This is probably one of the most talked about retirement questions. The reason is simply that no-one knows what the future will bring and there is so much unpredictability that it’s impossible to be for sure. There are a few theories and ideas around this but for each of us it will slowly become clearer as we get older. That of course might be too late so we need to start making plans now, even if they aren’t exactly perfect. See my thoughts on a retirement plan in uncertain times.
Thankfully there’s a simple and relatively sure way to work out your retirement figure, but it will change over time and it’s something worth looking at each year or so.
Note: I’m not a financial advisor and I’m definitely not saying that this is the exact calculation you need to do. This is simply one of many things you should consider and “play” with as part of your financial plan.
Firstly, your expenses
A big aspect of retirement is the fact that you’ll still have all your day-to-day expenses, but without your stable income. You may have other forms of income which we’ll discuss later, but for now let’s look at your expenses.
I have a spreadsheet which lists my monthly expenses in 3 categories:
- Compulsory deductions off my payslip which are not tax or pension related. In my case it’s things such as Group Life Cover, Funeral Cover & Disability Insurance and Medical Aid.
- Automated payments from my bank account or credit card such as subscription services, insurances, property rates, security, etc.
- A summary of my monthly budget. I don’t duplicate all the details from my budget, but you can if you want.
You can draw up your expenses in any way that makes sense to you.
Then, alongside each expense I have a column of what the expense will be when I’m retired. I’ve actually done this for my partner and I as a combined calculation even though we’ll more than likely stop working at different times. I’d rather overcompensate just to be safe and doing it as a couple also helps me plan better.
As an example, I won’t need to pay the compulsory insurances when I retire as I have my own life & disability cover. Also, I won’t need to buy work clothes once I retire so that portion of my budget can be reduced a bit. Our groceries would remain the same and most other items would be unaffected.
As far as housing goes, we currently have a bond which would definitely be paid off before either of us retire. I wouldn’t even vaguely consider retirement if we had any debt at all. So I don’t take this into account as an expense and I don’t think it’s wise to take debt repayments with you into retirement.
At the end I have two figures for expenses. One is our actual monthly expenses as they are now (let’s say R22,000 as an example) and the other is our expenses after retirement (perhaps R19,500).
If we take the after retirement expenses and multiply it by 12 we’ll get the annual expense figure which we’ll use as an example throughout. R234,000.
Do this yourself to get your annual expense figure as it will probably be totally different from this example!
The rule of 25
An interesting personal finance number that you may have heard of is “the rule of 25”. Let’s take the R234,000 annual expense figure from above and multiply it by 25.
This gives you R5,850,000 (5.8 million) which is the amount of money you should have invested if you want to retire.
Now think of this…. the less money you need to live off, the less you need to invest, the sooner you can retire. Are you feeling inspired yet to start some calculations?
How does the Rule of 25 work?
This is by no means an exact science and it’s really a bit of a “rule of thumb”.
If you have a lumpsum invested and you withdraw your annual expenses needed at the beginning of the year, the rest of the money will obviously grow at some unknown rate. Let’s say you withdraw exactly what your annual expenses are (it will be 4% of your investment) and each year you withdraw 4% more to cater for inflation. You can make your money last for 25 years if you are earning just 4% growth per year on your money.
That’s all fine and well, but 25 years may not be long enough. Especially if you’re considering retiring early, or if longevity is in your genes. Also, 4% inflation isn’t necessarily a valid figure in South Africa and hopefully one can get a better growth rate than 4% – especially for a long-term investment!
And this is where the “playing around with numbers” comes in. I created a little spreadsheet which you can download and you can see what changing the inflation figure and the annual growth will do.
Obviously the higher the growth and the lower the inflation the longer your money will last. But we cannot predict these things!
The “rule of 25” works alongside the “rule of 4%” whereby it’s assumed that the average annual growth is 7% and the average annual inflation is 3%. Using these figures your money will last you more than sufficiently. South Africa’s inflation rate is closer to 5% though and the 3% figure is really not a good assumption. Have a look at our historic interest rates here – last time we were close to 3% was in 2010 and the year after that it doubled!
I use an inflation rate of 6% along with a growth rate of 7%. This predicts that my money will last 28 years and thus I’ll need a little more than just 25 x my annual expenses.
Creating Income Streams
There’s unfortunately not much that you can do about inflation and growth on your money – unless you’re the Finance Minister and are able to change economic policies! LOL
But, something you can certainly control are your expenses and your passive income streams. If you can bring your expenses down, you’ll need less money to retire. And if you can create some sort of passive income that will bring in money while you’re retired, that will also make it better.
I haven’t ever experienced true passive income where you literally do nothing for your money. So when I talk about passive income I expect a few hours work here and there. Think about a rental property for example, you’ll have some admin to do, tax returns, finding a tenant, inspections and property maintenance. It’s a great form of passive income, but there is still a little bit of work involved. That’s fine though as it’s something you can do when you’re retired or you can pay someone to manage it.
In the spreadsheet you can download you’ll see a section for annual passive income. This will reduce the lumpsum you need invested before you retire as that income can be used towards your expenses.
Known future expenses
Something else to consider are any known large upcoming expenses. If for example you plan to travel when you retire, you may want to factor that into your figure. Same goes for if you plan to buy a new car or a fancy yacht. Obviously you’d want to keep your expenses as low as possible during retirement but if you plan for things upfront you could potentially make it all work out!
Although this is an interesting calculation to play with, it’s by no means exact! Higher inflation rates and lower growth can mess this up very quickly!
Planning for your retirement is something that you should be looking at annually. Each year your investments would have grown, you’ll know what your expenses have been (and hopefully you’ve reduced them) and you’ll have a better idea of what you need and how to do it. You may also have changed your mind about what is important to you for retirement and perhaps you’ve realised that you can live off less.
It’s important to note that the retirement figure you calculate with the “rule of 25” is the amount of money you need to have invested. This excludes assets such as cars or the property that you live in. You might live in a R1 million house, but you can’t withdraw money from it unless you sell it! So it adds to your Net Worth but not to your cash flow.
You should probably also discuss your thoughts and calculations with a financial planner who can look at your finances holistically and help you understand what all needs to be taken into account when looking at your future retirement. I can recommend someone if you need, just send me a message.
Share your thoughts and comments!