It is easy to postpone saving for retirement because it is far away in the future
and there are more pressing financial demands that have to be met. The intention
is to catch up on retirement savings later when there is scope for saving more.
But when retirement saving is started late, the amount of contribution that has
to be made to reach the required amount is much higher. In other words, the same
corpus will cost more.
Some important concepts of Retirement Planning
Need to apportion current income between current and future expenses
Individuals have to apportion their available income in their working years to meeting
current expenses and to saving for their goals, including retirement. A financial
plan will help identify the goals and quantify the amount required to meet the goals.
Once this is done, the savings available from the current income after meeting current
expenses is apportioned to the goals.
Importance of Budgeting
As mentioned earlier, the income or earnings in the working years is used to meet
current expenses first, and a part is saved and invested to create a corpus that
will generate income for the retirement years.
budget helps in prioritizing expenses and goals, given the expected income. It gives
clarity on what financial goals are realistically achievable given the available
income and level of savings.
Increasing Life Expectancy
The life expectancy at birth in India has gone up from 63.8 years in 2003 to 69.66
years in 2019 (Source: World Bank), and the trend is upward. Better diet, health
care facilities and lifestyles have contributed to this. While increased life expectancy
is a positive parameter for evaluating any population, it brings with it the risk
of longevity for retirement planning and the need to manage it.
Inflation and Time value of money
The concept of time value of money
Let’s take an e.g. with numbers
Suppose you need Rs.20, 000 per month today to meet the costs of living for his
family. If there is no change in expenses, will you be able to meet his family’s
cost of living with Rs.20, 000 per month 5 years hence? Assume inflation is at 5
percent.
You will need Rs.25, 525 per month to meet the same expenses 5 years hence. This
is because the cost of meeting the expenses has gone up each year due to inflation
at the rate of 5 percent per annum. The table below shows how the cost of living
expenses go up from one year to the next as a result of the effect of inflation
on costs.
|
Current (A)
|
Year 1 (B)
|
Year 2 (C)
|
Year 3 (D)
|
Year 4 (E)
|
Year 5 (F)
|
|
Expenses/Month(Rs.)
|
20,000
|
21000
|
22050
|
23153
|
24310
|
25526
|
|
Inflation ( percent)
|
5
|
5
|
5
|
5
|
5
|
5
|
|
Formula
|
|
A x (1+5 percent)
|
B x (1+5 percent)
|
C x (1+5 percent)
|
D x (1+5 percent)
|
E x (1+5 percent)
|
In planning for long term goals, like retirement, an understanding of time value
of money is essential to make the right saving and investment decisions. The following
are the areas where the time value of money will impact the calculations of the
retirement corpus:
- The cost of expenses expected in retirement has to be adjusted for inflation. The
cost for the same level of expenses will be higher in retirement relative to the
current cost because of inflation, and a higher sum of money will be required to
meet the expenses in retirement.
- The potential for the money saved to be invested to earn returns and compound over
time has to be considered. The final corpus will comprise not of the savings alone
but also the returns earned on the savings by investing it. This has to be considered
while determining the savings required creating the corpus required to generate
retirement income. The returns that are likely to be earned will significantly reduce
the contribution or savings required for creating the corpus. The effect of compounding
on returns is explained in the next section.
- Longer the time to retirement, higher will be the impact of time value of money:
both positive (ability to earn compounded returns on investment) and negative (impact
of inflation).
Real Rate of Return vs. Nominal Rate of Return
The return on an investment is usually expressed as a nominal rate. When the nominal
rate is adjusted for the effects of inflation, it is known as the real rate of return.
Calculation of the real rate of return on investments enables investors to understand
the actual purchasing power of their investment values. Consider the following example.
A bond pays 10% interest per annum. The inflation rate for that year is 5%. What
is the real return?
Nominal rate of return= 10%
Inflation rate= 5%
Real rate of return = 10% - 5% = 5%
Effect of compounding on returns
Compounding or compound interest is the effect of the interest earned on an investment
earning interest on account of re-investment. If the interest earned is not withdrawn
but allowed to remain in the investment, then the return for the next period will
be earned not only on the principal but also on the interest that was reinvested.
Overtime, the contribution of compound interest to the accumulated value of the
investment will be far more than the investment made.
Rs.1000 made each month grows to a value of aboutRs.1.5 crores over a period of
35 years, assuming a 15 percent return.
Notice how a delay of just 5 years in starting saving (from age 25 to age 30) more
than half the returns earned from Rs. 1.42 crore to Rs.65 lakhs.
The contribution made over 35 years is just Rs.4,20,000 out of a total final corpus
value of Rs. 146,77,180.