Think you have your retirement plan nailed? Think again, because your pension may not be able to sustain you. Here’s a smarter way to prepare for retirement. PHOTO/FILE
Julius is 35 years old. He has just started a new job and currently earns a monthly income of Sh100, 000.
Julius has never taken retirement savings seriously and has never contributed to any of his previous employers’ retirement schemes.
During induction to his new job, he was taken through the importance of retirement planning and has started getting interested in putting aside money for this eventuality.
A huge motivating factor for Julius to register for the organisation’s retirement benefit scheme is that his employer will match his contribution up to a maximum of 10 per cent of his income. Julius starts contributing Sh10, 000 a month towards this and his employer another Sh10, 000 per month. Julius is happy to keep it at this level (a total of Sh20, 000 per month) as this is the amount that he will receive a tax benefit on.
He hopes to retire at the age of 60 (in 25 years).
Julius has done a rough calculation based on past performance of this particular pension fund. In 25 years, assuming his contribution remains the same, he will have put in a total of Sh6 million together with his employers contribution.
He expects his retirement savings to be worth Sh25 million. This is assuming that he never pulls out, the fund achieves on average a return of 10 per cent per year and all the returns are reinvested.
Secure future?
According to Julius this is a lot of money and is enough to see him through his sunset years. With 25 million shillings, he can live for over 20 years based on his current lifestyle.
He figures he can now concentrate on other things such as educating his children, buying a home, enjoying his life, travelling, etc. That is exactly what Julius does. After all, his retirement plan has been secured or has it?
Fast forward to the future; Julius is 60 years old and his day of retirement has come.
A party is held for him at work and his achievements are recognised. He goes to the home he has now finished paying off with a fat cheque of 35 million shillings.
The investments in the pension fund did even better than he expected due to some bumper years on the stock market.
He banks the money, settles into his retirement years with ease, and draws on the funds to sustain his lifestyle. Three years later, Julius is dead broke. What happened? Isn’t this the guy who walked away with millions? Did he spend recklessly? No, he did not. He just did not know what planning for retirement is.
The first mistake Julius made is thinking that he can forecast his retirement needs (25 years later) based on his current income. Let’s even assume Julius maintains the same standard of expenses; that is he continues to spend the equivalent of Sh100, 000 per month today.
Well, there is still this animal called inflation to deal with. Assume inflation rate over the period is at 10 per cent per year. It is currently a bit lower than this but let us be conservative.
That means a year later Julius’s lifestyle will be 10 per cent more expensive. In 25 years when he wants to retire, his lifestyle will cost him over one million shillings a month.
That is the figure he needed to have made his plans with from the beginning.
So what seems like a huge amount of money to receive will in actual fact, sustain him at that lifestyle for 35 months. This is a very common mistake that people make when planning for retirement. With inflation the value of money today is not the same as it will be in the future. This is the primary reason why your pension fund is not going to be enough.
The second mistake that Julius made is putting the money in the bank and consuming it. When you receive your pension fund, you should not consume the capital or principal. As we have seen with Julius, because of drawing on the funds, he really can’t live very long off them.
What Julius should have done is put the money where it can earn interest or income and then live off the income only.
That way the capital is preserved and therefore it’s ability to generate income continues. For example if Julius put this money into a bond earning 10% p.a., each year, the bond will give an income of three and a half million shillings. He needed to be disciplined enough to cut expenses and live off this money without touching the thirty five million.
You don’t know whether you will live another 20, 30 or 40 years post-retirement so do not eat into your principal because when it is gone, what will you do?
Gravest mistake
The last and gravest mistake that Julius made is assuming that his pension fund would be the source of his retirement income.
It can only be a part of his income, not the sole source of income. Julius needed to have made other investments along the way, investments that would generate income to sustain the lifestyle he wanted to have at retirement.
In this example we assumed he maintained the same lifestyle but in reality expenses may change.
Remember, every time you increase the amount you currently spend on your lifestyle, it will mean a bigger retirement portfolio that you need to have. Plan for it.
Your pension fund is not the sum total of your retirement plan.
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