Retire On Property

Personal Finance – Essential skills to manage your money before you start investing in property

Erik — Sat, 04 Jun 2011 15:57:06 +0000

Before you start investing, whether it be in property, shares, commodities or whatever you choose as your investment vehicle. You need to be able to manage your money. Sounds simple doesn’t it?

It’s almost embarrassing to write about it. But if you look at statistics worldwide, whether it be Australian, American or European statistics they all tell the same story. People can’t manage their money. They’re over their head into debt, spending money they don’t have on things that lose their value as soon as they’re taken out of the box and investment returns of the average investor are just miserable. Heck, the majority of professional fund managers can’t beat their benchmark indexes.

The following, taken from Jamie McIntyre’s book “What I Didn’t Learn at School but Wished I Had”, illustrates the depth of financial intelligence of the average Australian, which I’m sure will be quite representative for the rest of the western world. Jamie states: “If we gave every Australian $10,000 right now, what would happen to that money in twelve months time? Statistics show that 80% of Australians would have spent all the money and have nothing left, because this is what most of us have been taught to do. 16% of people would have turned the $10,000 into $10,500. Where do you think they would have put it, to get such a handsome return? Of course, it has gone straight in the bank! Now, we can not call either of these categories financially intelligent and those figures make up 96% of the population! Less than 3% of the population would turn the $10,000 into as much as $20,000 inside twelve months. If you can do that you would definitely be considered financially intelligent. In fact, if you can do that, there is probably no dream on the planet that you could not afford to buy one day, that is up to 100% return on your money! The remaining 1% of the population can turn that $10,000 into as much as $1,000,000 inside twelve months.”

Not sure where Jamie got his statistics from, but they ring true. So, just think…Which group do you belong to?

I know I’m not in the top 1% otherwise I wouldn’t even be creating this website. I know I’m also not in the bottom 80% or even in the 16% who just made 5%. I’m one of those 3% of people who would make a good to great return on their $10,000 but not necessarily as much as 100% in one year though. But I also know that 5 years ago I would have been in the 16% who would have made measly 5% and 10 years ago I would definately just have blown the money and had lots of fun doing so – which is not a bad approach for a twenty something! But once you get older and if you have plans to not work till your 60th, 65th or even 70th that approach won’t work and you need to get smarter at managing your money.

Now, there are plenty of money web resources and books out there that aim to explain to people the basic concepts of properly managing their money. One of them is Robert Kiyosaki, author of Rich Dad Poor Dad who coined the phrase Financial Intelligence and in his books aims to explain a lot of basic money management skills most of us do not learn at home nor at school and therefore go through most of our lifes without them.

And that is what this section of the site is all about. I have summarized all the essential elements from Robert Kiyosaki’s Rich Dad Poor Dad, from the Millionaire Next Door and other classics in these pages and provide numerous external links to great sources of additional information. So everything you need is here.

Now, it’s up to you.

Read. Learn. Take action. Become wealthy.

Property Investment – Eight reasons why you should invest in residential real estate

Erik — Sat, 04 Jun 2011 15:55:32 +0000

Property and especially Australian property is an excellent investment. Not only is it much harder to lose money in property than in the stock market, but with property investing you benefit both from steady capital growth and from rental income. And as rental income increases over time it protects you from inflation. At the same time you can borrow money to buy property and despite Australia’s high taxation environment, property investment can be very tax efficient.

Let’s have a look at these advantages and some other positive aspects of residential property investment in a bit more detail.

1. An investment market not dominated by investors

First of all, you need to realize that some seventy percent of all residential property is “owner occupied” and only thirty percent is owned by investors. That means that residential property is the only investment market not in fact dominated by investors, which means that there is a natural buffer in the market that is not available in the share market. To put it simply, if property values crash by 10%, 20% or even 40% we all still need a home to live in and so most owner occupiers will simply ride out any major crash rather then sell up and rent (compare this to the stock market where a major drop in prices can easily trigger a serious meltdown).

