Question

Is $1 Million Enough to Retire?

This headline is from a recent popular business publication. The answer as to how much you need to retire can be calculated using the time value of money tools. Describe in detail what steps you would take to calculate the amount needed. Remember to state what time value tools you should use.

Answer 1

1. Split current monthly expenses into two
The first step is to calculate how much your expenses will be in retirement. Draw up a list of your total expenses. Most regular expenses such as grocery and utility bills, clothing, gifting and house maintenance will continue even after retirement.

However, several other expenses, such as travelling to work, professional clothing, home loan and children’s education expenses are likely to stop by the time you retire. So, conssider only the regular items when computing your monthly expenses in retirement.
Experts say you should be pragmatic while calculating the total expenses. Your medical expenses may go up significantly during old age, which may nullify the savings from other expenses. “Instead of coming down, your expenses may actually go up during retirement years due to jump in medical expenses. So it’s better to take the current expenses only as the benchmark,” says Vikram Dalal, Managing Director, Synergee Capital Services.

“Ideally, expenses during retirement age should be equal to the current regular expenses,” says Anil Lobo, India Business Leader – Retirement, Mercer. Besides, many of the outgoing expenses get replaced by new ones, such as transport assistance and gifting. “We have noticed that the travel related expenses (travelling to religious places, relatives’ houses) also increase after retirement,” points out Rajan.

2. Calculate expected income after retirement
The next step is to calculate your total income from all sources. Whether it is pension from the company, pension under the EPS from EPFO, income from any insurance plan or pension policy, include all such incomes in the calculation. Similarly, include income from property that you expect to continue in your retirement. Since we have computed retirement expenses under Step 1 at current values, consider the pension based on current salaries only.

3. Calculate net income needed in retirement
Next, calculate the net requirement by deducting the value in Step 2 from the value in Step 1. For instance, if your expenses are Rs 60,000 a month and expected income is Rs 26,000, you need Rs 34,000 more.

4. Calculate the future value of the additional income needed during retirement
The additional income needed may appear small now. However, it will increase with time due to inflation. Though the current headline inflation is below 3%, experts advise investors to use the long-term average of 6% in their calculations.

“Instead of taking current low inflation, one needs to take long-term historical average for calculations like this,” says Lobo of Mercer. We have used 6% inflation, the average for the past 10 years, in our calculations. Even at this modest rate, a monthly expense of Rs 1 lakh per month will balloon to Rs 5.74 lakh in 30 years and to Rs 32.99 lakh in 60 years. The calculation in the table below is based on a monthly expense of Rs 1 lakh. Multiply the number with the actual value derived in Step ..

If current expense is Rs 1 lakh, how much will you need in future

Note: Calculation assumes 6% inflation per year; figures are for monthly expenses of Rs 1 lakh; multiply with actual value if different.

If your age is somewhere in between, use this formula.
Future value = net income needed x (1+inflation) ^ number of years till 60.

5. Calculate the retirement corpus needed at 60
Calculating the retirement corpus needed at 60 is a bit complicated, because it depends on the life expectancy, asset allocation and the returns expectations considered for different asset classes. “Since life expectancy is increasing on a regular basis now, everyone should plan for a longer retirement age,” says Balram Bhagat, CEO, UTI Retirement Solutions. “Ideally, one should plan till the age of 90 years,” says Krishnan. We have considered a life expectancy of 90 years in our calculations.

The standard practice of getting out of equities and moving to the safety of debt immediately after retirement is no longer applicable. This is because the retirement corpus now has to last nearly 25-30 years after the person stops working at 60. Therefore, one needs to maintain a significant exposure to growth assets such as equities even after retirement.

“People should gain from the power of compounding. Even a small increase in return due to increased equity exposure will be big in the long term,” he says. How much should be the equity allocation after retirement? Most experts suggest that the thumb rule of 100 minus your age should be followed even after retirement. This means one should have 40% exposure to equities at the age of 60 years and at least 30% allocation to equities at the age of 70. We have used the 100 minus your age rule for ou ..

