The 30-60-90 Approach to Retirement Planning, Part 3: Adjusting the Savings Formula for Different Saving Periods

In Part 2, we have seen that using the 30-60-90 approach, and assuming an annual real investment return of 4.7%, you should save an amount equal to

Savings = Expenses/4

Where "Expenses" is your estimated monthly or yearly retirement expenses at today's prices.

But what if you don't closely fit the 30-60-90 scenario? What if, for whatever reason, you decide to start saving for retirement much later, like say, age 40? How can we adjust the savings formula above to better reflect your decisions?

Starting to save for retirement later than age 30 will obviously result a higher savings amount since you'll have less earning years to prepare for the same amount of retirement expenses. If you start at age 40, for example, then your savings for the entire year should be enough not just for year 60--your first year of retirement--but also a portion of your expenses in the following year. Furthermore, whereas in the 30-60-90 scenario all your retirement fund deposits have a 30-year horizon, starting later shortens your investment horizon correspondingly and exposes your retirement portfolio to greater risk.

To adjust the savings formula in order to reflect a variable saving period y, take the following. Assuming constant prices, you expect to spend an amount E every year starting on your 60th birthday--the beginning of retirement--for 30 years until you turn 89. You plan to finance your retirement by contributing an amount S every year to your retirement fund, starting on your (60 - y)th birthday, for y years until age 59. If your retirement fund earns a real rate of return r, then the future value of all S payments should equal the present value of all E expenses on your 59th birthday. In equation form, using the formula for future value and present value of an annuity, we get

S*[(1 + r)^y - 1]/r = E*[1 - 1/(1 + r)^30]/r

Simplifying,

S = E*[1 - 1/(1 + r)^30]/[(1 + r)^y - 1]

(I apologize, this equation can't be simplified any further.)

As an example, if E = 32,000, r = 4.7%, and y = 20, then

S = 32,000*[1 - 1/1.047^30]/[1.047^20 - 1]

S = 32,000*0.4967 = 15,894

Or almost double the savings amount if you start at 30 years old, or just half of the expense estimate. If you use y = 30 as in the 30-60-90 scenario, you'll actually get the original equation S = E/4.

Finally, you can also use the above formula for different saving and retirement periods. If z = the number of years of retirement, just replace "30" by z so that

S = E*[1 - 1/(1 + r)^z]/[(1 + r)^y - 1]

So if you're now 30 years old and you plan to retire by 50 and you retain the planning horizon of up to 90 years old, then y = 20 and z = 40. Using the same E and r,

S = 32,000*[1 - 1/1.047^40]/[1.047^20 - 1]

S = 32,000*0.5584 = 17,868

Remember that these estimates are only for the amount that you need to save in your first year (age 60 - y). For subsequent years, you need to adjust for inflation, like in the Part 2, but this time with a slightly different factor

Savings in Year t = (Savings in Year t)*(1 + g)^(z/y)

So that if you start saving at age 40 (y = 20), retire at 60 (z = 30), and the annual inflation rate is g = 4.5%, then

Savings at age 40: 15,894 per month

Savings at age 41: 15,894*(1.045^1.5) = 16,979 per month

...

Savings at age 55: 15,894*1.045^(1.5*15) = 42,791 per month

As always, figuring out the savings amount is just the first step. To meet your target real rate of return, you should invest your retirement savings in a low-cost equity fund and only redeem your units/shares at retirement and as needed.

The 30-60-90 Approach to Retirement Planning, Part 2: Considering Inflation and Investment Returns

According to the "30-60-90" approach to retirement planning, since the time it takes to accumulate funds for retirement and the retirement period are both 30 years, the amount that you save in any given month or year will finance your retirement expenses in 30 years. In this post, we'll discuss a simple way to estimate how much you need to save today to be able to finance what you intend to spend in 30 years considering the effects of inflation and investment returns.

Let's say that you estimate that on any given month, you'll need 32,000 pesos at today's prices to support your chosen lifestyle. If we consider inflation, then you have to save more than 32,000 this month so that in 30 years, you'll be able to buy what 32,000 can buy today (maybe you should read this phrase one more time, it can be confusing)--but how much more? The inflation rate is the percent increase in the prices of basic goods and services every year. Specifically, if the price a good or service at time t is Price(t) and the average annual inflation rate is g, then the price of the good after n years is

Price(t + n) = Price(t)*(1 + g)^n

(I hope you're not turned off by the math. Honestly, using a bit of math is unavoidable in practical financial management. I always try to make technical discussions as simple as possible, so I hope you'll bear with me.)