Sure, property values can and do go down but they simply do not show the same level of volatility as the share market and property offers a much higher level of security. And if you don’t believe me when I tell you that residential property is a safe investment, then just ask the banks.

Banks have always seen residential real estate as an excellent security and that’s why they’ lend up 90% of the value of your investment property; they know that property values have never fallen over the long term.

2. Sustained growth

Property prices in Australia tend to move in cycles and historically they have done well, doubling in cycles of around 7 – 12 years (which equates to about 6% to 10% annual growth). We all know that history is no guarantee for the future but combined with common sense it’s all we have. There is no reason to think that the trends in property of the last 100 years would not continue for the next few decades, but to be successful in property investment you must be prepared and capable to ride out any intermediate storms in the market, but that applies to any investment vehicle you choose.

And here is some evidence, the graph below shows Australia’s median house price between 1986 and 2006 as published by the Real Estate Institute of Australia (REIA) and it shows that back in June 1986 you would have bought an average home for $80,800. That same home would have been worth $160,500 in 1986, which is pretty much double of what you paid 10 years earlier. Another 10 years later in 2006 that average home was worth some $396,400. So between 1986 and 2006 that average home went up by nearly 400% or about 8.3% per annum.

GRAPH

Not bad. And quite in line with the longer term history.

Michael Keating points out in his blog on 24th January 2008 (Why Melbourne’s properties will keep rising), that the above growth is actually on the low side compared to the historical average. Australia’s property prices have been tracked for something like the last 120 years and according to Michael they have on average risen some 10% per year. Just in case you might believe that had to do with Australia being a newly found colony, and don’t believe this would be sustainable in the long term, consider this: in the UK records of property sales go back till 1088 and analysis of the data shows that in those 920 years UK property on average has gone up by 10.2% per year. If you want to know more, read my research on historical house prices which clearly supports this although the long term growth is a bit less than 10%.

What is also interesting about the above graph is it’s shape – it is a classical example of the property cycle, but we won’t go into that here.

3. Buy It With Other Peoples Money (OPM)

Now just in case the above has not been enough to convince of the value of residential property investment, let me tell you one of the great secrets of creating wealth, which also applies to investing in property. The secret is OPM. Other Peoples Money.

Secret? No that’s just marketing hype you see on the web, but the power of Other People’s Money or more common referred to as leverage or gearing is absolutely critical to building wealth. And, in the case of property the leverage you can apply is substantial. As I mentioned above, banks love residential property as security and therefore will easily lend you 80% or 90% of the value.

It was Archimedes who said, ‘Give me a lever and I’ll move the earth’. Well, as an investor you don’t want to move the Earth, you just want to buy as much of it as we can!

When you use leverage you substantially increase your ability to make profit on your property investments and, importantly, it allows you to purchase a significantly larger investment than you would normally be able to.

Let’s have a look at how this works. Imagine there are five investors each with $50,000 to invest. Say they all buy an investment property that achieves 10% growth per annum and has a rental yield (or return) of 5% per annum. Investor A borrows 90% of the value of his investment property (Loan to Value Ratio or LVR of 90%) and investors B, C and D borrow 80%, 50% and 20% respectively. Investor E doesn’t borrow at all and goes for an all cash transaction.

The table below shows the results after one year:

TABLE

What does this tell you?

Let’s start with cashflow, which is here simplified to rental income minus interest paid. Investor A, who geared 90%, has a negative cashflow of $15,500 for the year whilst Investor E who borrowed no money at all has a positive cashflow of $2,500. But that’s not the whole picture because each of the investment properties increased in capital value and once we include that the picture changes significantly, Investor A has a net worth increase of $34,500 whilst Investor E who didn’t gear increased his net worth by only $7,500. In terms of return on investment Investor A achieved a 69% return on his initial $50,000 whilst investor E achieved a return of 15%.

That’s pretty impressive for one year. And if the investors let their properties grow one or two full cycles we’re talking about serious wealth creation. And once the investors have enough equity in their investment property they can use that to fund a second purchase which after a few years growth will allow the purchase of a third and we’re on our way to wealth! That is, those investors who geared as Investor E is not going anywhere fast.

