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Financial planning – How much do you need? (V)

As we attempt to compute what we will need in our retirement years, we have gradually worked from the simplest model to a little bit…

As we attempt to compute what we will need in our retirement years, we have gradually worked from the simplest model to a little bit more complicated ones, all so that we improve the quality of our estimation. Let us see what we can do with ‘Retirement Number 404’.

‘Retirement Number 404’: If we were to make 404 ‘perfect’, if there is any such thing in social and economic predictions, we will need to take the following into consideration:

The inflation rate for each year before and after retirement,

Additional investments you can make at any point in time from today to the end of your retirement (polite way of saying to your death),

The investment growth rate for each year before and after retirement,

Possible withdrawals out of your investments to, perhaps meet emergencies or the wedding of your beautiful daughter,

Taxes.

And we can indeed come up with a formula that we can program to compute our retirement number by putting in the independent variables.

My lecturer and later head of our physics department spanning my years as an undergraduate and postgraduate student and graduate/research assistant, transferred his services to a university in the UK. Interestingly, I came across a paper he published with his colleague that developed an eloquent mathematical model for the financial requirement of ‘end-of-life care’ for the elderly in residential and nursing care in the UK. This model can easily be adapted to our situation and called ‘Retirement Number 505’! Those interested in the beautiful mathematics involved can check my professor’s model at https://www.researchgate.net/publication/344542679_Paying_for_end_of_life_care_in_the_UK and also its explanatory addendum.

Whilst the advanced mathematical models can theoretically give us a better estimation of what we may need in retirement, they remain only as good as the assumptions we make. This means if we don’t get projected inflation for just one year right, our figures will not be exactly right either. And we know how difficult such predictions are to make. Consequently, we will, instead, make retirement number 404 easier and hopefully more practical.

Investment Required: Apply the ‘25X Rule’- Retirement planning experts will often advise that you need to have twenty-five times what you expect to spend in a year in retirement. So, if you expect to spend N300,000.00 per month, then you need to have N90 million in investments. The assumptions here are many and include that you will live for 25 years in retirement and that returns on your investments can, at least, compensate for inflationary effects.

Investment Required: Apply the ‘75% rule’: It is generally assumed that people tend to spend less in retirement than during their active working lives. This is only correct assuming there are no costly medical issues that may come with age and that the retiree does not engage in some hitherto bottled-up spending spree!  Nevertheless, 75% of your spending in your last year at work is used for retirement budgetary purposes. That means if you were spending N300,000.00 per month in the last year before you retire, your projected spending in retirement will be N67.5 million. Again, this is not sacrosanct and you are free to use what is real for you.

Retirement Spending: Apply the ‘4% Rule’- The 25X and 75% rules above tell us what we need to have in a simple way and under the assumptions made. During our retirement, we need to particularly monitor what we spend. To maintain a steady pace of withdrawals, we apply what is called the ‘4% rule’.

What this means is that we will calculate 4% of our total investments at the end of one year and that is the amount we can spend in the following year. So, if you had N67.5 million on the day you retired, you can spend N2.7 million in the first year of your retirement. In the following year, you adjust for inflation and add to your last year’s spending estimate. This means if you project 12.6% inflation that year, then your second year’s annual spending will be N3.04 million.

Based on the three rules above, we can calculate your required savings and investments in year zero, 〖SI〗_i, i=0 and your spending in each year of retirement i, Si, respectively as:

〖SI〗_i=25.12.75%.SP; where SP is your monthly spending just before retirement; i=0. Note that  〖SI〗_i will grow at the rate of Ga p.a.

Si=4%.〖SI〗_(i-1).(1+Ii); where Ii is the projected inflation in year i and Ii ≤ Ga.

If you wish, you could plan for any number of years by replacing the 25 with the number of years you are planning for. But by so doing, you have to change the 4% in the second equation to the multiple of the number of years you have assumed to make 100. That means if you want to plan for 40 years in retirement, then you not only replace the 25 in the first equation with the 40 but also the 4% in the second equation with 2.5%. Similarly, you can replace 75% of SP with any percentage you wish.

The essence of retirement planning and particularly the exercise of getting your ‘retirement number’ is not about perfect! No! Instead, it is about making you think through the issues and planning sensibly, wisely and quite practically. Each of us can look around and see from the circle of our seniors two clear groups: One seems to be enjoying their golden years while the other seems to be struggling. Let’s plan to get our retirement finances right by thinking through these issues and doing what will create sufficient retirement wealth for us.

Next week we will take up Budgeting for Retirement.

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