PORTFOLIO POINT: Setting an income target for your retirement is important, but it’s difficult to know whether you’re on track to reach that goal. Using a flexible wealth benchmark as a guide may help.
When I was actively working as a financial planner, the number one question I got from people was: “How am I progressing financially – will I be able to retire in comfort?” While there is a reasonable amount of information available as to how much a person might need for a self-funded retirement – usually somewhere around 17 to 23-times their hoped-for retirement income – I am not aware of any models that try to measure the way this wealth is built over time; that is, a model that tells someone at age 40, 45 or 50 whether they are on track.
Thomas Stanley and William Danko, in their excellent book The Millionaire Next Door (Longstreet Press, 1996), propose a formula for a person’s net wealth based on their age and income. They suggest that a person's net wealth should be:
- Age multiplied by pre-tax household income, divided by 10.
By this formula, a 30 year old person with an income of $50,000 would have a target wealth of $150,000 (30 Ã $50,000 / 10).
I think that this formula proposed by Stanley and Danko, while generally useful, is unrealistic for people just starting their careers and, for those at the point of retirement, it understates what is needed for a self-funded retirement.
For example, someone who attended university following school, is 22 years old and earning $40,000, is unlikely to have the target net wealth calculated under the Stanley and Danko formula, which would be $88,000.
At the pre-retirement stage, someone who is 60 years old and earning $100,000 would be calculated as having a net wealth of around $600,000. If they were planning on retiring, they might be disappointed to see that this level of assets might only generate a retirement income (by itself) of $24,000 to $30,000 annually, based on the $600,000 providing an income stream of 4% to 5% a year (after some costs).
I suggest that it is possible to construct a more flexible wealth benchmark model to measure personal financial progress.
To produce this benchmark model, I propose two basic assumptions:
1. We are all hoping to be able to retire at some stage; and
2. The onus will continue to shift away from governments funding our retirement through the age pension, to us having to fund our own retirement
To work out our final wealth requirement, we can calculate that around 22 times our required retirement income will provide this income over even an extended period of retirement. So, if we decide that we require an income of around $50,000 in retirement, a final net wealth of around $1,100,000 would be sufficient to provide this outcome.
To provide an income of $50,000 annually, the $1,100,000 needs to provide an income return of 4.5%. Currently, Australian shares are paying gross income (including the value of franking credits) of around 6%, listed property trusts 6.5%, fixed interest investments 5.5 to 7.5% and cash around 4.5-5.5%. We can see that a balanced portfolio of $1,100,000 should comfortably provide this level of income, providing we are not losing too much of this income in fees to financial planners, fund managers and the like.
Having said that we need around 22-times our retirement income, let us assume that the intended retirement age is 60. This effectively allows people to retire five years before the age pension age of 65.
As well as a retirement point, we need to pick a starting point for our model, and I suggest that age 25 is a reasonable starting point. I assume that prior to this people are travelling, studying and spending most of the money that they earn. Of course, this is a gross generalisation, but these generalisations are required to build a generic model. So, at age 25 we will assume that people have a starting wealth of 0-times their required retirement income.
My definition of 'wealth’ includes any investments, any superannuation less any investment and consumer debt. I have not included the value of a principal place of residence and the attached mortgage. A principal place of residence will not provide any income in retirement, although it does provide the economic benefit of not having to rent, which means you will need less money in retirement. Provided the mortgage will be paid off by retirement, then this will not be a factor at this time.
If we say that the starting point is age 25 – with a target net wealth of $0 – we can then work out markers every five years based on expected investment returns (6% a year) and possible saving rates (initially saving about 10% of income each year, plus standard superannuation contributions). This is admittedly a fairly challenging rate of saving but, without such a strategy, it will be difficult to meet a challenging financial goal like retirement.
By age 30, we need to have 1.1 times targeted retirement income.
By age 35, we need to have 2.51 times targeted retirement income.
By age 40, we need to have 4.31 times targeted retirement income.
By age 45, we need to have 6.62 times targeted retirement income.
By age 50, we need to have 10.57 times targeted retirement income.
By age 55, we need to have 15.63 times targeted retirement income.
By age 60, we need to have 22 times targeted retirement income.
The following table shows this, and sets out what that means for a person/couple targeting an income of $50,000 a year in retirement:
|-Age||Multiple||Wealth Target $ (for someone wanting to retire on $50,000 a year)|
You can also adjust your position to where you are currently, and how long you might need to get to retirement. For example, if you want to retire on $50,000 a year and currently have around $500,000 in investment assets and are age 55, then you can see that you are likely to be around 10 years away from retirement (assuming you really want to get to the $1.1 million figure).
Between the ages of 55 and 60, the model sees the wealth of a person looking to retire on $50,000 a year increase by just over $300,000, from $781,500 to $1,100,000. This seems problematic; it seems like too much of an increase. However, the majority of these returns are assumed to come from investment earnings. Investment earnings of 6% a year provide $265,000 of this wealth growth. A target growth rate of 6% a year is certainly feasible (at just a little over the average online bank account rate currently); however, a period of poor or negative returns close to retirement will have a profound effect on your final wealth balance. This was borne out by the global financial crisis and people having to retire later than they would have liked, or with less income.
As a general rule, you can see that as you get closer to retirement, it is assumed that you increase your wealth more quickly. This is because the greater the investment base you have, the greater are potential earnings and, as you get closer to retirement, most people have a greater capacity for saving (as they may have finished paying off their mortgage, have fewer family commitments and may even have a windfall from downsizing the family home).
Every five-year period, people will need to rethink how much they need in current dollars for retirement, to keep updating their needs to account for inflation.
There are a lot of limitations to this model, which suggests that it might be useful as a guide, rather than as a strategy that should be rigidly followed.
Some key limitations include:
1. It does not take into account any possible age pension, which is important for many people given that a home-owning couple can have more than $1 million in assets and still receive some age pension.
2. It assumes a steady rate of earning from investments. We know that earnings for most investments will be volatile.
3. Everybody will have different levels of capacity to save at different times of their life, including windfalls from events such as redundancies, asset sales, business sales, inheritances and the like.
If the onus is increasingly on people to fund their own retirements, then having a way to assess progress towards an individual’s retirement goals is important. This model – albeit simple and with significant limitations – provides benchmarks for people every five years on their way towards retirement.
Scott Francis is an independent financial adviser based in Brisbane.