Since the release of myPlan application, many people have asked about the user guide. In fact, myPlan is not a complicated software to use. It may not have fancy and most user-friendly interface. But it certainly achieves one goal – making retirement planning easier and simpler to understand. Instead writing a user guide, I decided to write an article about retirement planning. As a disclaimer, I am not a Certified Financial Advisor (CFA). I am a Supply Chain Management consultant helping companies to optimize the supply chain and improve the bottom-line.
What is Retirement Planning?
According to Wiki definition:
Retirement planning, in a financial context, refers to the allocation of finances for retirement. This normally means the setting aside of money or other assets to obtain a steady income at retirement. The goal of retirement planning is to achieve financial independence, so that the need to be gainfully employed is optional rather than a necessity.
In layman’s term, you need to have enough money so you do not have to work. From time to time, someone may approach you – how you done your retirement planning? They may also offer free retirement planning service to you. In most cases, they are trying to sell you their products or services such as Annuanity, Insurance, Brokerage service, etc. Their products or services may be important as part of your retirement plan. However, their advices may not serve consumer’s best interest and are limited in scope. Therefore, we need to understand the retirement planning ourselves.
In summary, retirement planning is a process to achieve financial independence through saving and investing.
Why Retirement Planning?
Some of you may ask: I have Social Security and Pension. Why I have to do retirement planning? The short answer is you may not have enough to retire comfortablely. You need to understand your benefits and know the gap. There are many factors that requires you to do a retirement plan early:
- Inflation
- Uncertainties of Social Security and Pension
- How you considered early retirement? Working until you die is not a good plan. Working until you can’t is not neither.
Therefore retirement planning helps you understand the present financial situation and knows the future.
How Much Will You Need?
In this WSJ article Do You Have Enough to Retire? Do the Math, the author introduced a simplified approach. Indeed, this is very simple method to calculate the savings required for retirement. He briefly discussed about inflation, life expectation and investment rate of return. But these factors seems to be no effects on formula. Many financial organizations and researchers have invented many financial models to estimate the amount of savings required. The inputs to the model are still based on assumptions.
In fact, How Much WIll You Need is actually related to How Much Do You Spent now. You will not change your life style (unless you are forced to). It is true your daily expense may be reduced when your kids go to college and when you are retired. However, your spending habit will not change.
There is no simple formula to tell you How Much WIll You Need. I used to use spreadsheet to do the calculation until I developed the myPlan. The rest of the article discusses the approach used by myself and in myPlan.
The Planning Process
Some argued that you need to start the Retirement Planning as soon as you receives your first pay check. This is because Retirement Planning starts with Saving. If you spent all your income or even borrows to spend, you properly know you will have nothing left for your retirement. However, saving alone is not enough because of Inflation. Steady low-inflation is necessary for economy to grow. It also reduces the buying power of currency over the time. For example, the same $1000 will worth about half in 25 years assuming 3% yearly inflation. The only solution to inflation is Investing.
Life changes. Your goal changes as well. Therefore you will need to Review the progress of the retirement plan. If there is major gap between your goal and the reality, you my have to Adjust the plan accordingly. The retirement planning is an iterative process – Save, Invest, Review and Adjust.
Saving – The Importance of Budgeting
The objective of budgeting is not necessarily limit your spending. At least, it helps you to know where the money goes. Obviously the total spending should be below the total income. The question is how much do you need to save. Again this is not an easy question to answer. It depends on when did you start saving, what is your retirement goal and what is your plan for your child’s education. If you plan to retire early, you properly need to save more. At the beginning, you should not be worried about how much you need to save. As long as you save (not borrow to spent) and developed a habit of saving, you can adjust the plan along the way.
The best way to develop a budget is to categorize and track the spending. You can doing this easily using a Personal Financial Management (PFM) software such as Microsoft Money, Quicken, myPlan, etc. You should not divide the spending into too many categories which makes budgeting and planning difficult. In general, the spending categories should include:
- Living Expense – monthly expenses including groceries, bills, and other necessities.
- Discretionary Expense – expenses which are either non-essential or more expensive than necessary.
