By Lacey Filipich BEng(Hons) MAICD Cert Gov (NFP)
When talking to people about their financial goals, a common question they seem to ask themselves (and me, and I assume their financial planner) is:
How much money do I need to retire?
It’s an interesting question, but it’s not the right question.
1. It’s what you do with it that counts
‘How much’ – the finite amount of money – is not nearly as important as how you are allocating that money.
For example, in terms of cash flow, $1 million in a term deposit earning 2.5% is the same as half that amount ($500K) earning 5% in dividends after costs and taxes. In both cases you get $25,000 a year in cash to spend from your investment, but you needed twice the capital to do so from a term deposit.
This means it will take you twice as long to save the term deposit amount – that’s significant if you’re using the capital and cash flow to fund your retirement.
2. ‘Money’ ain’t money
In this context ‘money’ can, broadly speaking, mean two things.
It can mean capital – the value of your assets. This is what your superannuation balance or the equity in your investment property represents. We want our capital invested in assets that grow in value year after year.
It can also mean yield – the cash flow generated by your assets. This is the rent coming from your investment property or the dividends paid to you for your shares. We want our capital invested in assets that produce a decent yield – or passive income – that we can use to invest further or live on.
Capital and yield are two very different things. Be clear about which number you care about – and yes, the answer can be ‘both’.
3. It confuses ‘wants’ and ‘needs’
Don’t we all. How many times have I heard my mother say ‘But I need these shoes!’ Trust me, she doesn’t. She just wants them.
Strictly speaking, your needs will be what you might call the basics: food, shelter, clothing, transport. That kind of thing. Holidays, dinners out, designer handbags and flashy cars do not count as things you need. They’re just things you want. So if you frame your retirement target around just the ‘needs’, you’re setting the bar rather low.
Try instead to focus on what you want. You’ll still have the needs of course – these are a bare minimum required for survival – but without allocating enough resources to allow you to do the things that excite you and make you happy, you’ll be in for an unsatisfying time.
4. It insinuates an end-of-life retirement
The overwhelming majority of people I talk to assume their life will follow this broad timeline:
- Play (0-4yo)
- Study (5-15yo to 25yo)
- Work (15 to 25yo – 65yo)*
- Retire (65yo – 80ish)
*Note: I include having a family and stay-at-home parenting here. If you’ve done it, you’ll know that it’s definitely work, even if it’s not perceived that way because it usually doesn’t come with an income. Perhaps we should consider it a volunteer role…
People also tend to assume they will only be retiring when they meet the government-set retirement age (65-ish at the moment, and getting later as our lifespans improve).
These two items – the timeline and when retirement will start – is a very limited view of the world. Unfortunately it’s often the only view we’re offered by society and our educators (family, friends, teachers etc).
Let me dispel a few myths these assumptions create:
- You do not have to wait till the end of your working life to retire. They’re called mini-retirements. They’re fabulous. You should try them.
- You do not have to wait till the government approved age to retire. That’s just when you’re allowed to access your superannuation and claim senior citizen rights. You can retire whenever the hell you like – but you probably won’t until you’re financially able to, or forced to.
- You do not have to retire. You can be fabulously wealthy with not a monetary care in the world and work into your nineties if you so choose. The difference is, you’ll almost certainly be doing work you are deeply passionate about because you’re doing it by choice, not out of need.
5. It’s too often asked too late
It’s often not till a person is sporting more grey hair than their natural colour that they start to consider retirement in earnest. This is too late.
Maybe it’s the ‘I’m invincible’ factor – retirement is for old people and I’ll never be old so I don’t need to think about it. Perhaps we’re too busy thinking about how much money we need to earn to make it through the next week, month or year that we don’t think about the time when we won’t be earning any more. Or it could be that it’s just too hard, too scary or too abstract to be worth it.
Whatever the reason, if you’re older than 20, you need to be thinking about this now. Yes, you read right. 20 year olds should be thinking about their distant financial future. Why?
