You know what I’m talking about. It’s the number you think about more than you care to admit. No, it’s not your weight.
It’s the amount of money you think you will need to “retire” at any age – by which I mean not having to earn an active income from your job or your business for the rest of your days on earth. Now I’m definitely not saying the number should be the goal, as its more important to enjoy the journey. But that journey may not be commercially viable, so its nice to know what a sufficient number is, right?
Spoiler alert – it’s probably more than you think.
How do we calculate this number?
Let’s start with the 4% rule
Most financial advisors will tell you that a good rule of thumb to determine how much capital you will need in order to “retire” is the 4% rule.
Developed by William Bengen, a financial planner from MIT, the 4% Rule is based on a study that concluded “retirees” can safely take 4% of their initial retirement assets, and then increase that amount every year to account for inflation.
For example, say you have R10 million saved. Applying the 4% Rule, you would withdraw R400,000 per year, every year during “retirement” while increasing the initial number up annually to match inflation. Bengen’s study assumed a portfolio consisting of 50% to 75% stocks and the rest in bonds.
A study by Bengen published in 1994 found that even under the worst possible scenario, a nest egg subject to the 4% Rule would last 35 years. In nearly 80% of the scenarios, however, the money would last more than 50 years.
More recent studies have shown similar results. Even accounting for events like the bursting tech bubble of the early 2000’s and the financial crisis of 2009, the 4% rule is still relevant. One recent study found that over the last 80 years, even in the worst scenario, the money would only run out in 29 years if you stuck to the 4% rule.
I’m actually more interested in flipping the 4% rule around to find out how much money I need to retire. If I know what my annual income needs are, I multiply that number by 25 to get the capital amount I would need to have to be able to just chill out.
For example, if I needed R50 000 per month (or R600 000 per year) to get by, I would need to have capital of R15 000 000 before I could leave the daily grind.
Whoa!! That’s actually quite a lot. While it’s debatable whether you should include your primary residence in this figure, I don’t think you should – you have to live somewhere. Rather, I think this figure should only reflect the investable assets that can earn you an income.
Whoa!! Now that’s really a lot. And that’s before taking into account some of the unforeseen costs and mistakes we are prone to making during this whole process.
So here are my tips to help make sure you don’t miscalculate how much you need for this whole retirement thing and land up being unable to afford Netflix (heaven forbid) or being forced to head back into the workforce in your golden years.
Tip #1: Don’t underestimate your monthly cost of living
A few weeks ago I was having a discussion with a friend of mine. I asked him how much he thought his monthly expenses were on average. He said he was pretty good at budgeting and confidently gave me a number – one that I thought sounded way too low.
Hang on a minute, I said to him, have you included the cost of all those trips you have been taking and are planning? How about that new bicycle and all the wedding and birthday gifts you’ve been buying? What about that renovation you are planning? A few days later he came back to me and said he had probably underestimated his actual expenses by about 30%, mostly because he hadn’t accounted for the “once offs”.
A 30% underestimation in expenses makes a big difference to the amount of capital you need to retire. So instead of R50 000 per month, your expenses would actually be R65 000 per month (or R780 000 per year). That means you actually need R19.5 million capital in order to retire (based on the 4% rule). That’s a big difference.
When calculating your monthly expenses, it’s really important to factor in these “once offs” by averaging the annual cost over 12 months.
Tip #2: Factor in SA specific issues
Most of the empirical testing on the 4% rule has been done in the US. However, if you live elsewhere, it’s really important to factor in country specific issues.
The first of these for many emerging market countries, like South Africa, is the higher inflation rate. Even a 4% annual inflation rate turns an initial R40,000 monthly expense into R130,000 forty years later. While it’s true that we typically enjoy higher interest rates too, most of your investments will be in the stock market, so there is a chance that the returns we earn won’t compensate for the higher inflation rate.
This means that it may be tough to hold onto the 4% rule and keep the same standard of living. So it’s really important to factor inflation into the mix when figuring out how much you really need to retire.
Another consideration relevant to South Africans is remembering to factor in possible currency movements when calculating your investment returns. If, like me, you believe it’s prudent to invest a significant portion of your assets offshore, you have to take currency movements into account when calculating your return for the year. If the Rand strengthens considerably in a given period, your Rand returns from your offshore investments would be negatively affected.
One option to counter this is to ensure you always have enough invested in South Africa to be able to draw income from those investments in order not to lock in your currency losses.
So when calculating how much capital you will need, make sure you make allowances for these variables.
Tip #3: Many happy returns? Not always.
I don’t care how good an investor, businessman or judge of character you think you are – somewhere along the line you are going to makes mistakes and get burned. Whether it’s buying Bitcoin at $16 000, acting on that pipe dream to start an artisanal gin bar, investing in a tech focused venture capital fund, acting on a tip to buy Steinhoff shares or making a loan to your Uncle Stu for his sure-thing solar wind farm, you are more than likely going to make a sizeable mistake and lose a chunk of your money at some stage.
In addition, the results of research done by Dalbar Inc., a company which studies investor behaviour and analyses investor market returns, consistently show that the average investor earns below-average returns. For the twenty years ending December 2015, the S&P 500 Index averaged 9.85% a year. A pretty attractive historical return. However, the average equity fund investor earned a market return of only 5.19%. This is mostly due to illogical investor behaviour, like panicking during a market sell-off or chasing past performance.
Finally, you need to take fees and taxes into account.
South Africa has some of the highest investment and advisor fee structures in the world – which when combined can be as much as 5-6% of you assets every year. This means that even though the funds you are invested in may technically have shown a 10% return in a given year, after fees you’re only netting 4-5%. Then you still have to subtract the taxes on interest, dividends and any capital gains.
The 4% rule has been tested based on market returns, not investor returns. Once you factor in investor behaviour, fees and taxes, you can probably cut those market returns in half – making the 4% rule a little iffy.
Where does that leave us?
So given all possible pitfalls listed above, I’m thinking that applying the 3% rule may be more prudent. That means that my friend with the R65 000 a month living expenses should aim to have around R26 million in capital before he can hit the fairways or the bike trails for good.
Below is a table to help you get an idea of how much capital you would need to be able to retire.
|Monthly expenses||Amount of capital needed using 4% rule||Amount of capital needed using 3% rule|
|R25 000||R7 500 000||R10 000 000|
|R40 000||R12 000 000||R16 000 000|
|R60 000||R18 000 000||R24 000 000|
|R100 000||R30 000 000||R40 000 000|
|R150 000||R45 000 000||R60 000 000|
More than you thought, right?
Well, it may be, but I firmly believe that anyone can achieve this by a)getting smart about how you spend and invest and b)redefining your expectations of “retirement”. We can explore these themes more in future articles.
In the mean time, back to work then!
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.