Financial planning – How much do you need? (IV)

Over the last three weeks, we have been working to compute that magical quantum of investments that we need to have to live our chosen retirement lives. We are gradually iterating our way to successively ‘better answers’ by improving on our assumptions. Today, we will take up ‘Retirement Number 303’ and see how it can […]

Over the last three weeks, we have been working to compute that magical quantum of investments that we need to have to live our chosen retirement lives. We are gradually iterating our way to successively ‘better answers’ by improving on our assumptions. Today, we will take up ‘Retirement Number 303’ and see how it can improve the quality of the prediction made in 202.

You will recall that in 101 we simply took absolute figures and worked with them without taking inflation and investment growth into consideration. The surplus, S, or deficit, D, that you have at any point was calculated by subtracting the total expected/planned annual spending in retirement from the total of your investments. It was rather simplistic and, more importantly, unreal for the many reasons that we stated. However, it was a ‘first principle’ approach to beginning to understand the variables to consider in financial planning for retirement. In 202 we tried to improve upon the assumptions in 101 by taking likely inflation and investment growth up to the year of retirement. S or D was calculated by subtracting the total annual inflation-adjusted spending in retirement from total investments taking into consideration annual growth. Please, keep in mind the limiting assumptions in both cases.  In 303 now, we will try to make further improvements on 202.

‘Retirement Number 303’: Most retirees do get some one-off bulk payment at the point of retirement from their employers. These payments are called differently in different contexts, such as ‘handshake’, ‘gratuity’, ‘entitlement’, etc. In addition, retirees also get monthly pension payments from their PFAs that we discussed earlier and/or from their former employers as well. Depending on other personal plans that individuals do make pre- or post-retirement, they could also get dividends from companies they invested in; annuities from insurance companies and Funds Managers; or even salaries and allowances from post-retirement employment and services they may be engaged in providing.

In 303, we will take such benefits into consideration in establishing what surplus or deficits you may potentially have. Consequently, the previous formulae will be modified to

S =[├ A.(1+Gb)^n]┤+Bo+(12.N.Ba)-├ [12.N.SP(1+Ib)^n ]  ┤; (D, if S is negative)

The additional investment required today, AI, to cover the deficit, D, can be calculated as

AI=-1.D/(1+Gb)^n

Where A is your present investment holding (assumed in our working example as N22 million); Gb is investment growth rate before retirement (assumed at 14% p.a.); Ib is the rate of inflation before retirement (assumed at 12.4% p.a.); n is years to retirement (assumed at 20); N is years in retirement (assumed at 20); SP is projected monthly spending in current Naira (assumed at 300,000.00); Bo is one-off gratuity payment (assumed now at N10 million); Ba is monthly pension payment in retirement (assumed now at N92,916.67).

If we keep all the assumptions we made in 202 and put the two new variables in the formulae, your deficit will now be N411.2 million (instead of  N443.5 million in 202). This deficit will be covered by new additional investment of N29.9 million (instead of N32.3 in 202).

What is instructive here is that Bo (of N10 million) and the sum of Ba over your retirement life (of N22.3 million) add up to exactly N32.3 million, which is the amount you need to cover the deficit calculated in 202. Yet, there is still a deficit of N411.2 million. This brings out the impact of the time value of money in our financial planning. To arrive at the sum of N32.3 million in Bo and total Ba, so as to bring out this point, is my sneaky reason for using the curious figure of N92,916.67 as the monthly pension benefit you will be getting. Your S or D and the AI can be calculated in this modelling using the formulae above, Microsoft Excel or our online Simple Retirement Calculator.

By including gratuity and pension payments in 303, we have considered two more real-life variables (as long as you trust that your employer and the pension system will make the payments. Otherwise, make the two variables zero and work out what you need to invest today to cover yourself regardless of what your employer and the pension system do or don’t.) Despite the marginal improvements, 303 still has failures, specific of which are:

1. Your closing investment holding at the end of your working career will be the opening investment at the start of your retirement. On one hand, you can draw out of it gradually, and on the other, it should continue to grow over the rest of your life in retirement. However, we didn’t estimate the possible growth, meaning that we overestimated your deficit in our ongoing example.
2. Inflation will not stop simply because you have started life in retirement. Hence, we need to address that. The fact that we haven’t captured the likely impact of inflation post-retirement, means we have underestimated your deficit!
3. Both inflation and investment growth rates fluctuate over the years before and after retirement. Using flat rates is unreal. The net impact of the two will depend on which average is higher than the other.
4. For many people, gratuity payments are invested. However, we didn’t capture any possible growth by investing your gratuity, meaning that we overestimated your deficit.

Next week, we will try to see how the above shortcomings may be addressed in ‘Retirement Number 404’.