What to consider when planning your retirement goals
A retirement goal sets out when you plan to retire, how much you plan to have when you retire, and what standard of living that will enable you to achieve.
The starting point is to consider the standard of living you would like to have in retirement. For example, how often do you plan to travel? And what type of holidays will they be? Will you travel once a year overseas flying business class and staying in 5 star hotels, or perhaps three times per year within Australia travelling by car and staying in 3 star motels? Once you have worked out what standard of living you plan to have in retirement, you can calculate an annual budget. From the annual budget, you can make some assumptions about longevity and investment earnings. Then you should consider whether you are prepared to draw down on your capital or, alternatively, live off the investment income so you can leave an inheritance. Finally, you can work out how much you will need to retire. Then you can work out when it is realistic to achieve this level of savings.
The variables to consider are annual expenses, inflation, investment returns, longevity and social security. Because investment returns and longevity are unpredictable, it is important to consider what chance you are willing to take that you will run out of money. If you assume, say, 7 per cent investment returns and living to age 85, there is a 50 per cent chance that you will live longer and/or your investments will underperform your expectations. To have a greater level of confidence you might want to assume living to age 95 and earning only 5 per cent per annum (p.a.).
A great retirement goal would take these factors into account. It might be written as: I plan to retire at age 70 with investment assets of $1 million in addition to my home, and with no debt. This will allow me to spend $40,000 p.a. increasing with inflation, which will enable me to maintain my current lifestyle and have one overseas holiday every four years. It will also allow me to leave an inheritance to my children, which will comprise my home plus $1 million (inflation adjusted). In the event that my investment earnings do not earn 4 per cent+ Consumer Price Index, I will draw down on my capital and sell my home if required.
The typical mistakes people make are:
- They don’t allow for inflation. Some people assume if it costs them a certain amount to live today, then that amount will be the same in future years. In 20 years, with inflation of 2.5 per cent, living expenses will increase by more than 50 per cent. It is important to build in the rising cost of living.
- They forget about regular “One off” expenses. These can include holidays, home maintenance, car upgrades and large medical expenses. While each of these feels like a one off, you should expect that one of these will happen every couple of years and should therefore budget for it
- They underestimate how long they will live. The life expectancy for a typical 65 year old is another 25 years once mortality improvements are taken into account. This means half those people will live until they are 90. But many of them will live beyond 90 and even until 100. We should have a contingency plan just in case we do live until 100 as a reasonable proportion of today’s 65 year olds will reach that milestone.
- They assume future investment returns will be the same as past returns. There is a strong possibility that future investment returns won’t be the same as past returns. Whatever you think you will earn from your investments, assume, say, 2 per cent p.a. less and ensure you have enough to live in this scenario.
- They don’t monitor and adjust their goals. Retirement goals should be reviewed regularly as circumstances change.
- Once in retirement, they invest too conservatively. Most people will be retired for more than 25 years. Therefore, they should have a long term horizon when investing. People who run out of money will usually do so because they lived too long not because the sharemarket fell. In fact, putting all your money in the bank is more likely to result in you running out of money because, on average, you are likely to only earn a return in low single digits each year on your funds.