Retirement Planning: The One Financial Goal we Can't Borrow For

Why do we need to do retirement planning?

Retirement planning is the most important part of one’s life due to an increase in life expectancy. Life expectancy refers to the number of years an individual is expected to live.

For example, Satya Prakash, currently 20 years old, has a total working life of 40 years (assuming that he will take retirement at the age of 60). If his life expectancy is 80 years, then Satya Prakash has to spend 20 years of post-retirement life without a regular source of employment income. So, to sustain the expenses during his retired life, Satya Prakash needs to plan for his retirement.

In present time the need of retirement planning increased for mainly these reasons –

• Joint families are shrinking – Earlier, children supported their ageing parents as a matter of course. Today, with the increase of nuclear families and children often working in different cities or countries, that safety net is thinner.

• Inflation quietly depleting savings – At just a 6% rate of inflation, the prices double roughly every 12 years. A monthly expense of 40,000 today could be around 171,675 in 25 years.

• Increasing life expectancy – Due to an increase in better healthcare and technology advancements, people are living longer, which is good news, but it also means your retirement corpus has to last longer too.

Example: Kajal, whose age is currently 30 years, spends 50,000rs per month. If she assumes she will need the same 50,000rs when she retires at 60, she is making a costly mistake. By the time of retirement, at 6% inflation, she will need close to 290,000rs per month just to maintain the same lifestyle.

How is retirement planning different from other financial planning?

Not all financial goals are the same, and retirement is a special case. Here's how it differs –

If we say it in short – we can take a loan for almost every other financial goal, but you cannot take a loan for retirement. That's why we cannot ignore it. It has to be self-funded, and it has to be planned for early because compounding needs time to work.

Example – If Kajal starts investing 5,000 per month at 30 in an instrument earning 12% annually, she will have a very different outcome than if she starts the same 5,000 per month at 40. The 10-year head start could nearly double her final corpus, simply because of extra compounding time.

The process of retirement planning –

Retirement planning involves a process; it is not a single decision.

The steps of retirement planning are given below –  

1. Determine expenses in retirement – The first step in retirement planning is to determine the expenses in retirement; mostly it is the same as prior to retirement. The categories of expenses during the retirement period are –

Housing – (Utilities, maintenance costs, Taxes etc.), living expenses (food and personal upkeep), medical expenses, transportation, recreational expenses and insurance (life, health, disability) and taxes.

2. Time horizon – Time horizon is the crucial part in determining the retirement corpus. We use two types of time horizon in calculating retirement corpus –

i - Years to retirement - This is the period from the current point in time to the year of retirement. It is difference between current age and retirement age.

ii - Years in/during retirement - The years in/during retirement are the number of years from the beginning of retirement to the end of life for which an income has to be secured.

3. Determine the retirement corpus – The retirement corpus that will generate the income required in retirement is to be calculated. The various variables affect the retirement corpus –

·         The periodic income required

·         The expected rate of inflation

·         The rate of return expected to be generated by the corpus

·         The period of retirement

Estimating Retirement Corpus –

There are mainly two methods through which we can estimate the retirement corpus –

• Replacement Ratio Method

• Expense Protection Method

Replacement Ratio Method –

In the replacement ratio method it is assumed that the standard of living remains the same as just before one enters the retirement phase. This helps in defining the target much more easily and accurately. For example, if one is at 58 years of age and is earning 100000 per month, then the retirement should maintain this income. Thus, the assumption of a standard of living becomes an important factor in estimating the retirement income. If income is 100,000 and a standard 80% replacement ratio is assumed for retirement, then one will have to plan for an income of 80,000 in the first year of retirement. This income is then increased by the inflation rate every year to maintain the purchasing power.

Replacement Income (Year 1) = Pre-retirement Income * 0.80

Replacement Income (each subsequent years) = Pre-retirement Income * Annual rate of Inflation (added per year) * 0.80

Let us take an example for easy understanding.

Mr Atif (age 50 years) earns 100000 per annum now. He wants to retire at the age of 60 years with 50% of his income as post-retirement income.  Let us assume that his income goes up at 10% p.a. 

At the time of his retirement, his income will be 259374 rs per annum (i.e., 100000*1.1^10). 

Then replacement income just after his retirement income will be 259374 * 0.50 = 129687 rs.

His replacement income will increase by inflation every year to maintain the purchasing power. Here the inflation rate is assumed to be 7% p.a.

Replacement income in the second year of his retirement will be 129687*107/100 = 138765, and so on.

Expense Protection Method –

Expense protection method defines retirement income based on expenses in retirement. Many people using this method keep a detailed monthly budget. Tracking expenses enables them to have a reasonable understanding of what it will cost to retire.

Let us take an example for easy understanding. Mr. Alok is earning 60,000 per month of which 50% is household expenses. He is 40 years old and is planning to retire at the age of 60 years. He is expecting additional expenses of Rs. 15000 at his retirement. If we assume inflation at 6% then his expense at the time of retirement will be as below:

 Till now we have understood the need and corpus required for retirement. In later posts we will understand the products through which we can accumulate the corpus for our retirement.