For example, let's say that today, or t = 0, 32,000 pesos, or Price(0), can buy a certain amount of goods and services. In 30 years, or  n = 30, how much money do you need to be able to buy the same amount of goods and services if the average annual inflation rate, g, is 4.5%? Using the above equation,

Price(30) = 32,000*(1.045)^30 = 119,850

Which means that 32,000 today will be able to buy as much stuff as 119,850 in 30 years. Does this mean you have to save 119,850 today in order to to finance your target lifestyle? Well, yes, if you plan on keeping your savings in a piggy bank or under the mattress--if your retirement savings will earn zero or very little interest. But if you keep your retirement savings in an interest-earning vehicle, you won't have to save as much. In fact, if you invest in vehicles that provide returns that beat inflation, then you can even save an amount that is less than your target expense. But how much less?

To take investment returns and the time value of money into account, we need to use the present value concept. If you need an amount Price(t + n) in n years and invest your savings at time t in an instrument that earns a rate of return i per year, then the amount that you have to save and invest at time t is

Savings(t) = [Price(t + n)]/[(1 + i)^n]

Using the same example above, in order to accumulate 119,850 in 30 years by investing in an instrument that earns an average annual return of 7%, then you have to save

Savings(0) = 119,850/[(1.07)^30] = 15,744

Less than half of our original retirement expense estimate of 32,000.

Taking inflation and investment returns simultaneously by combining the two equations above, we get

Savings(t) = [Expenses(t)*(1 + g)^n]/[(1 + i)^n] = [Expense(t)]*[(1 + g)^n]/[(1 + i)^n] 

Where "Expenses(t)" is the estimated monthly or annual expense at time t. With the 30-60-90 approach, t = 0 and n = 30, so

Savings = Expenses*[(1 + g)/(1 + i)]^30

This equation shows that if your annual investment return is the same as the inflation rate, or i = g, then Savings = Expenses, or you have to save an amount equal to your projected future expense at today's prices (32,000 in the example above). If you invest such that i > g, like in the above example, then your savings requirement will be less than your estimated expenses (e.g., 15,744 vs. 32,000). Finally and most importantly, if your annual investment return is less than the inflation rate, such as if you invest in savings deposits, time deposits, or not at all, then you would need to save more than your estimated periodic expenses.

(1 + i)/(1 + g) is a special quantity in finance and economics that is referred to as the real rate of return on investments, for which we'll henceforth use the symbol r. It is the rate of return of an investment at constant prices, or at g = 0. Approximately, r = i - g, so that

Savings = Expenses/(1 + r)^30 

To check, at i = 7% and g = 4.5%, r = 2.5%. If your target monthly expense is 32,000, then Savings = 32,000/(1.025)^30 = 15,256. Not exactly the same as the earlier result of 15,744, but close enough for all intents and purposes.

This last equation shows that as long as you invest your retirement savings in an instrument with a consistently positive real rate of return, then you can save an amount that is less than your estimated retirement expenses. But which instrument can reliably provide a positive real rate of return? Low-cost equity funds, particularly in long-term horizons such as 30 years. I'll discuss this in more detail in a future post, but if you want to look into it now, I suggest reading Jeremy Siegel's Stocks for the Long Run.

In the Philippines, the average annual inflation rate in the past decade is 4.5% and the average one-year change in the PSEi from 1994 to 2013 is around 8.5%. Assuming a PSEi dividend yield of 2%, the average annual return of the market is 10.5%, resulting in an average real rate of return r of 6% per year. For a conservatism, however, we can use a lower estimate for r, such as 5%.

Savings = Expenses/(1.05)^30

Savings = Expenses/4.3

For further simplification, you may want to round the divisor to 4, which is equivalent to r = 4.7%.

Savings = Expenses/4

To summarize, using the 30-60-90 approach and assuming that the average real rate of return of an equity fund is 4.7%, you need to save an amount equal to your estimated expenses divided by 4. It does not end here, though, because in order to realize your estimated real returns, you have to religiously invest your retirement savings in a low cost equity fund and withdraw no earlier than 30 years after.

