FLM Step 15: Pinyo from Moolanomy talks about securing your financial future

4/15/2009

In honor of Financial Literacy Month, we created a microsite that offers 30 simple steps to financial wellness–one for each day of the month. To enrich the experience, we asked some amazing people to guest post during the month on a topic that is related to the day’s step. Their dedication to financial literacy is truly inspiring! Today, Pinyo, the primary writer of Moolanomy personal finance blog, talks about securing your financial future.

If you have been reading through the first 14 days, you should have a good grasp on ways to improve your finances and clean up any past mess. Now, it's time to look to the future and see how you can save for retirement, secure your financial future, and enjoy your golden years.

In case you skipped a few days, it's a good idea to eliminate your non-mortgage debt before you start saving and investing for retirement.

Why Do You Need To Save For Retirement

Well, you don't want to work for the rest of your life, do you? And if you haven't noticed, Social Security will not be enough for a comfortable retirement. This means you'll have to take charge and control your own destiny. The way to do this is to understand what you'll need and design a financial plan that makes retirement possible.

How Much Do You Need To Save

The first step in retirement planning is determining how much you'll need. A general rule of thumb is you'll need 80% of your current income to cover your expenses. You will have some new expenses like higher healthcare costs, more frequent trips with your buddies, money for grandchildren, etc. But you won't have some usual expenses either -- e.g., mortgage payments, commuting costs, saving for retirement, etc. Remember this amount is in today's dollars so you'll have to factor in inflation. For example, 30 years from now you'll need $x to cover $50,000 a year expense in today's money assuming inflation increases at 3% per year. Here's how the calculation is done:

Amount Needed = Income needed today * ((1 + inflation rate)^ Number of years to retirement)
Amount Needed = $50,000 * (1.03 ^ 30)
Amount Needed = $121,363

Impossible? Not at all. A good financial plan will allow you to meet this need without problem.

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Saving and Investing For Retirement

So how much do you need to save? Actually, that's not the right way to look at it. The correct way to look at this is how you can generate $121,363 a year in passive income (i.e., involving minimal work). Oh by the way, this is your first year figure, the amount increases each year due to inflation. Here's an example to explain what I mean about cash flow.

Fixed-income portfolio only -- Let's assume are planning to rely solely on a fixed-income investment portfolio to support your retirement income, and assume that your portfolio yields about 4% per year. You'll need approximately 25 times the annual income requirement in savings to generate enough cash flow without digging in to your principal. This amount is approximately $3 million.
Fixed-income portfolio with real estate -- Now, let's assume that you own a rental property which will net you $2,000 per month, or $24,000 per year. This will lower your annual income requirement to $100,000. As a result, you can live off a $2.5 million portfolio plus rent.
Fixed-income portfolio with multiple passive income sources -- Lastly, let's assume you'll have additional $1,000 per month from pension and another $1,500 from annuity. These further reduce your annual income requirement to $70,000. As a result, you can live off a $1.75 million portfolio if you have additional income from rent, pension, and annuity.

What I am trying to demonstrate here is that it's all about passive income generation, and not how big an investment portfolio you'll need. Please note that these examples do not include taxes, so you'll need more than the examples shown above.

How To Save For Retirement

But you may ask "how on earth am I going to save $1.75 million?" Well, here's a basic plan that can get you there.

Contribute $___ per month.
Start with ___% in equities and shift ___% per year to fixed-income investments (to reduce risks and preserve your principal).
Rebalance your portfolio once per year.

Scenario 1: Basic Plan

Save $1,800 a month for 30 years
Start with 85% in equities and shift 2% per year to fixed-income investments -- ending with 27% in equities by retirement age.
Net savings is $1,741,369

Scenario 2: Give it more time

Save $900 a month for 40 years.
Start with 100% in equities and shift 2% per year to fixed-income investments -- ending with 22% in equities by retirement age
Net savings is $1,760,785

Scenario 3: Strive for better return on investment

Save $1,500 a month for 30 years
Assuming 10% ROI on equities instead of 8%
Start with 85% in equities and shift 2% per year to fixed-income investments -- ending with 27% in equities by retirement age
Net savings is $1,740,059

Scenario 4: Give it more time and strive better return on investment

Save $675 a month for 40 years
Assuming 10% ROI on equities instead of 8%
Start with 100% in equities and shift 2% per year to fixed-income investments -- ending with 22% in equities by retirement age
Net savings is $1,749,590

As you can see here, there are a lot of ways to get the same result. And you should notice that the earlier you start, the easier it is to accomplish your retirement savings goal.

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Where To Keep Your Money

Now the question is where should you save and invest your money. Luckily, our government wants you to save for retirement and offers several tax-advantaged plans. Here are the top retirement savings vehicles:

401(k) Plan -- If you work for a relatively big company, your employer probably offers a 401(k) retirement saving option either in addition to, or in lieu of, a pension plan. 401(k) allows you to save up to $16,500 in pre-tax dollars, with a $5,500 catch up contribution limit if you are 50 or older. You can withdraw money after you reach the age of 59 1/2 without incurring any early withdrawal penalty. Any amount withdrawn will be taxed at your then current tax rate.
Traditional IRA -- An IRA is a self-directed retirement account that you can open at any financial institution. You can contribute up to $5,000 in pre-tax dollars, with a $1,000 catch up contribution limit if you are 50 or older. You can withdraw money after you reach the age of 59 1/2 without incurring any early withdrawal penalty. Any amount withdrawn will be taxed at your then current tax rate.
Roth IRA - This is similar to Traditional IRA but you are contributing with after-tax dollars and your withdrawals are tax-free.

There are many more retirement investment options and you should do your research before choosing one, or a combination, that's most suitable for your needs.

Here are a few more relevant articles:

Hopefully, this information is helpful enough to get you started with retirement savings, investing, and planning, but not too overwhelming. Please enjoy the rest of the Financial Literacy Month and don't forget to stop by my blog at www.moolanomy.com.

Pinyo is the owner and primary writer of Moolanomy personal finance blog. To get more practical financial information that you can use, please visit his blog at www.moolanomy.com.