However, it is not all that easy. As you saw Investor A incurred a negative cashflow in his first year and would continue to do so for a few years until the rental income had grown sufficiently to pay his interest. He has to fund this annual shortfall from his salary. And this is called negative gearing – you borrow money to generate capital growth in your property but incur an annual shortfall in the near term. For most investors this means there will come a limit on how many investment properties they can buy with negative gearing, as they don’t have too much spare income. If you look in our strategy sections you can read more about negative gearing and techniques to avoid paying the shortfall out of your own pocket. We also address cashflow positive properties.

But let’s get back on topic and have a look at some other compelling reasons to invest in Australian residential property.

4. Income That Grows

We’ve discussed that Australian residential property investment is safe, with long term growth prospects and combined with the right level of leverage can create significant wealth. We also briefly touched on the fact that it generates a rental income. The good thing is, that over the years the rental income received from property investments has increased and this increase has outpaced inflation. In fact the last few years have shown tremendous increases rents – I know because the rent on my investment properties has been booming. Still is actually.

Ok, but are rents likely to keep growing? Well, statistics show that the level of home ownership is slowly decreasing in Australia. There are a number of reasons for this like demographic trends but, in particular, as property prices keep rising, fewer people are able to afford their dream homes. The latest Australian Bureau of Statistics figures confirm that more and more Australians are renting and many industry commentators are suggesting that the percentage of Australian who will be tenants in the near future will go up to 40%. So demand is growing. We also know that supply of good quality rental properties is limited (very low vacancy rates across all of Australia) and the government is having difficulty providing public housing. So all in all, it is very likely that rents will continue to grow at a pace faster than inflation – good news if you intend to become a property investor!

5. Tax Efficient

When it comes to property investing, your best friend is the bank as they provide the leverage you need to accelerate your wealth creation. Your second best friend is your tenant, as without a tenant your investment property would stand empty and your third best friend is the taxman.

The taxman? Absolutely.

How can that be when Australia is not know for attractive tax rates, in fact the opposite?

Well, first of all the interest you pay on the loan to buy an investment property is fully tax deductible and if you own the property longer than a year you only pay capital gains tax over 50% of the gain. Add to that various depreciating allowances and you have the makings of a very tax efficient investment. If you do your homework, the bank will happily give 80% or 90% of the money you need to buy your investment property and once you own it, your tenant and the taxman will pay your interest and your rental expenses. Guess who gets to keep the capital gains, you!

Talk about OPM.

6. Millions of Millionaires

And if the above doesn’t get you going, consider this: most of the world’s richest people got rich by investing in property. Those that didn’t get rich from property typically invested their newfound wealth in property.

So, if the majority of wealthy people have used investment property to increase their wealth than why not use that knowledge to you advantage and do the same! There’s nothing wrong with seeing what successful people do and applying those principles to your own life.

Even McDonalds make more money through its real estate than through selling burgers and fries as it owns most of the land and buildings in which it’s franchises are located!

7. You Can Do It Too

Before you say, it’s ok for the rich, but how the heck am I going to get into property investing, let me tell you this. You do not need to be very wealthy to get into property investment; it really doesn’t take large sums of money to get involved. And that’s because many of the banks will lend 80%, 90%, 95% and sometimes even 100% or more of the value of a residential property. As long as you have a steady job and a little starting capital (spare equity in your home) you can afford to buy investment properties.

It has been shown over and over again that careful and intelligent use of real estate can enable ordinary people, like you and me, to become property millionaires in about 10 years. If you truly intend to become one of the wealthy people in the future, you should probably take a serious look at using property to your advantage.

8. Too Much Hard Work?

There are many ways to make money and some say that property investment isn’t that easy and takes a lot of time and effort. It takes time to get an understanding of the property market and how to go about investing in property. It can take weeks if not months to research areas and find the right investment property for you. And then it only gets worse, you have to organize finance, get a solicitor to deal with all the legal work. Just the finance and legal work can take 30 to 60 days. And once you own the property the work isn’t over, as you need to look after it and do your tax!