Finally, I must clarify that the savings amount given by "Savings = Expenses/4" is only for the first month or period of the earning period, or at age 30 in the 30-60-90 framework. In the succeeding years, the savings amount must be adjusted by the annual inflation rate.

For example, if Expenses = 32,000 per month, then

Savings at age 30: 32,000/4 = 8,000 per month
Savings at age 31: 8,000*1.045 = 8,360 per month

...

Savings at age 55: 8,000*1.045^25 = 24,043 per month

But what if your situation does not adequately fit the 30-60-90 scenario, like if you're just starting to save for retirement at age 40? In a follow-up post, I'll show how you can adjust the savings formula to better reflect your situation.

***

EDIT: 2 July, 2013

I checked my numbers again, and the average one-year change in the PSEi from 1994 to 2013 that I got was 8.6%, not 12%. I will make the necessary changes in the above discussion to reflect this difference.

Concerns about Early Retirement

DEAR INVESTOR JUAN

Dear Investor Juan,

I've been reading your blog and I find it entertaining and at the same time educational. I have a few questions for you but let me give you a little background about myself. I am 27 years old and single. Been working as a caregiver and my goal is to quit work by next year and follow my long time dream of becoming a lay missionary. I wasn't able to follow my dream coz my family needed me financially and now that I settled them already, it's time for me to follow my heart's desire.

Let me give you and idea on my financial life and please tell me if you think I can  follow my goal or if I should extend a year or two before quitting work for good.

Net worth: Php 4 Million
Mutual fund : Php 150k
Stocks:  Php 1M
Debt : 0
Other investments : Small land
Home: owned

I am a frugal person and live simply. I am also a minimalist and I don't dabble in consumerism. I'm planning on not touching my paper assets till I'm old. I also have emergency fund worth 6 months of living expenses. However, I don't have insurance and would like to avail one. Please take note that I'm single and with no beneficiary.

You think it's possible to quit work and "forget" about my paper assets and just move on with life without adding to it? How much you think my money would grow in 40 years considering inflation? I'm still investing 70-80 percent of my income as of the moment. How am I doing financially. I am a voluntary celibate and don't plan on marrying in the future so please consider that too esp with health care cost with no one to share the expenses when I'm old.

Sorry if I have tons of questions. I just needed some advice on where I stand financially or if I can quit work by next year coz I feel so empty. I keep thinking if next year is the time where I can say to myself that " My earning days are over. Time for me to follow my dream"

Good luck and thanks so much,

Cory

(Additional information in response to a follow-up email.)

4 million consist of emergency fund, mutual fund, stocks and the townhouse  in Cebu (subdivision) which actually appraised at 1.3M and its in use (that's where I will live once I get home). My other land is totally small and idle that I did not count it in my asset. I consider my townhouse an asset, though.

My expected expenses is P15k (scrimp) - P25k (splurge). I'm totally used to simple life and would like to live frugally. I am planning to live on my townhouse that I own when I grow old which is situated in Mactan, Cebu or I'll probably move somewhere quiet depending on the cost of living as long as its safe. I'm not maarte :) (Emphasis is mine. - IJ)

Thanks a bunch.

Cory


Dear Cory,

Choosing to retire early compounds the "retirement problem" because the longer retirement period increases funding requirement, and at the same time, the smaller earning window makes it harder to meet the higher retirement fund target. It's still possible, though, if one starts saving early enough and earns (and saves) high enough. And from the information you've provided, I think you meet both criteria to a certain degree, we just have to see if you meet the criteria well enough.

It's time to crunch some numbers (since we can't really use the 30-60-90 framework that I introduced a couple of posts back).

Let's start by assuming that your assets will earn just enough returns to be able to beat inflation so that the spending power of your assets is constant throughout the planning horizon. Speaking of planning horizons, the typical end-of-horizon age planners use is 90 years, so let's start with that.

Retirement period = 90 - 28 = 62 years * 12 = 744 months.

Net worth = 4,000,000/744 months = 5,376 pesos per month. Can you live on this amount?

Honestly, 90 years may be a bit conservative since it's well above the estimated life expectancy of Filipinos (or people living in the Philippines?) of around 68 years. If we use 80 years, we get:

Retirement period = 80 - 28 = 52 years * 12 = 624 months.

