36 Saving for retirement – the professional view

In a previous post (34 Retiring comfortably, or your lifetime savings plan) I referred to a pretty nice book by one Paul Westbrook, JK Lasser Institute (Saving for Retirement, Wiley, 2003), which deals with these questions in a professional manner. I’ll run through his main conclusions and see how my own home-spun analysis stands up.

First, the main points about the arithmetic of saving.
Chapter 6 forms the core of the formulae that I worked out in my post: his Table 6.1 gives the Future Value  of a one-time investment of one dollar (or whatever currency), growing at a certain compounded rate of interest. Instead of formulae, Table 6.1 gives a selection of time periods to maturity (5, 10, 15, 20, 25, 30 years) and interest rates (3%, 4, 6, 8, 10%). I’ll cite here his maturity values for 30 years (which is the time to retirement I used for my calculations) for 10% (which is the interest rate I used “for convenience” (!): 17.45, which confirms the correctness of my calculation! I also give the maturity amount for 8%, in case you feel that 10% compounded interest is too hopeful: for 30 years at 8%, one dollar will amount to 10.06, or say 10, which is rather convenient for a guy like me who likes to work the tens! Just for the record, a senior citizen gets a half percent extra interest, so I think 9.5 or even 10% may not be too off the chart (especially as our Reserve Bank of India is hesitant about lowering the bank rates do far!).

The same Table 6.1 is also perfectly useful for projecting the effect of a continuous inflation: if we assume an inflation of 8% per year, a price of one dollar today would stand at 10 in 30 years, or at 10%, it would be 17.45 in 30 years. Conversely, we can use the same numbers for computing the Present Value of a dollar received 30 years in the future:  we divide by 10 for 8%, or 17.45 for 10%, inflation rate, instead of multiplying. This is called deflation or discounting, as against inflation or compounding from present to the future. It’s what I did for my PhD in Forest Economics (subject for a future post!).

Westbrook’s Table 6.2 is a second core engine of the retirement savings calculations. This one gives the cumulative value for the same range of interest rates and maturity periods, except that it also adds another dimension (parameter) to the computations: the investment is made every year, instead of a single one at the start, so that the table gives what we can call cumulative maturity values of the series of annual contributions (annuity). Additionally, the table also provides for the annual instalments to increase from year to year, at either 0%, 3%, or 5%. We may remember from the previous discussion that if inflation is making things costly (eroding the value of money), it is also making your salaries higher (hopefully in step). If you don’t want inflation to completely neutralize the value of your interest earned (by the sweat of somebody else’s brow, I may add, but let’s discuss that under the Economics of saving!), and return you just a dollar for every dollar invested (which, of course, is going to have that much lower purchasing power in Year 30!), then you will have to make sure to keep your annual contributions also rising in step, or keep up your investments in real terms to counter inflation and erosion of the dollar. Table 6.2 gives you the cumulative value of a series of annual investments, increasing at either 3% or 5% from year to year, take your pick (but not 10%, or even 8%, so we may have to fall back on the formulae if we want to use such rates). To compare with my formula results in Post 34, Table 6.2 gives the following number for 30 years, 10% interest, 5% annual increase in investment: 275.66;  a bit higher than mine, 263, probably because of the different assumptions about the first year’s interest. Westbrook’s number for 8% interest, 30 years horizon, 5% annual increase in invested amount, is 199.01 (or let us say, a round 200!). This is perhaps as reasonable a figure as any for us in India.

Using these round numbers, we can calculate the starting investment needed to build up a reasonable nest-egg or capital so that we can subsequently live off the interest alone.  You may remember that I started with a basic living expense of 10,000 a month or 120,000 a year, assuming a starter earning 20,000 a month today. If you wished to retire in 30 years, and assuming 8% inflation, this 120,000 a year of today’s would translate to an annual disposable income of around 10 times (10.06, exactly), or 1200,000 (12 lakhs, 1.2 million) which you intend to get from your 8%-interst rate cumulated deposits (10% would be a more convenient number, but I am trying to be realistic here!). The principal (capital) amount to get 12 lakhs at 8% interest would be (12/0.08) lakhs = 150 lakhs (15 million). At 10% interest, it would be (12/0.10) lakhs = 120 lakhs (12 million). To have 120 lakhs accumulated by 30 years, at 8% compound interest, and annual contribution rising at 5% from year to year, the investment in Year 1 would have to be (120/200) = 0.6 lakhs (60,000) per year (on the basis that it would multiply cumulatively to 200 times as per Westbrook’s Table 6.2). As a percentage of income, this amounts to (60,000/240,000) = 25% or one-fourth of the income at the first year. If we wanted a nest-egg of 150 lakhs (more realistically!), then investment at year one would have to be (150/200) lakhs= 0.75 lakhs (75,000), which forms (75/240) = 31.25%, or say a round one-third, of the annual income now, to rise at 5% (3750) from year to year.

