Question: I have several questions about retirement. First, when is it a good time to start preparing for retirement? Second, how much should I set aside to have a comfortable retirement? Third, where is the best place to invest my retirement fund when I am still building it and when I am already in retirement?—Asked at “Ask a friend, ask Efren” free service at www.personalfinance.ph
Answer: There are many rules of thumb in personal finance, particularly for retirement. One of them is the 20:20 rule. The rule states that if you want to be retired for 20 years, you should start preparing 20 years before retirement age.
Put another way, if you want to be retired up to the age of 80 and your planned retirement age is 60, you should start preparing for retirement by the age of 40. Now the rule is not that strict. It simply means that the length of retirement should roughly be equal to the length of preparation.
Let us see if this rule of thumb does apply.
If you were to retire today, let us assume that you will want to enjoy a lifestyle worth P50,000 a month or P600,000 a year. Let us also assume that you will retire at the age of 60. Now let us compute using three scenarios: 1) retirement period up to age 80; 2) retirement period up to age 90; and 3) retirement period up to age 100. What happens after the end of your retirement period? Let’s just pray that you will enjoy eternal bliss thereafter.
Mathematically, regardless of the length of your retirement period, you will have to save your total retirement cost (P600,000 x length of retirement period) over the same length of time prior to your retirement age. And the answer will always be P600,000 a year.
However, as we all know, there is an invisible financial moth that eats away at the purchasing power of our money, and that is inflation. If we assume a mere 4 percent inflation rate per year, you will now have to save as follows: P1.96 million a year for 20 years under scenario one; P3.64 million a year for 30 years under scenario 2; and P6.84 million a year for 40 years under
scenario 3.
At this point, gingerly close your jaw, which had just recently dropped because of the eye-popping numbers. The question that is probably bouncing up and down inside of your brain is, “How in the world can I save such huge amounts of money for long periods of time?”
Now many would rush to say that you should invest purely in stocks given that your planning period is very long. If I were you, I would shrug off such “off the cuff” recommendations and analyze the situation first.
Remember that you will not and should not stop investing when you are retired. Thus, your retirement period plus your retirement planning years equal the total period of time that your money will be invested. It may be that with the long investing period, you will not need to take high risks associated with stock investing with your money.
For the sake of argument, let us assume that all you can afford to save is P600,000 a year. Let us also assume that you will target just one level of investment return.
Given these assumptions, my trusty worksheet says you will need to target a return of: 6 percent a year in scenario one; 5.82 percent a year in scenario 2, and 5.68 percent a year in scenario 3.
With a historical compounded annual growth rate of 15 percent for the Philippine Stock Exchange index, the computed returns are hardly an indication of the need for a pure stock investment portfolio. A balanced investment portfolio will be more appropriate.
Of course, some may argue that target returns drop as a person ages and becomes more risk averse.
But even if we assume further that the target return is cut in half once a person retires, the target returns based on our foregoing assumptions would be: a) 7.72 percent a year up to age 59 and 3.86 percent a year thereafter for scenario 1; b) 7.40 percent a year up to age 59 and 3.70 percent a year thereafter for scenario 2; and c) 7.16 percent a year up to age 59 and 3.58 percent a year thereafter for scenario 3. A balanced portfolio is still adequate for such target returns. In fact, a bond portfolio could answer for the target returns from age 60 onwards.
But wait, income does not and should not stay stagnant. So assuming that your income also grows by the rate of inflation, your target returns under all scenarios will fall to below 6 percent p.a. up to age 59.
Two things are clear here.
First, the 20:20 rule, like all other rules of thumb, is a good starting point but not necessarily the answer. You will need to look deeper into your own particular situation and do some true financial planning. For example, you can add your future retirement pay and starting investable funds to the equation but deduct any inheritance that you would want to leave to your loved ones. Second, the actual allocation of your money will depend on the risk level you are willing to take. A greater risk appetite could also mean a shorter retirement planning period. To know your risk appetite, it would truly be better to talk to an independent financial planner for pure advice.
To know more about investing for retirement, visit www.personalfinance.ph. There is a plethora of free tools and articles to allow you to hit the ground running with financial planning. You may also want to attend our Financial Planner’s training in the cities of Mandaluyong, Baguio, Davao, Cebu, Cagayan de Oro and Iloilo, the details for which can be found in our website.
(Efren Ll. Cruz is a Registered Financial Planner of RFP Philippines, personal finance coach, seasoned investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-5050709 or e-mailed to efren@personalfinance.ph. To learn more about estate planning, attend Chartered Trust and Estate Planner (CTEP) Program on March 28. E-mail info@rfp.ph or text <name><e-mail><CTEP> at 0917-3464126 to register.)