You won’t need Pension Income if you read this…

michaelFinancial PlanningLeave a Comment

If everyone invested 8% of their gross income and had a balanced portfolio with an average 5% annual return for 35 years, company and government pension would be unnecessary. Can you imagine the impact that this would have?

Sure I’m making some assumptions here, such as:

  • The 5% annual return, in the retirement years there will be a 4% return to reflect a decrease in risk tolerance/capability (The S&P had an average return of over 7% in the last 45 years despite the tech bubble crash and the financial crises in 2008)
  • Because I’m calculating the return on a monthly basis (since funds are invested monthly) the actual return is a little higher
  • The 8% of gross income invested might seem high to some (although the rule of thumb is you invest 10% of your income, some countries have a rule of thumb of 20%)
  • That your income won’t increase for 35 years, without a doubt it will. In fact, you’ll like have a lower income initially which will increase over time. Think of this as the average income for your lifetime and yes that will change the final numbers but that isn’t my point
  • No taxes, but this is possible at least proportionately, if you put a portion of your money in a tax deferred or tax exempt account (in Canada we have the RRSP and TFSA while in the US there is the IRA)
  • Life expectancy of 79 years which I have researched to be the life expectancy average in the US. Adjust accordingly for yourself =)
  • The amount of money you need in retirement will be less than in your working years, which I usually find to be the case. For example, you won’t have a mortgage to worry about (hopefully) and this WSJ article argues this as well.

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My purpose here is to hit the idea home that you actually don’t need as much as you think in retirement and how we can stop depending on the government. I’m not saying ignore pensions altogether as we are entitled to this and they will likely never go away, but what I am saying is that we can take matters into our own hands and have complete control of our retirement.

For those that are savvy with Time Value of Money here are the calculations that I have used based on a $25,000 annual salary. Read my article about finding your “Magic” number to financial freedom which touches upon Time Value of Money or watch this Youtube video to see how you can do this calculation yourself.

The Calculation for no pension

PMT = $25,000*0.08=$2,000 annually ($166.67 invested monthly)
T = 35 years x 12 months = 420 months
I = 5%/12=0.4167%/month
PV = 0
FV = $189,352.52

Retirement at 65. Average life expectancy is 78.74 years (say 79 years)
T = 14 years x 12 = 168 months
I = 4%/12 = 0.3333%/month (risk reduced in retirement)
PV= $189,352.52
PMT = $1,473.82/month = 70.7% of pre-retirement income!

The amount you make isn’t important, if you put in $50k, $100k, or even $1 million annual gross income, you’ll still get the same percentage of income.
Although I’m sure some will say that a 5% return is too high but I know many of you will agree that 5% is very realistic. And you’re absolutely correct that’s it’s too high if the only investments you have in mind are term deposits and savings accounts.

You might say, “but 70% isn’t enough!” And you might be right, this will completely depend on each person’s individual situation but I know of many people that needed less money in retirement than they did in their working years. You don’t have to worry about commuting, work clothes, eating out and drinking as much and hopefully don’t have a mortgage to pay. Yes you might want to go on vacation more and have other hobbies to worry about but I have found that in general you need less in retirement. When you don’t earn an income by actually going to work, you tend to spend less at least to some extent.

Now let’s take this one step further and increase the amount you stash away from 8% to 20%. This time I’ll use a $50,000 annual income. I’m still using a 5% return pre-retirement and 4% return during retirement. 35 years until retirement and 14 years in retirement.

PMT = $50,000*0.20=$10,000 annually ($833.33 invested monthly)
T = 35 years x 12 months = 420 months
I = 5%/12=0.4167%/month
PV = 0
FV = $946,739.90

Retirement at 65. Average life expectancy is 78.74 years (say 79 years)
T = 14 years x 12 = 168 months
I = 4%/12 = 0.3333%/month (risk reduced in retirement)
PV= $189,352.52
PMT = $7,368.91/month = 176.85% of pre-retirement income!

You know what this means? You could actually retire early, increase how much you spend in retirement, or leave funds for your loved ones. It gives you flexibility to do as you please.

Numbers aren’t important, keeping it simple is

Again the numbers aren’t important! I’m not saying that you could have close to a million or have $7368.91 per month, what I want you to focus on is the percentage of income that you could have if you stuck to this plan.

The calculations aren’t perfect and I’m using a few assumptions but I hope you get the idea. If we could all stash away even 10% of our income we would all be much happier and comfortable with our financial situations. Yes, that’s only one part of the equation since saving and investing alone won’t guarantee financial freedom because we have to think about the other side of the balance sheet, but retirement and financial freedom isn’t as difficult and impossible as it might seem if we break it down into smaller pieces.

If we all didn’t need a company and government pension imagine the impact that this would have. The government could spend money on other areas such as environment, education, and health care just to name a few.

Again, what I’m stating here isn’t perfect but I hope I get my point across. If you’re young and have time on your side it pays to get started early. Even if you aren’t as young, it’s never too late to start. Yes it’ll be a bigger hill to climb but you can (and should) adjust your spending to see how much you need.

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