Retirement Planning is getting prepared for transition from an active income yielding working life to a phase with partial or no work. It is the strategy to meet financial & non-financial challenges, that would inevitably follow. Getting this process right leads to a life of freedom, fulfilment & financial security but going unprepared into retirement could mean dependence, penny pinching or even poverty.
Plan for retirement is a specifically designed framework for meeting expenses & liabilities of all those dependent on income of retiree – once earned income ceases. Such kind of life time endeavor, needs a holistic approach that is not only true to one’s core values & finances but also cognizant of the limitations of forecasting too long into future.
Big Picture of Retirement Planning
Retirement Planning is much more than mathematical projections & it is essential to do it right the first time because the stakes could not be any higher. There are no second chances waiting in retirement & mistake(s) could do irretrievable damage. It is important to keep an eye on the big picture of this extremely crucial subset of personal finance. Be financially literate, make this your highest priority, set goals in writing & remain committed to them.
Underlying Assumptions hold the key
A plan of such long-term future has to necessarily factor in many variables, some of which are guesstimated, while others are simply unknowable. Retirement plan & its’ mathematical calculations are only as accurate as the underlying assumptions, on which these are based. The essential inputs required to plan are –
- Retirement Age,
- Life Expectancy,
- Savings Rate,
- Return on Investment – before & after retirement,
- Savings Withdrawal Rate
- Health Insurance Needs
With so many moving pieces, this jigsaw puzzle will not have easy answers. The plan, if it has to any chance of success, has to be true to planner’s core values & assumptions should reflect these values.
It is never about the amount one saves but always about savings as percentage of post-tax income. This perspective immediately takes victimhood, low income or any such excuse out of the equation & does not give even a toe-hold to procrastination. The rationale is that income should support the lifestyle & savings should be treated as payment to your future-self. What is left after savings is only to be expended.
Saving is not an option, lifestyle is. Income & expense are two variables of this conundrum. If income is found insufficient to meet expected lifestyle standards, then solution lies in increasing income through harder work & leveraging of – knowledge, time, technology, communication, marketing, network & (risky option) finance. On the other hand, expenses should be viewed from prism of need vs. want &, if need be, reduced through minimalistic lifestyle.
Savings should accumulate to a corpus sufficient to sustain lifestyle over retired-life span, which could be as long as the working life. High savings rate & minimalism are key to early retirement, if that is the ambition.
Nothing damages retirement vision as financially illiterate investments. Most retirees have a long investment horizon – 30 to 35 years of working life & as much after. Viewed from a five to six-decade perspective, time tested golden rules of investment are key to successful retirement phase. Consequence of financial apathy is more mistakes, greater losses, reduced investment return & less wealth.
- Financial Education shortens the learning curve of wealth creation
- Asset Allocation overwhelmingly affects investment outcome
- Investing for inflation adjusted return – with positive payoff expectancy
- Risk Management prevents life altering loss – in particular, ***’Sequence of Return’ risk
- Goal Based Approach prioritizes life goals over return & volatility
- Investment Plan detailing investment selection process, valuation & expected return
***‘Sequence of Return’ risk could have an outsized impact just before retirement when retirement corpus is at its peak & post-retirement, when withdrawals are planned based on return assumption. This risk needs to be mitigated by building income ladder, progressively reducing volatility, flexible management of expenses & maintaining cash reserves for short term needs.
Concept of Compounding
Compounding is the process of generating income on asset’s reinvested earnings. With every passing year, the size of ‘return on accumulated returns’ increases at geometrical rate & not average rate. Influence of compounding increases with time. When the retirement plan duration is short, the compounded effect of return & inflation is not much. Compounding gets to play a role in retirement plan, only if reasonably long period is allowed for it.
Retiring Early – Compounding effect neither increases savings rate required to replace income need nor reduces purchasing power via inflation effect on expenses, if time left to retire is 10 years or less. Higher savings rate overrides any compounding concern. The necessary conditions are that one has to be satisfied with present living standards, save 70% of income & have 3% withdrawal rate.
Compounding of Returns in Normal Retirement – Procrastination is said to be wealth suicide in instalments precisely for the reason that it reduces time for positive impact of compounding to present itself in all its’ glory. Every bit of delay in starting the savings for accumulation of retirement corpus, costs dearly. A thumb rule suggests that delay in savings for retirement by 6 years would double the required savings rate.
‘Rule of 69’ computes the number of years it will take to double the money, given the compounded annual rate of return (T = [(69 / R) + 0.35]. Giving more years to investment creates twin advantage of superior retirement corpus & smaller savings rate requirement. Thus, perfect recipe for successful retirement is a combination of improved return on investment & starting the savings programme early in one’s career.
Compounding of Inflation in Normal Retirement – Inflation reduces the purchasing power of wealth & compounding effect accelerates the process over time. ‘Rule of 70’ can calculates years in which future purchasing power reduces to half (70/Inflation = n). That translates into higher need for funds to sustain the desired lifestyle & unless one has saved enough, choice is between downgrading lifestyle or running out of funds in your lifetime.
The greatest threat to retirement investors is the wealth-destroying triple combination of Monetary Inflation (due to increased money supply), Asset Deflation (reduction in value of asset), & Inflation Taxes (tax on inflation component of capital gains). Inflation is particularly tricky to factor in retirement plan as rate of inflation is different for different segments of population & post-retirement period is very uncertain.