Nobody said it would be easy. Nobody said you didn’t have to get your hands dirty.

Iit will take time and you will have to work at it and educate yourself. But hey, if you are serious about creating wealth and retiring early then property is a great way to achieve that. And once you’ve started and get some experience under your belt, you’ll see that I gets easier, and actually the process of building a investment property portfolio can be very rewarding and a lot of fun too.

3 Ways to Retire on Property

Erik — Sat, 04 Jun 2011 15:52:37 +0000

This post is based on an article written by Michael Carman.

Michael Carman is the Managing Director of property investment information publisher Wealth Enhance. You can subscribe to the free ezine, Wealth Enhancement Bulletin, at the Wealth Enhance website at www.wealth-enhance.com.au. This is an edited version of ‘3 Ways to Retire on Property’, originally published in the December 2007 issue of Australian Property Investor magazine and shown here with permission of the author. © Michael Carman 2008.

Financial Independence: An Introduction

In the same way that there are many ways investing in properties, there are also many ways to use property to retire wealthy (or early). We’ll look here at three ways to do that, and the ins and outs of each, as well as examples of how an investor might use each one to retire. Before we do though, there are two key concepts that we need to understand.

The Three Phases on the Road to Retirement

The first is the distinction between the accumulation phase, transition phase and the drawdown phase.

The accumulation phase is what financial planners refer to as the time when you are building your portfolio of assets, usually while you’re in the workforce. These assets might be superannuation, shares, or profits from ownership of a business, but in this case the assets we’re talking about building up in the accumulation phase are properties.

The drawdown phase on the other hand is when you retire and ‘draw down’ income from your assets. The accumulation of assets has stopped and instead the investor is living off the income generated by the asset portfolio.

The transition phase is just that: the transition from the accumulation phase to the drawdown phase. It’s important to understand these phases because each one fulfils a different function and has its own characteristics.

Passive Income

The other key concept is passive income. Passive income (or residual income as it’s sometimes termed) is money you earn which comes to you without any effort on your part. As some authors and commentators like to describe it, passive income is money you earn without getting out of bed. The most obvious example familiar to property investors is rental income, but other examples of passive income include interest, dividends, profits, royalties and licensing fees.

These two concepts are linked: passive income is what you ‘draw down’ in the drawdown phase, generated by the portfolio of assets you built during the accumulation phase.

Obviously, the more passive income you have, the better. And the higher the proportion of your total income represented by passive income, the better. And the real coup de grace comes at the point when your passive income exceeds your expenses (or the level of your desired income). On that happy day: Voila! you are officially financially independent.

Method 1: Retire on rents

This is the ‘plain vanilla’ approach to retiring on property: the investor accumulates a leveraged portfolio of properties over time and then sells some properties to pay down debt. The remaining properties in the portfolio are either unencumbered (that is, there is no debt associated with the properties) or have only such a small amount of debt associated with them that the interest on the loan is minimal. The passive income supporting the investor in retirement is the rental income generated by the unencumbered properties.

With this method, extra properties have to be added to the portfolio which serve the purpose of generating equity that’s used to pay down debt (rather than generating rents to live off). The other, remaining properties are the ones that generate the rental income used for living expenses rather than repaying loans. In this method then, properties serve two purposes: they generate rents to live off, and equity through capital appreciation to pay down debt.

The twist here is that the properties used to add equity that pays down debt are themselves debt-financed, thereby adding more debt to the mix. That debt must also be paid down. All of this makes the calculation of how many properties are required to retire, and the size of the asset base needed to generate the retirement income, very complex.

Example: Jane calculates that she needs five unencumbered properties to retire. She acquires eight properties over a period of years, lets them appreciate to a value of $8 million financed by $3 million in borrowings, then sells three properties (paying sale costs and capital gains tax) leaving five unencumbered properties. The rent from these five properties provides the funds to pay Jane’s living expenses in retirement.

