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Estimating retirement needs & How much do you need on retirement?

he entire process of retirement planning is based on a few factors that form the basis of the entire planning. One of the crucial pillars is that the retirement needs will have to be estimated correctly. If the base of the entire building is wrong then there is likely to be several problems as the planning proceeds. Thus, the most important step for a person is to ensure that the needs are estimated correctly. The retirement planning process is a linked process that deals with various steps providing direction to the future course of action. In that sense, the estimation of retirement needs will arise only after the financial objectives have been determined. The determination of objectives is one part of the process but when there is a financial element to it then the situation becomes easy to understand for an individual. This will mean that the person is very clear about the exact requirements that are expected of him. The process of estimating retirement needs can be done by two main methods: a) b) Estimation of Expense Replacement of Income

Estimation of Expense Under this method, the various expenses of the person are estimated at the time of retirement. This figure is then used to determine the amount that will be required as the retirement corpus so that there is no problem in meeting this need for the individual. This is a slightly detailed and long drawn out exercise, as all the required expenses have to be estimated and then calculated for the planning purpose. In the estimation of expense method there is a move to start from scratch and then all the items of expense are listed out. Figures are then put against these items to arrive at the requirement. This would consist of the following: The process starts with drawing up of the list of expenses at the time of retirement and after retirement. This is the list that will generate expense for the individual that has to be met by the available funds. There has to be an estimate of the items in the list of expense under each head. This will help in arriving at the total of the expense list. Current expense as well as expectations will have to be taken into consideration. Replacement of Income This is a slightly easier method as far as determination of the funds for retirement is concerned. Here the income of the person just before retirement is taken into consideration. This is the amount that the person is receiving from employment. The replacement method looks at what percentage of this figure will have to be replaced at the time of retirement. The current income figure will cease after the date of retirement.

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The replacement method is easy to understand. It works on the approach that a certain percentage of the figure of the income before hand will be enough to meet the needs at the time of retirement. The process is: The process starts with the current level of income. From the current level, several estimates then come into the picture. Additional items of expenditure are considered. Those items of expenses that will impact the income in addition to the current expenses will be considered. Then the position as compared to today will be taken into account. Usually this figure turns out to be less than the current income figure. Thus, it could be something like earning 70-75% of the current income. This gives an idea about the kind of requirement that will arise. The percentage arrived at by the calculation is the replacement figure. The figure could be 50% or it could be 70% and it would vary with the situation of each particular individual. Determine your retirement income needs Determining your retirement income needs is a process that helps you identify your retirement planning needs. This is based on: The desired standard of living Resources available There is a need for estimating these kinds of needs because: Today, you can no longer rely on just the provident fund and a small pension check to fulfill all your retirement income needs. Provident fund benefits will probably satisfy only a fraction of your overall retirement income needs. The era of generous company pensions has largely been replaced with defined contribution plans. There is little likelihood of a person earning high retirement benefit from an employer in the future. Now even other retirement plans offered by an employer are paid for or funded by employees to a great extent. Use your current expenses as a starting point, but note that your expenses may change dramatically by the time you retire. If youre nearing retirement, the gap between your current expenses and your retirement expenses may be small. If retirement is many years away, the gap may be significant, and projecting your future expenses may be more difficult. Remember to take inflation into account. And keep in mind that your annual expenses may fluctuate throughout retirement. For instance, if you own a home and are paying a housing loan, your expenses will drop if the loan is paid off by the time you retire. Other expenses, such as health-related expenses, may increase in your later retirement years. A realistic estimate of your expenses will tell you about how much yearly income youll need to live comfortably. Identify your sources of Retirement Income Once you have an idea of your retirement income needs, your next step is to assess how prepared you are to meet those needs. In other words, what sources of retirement income will be available to you? Your employer may offer a traditional pension that will pay you monthly benefits. In addition, you can likely count on your own savings to provide a portion of your retirement income.

