04 October, 2014

How can you know if you are saving enough for retirement?

You see him often these days…  there is this genial gentleman on a recliner, who has welcomed the summer, five dozen times … these days he greets the sunsets with a martini in hand, garnished with a lemon slice.  He is laughing at something and is raising his glass to someone. How we wish we were in that position!

That is the powerful imagery one gets to see in ads for retirement homes and the pension plans.  But to be in that position, one would need to do some serious planning. Most people depend on PF, PPF, Pension plans, investments in FDs, Equities, MFs, bonds, NCDs etc., to accumulate a corpus for retirement. The corpus so accumulated needs to last for the entire lifetime, after retirement.

How much is required -  The individual/ couple will need to have an amount which will enable them to live comfortably for the next 25- 30 years.  The couple after retirement would require money for regular living expenses, medical expenses, travel & other expenses.  They need to have an amount that will take care of all these, taking inflation into account in this period.

When does one start saving -  There is a simple thumb-rule here.  One needs to save an amount equivalent to expenses one incurs now for as many years in the working period, as one is expected to live after retirement. Confusing, isn’t it? 

Let us consider an example – Raghav is 30 now. His expenses are Rs.25,000/-pm. He is earning Rs.59,000/-pm. He saves Rs.29,000/-pm ( including statutory savings like PF ). What is required for him to have a comfortable retired life is to save the amount he is spending today, which is Rs.25,000/-pm. He would continue to save an amount equivalent to his spending in that year, till he is sixty. This will ensure that he will be reasonably well funded till he is 90.

 In this simplistic rule of thumb, what we are assuming is that the expense amount today would grow by a factor equal to or higher than inflation. Assuming that the amount saved today is required after 30 years, the amount saved now will grow at a rate higher than inflation for 30 years and help in meeting the expense in the first month in the 61st year. Every investment, every month will have 30 years for compounding, in this example.

We are assuming that the expenses today would be similar to expenses in future ( adjusted for inflation ) though the expense heads can change. For instance, in the earlier years, one may spend more by way of entertainment, vacation & apparel. Also one will be spending on education. In the retirement period, medical expenses could go up. Expenses pertaining to travel, gifting etc. can be high.  

What is not accounted here is the fact that in retirement, there are expected to be just two people and not four or more people like in the early years.  Hence, the expenses are expected to be less. Also, lifestyle & consumption expenses are expected to come down in the retirement period, which has not been accounted for in this rule of thumb. With all the limitations, this is still a reasonably good thumb rule to use.

Savings to expenses ratio – In the accumulation phase, one needs to look at savings to expense ratio. If one has as many years of working life as the lifetime after retirement, this ratio can be 1. If one starts early, say at age 25, then this ratio can be less than 1 as there are more years for saving. If the number of years to retirement is less than the survival years in retirement, the ratio needs to be more than 1.  This is just a rule of thumb to assist a person to estimate whether (s)he is saving enough or not.

Earnings to expense ratio – In the retired phase, one needs to focus on what one is earning after tax in the year from the corpus and whether the earnings are good enough to meet the current expenses for the year or not. If this ratio is one or more, it is a good sign – the higher the better. A figure of one or more would indicate that a person is able to live off their income alone and not touch the corpus.  If the figure is less than one, they would start eating into the corpus, which is a danger sign.

What has been discussed are general indications of what needs to be saved for retirement, which ratios to focus in the accumulation phase and which ones to look at in the retirement phase.  Retirement is a period for enjoyment only if one has planned properly.  All of us deserve to spend our evenings in the assurance only a good corpus can assure. Otherwise, the martinis will be in someone else’s hand and one would end up wistfully looking at it!

Author - Suresh Sadagopan

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