Net worth = 4,000,000/624 months = 6,410 pesos per month. Better, but maybe still not enough.

Things don't look so good given the above assumptions. But if you subscribe to the concept of long-term passive investing, something like Jeremy Siegel's "stocks for the long run" argument (to which I completely adhere, but that's for another post), then the returns on your assets should be able to reliably beat inflation year-on-year and give your assets more spending power. The question is: how much more?

Click to enlarge

Please consider the timeline at the top of the image above. Say you withdraw an amount X from your assets for your expenses on your first year of retirement. The following year, you withdraw a higher amount, X*(1+g), where g is the average annual inflation rate. You keep on doing this until age 89, where you withdraw an amount equal to X*(1+g)^61.

The sum of your withdrawals should of course be less than or equal to your total net worth of 4 million plus your investment returns, if your assets earn annual average return of i. Then, what would be the largest value of X given that you have 4 million in assets today, your assets can earn an annual return of i, and annual inflation is g? There are several approaches in solving for X, but the most straightforward is to get the present value of the withdrawals and equate it to 4 million using the formula:

The final equation is boxed in the image above.

The average annual inflation rate in the Philippines in the past 10 years is around 4.5% (I thought it would be lower for outside the NCR, but it's not. This figure is for the entire country), so let's use that for g. Let's assume that you'll invest your assets in a diversified portfolio of stocks such that you'll earn the average annual return of the PSEi. I don't have exact numbers at the moment, so let's just use i = 7%, which I believe is a conservative estimate (given that the S&P 500 has had an annualized return of close to 10% in the past 25 years). Solving for X as shown in the image above, we get:

@ g = 4.5%, i = 7%, X = 122,394 or 10,200 per month. More workable?

Of course, higher assumptions for i would further improve the situation.

@ g = 4.5%, i = 8%, X = 149,695 or 12,475 per month

@ g = 4.5%, i = 9%, X = 178,797 or 14,900 per month

You'll notice that this last estimate almost meets your "scrimp" budget, so I think your plan is workable. To make it really work, though, you would have to keep most of your assets in equities so that you'll have a higher chance of beating inflation every year, and beating it by a higher amount. Also, I still strongly encourage you to stick to the DRREW plan--particularly, always have some amount ready for unexpected expenses and get some form of private health insurance.

Finally, you may want to delay retirement for a few years and maybe build up your funds to 5 or 6 million. Try to play with the equation, change 4 million to a higher amount and instead of 60 change the exponent to years of retirement - 1, and see by how much X will increase.

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!

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.

Investing Lump-Sum Pension Proceeds

DEAR INVESTOR JUAN

Dear Investor Juan,

I would like to take a chance this to ask you, if you have a post /recommendation regarding on what to do with SSS pension once claimed. 

My mother will receive her SSS pension this, I am not sure of how much would it be.(but I think it will be 100K++) 
I would like to help her , by putting 
-at least 60% in a Mutual Fund (index fund, since it is not that risky compared to equities), so it will earn interest much higher than banks. 
-20% - Putting up a business, see is unemployed for 5 years. 
-10%- on bank for emergency purposes 
-10% - for herself. 

I would to ask for any options that I/ we can take. 
I believe my parents do not have retirement fund, since all their life they have been working for us and helping other relatives as well.. 
I want to help to utilize this money very well. 

Thank you very much. 

PS: Thank you for guiding/helping to be an Investor Juan. Godbless! 



Best Regards,

Maria

Dear Maria,

I don't think you should invest a bulk of your mom's pension in an equity fund. Even if it's an index fund, it's still exposed to risks that affect the entire market, and the chances of losing principal would still be considerable. At this stage, since your mom is not earning anymore, capital preservation should be the primary objective of her portfolio. Also, since she'll (presumably) need to withdraw portions of her portfolio from time to time, her investment horizon might be too short to weather the short-term up and downs of the market.

Generally, at retirement a person's portfolio should mostly be invested in safe instruments like time deposits or money market funds, so I normally would advice against starting a business, which is even riskier than equity funds--unless you can think of one that you're 99% sure will work. Or maybe something simple, something that requires minimal capital outlay, something that won't break the bank if things don't go as planned.

I don't know what your specific circumstances are, but I hope you're not just going to rely on the SSS pension proceeds to support your mom's retirement--it's obviously far from being enough. Even if you can reliably earn 10% per year on a 100,000 peso investment, that's just 10,000 per year in earnings, and that's assuming you won't spend a cent of that principal. 

