Firstly I would like you to know that you DO NOT NEED:
1. to accumulate a large retirement fund in order to achieve your financial objectives as a lot of financial advisors would have told you that you need S$2m to retire.
2. a big sum assured from your insurance coverage
3. to invest aggressively to have a big retirement fund
What you need to do:
1. Know your present financial commitment before you decide on your insurance sum to be covered
2. Know how much you need in a retirement fund and build that fund over time
3. Protect and grow your investment
Four Factors which affect your Journey to Financial Freedom
You need to consider these four factors when you are generating your road map to financial freedom.
1. Available Resources: Where are we financially. This information can be obtained from the Personal Net Worth Statement. Personal Net Worth Statement shows your assets and liabilities. We need to look into the Personal Cash Flow Statement to understand the movement of funds and the availability of cash.
2. Time: We need time for a financial plan to compound to reach our goals and destination. The power of 72 tells us that a 6% return will allow us to double our money in 12 years.
3. Inflation: It is out to erode your purchasing power
a) The higher your return, the shorter time is required. If you can achieve a 12% return, you just need 6 years to double your money.
b) Higher availability of initial resources means a lower return is needed to achieve the same financial goal. If you have initial capital of S$1 m, your ROI of 10% will take 8 years to double. If your initial capital is S$0.5 m, your ROI needs 20% to double in 8 years’ time.
c) Longer time frame means a lower return is required
d) A lower inflation rate means a lower return is required
SMART stands for Specific, Measurable, Attainable, Realistic and Timely in goal setting. This will be used in financial planning.
Here are examples of Specific and Measurable:
1. To retire at the age of 40 with a retirement fund of S$2,000,000 in hand
2. To fully pay a house worth S$800,000 by age 35
Attainable: You need an action plan to move you towards your goal.
Time Frame: Your resources are limited and there’s always opportunity cost in everything. You need to set a reasonable time frame to reach your objective to ensure it is attainable.
Prioritize: You need to focus on what are the most important things for your funds to be allocated to. For example your first house or your children’s education fund.
Action Plan: You want to get from Singapore to Kuala Lumpur, you have options like ride a bike, ride a motorcycle, drive a car, take a train or take a plane. The action plan shows what sort of vehicle you will take, how fast you will reach there and what are the various paths to reach your end goal.
The above is our Investment Objective Setting. You need to believe in your plan, imagine the lifestyle you want to lead when you retire. Then you need to understand the time frame to achieve these, your objectives should focus on Needs and delay your Wants. From our examples, the Emergency Fund and Early Retirement are our Needs, the Hermes and Traveling are our Wants. Think through what is your ultimate objective? Break them down into smaller pieces will make them easier to conquer. Put in the actions and efforts you will take to achieve each small milestone.
Personal Net Worth Statement
A Personal Net Worth Statement shows your personal assets and liabilities. Net Worth is how much you have after your assets are deducted from your liabilities. See below for an example of a Personal Net Worth Statement.
Positive Net Worth: Your Assets are more than your Liabilities. Good Stuff!
Negative Net Worth: If your Liabilities are much higher than your Assets, this can be a situation where you are over-leveraged or not too careful with money such as too many loans or credit card bills.
Zero Net Worth: Not as bad as negative net worth but need to grow your net worth positively.
Your Personal Net Worth statement shows you liabilities which explains that there are two types of debts, good ones vs bad ones. Good Debts are used to purchase money-earning assets. For example, a mortgage to purchase a freehold shop to lease to a restaurant on the ground floor and upper floors converted to residences and offices. If the rental income is more than your interest expenses, it is considered good debt. Bad Debts take money from you. Credit card interest in 2019 is going up to 26% per annum.
It also shows you Non-income Generating Assets which does not generate any income such as watches, cars, and house you stay in. Income Generating Assets are generating income when you are not working. They are your dividends, rental income, business income, and interest income.
Personal Free Cash Flow Statement
Do you know how you have been spending on your needs and wants? The only approach is to record how you spend every single cent. Through understanding how you have been spending money, you can improve your spending behavior. The Key is to be frugal and spend on needs rather than wants. As our financial aspiration is to have Financial Freedom, every cent will be spent on buying assets which create more cash flow.
For easy reference, you can create a spreadsheet for bookkeeping.
It helps to understand your expenses, understand how much you can save, where to cut in order to divert cash to an emergency fund or investment fund, plan your cash flow.
The purpose of doing this is to let you know where your main sources of income are and what the income generated are spent on. You can use this to look into the history and understand past cash flow records.
Purpose of Insurance
Insurance is for us, consumers to use a small sum of money to pass the risk to insurance company, protecting us from unforeseenable risks of life, illness or accident.
Do not be too concerned about “residual” value of an insurance policy, you should take the premium paid as an expense to serve as a protection. Do not aim for any returns from insurance and this will help to reduce your premium. With the savings from reducing your premium, you will have more options to achieve your Financial Freedom. After reviewing your insurance needs, you might find it advisable to buy term insurance for greater coverage at a lower cost. Invest whatever amount you have saved on premiums into shares or funds which can generate higher returns in the long term by practicing dollar-cost averaging.
How to determine the right amount of Insurance Coverage?
Find out your total liabilities as they need to be paid immediately if you are no longer around. You will be able to see this amount from the above Personal Net Worth Statement. Add your funeral expenses. Forecast future family expenses. Estimate your children’s fund. Add in any other needs.
