
D x 12 = E
No. of years income required (from retirement): 
Step 3: Calculate inflation-adjusted retirement income 
Assumed average inflation rate (%):    
Inflation adjusted-income (RM):     
FV = E x FVIF (C yrs, G %)
Step 4: Calculate funds needed at retirement:    
Inflation adjusted income at retirement (RM): 
Rate of return (%): 
Net return earned (less inflation):         
H – G = I%
Total funds needed at retirement:
PVA = FV x PVIFA (F yrs, I %)
Step 5: Project funds available at retirement (RM):    
Insurance (cash value): 
Stocks/shares/Bonds/Unit trusts:         
Step 6: Calculate surplus/(shortage) of fund at retirement:
Total fund required (step 4) (RM): 
Total fund projected at retirement (step 5) (RM):     
Total surplus/(shortage) of funds (RM):
PVA – J = K
Step 7: Calculate savings required to cover shortfall:    
Total shortage (RM): 
Savings required per annum (RM): 
PMT = K / FVIFA (C yrs, H %)
Savings per month (RM): 
PMT / 12

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