Method 2: Refinance in retirement

In this method a property portfolio is accumulated, but instead of selling properties to pay down debt (as in the Retire on Rents approach) the entire portfolio is refinanced in retirement so that the loan to value ratio is ‘topped up’ periodically to provide funds.

With this method the passive income is the additional borrowings made available by refinancing in retirement. In effect, the investor adds to their borrowings to pay for the groceries. The interest is capitalised, that is, it’s added to the principal and interest is payable on the new, larger borrowing amount. That makes this the riskiest of the three approaches.

The fly in the ointment with this approach is that the investor needs to have an accommodating bank or lender who is willing to grant additional borrowings when there is little or no increase in capacity to service the larger debt. In fact the only factor boosting the ability to service debt is the rise in rents, which is likely to be moderate.

The investor may need to rely on low doc or no doc loans and would open up a line of credit to allow them to borrow between 5 and 7 years’ worth of living expenses (to act as an equity cushion to buy time for the portfolio to appreciate further). Some commentators maintain that a bank will likely be happy to lend to a borrower with an LVR of 60 per cent or less without the borrower having to show a ‘real’ income.

Another consideration is that there must be ongoing capital growth somewhere in the portfolio to enable refinancing to occur.

On the plus side, however, the funds generated by the refinancing aren’t classed as income for tax purposes and hence income tax is not payable.

Example: Barry and his wife have accumulated a property portfolio worth $6 million, financed by $3 million in borrowings. Their LVR is therefore 50 per cent. They refinance to 60 per cent and pull out $600,000 in tax-free funds to live off for the next few years. The $600,000 is added to the $3 million debt, taking total borrowings to $3.6 million.

Method 3: Sell up and park the proceeds

The third approach to retiring on property involves accumulating a leveraged property portfolio, selling all the properties in the portfolio, and investing the proceeds in a low-risk investment vehicle such as a cash management trust. In this approach, the passive income which supports the retirement is the interest payment from the trust.

This method treats property investing as a means of accumulating wealth to retire, but not generating wealth in retirement. The capital growth of the portfolio is what creates the wealth with this approach, and the wealth is then transferred to a different vehicle that has no borrowing commitments, nor any tenant or property management concerns. An investor using this approach would build their property portfolio focusing on high capital growth properties rather than cash flow positive properties.

Example: Ted builds a high capital growth portfolio of four properties worth $3.5 million financed by loans of $2 million. He sells all four properties, and after extinguishing the loans and paying capital gains tax on the sale plus sale expenses, is left with net proceeds of $1.1 million. This amount is invested in a cash management trust which pays an average six per cent (or $66,000) interest per year, providing the passive income that pays Ted’s living costs in retirement.

The trade-off for these benefits however, is that in retirement the income is subject to other forces such as interest rates if you park the capital in a cash management trust, or the stock market if you park your capital in a managed fund that invests in shares.

Making your retirement yours

The beauty of property is that it can be a highly flexible means of accomplishing what you want to achieve. The methods outlined here are not mutually exclusive: they can be combined in innovative ways. For example, you might choose to adopt the Retire on Rents approach, but refinance to access funds on an ad hoc basis or in case of an emergency. Or you might favour the Sell Up & Park the Proceeds method, but retain one rental property and some debt in retirement in order to improve the tax effectiveness of your portfolio. There are many combinations to mix and match, according to your personal preferences and your preferred trade-off of risk and return.

It’s good to know that in considering how you’re going to spend the latter part of your life, that there are many options open to you in creating an earlier – or wealthier – retirement.

Comments by Retire on Property

The article written by Michael was part of a series on retirement through the use of property and published in API Magazine. We will soon either publish the remainder of the series which goes more in depth into the different phases (e.g. accumulation) and the methods (rent vs equity) or publish our own articles on these subjects.

How To Retire Early

Erik — Sat, 20 Nov 2010 17:23:01 +0000

There are four things you need to do to retire early:

Manage your expenses and reduce or eliminate debt
Save and accumulate capital
Invest wisely and most importantly
Manage yourself

Sounds easy, doesn’t it. Actually it is, but it takes patience, self-control and above all commitment and clarity of purpose.

