Dangerous thoughts on retirement: ‘Better late than never’

By Dr. Johnny Noet Ravalo
INQUIRER.net

We all get pre-occupied by the rat race. Surely taking a few years off wouldn't hurt my retirement plan. Or would it?

Anyone who wants to retire well needs to ask himself (1) how long do I expect to live and (2) how much time do I have before I retire?

The last thing we want is to run out of resources after we retire. We would rather bequeath what we have left rather than ask our children to feed us. That’s why the planning horizon is important. We need time to prepare.

Figure 1 in the gallery shows what happens when we have set aside P100,000 (for the lump-sum, just-in-case expenses) and then we add P50,000 each year to our retirement fund. Let’s assume that it generates a return of 5.0 percent per year.

Getting one's first full-time job at 21 to 22 years old, a young worker usually needs a few years to get “settled” (complete change of wardrobe, treating the immediate family, spending on “tools” that make us look more professional). This transition is normally done by 25 years old, which leaves 30 years before retirement.

Using the assumed parameters, the potential retirement kitty will come out to P3.92 million. This figure is not etched in stone as many things can and do change. Rather than get caught up in the accuracy of an absolute number, I find it more useful to think in “relative terms”.

Now, what happens if we take a few years off from the 30-year plan? After all, 30 years is a very long period and surely some time off wouldn't hurt. Or would it?

Five years off from the 30-year planning horizon - that's 16 percent if you're counting - makes us lose more than 25 percent of the full potential value of our retirement kitty. And if we take a third off the planning timeline, we lose almost half of the potential value! (See Figure 1 in the gallery).

There is a world of difference between starting to plan for retirement at 25 years old versus starting at 40. Roughly two out of every three pesos that could have been generated is lost just because we start later than sooner.

Is the gap permanent? Absolutely not. Can we retire then in five or 10 years if we only start to prepare our retirement kitty now? Not exactly.

The same graph shows that catching up is increasingly difficult the more we delay. If we only allow five years of pension contribution, we would have lost 89 percent of what the fund could have been. For a vesting period that short, the problem becomes more absolute than relative: five years is too short to have enough in a retirement fund irrespective of any consideration of foregone opportunities.

The only cure for a short vesting period is either to invest more or generate much higher returns.

Going back to the numbers, we need to invest roughly P163,850 annually for 15 years to get a retirement kitty of P3.92 million. This is over three times my initial target of P50,000 annually and all because I gave up half of my planning horizon. If I started even later, I would need P284,500 a year for 10 years or P654,000 annually for five years.

Since most of us do not have the luxury of this much saving, the harsh reality is that beyond a certain point there isn't enough time to prepare for retirement because the demands on saving and reinvestment would be too great.

How about generating better returns? We all know that higher returns mean a bigger retirement kitty. We probably also know that higher annual rates of return increase the amount of the retirement fund at an increasing rate (See Figure 2). The more interesting question though is whether higher returns can make up for a shorter vesting period.

The answer is in Figure 3. For a 10-year horizon, we need a return of 29 percent per year while a 5-year horizon requires an annual rate of return of 80 percent to match the 30-year planning period. I simply cannot think of any legal - never mind, prudent - means to earn this much from an investment.

To lower the threshold return, we need to raise the annual amount we set aside for retirement. The impact of that is in Figure 4. Despite increasing the amount set aside for retirement five-fold, 36 percent per annum for five years just isn't doable. This is already a quarter of a million pesos annually and the numbers still don't work out. Remember that I have not even talked about the risk-return trade-off.