The case
Joseph, 40, is single and has no intentions of having a family. He also decided that he does not have the energy to deal with tenants and the issues associated with property ownership. He wants a simple, low-stress life in retirement and plans to live off of his savings and whatever he gets from NIS. He currently earns $8,000 before taxes but figured that if he were 60 years old today he could live quite comfortably on $5,000 per month.
Joseph wants to start an annuity but does not know how much money he should save per month. The agent told him that the plan has been yielding an average of 5.5 per cent annually for the past five years.
He is a bit indifferent about inflation but would still like to know how much money he needs to save in this plan so he can have the equivalent of $5,000 at age 60 (assuming inflation is five per cent) and maintain this standard of living for at least 15 years after he retires.
Nick's assessment and advice
I believe that Joseph's circumstances are not unique and many people in this country neither have the desire nor the financial capability to acquire a rental property to supplement their retirement needs. Because of this, their only choice, like Joseph, is to depend on NIS, an employer pension or a personal annuity. They simply have to do the best they can with what they have and leave the rest up to God.
One of the challenges with saving is not knowing if one is ahead or behind. The reason for this is the difficulty in estimating the dollar value of the goal they would like to accomplish. For many, it is a hit and miss strategy.
Even though no one can say for certain what the future holds in terms of the economy, foreign exchange rates, inflation or interest rates, it is often necessary to make some reasonable assumptions in order to come up with a workable retirement plan.
Retirement planning is also not a static activity that one just sets and forgets. It requires at least annual reviews to account for changes in the variables that could impact the end result.
Starting point
We know two things: how much money Joseph wants to collect monthly at retirement and, secondly, his intended sources of income.
NIS (National Insurance) plans internationally are facing serious problems because of the increasing numbers of retired individuals and a shrinking workforce who contributes to the latter's current benefits.
With this in mind, even though there could be funding problems that might necessitate–extending eligible retirement ages, reducing benefits or increasing current contributions–for all intents and purposes we will assume that the current NIS pension of $3,000 monthly will continue and, hopefully, keep up with inflation by the time Joseph is ready to retire.
Speaking in today's dollars, Joseph will need to deal with the difference between $5,000 and his $3,000 NIS pension, that is, $2,000 per month.
We will project that monthly amount to age 60 using the rate of inflation given. We will then calculate the lump sum needed to fund his monthly pension for life, assuming he is only living off of the interest from his investment (not factoring actuarial calculations.) We will then project what his age-60 income need should be when he turns 75 and work backwards to see what his funding gap would be.
In our calculations we have assumed the following:
Inflation: 5.0 per cent per annum
Annuity growth rate: 5.5 per cent per annum
Interest earnings after retirement: 5.5 per cent per annum
Results
Part 1
The $2,000 monthly income, adjusted for inflation would be $5,307 by age 60
This $5,307 monthly figure will require a lump sum of $1,273,583
To achieve $1,273,583 he will need to save $2,924 monthly today
Part 2
The monthly income figure of $5,307 should be $11,032 by age 75
The income gap between these two figures is $5,725
To have $5,725 extra he will need an additional lump sum of $1,374,104 by age 75
To achieve $1,374,104 by 75 he has to save an additional $1,081 monthly today
To achieve $1,374,104 by 60 the amount will jump to $3,154
Just looking at the numbers above, Joseph will need to carve from his salary anywhere between $4,005 ($2,924 + $1,081) and $6,078 ($2,924 + $3,154) to ensure he maintains that $2,000 extra buying power by and beyond retirement.
If he decides to save the $1,081 he will have to wait until age 75 before he starts collecting the extra $5,725.
But there are two challenges with this option:
1. The income he started collecting at age 60 will gradually erode with inflation for the 15 years before age 75.
2. He will have to continue saving even after he retires at 60, which means he will either have to set aside $1,081 from his age 60 pension or continue working and saving until age 75... poor guy!
If he decides to get the full $11,032 by age 60 he will need to cough up $6,078 from his $8,000 salary!
If there was a remote chance that this was at all possible then he would have some healthy surpluses at retirement and would be able to save for life beyond age 75.
Note: Not all of the savings should be in a registered plan as he may exceed the tax-deductible limit of $50,000 annually nor will he get the full tax benefit on $50,000 ($12,500 annually, $50,000 x 25%) because his salary is only $8,000 and his tax liability will only be approximately $4,950 annually.
How to fix the problem?
There are a lot of assumptions in this case and the longer the investing time horizon the more the variables could change; in or out of his favour. This case rests heavily on NIS, which no one has a guarantee for. It also depends on certain interest and inflation rates.
Joseph will have to do a combination of things to fix his problem. He has to save as much as he can, as fast as he can, for as long as he can!
He may need to find ways to increase his current level of earnings without the corresponding increases in expenditures. He could consider slightly higher risk annuities that are based on the stock market to get better returns and gradually shift to safer portfolios as he nears retirement. He may need to even consider light work after retirement to bring in the extra dollars.
Of course, if he revises his targeted income figure of $5,000 downwards the burden of saving will not be as great.
If you have any questions or need advice on today's subject please email me at: nickadvice@gmail.com or visit website: www.FinancialCoachingCentre.com