The third element here is the return assumption for asset classes like equity and debt. Though most equity funds have generated low or negative returns during the last one year, we can’t take that as the benchmark. Instead, we should go with long-term average. “The Sensex has generated around 14% return in the long term. On a conservative basis, one can assume 12% returns from equities in the long term,” says Lobo.

Required retirement corpus at 60
Since the required retirement income will be more for younger investors, they need to save more.

Similarly, the return from debt funds and bank FDs are also down to around 7% now, mostly because of the prevailing low inflation. But fixed income products have generated better returns in the past. Since their long-term average returns are around 8%, we have used that in our calculations. With inflation assumed at 6%, a 2% real return from debt is reasonable.

The graphic above shows how big a corpus is required to fund an individual’s retirement. If someone is 60 and needs an additional income of Rs 1 lakh per month, he will need a retirement corpus of Rs 2.57 crore to sustain till 90 years. Multiply your value from Step 4 to know your actual requirement. Don’t get upset if you see a very large figure here. The requirement will be higher for younger people because inflation will compound their expenses. “But young people have long time (20- 30 years) to create this corpus also,” says Sumit Shukla, CEO, HDFC Pension Funds.

6. Find out how much have you accumulated
Most people would have also accumulated some corpus dedicated for retirement through various instruments (EPF, PPF or NPS or other investment). Add all these up to know how much is your current corpus for retirement.

Saving for retirement

• EPF
• PPF
• NPS
• Bonds
• Pension plans
• Equity funds
• Debt funds
• Bank deposits
• Ulips
• Insurance policies
• Others

7. Calculate how much your current retirement corpus will grow to
The next step is to calculate how much will the current corpus grow to. Due to the power of compounding, the growth will be higher for younger people. The final value will depend on the asset allocation. Growth will be higher if your retirement corpus is loaded with equity-oriented instruments (equity funds, stocks, hybrid funds, NPS with high equity exposure).

The calculation in the table is based on Rs 1 lakh; multiply with your actual value got in Step 6 (with 15 if it is Rs 15 lakh; with 5 if it is only Rs 5 lakh). Keep in mind that this is based on an asset allocation of 100 minus your age rule . If your asset allocation is significantly lower, you need to compute it separately. The formula to be used for each investment then is:
Future value at 60 = Current corpus * (1+assumed return) ^ number of remaining years

How much will Rs 1 lakh grow to when you are 60 years old

8. Calculate the additional corpus needed for retirement
Once you calculate the total retirement corpus needed at 60 and how much your existing corpus will grow by 60, computing the additional corpus required is easy. Just deduct the value derived in Step 7 from the value in Step 5.

9. Calculate how much is required to be saved per month for additional retirement corpus
As we mentioned earlier, there is no reason why youngsters should get worried if the calculation throws up a big fat requirement. They have a long time to save and grow the required corpus. As the chart shows, generating a corpus of Rs 1 crore by the age of 60 is not difficult for a young person aged 30-35. The power of compounding works in their favour. The values given in the chart are for generating Rs 1 crore; multiply with your actual value got in Step 8 (with 2 if it is Rs 2 crore; with 5 if it is Rs 5 crore).

Additional investment needed per month to generate Rs 1 cr at 60 years
If you don’t start early, you may find it difficult to generate the required retirement corpus

10. Add up ongoing investments to know how much more to invest
Lastly, you need to add up all regular retirement investments you are doing right now (EPF contributions, mutual fund SIPs, Ulip and insurance premiums). Deduct this figure from the value derived in Step 9 to find out how much additional contribution is needed per month. Please note that the value in Step 9 is arrived at based on an asset allocation of 100 minus your age. This figure of required investment would be higher for people who want to invest only in debt instruments.

Conversely, it will be lower for people who are willing to invest more in growth assets. An investor can change his asset allocation and increase the equity component if he is comfortable with the risk. While EPF contribution can’t be changed, you can reduce PPF or VPF contributions and divert that amount into equity funds. Similarly, one can increase the equity portion in the NPS.