From your Net Worth Statement, you can tell what are your income-generating assets and estimate the growth of these financial resources. You can start to generate your available resources after all debts and expenses are deducted. If it is negative, it means your insurance coverage is insufficient. Do note that your insurance premium expenses should not exceed 10% of your take home income.
Funds for Passive Income
Do you have any idea how much is required to retire in your country? In Singapore, a lot financial advisers’ advise will require S$2 million. This figure was generated based on constant principal, assuming that during your retirement, you are using the return generated from your principal.
For example, see below:
(Monthly Expenses x 12) / Annual Investment Returns
= (S$6,500 x 12) / 5%
With S$1,560,000 you will be able to generate S$78,000 annually for your living expenses. This assumes your expenses and Investment Returns are constant. However, this does not consider inflation and taxation (in Singapore there is no tax for dividends). Therefore you will need S$2,000,000 for your retirement. What is the solution then?
You can choose Gradual Principal reduction during later years of retirement. We will recommend to draw down using 1st pot of retirement funds while letting your retirement fund to grow and compound. After this 1st pot of retirement fund is used up within the first 5 years, we will recommend to use your investment returns for expenses during the next few early years of retirement. When expenses increase due to inflation during later years, fund your retirement by using investment return and portion of your retirement fund.
How Much Do You Really Need for Retirement?
Step 1 Calculate years to retirement
Let years to retirement be defined as YR
Define your target retirement age and subtract from your current age.
For example, current age is 38 years and years to retirement be 3 years till 41 years old.
Step 2 Obtain your current annual income after tax (called it I)
Do not add in bonus as it will vary from year to year.
Step 3 Determine your current annual expenses (called it E)
Step 4 Get your Personal Inflation Rate (Called it iR)
Personal Inflation Rate is defined as dividing current year expenses over previous year expenses, you will get your Personal Inflation Rate.
For example, your current year expense is S$80,000 while the previous year expense is S$75,000 therefore your inflation rate will be 6.67%
(($80,000/ $75000) – 1) * 100 = 6.67%
Step 5 Determine Estimated Rate of Return (called it R)
10% for equity and 2% for government bond.
Step 6 Get a future value of annual expenses at retirement age (called if F)
The formula = E x (1 + iR)^YR
For example, FV of annual expenses at retirement age 41, take iR as 2%
F = (80000) x (1 + 2%)^3= S$84,896.64
Step 7 Calculate capital required to generate income to cover annual expenses (we called this K)
K = F/R = S$84,896.64/0.1 = S$848,966.4
Step 8 Use your CPF or CPF Life (called as CPF)
You need to estimate your CPF contribution until your retirement age. CPF withdrawal or CPF Life
Determine this CPF contribution and estimate your CPF with compounding interest.
For instance, the current CPF SA till end of 2019 is S$63,720.
Annual contribution in 2020 is S$1,680 x 12 = S$20,160.
By end of 2020 = S$63,720 x (1+4%) + S$20,160 = S$86,428
By end of 2021 = S$86,428 x (1+4%) + S$20,160 = S$110,045.95
By end of 2022 = S$110,045.95 x (1+4%) + S$20,160 = S$134,607.79
After 2022 there will be no further contribution to CPF SA but just pure compounding till say 70 years old (delay draw down).
Based on simple estimation without consideration if CPF MA achieving maximum limit to spill over to SA.
We obtain approximately S$484,589.
Step 9 Deduct K with CPF to get balance of capital required at retirement (hereafter known as Kr)
Kr = K – CPF = S$848,966 – S$484,589 = S$364,377
Step 10 Get all the current value of your investment (shares, unit trust, etc). Calculate the future value.
FV Investment = I x (1 + Estimated Rate of Return)^YR
FV Investment example = (1,296,000) x (1+4%)^3 = 1,457,823
Step 11 Calculate the capital shortfall/surplus by deducting Kr with I
I – Kr>0 => surplus but if I – K<0 => This is the amount needed to earn before can achieve early retirement/retirement.
For example, S$1,457,823 – S$364,377>0 => good to retire at Yr = 3
Next, we need to access whether this is possible to sustain all the way till the end of life expectancy. We are using 85 years as the benchmark as of 2019. There is a likelihood life expectancy will improve to 100 years old for the next generation.
For example, Ms L:
1. Is currently 38 years old
2. Is earning $120,000 a year with yearly expenses of $48,000.
3. Has an estimated inflation rate of 3%
4. Desire to retire at 41 years old
5. Estimates her rate of return from investment at 4% p.a.
6. Uses her cash of $200,000 to pay off expenses during early retirement years
7. Has a lumpsum investment capital of $1,296,000
8. Assumes CPF will hit S$484,000 and will buy CPF Life to pay out S$3,000/month and grow at 2% per annum
9. Has a life expectancy of 85 years old.
There are ways to further enhance the chance of the retirement fund to last through her life.
1. Control expenses: Look at ways to reduce unnecessary expenses. As we grow older, the daily expenses will be reduced accordingly.
2. Reduce inflation rate: She needs to look for cheaper alternatives to control the inflation rate. It will be a balance between value and quality of life. Or she can move to other countries to reduce the inflation rate and expenses.
3. Increase investment: Pump more money into investment funds.
When there is a plan laid out, you can work towards the end goal. What gets measured will be managed and improved on. Do remember to constantly review your plan to see whether you are on track, this will allow you to take action to adjust back to your path towards Financial Freedom.
Speak to me today via firstname.lastname@example.org and I can show you how you require lesser Retirement Funds to achieve your retirement objectives.