1. Managing Expenses

Controlling your expenses and reducing or eliminating debt is the first step towards early retirement. Most families spend almost all of their income and save very little. It’s not uncommon for families to spend 20-30% of their income on debt service. (Even the Federal government doesn’t do that.) Credit card debt at 15-20% interest is the number one reason folks remain poor. If you don’t pay your credit card bill in full each month, start making plans to do so today. Just about everyone spends 20-50% more than they need to for their day to day expenses. Do you ever buy food at 7-Eleven? It’s probably much cheaper at the supermarket. Do you buy your clothes at the fancy department stores in the mall? You can get the same items at Marshall’s or SteinMart for half price. Think of what you could save if you bought generic rather than name brand. It really adds up.

2. Accumulating Capital

Once you’ve got your spending and debt under control you should begin generating a surplus (i.e., your expenses are less than your after-tax income.) Retire Early’s Generation-X Retirement Planner can show you how quickly this surplus can grow into some real money. Talking full advantage of tax protected vehicles like your employer’s 401k plan or even an IRA will make your nest egg grow even faster. It’s really amazing how fast your accumulated capital can grow, especially if you’re getting a good rate of return. Even a 7% return will double your money in 10 years. Prudent investors can do better than 7% over the long term.

3. Invest wisely

If you’ve been wise and frugal enough to accumulate some capital, it would be a shame to lose a large piece of it to excessive fees and commissions. Unlike dentistry or brain surgery, investing is one of those activities that you really are better off doing yourself. More than 85% of investment professionals under perform the market averages after you adjust their stated returns for the fees and commissions you pay up front. (See, “How much should I be paying in fees ?”) Unfortunately, it’s almost impossible to identify the 15% of investment advisors that outperform the market ahead of time. The investment world is a lot like baseball, last year’s batting champion tends not to repeat. You can easily add 1% to 2% to your investment returns over time by making your own decisions and minimizing what you pay in fees and commissions. Adding 2% to your investment return might allow you to retire 10 or 15 years earlier. The small amount of time you spend learning about investments and managing your own portfolio could be your most highly compensated hours of the year.

4. Manage Yourself

Don’t leave retirement up to chance. Qualified retirement counselors can sit down and help you find out just how much you need to save, how to invest, how much money the retirement you want will require, and what changes you need to make in your preparation and expectations. In many cases, people learn they really can have a well-funded retirement by using smart financial management techniques.

But money isn’t the whole story. There are plenty of people who amass a nice nest egg only to wind up sick and disabled in their senior years. They have the money, but they don’t have their health or mobility. If you don’t have an exercise program, start one now. It can be as simple as parking further from work and walking briskly to get there in time. The key is to get your heart rate up and breathe deeply. Recent studies show people who have good lungs live the longest.

Just as important, exercise your mind. Learn something new. Take up an entirely new hobby. Studies reveal teachers who learn all their lives suddenly stop learning when they retire. On average, a teacher lives just 18 months past retirement. Learning is essential to life.

Finally, build a network of friends outside work. When you retire, few things will be as important to your enjoyment of life as solid friends you can count on for companionship and help when assistance is needed.

How Much Do I Need To Retire?

Erik — Sat, 20 Nov 2010 11:27:41 +0000

The question is simple enough, but it can be quite a difficult one to answer. And that’s primarily because the answer typically depends on such a wide range of variables and assumptions. The result is that many of us simply avoid the question – but as we all know not asking the question doesn’t solve the problem.

There are many different approaches to determine how much money you will need to retire and none of them are right. They are all nothing more than an estimate and in some cases not much more than a guestimate. Some approaches are quite scientific and others are not much more than using a simple rule of thumb.

The main thing is that you need to be comfortable and confident with how you plan for your retirement, but you need to be realistic and take into account some key issues many people forget or simply ignore, like healthcare or the issue of inflation.

