Hands up all those who want to rely on the age pension in retirement. Of course you don’t – so that means you need to fund your own retirement. It may not seem fair after paying taxes all your working life – but it is necessary for financial independence.
Now people can expect to work for around 35 years and spend 25 or more years in retirement. It’s a big change.
More people are now starting their working life later after tertiary education, retiring earlier (many because of redundancy) and living longer.
It all adds up to a shorter working life and much longer retirement – especially for women having children.
The longer retirement still needs to be paid for, but in a shorter working life.
There are three steps to financial independence in retirement:
1. Estimate the annual income you need in retirement in today’s terms
2. Work out the amount you need to invest to generate your desired income level
3. Calculate how much you need to save each year in order to accumulate the necessary capital.
There are only three steps – but Mrs Kingston says the end goal can usually only be achieved by saving consistently across your working life.
1. Retirement Income
Everyone’s needs are different, but Mrs Kingston suggests that the minimum income for a couple in retirement to give a degree of financial comfort is $35,000pa before taxation. This income level assumes that you own your house and have no debt, other than for investment purposes.
Annual household income of $35,000 equates to around $500 weekly after tax if the income is earnt by one person.
Strategies such as income splitting can make the $35,000 go further after tax – and are certainly something to consider carefully if you are approaching, or are in, retirement. Seek professional advice in planning and implementing such strategies.
Note that as you get older, expenditure patterns will probably change. The amount you spend on health maintenance may well increase, as will the amount spent on services such as cleaning and gardening. Widows, in particular, may find they need to spend money on tasks they or their husbands previously undertook.
Indeed, part of the attraction of retirement villages is the low maintenance work level required. Other attractions include security and camaraderie.
We all lead different lifestyles and have different income requirements. Think carefully and seek professional assistance when determining this figure because it drives all other calculations.
2. Capital Amount
How much capital do you need to have in order to produce your desired annual income? This depends on several factors, including:
• how long you expect to live
• the return on capital you expect (after inflation)
• whether you expect to draw down capital.
The key issue is whether you are expecting to draw down capital in retirement. For most of us this will be necessary – but it means that we are effectively gambling on how long we will live.
You may be beyond caring by then, but the thought of running out of money in old age is not very pleasant.
As Mrs Kingston notes, capital draw down involves the SKIN principle – Spend the Kids’ Inheritance Now.
According to Mrs Kingston, a reasonable rate of return to use in calculating capital requirements is 5%. So, to achieve an annual income of $35,000, $700,000 would need to be invested.
The attached table shows capital requirements for various annual income levels and real rates of return.
Note that the term ‘real rate of return’ means the return after inflation, and using it allows us to talk about future income amounts on a level footing with those of today.
If you are planning to draw down capital, the calculations are a lot more complex and also depend on for how many years you want to receive the income level.
Matters are complicated because capital drawn down is not taxable – so the original investment would provide a consistent level of after tax income for a longer period of time.
Furthermore, as capital decreases you may become eligible for some age pension payments which will supplement your income.
Advisers can provide expert assistance in calculating the amount of money you need to fund retirement.
3. Accumulating Capital
This is the toughest step of all and usually seems pretty daunting – but thankfully there is some good news.
Money put aside now will benefit from the power of compound interest. To illustrate, and assuming zero taxation, $1 invested at 5% would be worth $1.05 after one year, $1.63 after 10 years, $2.65 after 20 years and $4.32 after 30 years. At a 5% real rate of return and with no taxation, every $1 saved now will be worth 4.3 times as much in 30 years.
Suddenly the amount of capital needed doesn’t look so daunting. For example, an investment of $163,000 today that generated a 5% real rate of return would be worth $700,000 in today’s terms after 30 years.
The second piece of good news is that while you generally need to pay tax on your returns, the rate of tax on superannuation funds is just 15%. That is probably a lot less than the marginal rate of tax you are used to paying.
Expert help is needed in determining how much money you need to set aside each year for your retirement – but the key really is to consistently set aside as much as possible. The longer before retirement you invest the better.
Mrs Kingston says: “compulsory superannuation is definitely NOT enough – particularly for women”. She advocates consistent additional saving to enjoy a financially independent retirement.
Achieving the desired level of income in retirement is something that is worth putting time and money into now.
Picture yourself as a 75 year old thinking how much every dollar you put aside as a 45 year old would be worth to you now. Wouldn’t you rather reflect upon how wise you were in actually putting the money aside, than rueing the fact that you didn’t?
Planning now and taking advantage of professional advice will gain a comfortable and lucrative retirement.
