The 30-60-90 Approach to Retirement Planning, Part 1: Estimating Monthly Expenses

This is something that I have been working on in the past couple of months, and I feel that now is a good time to share it with you.

The right way to do retirement or financial planning is to estimate future annual earnings and expenses, before and after retirement, using a set of assumptions as I have demonstrated here and here. The problem with this approach is that it may be too complex and daunting for many individuals. The 30-60-90 framework is a simple, easy to use and understand tool for estimating the amount one needs to save in order to cover retirement expenses. Despite its simplicity, the approach is well grounded in theory as it considers important considerations such as inflation and investment returns.

30-60-90?

The name comes from the premise that an individual would start to save for retirement at 30, retire at 60, and pass away at 90; the implication that the saving period equals the retirement (or zero income) period equals 30 years makes a simpler analysis possible. Being in a 30-60-90 situation means that you have 30 years to earn what you expect or aim to spend in your 30 years of retirement. Ignoring inflation and interest for the moment, this means that by the time you retire you will have accumulated 3 million pesos in wealth, which you will then use in equal increments of 100,000 per year in the next 30 years and your wealth will have been depleted to zero at the end of your 90th year. (While the 30-60-90 scenario may not perfectly fit everyone, it's a good enough description of a person's condition such that whatever accuracy is lost is made up for by the usefulness of the model. In any case, the model is easy enough to adjust to a comparable configuration such as 35-60-85 or 40-60-80, as long as the saving period is the same as the retirement period and you're comfortable with the life expectancy estimate).

Click to enlarge

The question is, in a 30-60-90 scenario, how much do you actually have to save per month or per year  for retirement, given your chosen lifestyle, inflation, and the possibility of earning from investments? To find an answer, let's take look at the situation in another way. The image above shows how your total wealth will behave given the saving and spending pattern described previously. What we can do is rearrange some of the green "blocks" above and invert the right side of the pyramid so that it will look like this:

Click to enlarge

In the first image, it seems that the first 100,000 deposit takes 59 years before it is used up, the second 100,000 takes 57 years, and so on, until the 29th 100,000 lasts for three years, and the final 100,000 (the tip of the pyramid) gets used up in one year (the 60th year). If we rearrange the blocks like in the second image, instead of having multiple/different horizons for your deposits, now each 100,000 deposit gets withdrawn after 30 years, and all deposits have the same 30-year horizon.

This is what makes the 30-60-90 tool useful: it assumes that whatever you set aside for retirement in a particular month or year, you withdraw and use 30 years later. And since all deposits to your retirement fund have the same horizon, you just have to compute for one amount that you need to save in a particular month or year.

Estimating retirement expenses

The process starts by estimating your monthly or annual expenses for when you retire but at today's prices. If you want to maintain your current lifestyle, just estimate your personal expenses per month, on average; adjust the amount upward or downward if you prefer a more comfortable or a simpler lifestyle, respectively. Do not adjust for inflation--at least not yet, we'll go to that later. Also, estimate only your personal retirement expenses--not your wife's or whoever else's--unless your wife is a home-maker (i.e., unemployed for life) and do not include discretionary expenses such as your child's college tuition as these will have to be considered separately. The basic components of your estimate should be food, rent/housing, and transportation.

To give you an example, I recently asked a good friend to do this exercise. According to him, he would need 400 pesos per day for food and other daily expenses, and 20,000 per month for rent and car payments, which amounts to 32,000 pesos per month in today's peso.

If we live in a world where prices are constant and investments don't earn returns, using the 30-60-90 framework, my friend has to save 32,000 per month just to meet his retirement expenses given his chosen lifestyle. Seems daunting, doesn't it? What if we consider inflation, and my friend just chooses to tuck away his savings in a bank savings account? Then he'll definitely need to save more than 32,000 per month today. How about if he invests his retirement fund in a "riskier" investment such as an equity UITF, how will this affect his savings goal?

In Part 2 next week, we'll discuss exactly how inflation and investment returns figure into the model. For now, try to estimate your monthly retirement expense in today's peso and see if you can afford to save that amount.

Have a great weekend!

Invitation for the First Philippine Junior Finance and Investment Summit

DEAR INVESTOR JUAN

This request is from one of my former students. Since CFA Philippines is a non-profit entity, I feel that promoting one of their events on the blog does not violate my self-imposed ban on advertising.


