Monday, October 30, 2006

Is saving a thousand monthly enough?

A friend posted me a question last week if saving a thousand a month is enough. The answer is it depends on the spending habit and lifestyle of the individual. Let’s see what does saving a thousand a month till your retirement age – assuming to be at age 55 – brings and provides you for the rest of your life. There are some important assumptions in order for this estimation of savings for retirement fund to work out. 1) Assumed you stop working at age 55 and live till age 70, 2) The risk free interest rate (government bonds will provide a higher interest than Fixed deposit) is to be at an average of 3% throughout, 3) the savings done is started from age 29 and all of it are to be reinvested yearly till the age of 55 and each year, you are to save $12,000, and 4) at the age of 55, the sum which has been grown and saved to then will have to be disciplinarily spent equally from age 55 up to age 70.
If one starts saving $12,000 yearly from age 29 up to age 55, you will have a sum of about $503,000 by then. Assuming now you are at the age of 55 and you anticipate you will not live beyond 70, how much can you spend monthly for this $503,000 to last you for the rest of your life? You have 180 months to live from age 55 to 70. Does it means you should then switch your savings from bonds or Fixed Deposits to normal savings accounts and spend about $2793 ($503K divide by 180 months)? It will be a big mistake if that is done.

Let’s see why it is a mistake. At age 55 – which is 28 years later – the total sum ($503,000) which is saved by then does not have the same value compared to the day you started out saving. Thus, the next question to ask is “what is the present value of the $503,000 worth at today’s value?” If you apply an average inflation rate of 2% yearly and discount the sum of $503,000 back to today, it is worth roughly $295,000. In other words, you have about $295,000, at today's value, to spend for the rest of the 15 years from age 56 to 70. At today’s value, it means you can afford to spend about $1640 per month with this amount. If you are a single and live in a bare minimum house, it should be enough to last till the age of 70. Then when you hit your retirement age, you must still maintain your discipline in controlling your yearly spending to about $34K at age 56, $34.9K at age 57, $35.6K at 58 and so on. The yearly spending will increase by about 2% yearly to cater for inflation and ultimately, at age 70, your yearly spending will be about $45.1K. However, to not, there is no difference in value between the amount of $45.1K at age 70 or $34K at age 56 because it is eaten up by inflation which is assumed to be at an average of 2%. All these yearly spending are equal to a present value of today at about $19.6K. So if at the age of 55 and if you decide to lose your discipline and forget to continue to put in a higher yielding sort of risk-free interest investments, the amount will not last till the age of 70.
So, is this enough? It boils down to your lifestyle and your commitment by then. But most likely, it will not be sufficient because one cannot be sure his lifespan is up to 70. Then it takes a lot of discipline since the amount is just treading on the line But the biggest problem is not saving or growing the fund, it is maintaining one’s discipline and controlling the urges and temptations which is the trap for many. Anyway in my opinion, saving a thousand dollar monthly is way too little if you can only grow it at a normal interest rate.


8percentpa said...

Wow, good calculations. Impressive.

I thought about this and came out with the answer below.

Assuming that you will work 2/3 of the rest of your remaining life and then retire, you should save at least 1/3 of your salary. No inflation taken into consideration, of course.

i.e. you are 30, you expect to reitre at 60, die at 75, which means you work 30 out of 45 years of remaining life = 2/3. Then you should save 1/3 of your salary.

Berkshire said...

Well, i think it is more important to have an idea how much you would like to spend monthly during one's retirement life. If let's say a person wants to maintain his lifestyle as how he has during his working life, he must work out a plan to save and grow so much with inflation taken in to maintain the lifestyle. For some, having a value of $1500 per month is enough, for others, they want $5000 per month, for some others, they can do with much lesser than how they used to. Most important is to have an idea of what a person wants in life and then figure and calculate out a plan to achieve that goal. It is not impossible though it ain't that easy. But it is with high chance any one can achieve a reasonable after-work life if prior planning is done with due care and discipline.

By the way, if you are interested, I can forward you the file which i work out for this article. In fact, this is the first time i work out a file like this to explain what is needed if the plan is to start saving a thousand monthly. But I ain't sure if the logic behind my calculation is totally correct which if you could, you may help me to see if my method of calcution is right.

fishman said...

You guys paint such a freaking gloomy picture that you are freaking me out! Now I'm wondering if a million bucks is seriously enough for me....

I have no idea how accurate you guys' calculaton is, but I do know that having and keeping to a strict budget is good habit to instil financial discipline. At least that's what I hope will happen so that I won't overspend - too much!

Berkshire said...

Hi Fishmen, haha, at least we are painting a picture which represents probably a not so good case scenario. Only on Wall Street will they paint a rosy scenario where it is not at all just to keep people happy but in reality, it is what is real that counts, not what that are potential.

In any case, it is a simple calculation. You can also do it yourself. Here's the steps.

If you think you can save a thousand every month starting from age 29. At the end of age 29, you will have $12k to start investing. By age 55, this $12 will ends up having a value of $X with an applicable interest rate compounded (the current long term goverment bond is about 5% while FD is about 3%). Then every year, if you save 12K, you should also compound the amount at the applicable rate of interest.

No one can fool any one with such a simple calculate if you think thru the steps logically.