So in this article I will look at the 3 basic questions you need to answer to determine how much money you need to retire, these are:

1. How long will you live?
2. When do you want to retire?
3. What level of retirement income do you aim for?

There are many more issues that can come into play like inflation, how risk averse you are, what tax structures you have in place, what level of insurance do you need etc. but those can all be dealt with at a later stage. After we have these basic questions answered we’ll look at some of the common approaches to determine how much money you’ll need to stash away.

So let’s start.

How Long Will You Live?

Easy question and if you want to give an easy answer you just use the current life expectancy, so in Australia that is 79 if you’re a man and 84 if you’re a woman (based on ABS Life Tables, Australia, 2006–2008, 3302.0.55.001, updated in December 2009).

Personally I am an optimist and like to be conservative so I simply use 100 in my own calculations, but being too conservative is not advisable either as you’ll end up working / saving too long. So when we get close to our retirement target I might just bring that expectation back to statistical reality.

Then again, studies in the US show that life expectancy might well just reach 100 years of age by 2030! At least, that is the claim of Stanford University biologist Shripad Tuljapurkar, who bases his finding on biological advances and anti-ageing technology. If Tuljapurkar is right, then many people now in their 50s will live to at least 2050. If they were to retire at age 65, that means 35 years in retirement. Then it’s not just a question of having enough income each year during your retirement, but a key concern is whether you will outlive your retirement savings.

We’ll cover that later.

For just let’s just run with the average life expectancy so we can determine how long you will be living without a regular income and that brings us to the next question.

When do you want to retire?

All you need to give is a simple number: 60, 55, 50 or even 45. Start with your ambition not what you think you might manage or what people around you would expect you to do. This is you life so you need to decide. Love your job? Then 60 might be just fine for you. Some of us, have held down a job which hasn’t done too much for them other than pay the bills so they may well want to get out early. 50 anybody?

Really there is not much more to it at this point, just pick an age. Once you start crunching numbers you’ll soon enough see if you need to adjust the age, your lifestyle expectations or in some cases both. Bummer.

To avoid too much frustration do start with something challenging and reasonable. If you’re 35, have piles of bad debt, no savings or investments aiming for retirement at 45 is unlikely to work unless you aim for an extreme adjustment in your lifestyle or are expecting a windfall.

What level of retirement income do you aim for?

This is where you really need to sit down and start doing some homework. It’s easy to say I want $100,000 a year, but in many cases that won’t fly. I would recommend you do two things at this stage. First you use a simple rule of thumb to determine your required retirement income and after that you sit down and develop a detailed annual budget. Put the two numbers together and you can come up with a reasonable first estimate.

So, first we apply the general rule of thumb, which says that the income you’ll need in order to be “comfortable” when you retire is between 65% and 70% of your pre-retirement income. This figure was first set by a Senate committee looking into the adequacy of retirement savings in Australia. The figure has since been adopted by industry bodies, financial planners and the media – in other words all the “experts”.

Bear in mind that the higher your pre-retirement income, the higher the retirement income you’ll need. And the higher the income you need, the more capital you need to accumulate before you retire. If your income in the years before you retire is, let’s say, $100,000 a year, then a “comfortable” retirement according to the generally accepted view is something between $65,000 and $70,000 a year.

In my personal view, the 70% rule of thumb is way too crude and this is why I’m suggesting you should do a bit more homework and develop an annual budget. If you don’t and simply go blind on the 70% assumption you risk either working till you die as you’ll never be able to afford your unreasonable lifestyle expectations or you’ll suffer a far from comfortable retirement, 20 years or so at the poverty line.

Remember, I am writing this article with a view on retiring early, nothing extreme but simply with the intention of escaping the rat race a bit earlier. And the art in retiring early will be achieving a balance between the lifestyle you want and the money you have. The more you want the later you can retire. Keep that in mind when you develop your annual budget.

When you develop your annual budget think about: food, accommodation, transport, regular household costs, health insurance including allowances for excess health costs, life insurance, travel and of course leave some money for having fun and just discretionary spending! Add to add anything ‘unique’ like whether you still have kids at uni, have an ex with kids to support etc.

