13 September 2010

Financial planning for the absolutely idle

There are several ways of looking at the title of this post. But let me take "idle" to refer to mean a simplistic way of determining what is needed for retirement - i.e. the investment target amount?  Suppose you have determined that you need \$5,000 per month (today's currency) and you intend to retire in 20 years time.  The going rate of inflation is estimated at 3% annually. Then one formula would be to compute as such:

\$5,000/month * 12 months * 100%/4% * (100% + 3% inflation)^20 years

That works out to \$2.7 million in this instance.  In fact, the annual expenses so computed would suggest that \$108,367 would be needed per year.

Let's break this down a bit.

How does one arrive at how much is needed a month (\$5,000 in the example)?  I would suggest adding up all the expenses that one expect to incur during retirement (each month) - e.g. taxes (personal income tax if still relevant, property tax, MDA radio/tv license), insurance (medical, property, car), handphone/phone/Internet, cableTV, power/gas/water, transportation (car maintenance, petrol, bus, taxi fares), medical, meals/food/grocery, newspapers/magazines, barber/hairdresser, sports, donation, and a generous dose of miscellaneous (e.g. holidays!).  You could do so by conscientiously tracking all these details based on your spending habits today, over 3 months or more, to get a good gauge (for the relevant expense items).

Multiplying this by 12 months gives us the annual expense.

"100%/4%" gives us 25.  This assumes that one expects to reap a 4% return annually from the capital.  4% is probably a reasonably conservative investment target.  4% is the same as the current interest rate for CPF-SA/RA/MA accounts.  It is close to the coupon rate of SGS Bonds (presently weak at <3% for 10-20 year bonds).  Other alternatives that could offer 'similar' (with some trepidation) yields would be NCPS, or high dividend yielding SGX stocks.

"(100% + 3%)^20 years" is to calculate the compounding effect of inflation (estimated at 3%) from today's value of money into the future (20 years later).

There are many parameters to play with here, depending on our assumptions.  How would the target number look like for you?  This isn't the only way to work out what is needed.  There are other models that would arrive at significantly different results.

One of the key benefit of this approach is that the "capital" is never touched during retirement.  You would only be living off the generated returns from the capital.  Consequently, the capital becomes the "estate" that you could bequeath to your loved ones, or donate to your favourite charities!

Conversely, this model requires a very high capital (investment target) to be achieved.  If one is prepared to whittle down the capital to near \$0 upon one's demise, a much lower target would actually suffice.  The catch though, is how does one know when "the end" might be?

There are some additional precautionary measures that would be needed to complement this, in order to manage other risks.  But let's leave that for some other time.