When Will I Achieve Financial Freedom?
The more traditional formats of this question are:
- How much do I need to retire?
- How much do I need to be financially independent?
What does freedom or independence mean? It means not relying on anyone else but yourself. Freedom from work, government and family.
“A large income is the best recipe for happiness I ever heard of.” Jane Austen
I am going to approach the question in a fresh way and look at many of the mistakes made when asking and answering this question.
1. We think in terms of work income
A 40 year old earning $200,000 p.a. would never imagine that she would be happy to live on $60,000 in retirement. It is counter intuitive until you stop to think about where the $200,000 goes. To begin with there is the small issue of taxes, about $70,000. Then there is the issue of paying off the $600,000 mortgage at about $40,000 p.a.. That leaves us with $90,000 to raise two kids, general living and travel and saving for retirement.
Whereas $60,000 in retirement is tax free if sourced from your super, the debts are gone and the kids have flown away. It’s all yours to spend. It’s actually quite a lot when you stop to think about it.
When creating an income target for retirement, imagine yourself in the future and not now.
2. We forget taxes
When you are working it is hard to imagine a world where you pay no income tax. The idea that you could earn substantial amounts of income and keep it all for yourself is entirely alien to an employee. But in fact that world does exist in the form of a parallel universe called retirement.
All income within and from a superannuation sourced pension fund is tax free. In thinking about the question of how much I will need in retirement, this point is too often forgotten.
3. We don’t understand how much is required
The ASFA Retirement Standard for a 65 year old couple is $58,444 p.a. for a comfortable lifestyle. I would concur from personal experience of working with clients over many years that about $60,000 p.a. is the “shape” of a comfortable retirement. It isn’t extravagant but with some discipline it should be comfortable.
The full Age Pension for a couple that qualifies for it (it has been getting harder and harder over the last 20 years and will continue to be so) is $30,743. This is an uncomfortable retirement with not much wiggle room, overseas travel or luxuries. At this end retirees are struggling to absorb even small inflationary increases in cost of living.
4. We don’t understand how long we are going to live
We all know that we are going to live a while, certainly longer than previous generations, but few understand the length of the journey ahead.
When looking at Life Expectancy tables you will see that the life expectancy of a 45 year old male is 82. It is easy to then think that if you retire at 65 you just need to organise income for 17 years. Nothing could be further from the truth.
Let’s say that the 45 year is married to a 40 year old woman. Now let’s assume she is healthy, makes good lifestyle choices, eats well, sleeps well, exercises, has low cholesterol and low blood pressure and most importantatly of all has great genes. Her parents and grandparents lived long lives. Your wife’s life expectancy is well over 100, probably around 105.
So when you retire at 65, she will be 60 and will most likely to be around for another 45 years!! You are not the problem!!
Too few are preparing for 40-50 years retirements.
5. We don’t understand inflation
Humans are not good at understanding things that move really fast, such as the speed of light or things that move really slow, such as evolution. Inflation is another one of those things that we struggle to fully grasp because it happens so slowly.
$60,000 today will need to be $145,000 in 30 years’ time at 3% inflation.
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Ronald Reagan
Just like the frog in the water that is gradually brought to boil, ultimately cooking the frog. You will never quite know when the $145,000 crept up on you, it will just happen very, very slowly and over decades.
Inflation needs to be respected and is a deadly force in retirement and strategies need to be put in place to defend against it.
6. What about capital consumption?
Will you consume capital or not?
Capital consumption may be a deliberate part of your retirement strategy. In and of itself it may not be a problem if you have enough capital to begin with.
But if you start your retirement journey underfunded (as most Australians are), then capital consumption can have an exponentially negative impact on the longevity of your retirement income. The issue here is inflation again. If your goal is to increase your annual income with inflation, then capital consumption makes that extra hard to achieve. The whipsaw effect of a rising income but falling capital base needs careful consideration to combat.
An antidote is to be conservative with your pension drawdowns and even more conservative with the rate at which you increase your drawdowns.
7. Maths and The Rule of Real Returns: The Rolls Royce of formulas
There are several formulas and rules of thumb about how to answer the question about how much you will need to live comfortably. They are all embedded with different assumptions regarding how long the money will last, capital consumption and income indexation.
The simplest and most powerful formula you can use to develop a “retirement fund” number to aspire to is The Rule of Real Returns. If you only live off your real returns, you will be ok forever.
If you are happy to live on $60,000 in retirement (indexed) and inflation is 3% and you achieve a return of 7%, then your real return is 4%. To achieve $60,000 assuming a real return of 4% you need $1,500,000.
In general terms the definition of a comfortable retirement in Australia at the moment for a couple is a home plus $1.5m. If your net worth is $2m at retirement, you need to decide how much of the money you want to “live in” vs “live on”. The more of your balance sheet that you live in, the less there is for income generation to live on.
If you achieve 3% real returns then the capital required jumps to $2,000,000. 4% real return is a mid-range assumption, it is not overly optimistic but not overly conservative either.
Most Australians are retiring with far less than this in their “Retirement Fund”, the sum of their net assets outside of the home. What this simply means is that concessions will need to be made such as:
- Capital consumption
- Income not keeping up with inflation
- Income reducing in later years
- Reduction of inheritance to the kids
- Absence of a buffer to deal with financial shocks
8. Imagine that you will live forever
In preparing for retirement it is best to imagine that you will live forever and work backwards from there.
“I intend to live forever, or die trying.” Groucho Marx
Half of us will live longer than our life expectancy and half shorter (it is an average). Unless you are a pessimist, you need to aim for the longer half. As discussed earlier, a healthy woman may need to survive 45 years in retirement. That is what living forever looks like!!
9. What concessions are you willing to make?
If you don’t think you can get to the “Rolls Royce” number, then what concessions are you going to make. How will your retirement fit in with your financial reality? This is where a good adviser is extremely valuable to help you navigate the complex and often three dimensional aspects of making decisions that are laden with concessions.
“As we get older, life becomes very complicated in terms of concessions we have to make.” Charles Cumming
Planning for retirement (or financial independence) is a long and complex affair. Most people are no good at it, evidenced by the fact that most Australians are chronically underfunded for the retirement.
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Frank Paul is Chief Operating Officer & Head of Advice Services with Spring Financial Group. Frank has over 20 years' experience in financial planning and investment advisory.
|Frank has extensive experience in private client advising and the management of financial services operations. Frank is actively involved in the recruitment and management of advisory personnel and heads the advisory panel. He holds a Master of Commerce (Financial Planning) and a Dip. Financial Planning and has authored literally dozens of financial education publications.|