- Education Expense – this includes contribution to child education fund and other education expense. This expense category will properly be no longer needed when your child goes to college.
- Entertainment, Leisure and Vacation – these are necessary to improve the quality of your life. But you should avoid them during the difficult times.
- Health Care – this includes health insurance premium and other out of packet expense. This type of expense may subject to larger inflation rate (a reality) and may be deductible for tax purpose.
Once you know your budget, your income and the savings each year. You can simply plug the numbers into a spreadsheet and calculate the yearly cash flow until your retirement years. (Use the total income subtracts total expense and carry-forward the savings to the following year). The income should include your social security and pension incomes. The expenses and your salary incomes should be adjusted for inflation – you may use widely accepted inflation rate of 3%.
Wait a minute, my plan does not work. It seems that I have to save a lot. In fact, you are right. We have not considered the most important step in Retirement Planning – Investing.
Investing – The Objective of Investment
What kind of rate of return should I expect from my investment? 5%? 10%? The higher the better? If you come to later conclusion, you have not understand the objective of investment for retirement. Let us look at an example: assume your yearly expense is $10,000 and the inflation rate is 3%; you have $10,000 savings now and investment rate of return is 5%.
| Year | Expense | Savings |
|---|---|---|
| Year 0 | 10,000 | 10,000 |
| Year 1 | 10,300 | 10,500 |
| Year 2 | 10,609 | 11,025 |
| Year 3 | 10,927 | 11,576 |
| Year 4 | 11,255 | 12,155 |
| Year 5 | 11,592 | 12,762 |
| Year 6 | 11,940 | 13,400 |
| Year 7 | 12,298 | 14,071 |
| Year 8 | 12,667 | 14,774 |
| Year 9 | 13,047 | 15,513 |
| Year 10 | 13,439 | 16,288 |
| Year 11 | 13,842 | 17,103 |
| Year 12 | 14,257 | 17,958 |
| Year 13 | 14,685 | 18,856 |
| Year 14 | 15,125 | 19,799 |
| Year 15 | 15,579 | 20,798 |
| Year 16 | 16,047 | 21,828 |
| Year 17 | 16,528 | 22,920 |
| Year 18 | 17,024 | 24,066 |
| Year 19 | 17,535 | 25,269 |
| Year 20 | 18,061 | 26,532 |
After 20 years, your yearly expense is 18,061 (simply multiply the yearly expense by 1.03 for 20 times) and your investment has grow to 26,532 (multiply yearly saving by 1.05 for 20 times). As you see, your investment return is more than enough cover the expense increase due to inflation and generated additional $8,471 of savings. This is the power of compounding. Therefore, your investment goal is to beat the inflation, not to chase higher return with higher risk. Of course, you can achieve better return by deploying various investment strategy. The emphasis of this article is to help reader to understand the importance of investing.
Now you can modify your retirement plan using 5% rate of return for your cash savings. You properly do not have to save a lot and hopefully you can retire early.
Reviewing – What to look?
At this point, your retirement plan is still on paper. From time to time, you have to review its progress:
- Is your spending under budget?
- Have you achieved your saving goal?
- Is there any area of improvement?
Most importantly you need to review your plan as a whole by setting a baseline. There is no point to look at one area only. Your spending may be higher as your life style changed because you advanced in your career. Now it may be the best time to adjust your plan.
Adjusting – Understand the Uncertainties
You need to adjust your plan because life is not a constant. There are many uncertainties in your life.
- Oil price is sky-rocking. The gas price is eating into my budget.
- The jobs are going overseas. My salary has not increased for years.
- My 401(k) is becoming 201(k). How can I achieve 5% rate of return for my investment?
- and many more…
In fact, a retirement plan is never a math problem which can be solved by a financial model. The best solution is to understand the uncertainties and prepare for changes. No matter how well you planned for your retirement, you need to prepare yourself for changes. Otherwise, your plan is still on the paper.
Of course, it is easy to say but difficult to do. The question is have you tried to understand the uncertainties? In coming months, I will continue to write a series of articles on Personal Financial Management. If you are interested on certain topic, leave a comment or send me an email to myplan@voyagebc.com.