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Additional sources of retirement income may include an annuity or a pension from an insurance company. The amount of income you receive from those sources will depend on the amount you invest, the rate of investment return, and other factors. Finally, if you plan to work during retirement, your job earnings will be another source of income. Calculate the gap Once you have estimated your retirement income needs, take stock of your estimated future assets and income. These may come from your provident fund, public provident fund, a part-time job, and other sources. If estimates show that your future assets and income will fall short of what you need, the rest will have to come from additional personal retirement savings. Figure out how much you will need to save By the time you retire, youll need a nest egg that will provide you with enough income to fill the gap left by your other income sources. But exactly how much is enough? The following questions may help you find the answer: At what age do you plan to retire? The younger you retire, the longer your retirement will be, and the more money youll need to carry you through it. What is your life expectancy? The longer you live, the more years of retirement youll have to fund. What rate of growth can you expect from your savings now and during retirement? Be conservative when projecting rates of return. Do you expect to dip into your principal? If so, you may deplete your savings faster than if you just live off investment earnings. Build in a cushion to guard against these risks. Build your retirement fund When you know roughly how much money youll need, your next goal is to save that amount. First, youll have to map out a savings plan that works for you. Assume a conservative rate of return (e.g., 5 to 6 percent), and then determine approximately how much youll need to save every year between now and your retirement to reach your goal. The next step is to put your savings plan into action. Its never too early to get started (ideally, begin saving in your 20s). To the extent possible, you may want to arrange to have certain amounts taken directly from your salary and have it invested. This arrangement reduces the risk of impulsive or unwise spending that will threaten your savings planout of sight, out of mind. If possible, save more than you think youll need to provide a cushion. Understand your investment options You need to understand the types of investments that are available, and decide which ones are right for you. If you dont have the time, energy, or inclination to do this yourself, hire a financial professional. He or she will explain the options that are available to you, and will assist you in selecting investments that are appropriate for your goals, risk tolerance, and time horizon. To make sure your retirement plans are adequate: Determine how much you will need to live comfortably after retiring. Know how much you must save every year to reach your goal. Stay in control of your finances.

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Consider long-term needs. Dont leave your future to chance. Make up any income shortfall If youre lucky, your expected income sources will be more than enough to fund even a lengthy retirement. But what if it looks like youll come up short? Dont panicthere are probably steps that you can take to bridge the gap. A financial professional can help you figure out the best ways to do that, but here are a few suggestions: Try to cut current expenses so youll have more money to save for retirement. Shift your assets to investments that have the potential to substantially outpace inflation (but keep in mind that investments that offer higher potential returns may involve greater risk of loss). Lower your expectations for retirement so you wont need as much money (no beach house on the Riviera, for example). Work part-time during retirement for extra income. The multiple asset requirements Retirement planning does not just consist of investing in just one asset A lot of areas will have to be used for the process This means a complete asset allocation plan Many of these assets will take years to build This requires long term planning The planning process will have to continue for quite some time The high amount of requirement will mean that there has to be a long period of time for which the retirement planning will have to be undertaken. This will not get over quickly but will remain a continuous process in which the things have to be settled and once this is done the process continues. Earning Corpus A corpus is the total asset base of the individual that is earning some income. This is the amount that is invested in various assets so that there is an earning from these assets and income is generated for the individual. Examples are equity shares or bonds or mutual funds. Asset base This consists of the total assets of the individual. This will include a mix of the assets that generate income as well as those assets that are used by the individual but do not generate income. This is a wider term than several others that are commonly used in the investment process. There can be a gain on the asset but except for specific circumstances the entire asset base does not generate income. Examples of assets that do not generate income are a house used for self occupation or paintings. Planning for retirement using different assets The entire retirement plan has to be quite broad based as a complete approach to the entire issue will be required. This will mean that an individual will have to make use of several assets in order to ensure that the goals set out at the time of the planning are achieved Need for using different assets Assets have different characteristics in terms of risk and returns

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A single asset will lead to concentration in one area If the asset is risky then the overall risk will rise This has the probability of generating high returns If the returns are low then the entire portfolio will not get adequate returns There is no diversification This gives rise to the need for use of different assets They can tackle the rising need to match risk and return This will ensure the target of the individual is reached without additional risk Continuous process Retirement planning is not a one time affair but will be required to be undertaken over a long period of time. This continuity is required so that the objectives set out at the time of the start of the process are achieved. This might take quite some time but slow and steady is the mantra here to win the long term race The enormity of the task of retirement planning In specific kind of planning like planning for marriage or for the education of a child the need for funds is usually not very high This would still mean several lakhs of rupees at the current stage of planning However retirement planning is different The sum involved is also very huge This could well be over a crore of rupees This makes one step planning difficult to implement Retirement planning becomes a long process