There are many further issues that we have to consider.

One is the assumption that a young person can get by with expenses of only 10,000, or half our assumed income of 20,000 a month. Even then we saw that investment at 25% of the income would cover retirement with no shortfall in expenses, leaving another 25% (for extra savings and earlier retirement!). Perhaps you have higher salaries and expenses. Westbrook’s tables give you the flexibility to anticipate a range of scenarios, and moreover to do this at any stage of your career to check whether you are on track.

Which brings me to a second issue, which is that our idea of a reasonable life style may change over the years, so that a monthly expenditure of 50,000 or more (in today’s prices) may be the rock bottom we expect by retirement (as against 10,000 at the start). The hope is that we will not be perpetually at the bottom of the salary ladder (20,000 per month today in our scenario), but will move up in time to higher salaries in today’s currency (not just to compensate for inflation, but by actually moving to a higher level in the hierarchy). Government careers consciously provide for at least three such jumps in a lifetime for subordinate services, and as many as five or six for higher services (the top salary for government servants in India is Rs.80,000 per month, or some 135,000 with cost-of-living or dearness allowances – before taxes take away 20-25% of it!). If the present job is not going to take you there, another way is to go and get better educational or professional qualifications so that the type of job potential expands. The author posits that after retirement, monthly expenses do come down to some 65% to 75% of your working life expenditures. He gives detailed formats which you can use to compute all these things.

Westbrook gives a rule-of-thumb for young persons starting off in the career world to save up to 15% of the salary every year, which is a bit lower than I have derived (25 to 33%). His assumptions are an 8% interest rate, 3% increase in amount invested year to year, 3% inflation rate (as far as I can make out), retirement at 65 years age, and income required after retirement around 65% of last income before retirement (replacement ratio). We in India may have to count for higher inflation, lower increase in salaries, maybe retirement at an earlier age, and higher replacement ratio, on the assumption that our salaries aren't that generous to start with. Plus we may have bigger responsibilities to family (old parents, children still requiring support), whereas these things don't figure very much in Westbrook's calculations. Hence my estimate of 25 to 33% is probably safer, and anyway it's always advantageous to build up a corpus early and let compound interest do its work.

Another issue is that the nest-egg of 120 lakhs or 150 lakhs we have built up at such great lengths above is itself going to be losing value with inflation, so that our fixed interest income of 8% is going to look less and less satisfying as the years go by. That means that either we have to start digging into the capital from some later year, or that our nest egg should be a little bigger so that part of the interest could be ploughed back. That’s where the 25% cushion we worked out above should be going! You also need to find the extra savings to meet costs of buying a house if required (down payment and monthly mortgage installments), or for other major foreseeable expenses such as weddings, education, medical, etc. The book has tables to show the trajectory of the corpus with an annual withdrawal of 3%, which can be used before or after retirement.

Of course, everybody toys with the idea of making it big in business, but the game there is different: as I understand it, your efforts have to result in something that sells in large numbers, thereby multiplying the profit margin by many zeroes. I’m not sure I have that type of talent --  maybe those who design games are trying that mode. Another possibility is that instead of selling only your own services (one labour person), you become a contractor organizing the work of a hundred persons, and take a commission out of their efforts (body-peddling?). Somebody (Soros?) wrote that he would rather take a dollar off each of a hundred workers (i.e. be an entrepreneur) than work himself for a hundred dollars (be a slave to a salary). An example is the choice between giving tuition to a few kids yourself in one subject, or setting up a tuition enterprise with a dozen collaborating tutors covering many subjects and levels (maybe even developing a web-based coaching solution that covers all bases). The transition from the lone worker to an enterprise is fraught with difficulties, including the issues of adhering to laws and regulations, fulfilling contractual obligations, etc., and is not for those looking to reduce commitments. Well, it’s your life, and you know best; but as “Rich Dad, Poor Dad” advice in one of their many books, don’t be in a hurry to give up your day job as you try setting up your own enterprise! The best scenario would be that you build up an enterprise and then sell it for a few million dollars to Rich Dad!

Westbrook ‘s book has a whole shoal of other useful information, such as life expectancies, insurance cover, portfolio management and shares, real estate, relocating and holiday homes, old age homes and nursing care, estate duties and inheritance taxes, pension funds and the IRA (Indian income-tax rules seem almost laughably simple by comparison!), and many many other things besides. The book  (Saving for Retirement, Wiley, 2003) is classified at Dewey Decimal 332.024’01 WES in my personal library (the number for Personal finance / Planning for retirement), in case you want to find it in one!