As an individual staring my 30s in the face, you may not think I care much about my own retirement plans and just focus on the needs of the individuals I meet with, many of whom are mid-career, with kids and only just starting to think about their own retirement. You couldn’t be more wrong. I practice what I preach.
After reading a recent HSBC report called ‘The Future of Retirement’, I was shocked to learn quite how underprepared individuals are in many of the world’s developed nations in terms of their own retirement plans. A huge ‘pensions shortfall’ exists globally. Of the nations and individuals surveyed, retirement savings on average expect to run out at around the halfway point through retirement (56%).
The UK shockingly had the worst pension shortfall in the world with their retirement savings expected to last for 37% of their retirement, ranked behind Egypt (45%), France (47%), China (50%) and Taiwan (50%). That begs the question: What does your retirement look like? How does this compare to what you want it to look like?
First, let’s explore the notion of retirement. Romantically speaking many of us hope to enjoy a comfortable, care-free retirement with an abundance of travel, good health, relaxation and time to enjoy our hobbies. It’s the time in our lives that we should all be working towards; a time we’ve earned by a career of long hours, deadlines, mortgage obligations and child-rearing. By retirement, hopefully, the kids have flown the nest, the mortgage is paid off and you are burden-free. Is this a realistic thing to aim for and how do you get there?
From a financial perspective, it’s important to consider first what you want your retirement to look like, then start making plans toward making it happen. As near or far away as this might be, you need to start. The earlier, the better My preference starts with working out exactly what income you want in retirement. Would you be happy on your current income in retirement? Do you expect to spend more money when you have seven days a week of leisure time to spend it? Most people say yes. Consider retirement as a seven-day-a-week holiday. If you plan for this right, then it can happen. Plan for it wrongly, then, well, I hope you enjoy activities that don’t cost much money! Or worst case, you may have to go back to work mid-retirement or rely on family support. Most people don’t want their retirement to look like that.
Once you have your annual income number, multiply it by 20. Why? In retirement, you need to pay yourself an income from a pool of money, factoring in inflation. This pool of money cannot diminish (at least not significantly) since you don’t know the date of your death. You certainly don’t want it to run out. Life expectancies are continuing to rise so we must be prepared.
The following are examples (the figures on the left are the annual income required in retirement while those on the right are the retirement pool required):
How do you get there? Well, there really is just one way (or two) to reach your goal by your proposed retirement age: save and invest.
But what can you save into? Well, there are a number of different sources of funds and vehicles you can use with the specific purpose of saving for retirement. The suitability and availability of these are determined by where you live in the world.
1. Employment income
This will no doubt form the majority of most people’s retirement savings. Once you’ve created a cash-cushion (money for a rainy day, which is advisable to be 3–6 months’ earnings), write down your employment income and subtract living expenses. What remains is available to save for the long-term. As a rule of thumb, you should expect to save 10–20% of net income. If what remains to save is less than this, it’s advisable to adjust your lifestyle (otherwise you’ll need to significantly adjust your lifestyle in retirement or simply work much longer). This cash can then be saved into a wide range of suitable, well-managed, long-term investment structures, including private pensions, offshore savings plans and other tax-efficient investment platforms.
2. Employer/Government-sponsored retirement schemes
Available in most countries, these involve your employer matching a certain percentage of your pension contribution. For example, should you pay in 5% of your salary, and your employer may match it with 5% themselves. Government-approved schemes also exist in many countries; for instance, Singapore’s CPF requires up to a mandatory 20% employee contribution (subject to income) matched by up to a 16% employer contribution. The USA also has the IRA/401k and Australia, the Superannuation. Most of these schemes allow you to pay in your pre-tax income so you don’t pay any income tax on contributions.
3. Social Security
Certain countries provide a small income benefit to their population at a statutory retirement age. These schemes are funded by the working populations’ tax revenue. The UK, for example, has a state pension with a maximum weekly benefit of £107.45 (US$162.41) available from the age of 65 for men and 60 for women. As governments are faced with austerity measures and life expectancy continues to rise, so does the qualify age; the security and value of these schemes, therefore, hang in the balance – so it’s unlikely they’ll be around forever.
4. Life insurance products
At retirement age it is possible to purchase annuities from life insurance companies who will purchase your private, company or government pension in exchange for a guaranteed income for life. Term life insurance can also guarantee your loved ones have a sufficient nest egg should you suffer a critical illness or pass away. Whole life insurance, on the other hand, also includes an investment component and builds cash value against which you can take out a loan. Whole life insurance is usually a lot more expensive and many financial professionals (myself included) project that it may be wise to purchase term life and use the extra money to fund an offshore savings plan or private pension.
5. Current savings and investments
If you already have a sizeable investment portfolio, it may be sufficient to cover your retirement needs all by itself. If you have yet to begin saving for your retirement or are coming into the retirement-planning game late, you will need to compensate for your lack of current savings with greater ongoing contributions.
Perhaps you’re expecting to receive an inheritance from your parents before you reach retirement age or have assets including property that you plan to sell before retiring (or perhaps rent out to generate an income in retirement). Whatever additional sources of funds you do happen to have, be sure to include them in your retirement projections only if they are certain to occur. You may be expecting to realise a large inheritance, but your family may have other plans for their surplus savings (such as donating them to charity or other family members).
Your overall retirement funds need to be diversified. If it’s 100% cash and interest rates are at Singapore, UK, European or US levels, then this will be quickly eroded, especially if inflation is running at 2–4% as it is in most of the world. If you’re 100% in property, then I hope you own them outright, otherwise you run the risk of rental income simply paying the mortgage and not providing a sustainable income source. Your retirement pool, therefore, should be made up of a variety of diversified assets – including property, some cash, life insurance, private/government pensions and other investments that provide an income hopefully at or above the 7% rate mentioned earlier.
Compound interest: the most powerful force in the universe!
Given the size of the retirement fund you need, it is obviously important that you start sooner rather than later. One of the most significant aspects affecting the size of your eventual retirement pot is the length of time you save for because of compound interest – interest on top of interest. In fact, it is often more important how long you save for rather than how much you save. Consider the following simple example.
Ben started saving US$10,000 per year at age 20, while Louise started saving US$15,000 per year at age 35.
They both want to retire at age 65.
Assuming 9% return per year, who has more money?
As you can see by the table, over the time frame they have both saved $450,000; however, Ben’s retirement pool is worth about 60% more, US$5.75 million (or roughly US$290,000 per year), whereas Louise’s is worth US$2.26 million (or roughly US$113,000 per year).
The fact is, assuming the above growth rates (which are achievable at this time), by avoiding to plan for retirement by one year, you need to save 12% more per year for every year afterwards just to reach the same goal. Therefore, defer by five years and you have to save 60% more each year to reach the same goal (or retire five years later). So start early – as small as it may be.
So let’s return to the original question: what does your retirement look like? Well mine is certainly starting to look comfortable, considering the earlier example. I’m not intending to retire any time soon, but I know I’m doing something so compound interest is working its magic. It’s never too early to start saving.