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Exercise : 1
Aman Jain, 27, is an MBA from a top-rated business school with a great job with a major retail chain. He has recently married his batchmate, Namita (also 27), who has a similar work-profile. Both live in a rented apartment in central Mumbai. Their parents have settled in their respective home towns and are well provided for. Both have good jobs which pay them Rs 35,000 each every month. They have now started thinking about their retirement. They need to understand how big their retirement corpus needs to be so that they can lead a comfortable life in their golden years. They both expect to retire at the age of 58. Money looses value with time: This phenomenon is called inflation. Assuming a 6% inflation, the Jains will require approximately Rs 3 lakh a month at the time of retirement (31 years from now) to enjoy the same lifestyle as Rs 50,000 per month would allow today. It is important to note that inflation will continue to erode the value of money even after retirement. Hence, the Jains need approximately Rs 11 lakh per month by the time they are eighty to live the same life-style as today! Typically, a person should budget for 70% of pre-retirement expenses as his or her expenditure after retirement. Hence, in the case of the Jains, who now spend Rs 50,000 a month, they should expect to spend Rs 35,000 per month in todays value terms. Step 1 - Determine the post-retirement annual income needed: Assuming, in todays terms, Jains need Rs. 50,000 a month to live a comfortable life, applying the post-retirement expense factor of 70%, we estimate that the Jains will need Rs 35,000 a month in todays terms to live a similar lifestyle after retirement. An expense of Rs 35,000 a month translates into a total expenditure of Rs 4,20,000 a year. Note that we have not yet accounted for the inflation, which we do in step 3. Step 2 - Define the quantum of bequeath: You can, if you plan well in advance, determine bequeath that you want to leave your posterity with. Assume, the Jains want to leave a sum of Rs. 50 lakh in todays value to their children, which will be available to them after their death. Note this also acts as a buffer against the surprise of life: either of the Jains living longer than 80! Step 3 - Account for inflation: For every year (from the 59th to the 80th), determine the sum of money that will be required every year on a nominal basis (i.e. after factoring in inflation). We assume a 6% constant inflation rate. Hence, Rs 50 lakh bequeath in todays value would mean a sum of approximately Rs 11.89 crore at the age of 80! Step 4 - Determine the rate of return that your corpus can earn: After retirement, it is typically (well) advised that a substantial chunk of your money be parked in safe securities like government-guaranteed debt, bank fixed deposits, etc. While this protects your capital, this also means that you will get lower returns post-retirement. Given the current scenario, it is good to assume that you will earn 8% on your post-retirement portfolio. Step 5 - Determine the present value of the annual amounts and bequeath: Calculating the present value means determining the principal amount that you need to have such that the interest and drawings from the same will meet your future expenditure needs. Assuming the 8% rate that we discussed in step 4, we determine the present value of each years expenditure and bequeath Step 6 - Determine the corpus required: Based on the present value calculated in Step 5, we can determine the corpus for the Jains. The amount that the Jains need to have before they retire at the age of 58, is approximately Rs 6.59 crore. The return on this corpus helps the Jains with two things a) to meet their yearly expenditure b) to build the bequeath for their children.

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In the first year after their retirement, a return of 8% on the corpus of Rs 6.59 crore would yield Rs 52.7 lakh. Of this, around Rs 27 lakh would go towards meeting the annual expenditure and the remaining would go towards building the bequeath of Rs 11.89 crore they plan to leave for their children.

Exercise : 2
Calculate the sum required as a corpus if the earning rate of the entire portfolio is put at 8% and the amount required is Rs 75,000 per month. Analysis Determine the amount required on annual basis Work backwards to calculate corpus based on rate of return that will earn the specified amount Estimating the kind of expenses that will be incurred at the end of a year as being the monthly figure multiplied by 12 this will come to around Rs 9 lakh. At 8% earning the corpus required would be well over a crore for this purpose.

Exercise : 3
A person requires Rs 12 lakh per annum in the future. The expected earnings rate at this period of time would be in the range of 7-8%.What is the kind of corpus that is being considered for the purpose of meeting the planning requirements? Hint: There will be a range for the corpus required here.

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Chapter Review

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