Anyway, I wish you and your family well and I hope you find my reply helpful.

Retirement Planning with Excel, Part 2: Making Ends Meet

If you're facing this:

Click image to enlarge

What can you do to improve your prospects? What can you do to improve the chances of meeting post-retirement expenses? Using the template that I provided in Part 1, let's see how much of an impact different strategies can make.

1. Save more

Who would have thought that a 32% savings rate (on a 30,000 per month budget) won't be enough for retirement? On the plus side, it turns out that a just bit more belt tightening, specifically saving around 2,000 per month more (or saving a total of 38% of annual income), will do the trick.

Lowering monthly expenses to 20,000 per month from 22,000

2. Earn more

If you feel that living strictly on 20,000 pesos per month (in today's peso) is unrealistic, then you would have to find a way to earn more. Fortunately, it won't take much to bridge the gap as increasing the annual salary growth from 4% to 5% will be more than enough. If a sustained, annual increase is not possible, then aim for one-time significant wage bump, like 20% at age 40, for example.

A one time wage increase to 51,000 per month at age 40

3. Don't be "too conservative" with investments

Changing the "Annual investment return" value in the template will show how sensitive retirement cash flows are to this variable. Keeping all your savings in a savings account which earns an annual return of 1% (nowadays, that's being generous), for example, will accelerate bankruptcy to age 70, and result in an end-of-horizon deficit of 26 million. Investing in still-safe but higher-yielding instruments like time deposits and T-bills will probably earn 2 to 3% per year; at 3%, bankruptcy is at age 73 and the shortfall is 24 million.

The "magic number" for annual investment return turns out to be 6% (keeping all other variables constant). Unfortunately, 6% per year after tax is not achievable with corporate bonds and bond funds alone, especially given today's interest rate environment. It's therefore important that you invest in "riskier" but higher-yielding assets like equity funds, especially while you're still young (and can afford to take on the additional risk).

Household scenario

But what if, like most people, you decide to settle down soon and raise a family. How would that affect your retirement planning? Using some assumptions from this past post about financial planning:

• Get married in three years (and spend 600,000 pesos on the wedding)
• Have and raise two kids, send them to good schools, and support them til they turn 25
• Buy a new car every 10 years
• Rent a house for 15,000 per month (at today's prices)

And assuming that your would-be wife is earning as much as you, your household cash flows and wealth will look like this:

Cash flows and wealth on a 60,000 peso monthly household income

As is, you'd be bankrupt at age 41 and would face a deficit of 100+ million at the end of the planning horizon. So please think very hard before you decide to get married on a 30,000 per month salary.

For the kind of lifestyle and decisions defined by the assumptions above, you would have to have a minimum monthly household income of around 100,000 pesos.

Cash flows and wealth on a 100,000 peso monthly household income

If you're not there yet, then you should make do with a more prosaic lifestyle. Or get a second job. Or stay single. Or something.

Hopefully, with this post you now have an idea how you can make ends meet.

Retirement Planning with Excel, Part 1: How Assumptions Impact Cash Flows and Wealth

Two posts ago, I asked the question: Do you save enough for retirement? Based on our example "Popoy," it seems that saving 32% of a 30,000-a-month income would not be enough to cover retirement expenses.

Click image to enlarge

In the graph above, using our example we plot annual income (blue bars) and annual expenses (red bars) against the left vertical axis; to help with our analysis, we also plot accumulated income (green line), accumulated expenses (purple line), and total wealth (blue line) on the right vertical axis.

The graph shows what happens before and after you retire/stop working: before retirement, as income is greater than expenses, you accumulate wealth; after retirement, you stop earning and continue spending, which depletes your wealth. We see here that at around age 75, Popoy's wealth will have been depleted to zero, so he would have too look for alternative sources of income to finance his expenses for the rest of his life. Suffice it to say, the objective of any retirement or financial planning exercise it to be able to achieve zero or more total wealth at the end of the planning horizon.

