Saturday, April 15, 2006

Retirement calculation - step two

The second step towards preparing a workable retirement plan is to evaluate what financial resources will be needed to fund the desired lifestyle when when you no longer work full time. This calculation comes in three parts.

1. how much income will you need? A review of current expenditure is a good starting point. However, things will be different in retirement. The mortgage will be paid off (hopefully). You may not have to spend as much on work related expenses (e.g. clothes). On the other hand, you will have more time for recreational activities and may expect spending on things like travel and dining out to increase. Also, medical insurance may currently be subsidised by your employer. A buffer should be added to the budget to allow for contingencies.

2. how much needs to be set aside for one off events and other contingencies? Will you still be supporting your children hrough school and university after retirement? Do you anticipate having to contribute to the cost of your children's wedding(s)? Anything else? A small contingency fund?

3. how much will need to be invested in non-income producing assets? This includes your home (unless you rent), furniture, car etc.

The income figure needs to be grossed up to allow for taxation and capitalised to produce a lump sum. If a before tax income of HK$40,000 per month is required and an assumption is made that assets can be invested in a manner that will earn 4 per cent per annum, then it follows that a lump sum of HK$12 million is required (approximately US$1.5 million).

The cost of one off events involves a bit of guess work, but could be anything from zero to a seven figure sum (in Hong Kong dollars) depending on individual circumstances. As an example, if you are still spending money on children and have to set aside money to cover the last few years of schooling and a university degree then this needs to be provided for. A lot obviously depends on which school and which university the children go to. Assuming good quality schools and a good quality university, the cost could easily be about HK$1 million per child. Let's assume that these one off costs work out at about HK$2 million in total.

Lastly, the non-income producing assets including the family home, furnishings etc need to be added up. In a place like Hong Kong where real estate is expensive, It would be easy to spend HK$7 million (US$900,000) on a modest sized flat and furnishings.

In this example, the grand total comes to HK$21 million (about US$2.5 million). For most of us that is a huge sum of money that would be difficult to accumulate in one person's working life. In another post, I will revisit this calculation and look at why the number needs to be so high.

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