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Dear Investor Juan,

Good day!

The Chartered Financial Analyst Society of the Philippines (“CFA Philippines”), a non-profit professional membership organization of finance and investment practitioners will be holding its “First Philippine Junior Finance and Investment Summit” on July 6, 2013, Saturday, from 9:00 A.M. to 5:00 P.M at the SMX Convention Centre. This event aims to enhance financial literacy and elevate the quality of the finance profession in the country. This finance career and educational campaign will help students and young professionals prepare for a career in the finance and investment industry through presentations and discussion forums. 

So far, we have invited well-known and seasoned speakers to talk in this event. I believe the admission fee will be less than Php 500 including packed lunch and snacks (emphasis is mine - IJ). Hope you can help us promote the event! :D

Confirmed speakers are:
           
Philippine Economy: Asian Perspective
International Monetary Fund
Peiris, Shanaka Jayanath

Stock Market Investments
COL Financial Group
April Lynn Tan, CFA

Trust Products
Banco de Oro Unibank
Marvin Fausto

Discussion on Careers in Finance and Investment Industry

Ayala Corporation
Ginaflor Oris, CFA

Bangko Sentral ng Pilipinas
Mary Jane Chiong, CFA

HSBC
Maria Corazon Dela Cruz-Purisima

(There are some other important speakers who have been invited, but I have removed their names from the list since their attendance has not yet been confirmed. -IJ)

Regards,

Jane

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The registration procedure is still in the works, so until it is finalized feel free to visit the event's Facebook page for updates.

Frontline: Secret History of the Credit Card

Here's another "must watch" from Frontline on PBS. "Things I Learned..." next week. Have a great weekend, everybody!

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Housing Loan Lump Sum Payments

DEAR INVESTOR JUAN

Dear Investor Juan,

I hope everything is well with you.

Are you familiar with loan amortization? My wife and I have a housing loan with a term of 20 years. Our goal is to shortened that to at most 15 years. We have discussed this with our bank and they said that they don’t usually reconstruct loan. We can try but it has a high probability that we will not be approved. So they suggested to us to pay in lump sum every annual repricing. There is no minimum amount for the lump sum payment but their suggestion is it has to be at least 6 times of our monthly amortization if possible so that it can also somehow lower our amortization. It will probably take us 2-3 years to save that amount of money (around 100k). Is it wise to do that or paying in lump sum every year even if it is only 30-50k a wiser move?

We got a fixed interest rate for the first 3 years. I can easily compute the amortization in Excel via the Loan Amortization template. I don’t know what will be the computation for the repricing in the 4th year and onwards that is way I can’t come up which is better. J

Here is the sample data that I used in computing for the amortization for Year 1 to 3 using Excel.

Loan Amount: 2,000,000
Annual interest rate: 7.88%
Loan period in years: 20
Number of payments per year: 12

Is this the correct computation for year 4?

Loan Amount: 1,860,550.26
Annual interest rate: 8%
Loan period in years: 17 ???
Number of payments per year: 12


Thank you so much.

Danison


Dear Danison,

So your objective is to shorten the term of your housing loan from 20 to 15 years by either paying a lump sum of 100,000 on the fourth year or annual payments of 30,000 to 50,000.

Using the information you have provided me, I have reconstructed your loan amortization schedule here. You have a 20-year loan with an annual interest rate of 7.88% (we'll get back to this later). Using the PMT function of Google Spreadsheet (same as in Excel; "Current" worksheet, double-click cell B4 to see the inputs), we can compute for the monthly amortization of your loan: 16,580 pesos per month. If you  paid down payment on your loan, you should actually deduct it from the loan amount, and it will give you a lower amortization. Also, the resulting amount does not include insurance and other fees, so it may differ a bit from what your bank quoted.

The monthly amortization amount is what you have to pay every month to pay off your loan. Every month, a portion of it is used to pay for the interest of your loan, and the remainder goes to the repayment of principal (see the formulas for the cells in the "Interest payment" and "Principal payment" columns. So every month, a portion of the principal is repaid, the loan balance gets smaller, the interest payment correspondingly decreases, and a bigger portion of the amortization goes to principal. In the "Current" worksheet, you'll see how much of the amortization goes to interest, how much goes to principal, and what the loan balance is every month. At the end of 20 years or 240 months, you'll see that the ending balance is zero and the loan will have been completely paid off.

