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

Last week we began considering models for computing our retirement number. Specifically, we took up the simplest of the models that we called ‘Retirement Number 101’ and also identified some of its weaknesses. Today, we will take up ‘Retirement Number 202’ to try to improve on some of the assumptions made in 101.

‘Retirement Number 202’: In 202, we want to see how we can improve the quality of our prediction by factoring in inflation and investment growth.

In trying to capture the likely impact of compounding on inflation and investment returns, we should not be ‘scared’ of the ‘large numbers’ that may be thrown up. For those of my generation, whom I define as those born between 1960 and 1975, we can cast our minds back a few decades and recall that our parents bought new vehicles in the 1970s for N5,000.00. But the basic of new vehicles now cost tens of millions of Naira. Similarly, assets such as farmlands and residential property that our grandparents bought for a few thousand Naira are now easily worth hundreds of millions of Naira.

My point is that inflation is real and can make things a little more difficult, but it doesn’t stop people from doing what they may need to do. On the other hand, incomes and returns on investment opportunities can and do beat inflation.

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Let us now return to the exercise we had last week. 

1. We still assume that you are 45 years old and that you intend to resign at age 65. Hence, you have 20 years to build the investments you need to see you through retirement.
2. We still assume that you will die at age 85, meaning that you will live for 20 years in retirement.
3. We used your current monthly budget of N300,000.00 as the yardstick of what you will be spending monthly in retirement. But we have agreed that this is not realistic both because of the differences in spending patterns between the young and the old and also because of inflation. This means that even if the same spending pattern is maintained, N300,000.00 today will not provide the same goods and services in 20 years.
4. To adjust the N300,000.00 to inflation, we will use average CPI YoY growth of 12.4% (according to CEIC Data between Jan 1961 and Dec 2023). Any decent calculator or simple application can do the computation. Otherwise, we can manually calculate it as: FA=SA(IRate%+1)^n

Where FA is the Future Amount, SA is the Starting Amount, IRate% is the Inflation rate in percentage, and n is the number of years.

Based on the above, the N300,000.00 in current Naira will be equivalent to N3.1 million in 20 years. Hence, to cover you for the further 20 years in retirement, you will need N745.9 million.

5. In the last example, we just took the absolute amount of your current N22 million investment as part of what you already have on the day you retire. But in reality, the investment you have now should grow by the time you retire. So, let us assume/target to achieve a compound annual growth of 14%, which, of course, will depend on your portfolio, its management and the economy over the years. At that rate, your N22 million will grow to N302.4 million in 20 years. Again, your calculator or application can compute this for you. You can also use the same formula above, replacing the inflation rate with the investment growth rate, GRate.
6. But you still need to cover a gap of N443.5 million (N745.9 million minus N302.4 million) of future Naira over the next 20 years that you will still be working. We can work backwards to get the Naira amount that should be invested today to cover that gap in 20 years. We can do that by reversing what we have done in 4 above, making SA the subject of the formula and replacing the IRate with the GRate. That is: SA=FA/(GRate%+1)^n

With that, we get N32.3 million as the amount that you will need in additional investments today that will cover the N443.6 million in 20 years.

Now while 202 tries to recognise returns on our investments and the impact of inflation on our future purchasing power, the model still falls short of certain realities, such as:

1. A flat rate of inflation is assumed. But we know that in reality inflation fluctuates over time, sometimes even becoming a deflation.
2. A flat rate of return on your investment is assumed. Again, we know that this is not realistic because like inflation, returns on investments fluctuate over time, sometimes even recording losses.
3. We assumed that the additional investment would be made today to grow over the next 20 years. But in reality, you are more likely to make the investments gradually over time.
4. We assumed that there is no further inflation from the beginning of retirement to death, just as we assumed that the investments at the beginning of retirement do not grow any further.
5. We still have not addressed the issue of additional income(s) in retirement and the ‘risk’ of living longer than the assumed 85.

Retirement Number 202 is more realistic than 101. Yet, we still have the above shortfalls. So, next week we will take up ‘Retirement Number 303’ to iterate further and hopefully better.