We also pointed out in the previous post that our example lacks details that would make it more realistic. Let's take a look at some factors that some of you suggested (thanks for the inputs, everyone :)):

• Inflation and interest on Popoy's savings (Anonymous)
• Unless we want to look at real (i.e., constant-price) cash flows, we need to take price increases every year into account.
• "Parking" savings in an interest-bearing instrument would boost income to a certain degree
• Health and medical expenses (Sean)
• Our example only considers basic, recurring expenses. As a person gets older, the likelihood of incurring substantial medical expenses increases.
• Post-retirement lifestyle (mac)
• A person's lifestyle of choice pretty much determines his or her level of expenses. In our example, we assumed that Popoy will maintain the lifestyle that he has today.

Apart from these, we also need to consider the following factors in our analysis:

• Annual income increase
• We can reasonably assume that income will increase by some rate every year, even if we don't get promoted.
• Retirement pension
• Apart from any retirement bonus provided by our employer, we should at least get a small pension from SSS or GSIS. For example, from the SSS website, members are entitled to a maximum pension of 7,500 per month, fixed.
• Current wealth
• People who have already started saving before age 30 would have a certain amount of "beginning" wealth.

We can thus incorporate the above factors in our analysis by using realistic assumptions. I made a simple "dynamic" Excel template where you can change inputs and see how cash flows and total wealth change correspondingly. You may download the file here.

For Popoy, let's use the following assumptions:

Age now: 30

Current monthly after-tax income: 30,000 

Monthly income multiplier: 13

Annual income increase (%): 4%

Monthly retirement pension: 7,500 

Current monthly expense: 22,000 

Annual inflation: 4%

Current wealth (net assets): 0

Annual investment return (%): 5%

Which leads to this:

Click image to enlarge

In this second graph, we see the profound effect that rising prices can have on wealth. Compared to the previous example, while bankruptcy occurs significantly later (80 years old vs. 75)  the wealth deficit at the end of the planning horizon is much worse (11.4 million pesos compared to 2.8 million). 

Using this tool, we see that Popoy needs to do something to make ends meet after he retires. If the goal is zero total wealth at age 85, what alternatives are available to Popoy and what set of inputs can lead to this goal? Also, remember that in our example, Popoy is single and is responsible only for his personal expenses. How would his future cash flows be affected if he is married, if he has kids or other dependents? How would cash flows change if our unit of analysis is a household rather than an individual? Are you happy with what you see if you plot your personal circumstances into the template?

If you have time in the next couple of days, please play around with the template, and see you can give some suggestions in the comments section below. We'll explore possible answers next week. 

Do You Save Enough for Retirement?

According to this article from Rappler, most likely not.

You can estimate how well you're doing easily enough. With your monthly disposable income (that is, your monthly salary minus taxes, SSS/GSIS, Pag-Ibig, and PhilHealth contributions) and usual monthly expenses, start by computing for how much you can save in one year. For example (all figures in pesos):

Monthly disposable income = 30,000
Annual total income (including 13th month pay) = 30,000 * 13 = 390,000

Monthly expenses:

• Rent and utilities =  10,000
• Food = 300 per day * 30 days = 9,000
• Transportation = 100 per day * 30 days = 3,000
• Total per month = 22,000

Total annual expenses = 22,000 * 12 = 264,000

Total annual savings = 390,000 - 264,000 = 126,000

Implied savings rate = 126,000/390,000 = 32%

Is saving 126,000 per year, or 32% of a 30,000 monthly income, good enough for retirement? Let's see.

Say "Popoy," a person with the above income and expenses, is 30 years old today, is planning to retire at 60, and is likely to live until age 85. Assuming he plans to spend the same amount--22,000 per month--from retirement til the day he dies, how much will his savings at 60 years old take him?

(126,000 per year * 30 years to retirement) / 22,000 per month = 172 months or 14 years

It seems that Popoy's saving habit will only take him 14 years into retirement, and his savings will fall considerably short of his needs. Are you doing better or worse than him?

Of course, the above example is very simplified as it ignores important factors that may alleviate or magnify the savings burden of a person like Popoy. Aside from those used above, what other factors should we consider in order to have a more realistic and useful analysis? I would love to hear your thoughts in the comments section below. At the end of the month, I will show you a model/tool that will help you come up with a better analysis.

Inflation Concerns at Retirement

DEAR INVESTOR JUAN

Dear Investor Juan,

Retired 75 years old without any employment and business seeks help to make money from life saving and SSS pension.

