I’ve been asked to talk to some teachers at United World College, Singapore  about planning for their retirements, and I thought I’d write out the basics here, with the hopes that some other people might find it helpful. 

I understand that most of UWC’s teachers are British.  My apologies, in advance, for using dollars instead of pounds.  It’s a keyboard thing.

The objective of my first talk is for people to be able to answer these two questions:

1. How much money will you likely need to retire?
2. How much money will you need to invest to reach that desired amount?

Q1. How much money will you need to retire?

Here’s a first step to take:

Imagine that you’re 60 years old, and you’re going to retire today.  How much income would you want to retire comfortably?  Would you be comfortable living on $40,000 a year?  Or would $80,000 annually be the figure you’d want?  If you’re going to be getting a small amount from the government, consider that gravy.  Considering that most teachers at United World College won’t be earning a typical teacher’s pension, the amount received from government assistance won’t likely be much.

Consider, also, whether you’ll have a mortgage-free roof over your head at age 60.  If you won’t, then you’ll have to consider mortgage payments or rental costs when figuring out a range of incomes that you’d aspire to if you were retiring today, at age 60.

Nobody can give you this answer because it’s so dependent on you.  But I’ll create a fictitious character for this scenario to show how the process could work.

Malcolm Elliot decides that he wants an income of $50,000 a year if he were retiring today.  He’ll have a roof over his head (mortgage free) and he’ll get some form of government assistance that he hopes to use for a bit of travelling, rather than needing it to buy groceries and pay his regular bills.

Year:  2011           

Malcolm wants:   $50,000 a year upon retirement

But Malcolm is only 40 years old today.  By the time he’s 60 years old, that $50,000 won’t go very far, thanks to the ravages of inflation.

So Malcolm needs to calculate the amount of income he’d need in the year 2031.

Nobody knows what levels of future inflation we’ll have.  We can only use the past rates to estimate the future.

Over the past 90 years, inflation in the developed world has averaged slightly more than 3% annually.  Let’s be safe, and assume that inflation will be 3.5% per year for the next 20 years.  Of course, it could end up being higher or lower, but for this purpose, we’ll calculate future inflation at 3.5% annually.

Now Malcolm needs to figure out how much “income” he’d need in 2031 (when he retires) to give him the same buying power that he’d get with $50,000 today.

An online compounding interest calculator would do the trick.

The following online calculator MoneyChimp is a nifty, simple tool for this: 

Current Principal:	$
Annual Addition:	$
Years to grow:
Interest Rate:		%
Compound interest time(s) annually
Make additions at start end of each compounding period
Results
Future Value:	$

1. In the current principal space, I typed in the amount of income that Malcolm would want, if he were retiring today.
2. I left the annual addition at 0 because we’re just trying to figure out how much income would be needed in 2031, to give us the buying power of $50,000 today.
3. The interest rate I used was 3.5%, as a rough guess of what inflation might be over the next 20 years.  As previously mentioned, this is very slightly higher than the 90 year historical average for developed countries, but we have had 20 year periods where inflation has been much higher. 

The future value that you see ($99,489.44) represents the income you’d require in 2031, if you wanted the same buying power that $50,000 would give you today (assuming 3.5% inflation)

So how much money will Malcolm need to provide $99,489 in annual income?  If he has total investments amounting to double that figure, it would only last him two years, right?

Malcolm plans to live until he’s 90 or 100.  He eats a lot of broccoli.

So what would the size of Malcolm’s investment portfolio need to be in order to provide him with income of $99,489 per year?

Studies show that if you want the highest chance of not running out of money as you age, the maximum amount that you should withdraw from your investments is 4% per year. 

Keep in mind that if you do this, you will also likely be able to give yourself “raises” to cover inflation, and based on historical probabilities, you won’t likely run out of money.

In this case, Malcolm would need an investment portfolio size of $2,487,236 in the year 2031.

By selling 4% of this portfolio, he’d be selling $99,489 worth.  And each year, he could give himself a 3.5% raise to cover inflation.  For example, in the first year he could sell $99,489 to live off.  And the second year, he could sell $102,971 for his living expenses.  The teachers’ pensions in the UK (as they are in many countries) are indexed to inflation, meaning that there are increments over time to allow for the increased costs of living.

That figure of $2,487,236 might look daunting.  But for teachers at United World College, it shouldn’t be.  Your incomes are solid, and there’s a reasonable probability of a 40 year old teacher at UWC attaining a portfolio of that size by the time they’re 60.

This leads us to our second question:

Q2. How much money will you need to invest to reach that desired amount?

Let’s use Malcolm to provide a further example.

At 40 years old, let’s assume that his current investments amount to $200,000.

Let’s also assume that his investments can make 8% annually for the next 20 years.  This is less than the UK markets/US markets/Canadian stock markets have averaged over the past 20 years, and it’s less than they have averaged over the last 90 years as well.  So it might be a decent assumption, going forward.  And we can always play with lower probabilities in case it isn’t.

Here’s Malcolm’s profile:

• Age:  40
• Current portfolio size (current principal):  $200,000
• Amount that he invests annually (annual addition):  $30,000
• Wants to retire in:  20 years
• Assumed rate of return:  8% annually
• Malcolm’s portfolio goal size:  $2,487,236

You can see by the compound interest calculations below, that Malcolm could reach his goal if he invested $30,000 per year, and if his investments made 8% annually.

Here it is, based on that compound interest calculator we used before.

Inputs
Current Principal:	$
Annual Addition:	$
Years to grow:
Interest Rate:		%
Compound interest time(s) annually
Make additions at start end of each compounding period
Results
Future Value:	$

 

However, if his investments make just 6% annually (which is entirely possible) then Malcolm won’t reach his target of $2.4 million while investing $30,000 a year.  For this reason, he may want to invest more, to give himself a margin of safety.  Here’s what the same thing looks like below, assuming that Malcolm makes 6% interest.  Instead of $2.4 million, he’d end up with $1.8 million.

Inputs
Current Principal:	$
Annual Addition:	$
Years to grow:
Interest Rate:		%
Compound interest time(s) annually
Make additions at start end of each compounding period
Results
Future Value:	$

 As you can see above, the difference between making 8% annually and 6% annually is substantial.  For Malcolm to reach $2.4 million, assuming a 6% annual growth, he’d have to invest roughly $46,000 a year, as you can see below:

Small percentage differences of investment returns (ie. 6% vs 8%) can make significant long term differences.

Here are the questions you’ll need to find answers to:

1. What would I want, in terms of annual income, if I was retiring today?______________________
2. What does this equate to, considering 3.5% inflation, at the planned year of my retirement?______________________
3. Considering that you’ll be selling 4% of your investment portfolio each year (while providing small raises for yourself to cover inflation) how much will your investment portfolio need to be worth when you retire?_______________________________
4. Based on your current portfolio size, and assuming a rate of investment return of 8% annually, how much will you need to invest each year to reach your goal? __________________________
5. Based on your current portfolio size, and assuming a rate of investment return of 6% annually, how much will you need to invest each year to reach your goal?__________________________
6. Assuming a future return of 8% annually, are you currently investing enough to reach your goal?_________________________________
7. Assuming a future return of 6% annually, are you currently investing enough to reach your goal?_________________________________

At my second session, I’ll provide evidence based strategies to give you the highest statistical odds of investment success, while providing safety at the same time.

 Cheers,

Andrew Hallam