Because of the power of compounding. Einstein allegedly called it the most powerful force in the universe (I wasn’t there so I can’t be absolutely sure he said it).
For example, let’s say two people put $1 in a bank account earning 4% interest per annum, compounding monthly. Person A is 40 years old, Person B is 20 years old. When they are each 70 years old, how much will they have?
Person A, the 40 year old, will be 70 in 30 years. She will have $3.31 at maturity.
Person B, the 20 year old, will be 70 in 50 years. She will have $7.36 at maturity.
20 extra years – an increase of 66% versus the 40 year old – means 222% more return. Every extra year has an exponential effect. The best way to harness the most powerful force in the universe? Start immediately. Do not delay. Time is against you if you delay, but it’s your best friend if you start NOW.
Asking the right question
Now you’ll have some understanding of why I cringe at the ‘How much money do I need to retire’ question. It’s simply not the right question to be asking. So what should you be asking?
When I’m setting long-term goals for my financial future, there is only one question I ask myself:
What after-tax passive income do I need to live the life I want?
It’s a fairly simple sentence, but let’s deconstruct it to make sure it’s crystal clear.
What is ‘after-tax passive income’?
It’s the amount of cash I have in my hot little hands to spend after the Tax Man takes his cut. The ‘passive’ part means yield: I want this income to come from my investments, rather than having to actively earn money (i.e. having a job). So, these four little words – after-tax passive income – mean I envisage a future where I don’t have to work to support myself because I have an investment portfolio that does that for me while also meeting my obligatory tax payments as a law abiding citizen of Australia. Note: this does not mean I do not intend to work. It just means I don’t want my work to be my means of supporting myself financially.
What is ‘the life I want’?
I’m adamant about this phrasing because:
- There’s no time assumption.
- There’s no insinuation about whether or not you’ll be working.
- There’s no limiting of the potential for enjoyment.
It’s all about your desires and creating what suits you. This is a much more powerful motivator than some distant, abstract point of retirement in your future. Phrasing it in this way means even a 20 year old can see the benefit.
It does however make one assumption: that you’ll be living off yield rather than drawing down your capital. I prefer this, as drawing down capital means you have to have an end-date in mind. In other words, you have to estimate when you’ll croak. Neither easy nor comfortable for me, so I like to think I’ll preserve the capital and merely live off its income.
So… what’s the number?
How much after-tax passive income do you need to live the life you want?
Whatever you decide. That’s the beauty of this: it might be $10,000 a year, it might be $5 million. It really depends on your preferences and desires.
- Ignoring housing costs, the poverty line in Australia is around $21,000 a year – approximately the amount you’d get on a full pension (which is why I plan never to rely on the pension).
- My personal number is around $100,000 assuming I’m debt free.
Now, go work out what it would cost you to live the life you want. It’s probably cheaper than you think.
How do I get there?
Now that you’ve set your target, you can work out your plan to get there. Then, you follow the plan. Job done…
… Just kidding.
This is a question worthy of a detailed and actionable answer.
During the process of writing what I think the answer is, I’ve realised it’s very lengthy, so I will be splitting it over four future posts starting in October 2015. They will cover:
Oct 15: The one-page financial model
I’m a big fan of the plan-on-one-page, adhering to the old saying ‘If you can’t explain it simply, you don’t understand it well enough.’ I’ve finally gotten to a point where one page is ample for all your calculation needs. The financial model post will include the calculations you need in a powerful visual format called a driver tree. It will also include what’s called a ‘sensitivity analysis’ to show which of the three major ‘branches’ of the driver tree have the biggest impact on your bottom line.
Nov 15: Focus Area 1 – Savings for investment
- Increasing active (i.e. work) income
- Increasing passive (i.e. investment) income
- Moving after-tax spending to before-tax spending
- Reducing after-tax spending
Dec 15: Focus Area 2 – Capital Growth and Yield
- Increasing nominal growth from your investment portfolio
- Reducing investment costs
- Maximising your yield on investment properties
Jan 16: Focus Area 3 – Time
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