And don’t forget the taxman!

Calculating how much you need to retire

Now that we have the basic questions answered we can crunch some numbers. And to make things a bit easier to follow, let me introduce you to Jake and Helen. They are both 38 years old and have a combined income of $100,000 a year. Their ambition is to retire at the age of 55 and having done their homework the believe they can live quite comfortably off $55,000 a year, but they also know that they want to do a lot of travelling in the early years of their retirement so they’ve increased their desired income to $70,000 per year. To keep things simple they assume a life expectancy of 85 for both.

Now the question is: how much do they need to retire?

A simplistic approach would be: 30 years of retirement from the age of 55 till 85 at $70,000 a year would require Jake and Helen to accumulate a nest egg of some $2,100,000.

Ouch.

The ‘true’ situation is a little more complicated than that and possibly a bit less daunting. Remember, when you stop working your money should continue to work for you assuming you have invested it wisely. On the flip side you also have to allow for your worst enemy when it comes to retirement planning and that is inflation. That $70,000 might be fine in today’s money for Jake and Helen to do what they want to do, but by the time they retire in some 17 years that same $70,000 will only be worth around $41,000 in today’s money. When Jake and Helen are 75 that $70,000 will buy them less than $23,000 worth of goods and services in todays prices.

And this is where the complications come in. First of all you need to estimate at what rate your investments will continue to grow whilst you are retired. Secondly, you need to allow for a certain amount of inflation. Thirdly, you do need to realize that your living expenses tend to be highest in the early years of your retirement and then gradually reduce as you age. Your healthcare costs on the other hand are likely to increase as you get older. Bottom line is, your retirement income needs won’t be constant from year to year. So that’s another factor that complicates the calculations.

At this stage a financial planner can be an invaluable ally when it comes to working out things like this. However, in my experience most retirement advice is too simplistic and does not account for the fact many of the variables like investment returns and inflation will go through big variations during your retirement. If you are lucky enough to retire with a full nest egg and encounter 10 bull years on the stock markets you’ll be fine, but if you’re unlucky enough to encounter the worst bear market in a century when you’ve just gone into retirement you may well have to come out of retirement before the first few years are over.

Doing these calculations can become very complex, and so the industry has established another rule of thumb, which suggests that it would be safe to withdraw 4% of your next egg each and every year without running the risk that in the last few years your bank account would be empty. This 4% is sometimes also referred to as a safe withdrawal rate. It basically means that if you have $1,000,000 invested you can spend $40,000 a year – each and every year, whether it’s a bull or bear market as over time they will even out and your initial $1,000,000 will remain intact.

So, for Jake and Helen who wanted to retire at the age of 55 and expected to live another 30 years with an annual income of $70,000 they would require a nest egg of $1,750,000. Still a very sizeable chunk of cash, but nonetheless it is some $350,000 less than the initial calculation we made.

Various people have looked at this subject in great detail and have actually done statistical simulations based on actual historical investment returns etc. to see whether this 4% safe withdrawal rate is indeed safe enough. There are no easy conclusions, but some key warnings are put forward. Firstly, the 4% withdrawal rate might be too optimistic if you retire young or end up living very long. Secondly, some argue that investment returns are coming down and as a result a withdrawal rate 4% could not be deemed safe anymore.

Most of these studies are based on the performance of US stocks and they have indeed not performed well in the last decade and are unlikely to be your best for good growth for the coming decade. So maybe it’s time to consider other markets or other asset classes like property. Personally we have invested in Australian Real Estate and have kept a portfolio of (index) funds on the side, which I do expect to grow steadily over the coming years.

o, how much do you really need to retire?

By now, you must see there is no simple answer to that question. But if you insist, I would say that the 4% rule is probably the best place to start with. However, I’d strongly encourage you to read much more about the various aspects of retirement planning which I have only briefly touched upon here. Then over time you can figure out what you will feel confident and comfortable with.

Good luck!