RETIRING after all those years of hard work is something to look forward to, but how can you be so sure that your financial situation is ready for it? Reality bites. Retirement planning is a financial necessity that should commence as soon as one finds some stability in his chosen career.
One of the more difficult issues in retirement planning is the determination of how much money to set aside so that the retiree will not outlive his money. It is important to maintain a livable income for life, to ensure that one has saved enough. How much should you spend for consumption now and how much should you save for retirement?
There are two approaches that you could take to computing how much you should save for your retirement: (1) aim for a target replacement rate of pre-retirement income, and (2) aim for maintaining the same level of consumption spending before and after retirement.
When you use the first approach, you first compute the amount you need to have accumulated in your personal retirement age. Then you compute the annual amount of savings needed to reach the future rate. Note, however, that this does not necessarily result in your having the same consumption level after retirement as you did during your working years.
If you plan to do the second approach, you will aim to save in order to spend the same amount of consumption before and after retirement. This implies that you need a constant stream of consumption at the same level in each of the next years of your existence.
Economists call the present value of one’s future labor income human capital and they call the constant level of consumption spending that has a present value equal to one’s human capital permanent income. This is computed by equating the present value of labor income until retirement with the present value of consumption spending over the remaining life cycle. It will allow determination of the regular savings needed to ensure constant consumption over one’s life cycle.
Milton Friedman was the pioneer thinker of the theory of “the permanent income” and not year-to-year income as the determining factor when assessing total consumption outlay. Although Friedman’s main objective was to challenge the traditional Keynesian consumption function, and in the end influence macroeconomic policy decisions, it is especially relevant for those seriously thinking about retirement.
The idea is one should smooth out spending over his career based on expectation about the amount of money to be earned over a lifetime, as opposed to only current income. Otherwise, the unintended benefit is a drastically downsized lifestyle just when one is in the twilight of his natural existence.
Admittedly, permanent consumption spending is based on what one knows about the future and on information that is readily available. Thus the concept while theoretically sound is not as easy to implement because of the many assumptions to be made about the future. Still, there is merit to consider one’s permanent income in calculating the magic number needed once retirement date comes into the picture.
After all, how many times have we seen retirees suddenly adjusting to an unfamiliar environment because they did not save enough. It is better to aim for a secured and constant quality of life for one’s lifetime so the journey at one’s end of day is peaceful and graceful. And may I paraphrase a quote from writer Gene Perret, “Retirement — it is nice to get out of the rat race, but do you have to learn to get along with less cheese?”
Benel D. Lagua is executive vice-president at the Development Bank of the Philippines. He is an active FINEX member and a long time advocate of risk-based lending for SMEs.