Now go to the "Lump Sum" worksheet to see how much impact a 100,000 peso payment will make. If you make a lump sum payment, the entire amount will go to principal and this will accelerate the repayment of the loan. To see how it will affect the schedule, just manually add the amount to the "Principal payment" cell for the month of your choice. Here, I assumed that you will make the payment at the end of Year 3.

If you go to the bottom of the worksheet, you'll see that with this lump sum payment you will be able to completely pay off the loan at the end of Month 219, or near the beginning of Year 19. So it seems that you would have to make more lump sum payments if you want to completely pay off the loan by Year 15 (Month 180). Feel free to play with the spreadsheet and add whatever lump sum amounts you think you can afford to achieve your goal.

In another email, you mentioned that the interest rate of your loan will be readjusted for Year 4 onward. In the "Adjusted Rate" worksheet, you'll see how a different rate will affect your subsequent payments. You're currently in Year 3, so with the recent credit rating upgrades, you should expect a lower readjusted rate next year (I assumed 6%).

Anyway, I know that I did not really answer your questions, sorry about that, but rather gave you a tool that can hopefully help you find the answers yourself. Good luck!

In case anyone missed it, you'll find the spreadsheet here.

12 Things That I've Learned from "The Retirement Gamble"

If you have not seen "The Retirement Gamble" yet, what better time than now? If you think it's not worth spending 60 minutes of your time or the topic is irrelevant to you, maybe my notes can change your mind.

1. According to Robert Hiltonsmith, the economist who first exposed the 401(k) fee "scandal" in the US, one needs to save around 10 to 15% of earnings for retirement, which is way lower that my estimate (40% on a 30,000 pesos per month income) in an earlier post. Obviously, the appropriate savings rate is a function of income: the less you earn, the more you need to save. Think about that statement for a minute and you'll see how ironically and sadly true it is.

2. It's hard to think of retirement since it's so far off into the future, said the lady professor in an interview. If you've just started thinking about retirement now, then you know how true this statement is. It also shows that a big part of the retirement planning "problem" is psychological.

3. The later you start, the harder it gets. The later you start, the more you have to save (as a proportion of your earnings). Start late enough, and you'll find yourself needing to work just to survive. No more retirement, just lifetime employment.

4. Not planning properly (or at all) may force you to use your retirement savings for other things like the education of your children, and this is something that you should avoid doing. Plan carefully and prepare for (i.e., save for) both retirement and discretionary expenses.

5. Three things that you have to think about when planning for retirement: how much to save; how to invest; and how to withdraw money.

6. In a bull run, you can't lose money in the market, even if you're stupid. Which is exactly what's happening now: everyone thinks he or she is an investment genius. The question is where does the bull end and the bear begin?

7. Investment risks are real. There's this one guy whose 13 years worth of returns was wiped out in a blink of an eye.

8. Fees matter. Costs are compounded over time the same way returns are. If you don't want to believe me, believe Jack Bogle (I wish I'll be as lucid and sharp as he is when I turn 83!).

9. There is ample academic evidence that investment/mutual funds can't beat the market systematically and consistently over long horizons. So why pay a premium for fund management if it's highly likely that a lower-costing fund can provide the same returns? Choose low-fee funds such as index funds. In the Philippines, index funds aren't the cheapest, which is a blatant scam. Reminds me of my favorite Dilbert strip:

10. The mutual fund industry is rigged against human psychology. People believe that funds that do well in the past will continue to do well in the future, fine print notwithstanding.

11. Even fund managers own index funds, they just don't talk about it.

12. Get advice from an adviser, not from a salesperson. The person who is selling you investment/mutual funds is a salesperson. And no one sells anything on this blog.

"The Retirement Gamble" on PBS

If my recent posts about retirement haven't pushed you to take action yet, hopefully this Frontline documentary will.

Don't gloss over discussions about "401(k)"--think of it as just a modern incarnation of our SSS and GSIS (and the US's version of Hong Kong's MPF). Let's compare notes next week.

Return and Risk (Annotated Class Slides, Part 2)

PERSONAL FINANCE 101

Click here for Part 1