I am really concerned about inflation, and I started reading about how to make money by investments, but I am really lost specially since there is a recurring warning all the time that I must be ready to lose all my life saving and accumulated SSS pension payments.

It seems that the only way to make money safely is to open savings accounts in banks, but the interest earned is so meager that it is not going to outpace inflation in any significant manner.

Are people like myself condemned to be eaten up by inflation so that they will if they live long enough end up penniless owing to inflation and of course from using up their life saving and SSS pension to continue meeting everyday life expenses as they continue in life?

Marius


Dear Marius,

I'll start by briefly discussing inflation in general. Then we'll go through alternatives that people in your situation can turn to to lessen its effects.

Inflation is the tendency of prices of goods and services to increase over time. It is a cause for concern because rising prices reduces how much of something we can buy with a given amount of money. And the less we have of something, the less of it we consume--and typically--the less happy or satisfied we are. And that can't be good.

That's not to say inflation is "bad," per se. Price increases are a part of life, and sometimes even favored and targeted in economic planning. If inflation is caused by increased demand, such as during an economic expansion, then it's good for everyone, on average, since it would be accompanied by low unemployment and proportionately higher wages which counteract the negative effects on spending and consumption.

However, retired individuals like you and others without regular income would be more affected by rising prices. Ideally inflation should be accounted for in financial or retirement planning to make sure that there would be enough money for needs and wants after accounting for inflation. The primary objective of any financial planning exercise is to have enough to cover expenses while one is still alive, and some subjective terminal amount at the end of the planning horizon.

When is enough enough? Technically, "enough" means that the present value of all cash inflows (e.g., retirement pension) and cash and disposable assets at hand should at least be equal to the present value of all future spending and some terminal value/amount. In equation form, it should look like:

cash + disposable assets + PV(pension) >= PV(spending) + PV(terminal amount)

(For a more detailed form of this, please refer to the spreadsheet in this post.)

At retirement, our objective is for the left side of this equation to be greater than or equal to the right side. Inflation increases PV(spending) and the right side of the equation, so it's a cause for concern. Fortunately, this simple model also shows us alternatives that can help us achieve our objective.

1) Invest appropriately. At this stage, your investment should be to earn returns while preserving capital and liquidity. While high expected returns would significantly decrease the right side of the equation (more than it will decrease the left side), it would also entail unnecessary risks that might erode capital and/or limit liquidity. This means inflation being greater than investment returns is pretty much a given at this stage of our lives, but it should not matter as long as our primary objective is met.

2) Control spending/expenses/comsumption. If last year you can buy five apples with your 100 pesos, and now you can only buy four, then maybe you should try to be satisfied with four.

3) Earn extra income. I know it must suck if we have to do this just to make ends meet at this stage of our lives, but we can just think of it as penance for making bad decisions in our youth.

4) Minimize terminal amount. In my opinion this should be zero. Only reason why it should be anything else is if you want to leave your children and grandchildren with some inheritance. But if you're worried that you don't even have enough to cover your needs for the remainder of your life, saving for your descendants' inheritance is a luxury that you can't afford.

I guess what I'm really trying to say is that instead of being overly worked up by "ending up penniless" or by inflation outpacing investment returns or by "using up" life savings (what else are savings for but to use up?), we should be more concerned with making sure that we have the means for a good-quality of life while we're still alive to enjoy it.

Filipinos Poor Financial Planners -- Study

IN THE NEWS from Business World Online -

According to a study by financial services firm Sun Life of Canada (Phils.), Inc., Filipinos are poor financial planners, with only one in 10 able to leave something to their families when they die. Sunlife’s Study of Lifestyle, Attitudes and Relationships or SOLAR also showed that only 2% of Filipinos have saved enough for retirement, with 45% becoming dependent on relatives and 30% on charity. Meanwhile, 22% continue to work after retirement.

This is a pretty scary finding, one we would do well to heed and take notice. While some of us may not feel too obliged to save a little something for those we will eventually leave behind, preparing for our retirement is simply a must; we can think of it as the most important reason why we should take control of our finances now. When we retire, most of us will have limited periodic income (mostly from pension payments) and inflated expenses (mostly going to health care). In general, the best way to prepare for retirement would be to make sure that you have access to a substantial amount of ready, liquid capital and/or that you have the right kind of insurance. What this means exactly and how it can be done will be the topic of future posts.