What's Your Percentage?

The title of this post sounds like something we would typically ask our friends and classmates the day our exam results were announced. But I assure you that this post has nothing to do with exams or scores. It has everything to do with retirement planning. When we plan for retirement, we usually end the calculations when we arrive at the monthly and annual investment targets. But we rarely check to see how much these targets would constitute as a percentage of our take home income. This number can provide very useful insights that can guide our retirement planning endeavours. So that is what I am going to talk about today in this short but useful post.

Calculating The Required Savings Percentage (RSP)

This entire calculation would be based on the assertion of Zero Real Returns. The assertion states that the required retirement corpus can be given as follows :

Corpus = Current annual expenses × Number of years post retirement

So someone planning to retire at age 55 would need a corpus worth 35 times their annual expenses (assuming a life expectancy of 90). Now assume that a 30 year old has annual expenses of Rs 18 lakh and a current post tax liquid net worth of Rs 54 lakh. Their annual post tax income is Rs 40 lakh per annum. They plan to retire at age 55. They expect to live until 90. Their current net worth is worth thrice their current annual expenses. (54/18 = 3)

This means they need a further 32 years of expenses for retirement at age 55 (35 - 3 = 32). To build the required corpus, they have 25 years available to them until retirement. This means they need to invest an amount worth 1.28 times their annual expenses over the coming year for retirement (32/25 = 1.28). This figure is known as the investment multiplier.

In this case, the required annual investment of 1.28 times annual expenses would come to Rs 23 lakh (18 × 1.28 = 23). To find the required savings percentage we must divide the annual investment target by the annual take home income of the individual. The resulting figure must then be expressed as a percentage. Therefore :

Required Savings Percentage = (Annual Investment Target/Annual Post Tax Income) × 100

In the present case the required savings percentage can be calculated as follows :

Required Savings Percentage = (23/40) × 100

= 0.575 × 100

= 57.5%

This means the 30 year old must save 57.5% of their annual take home income during the current year for a comfortable retirement at age 55. The required savings percentage must be calculated afresh every year. Updated figures must be used for key inputs such as annual expenses, net worth and the investment multiplier.

Interpreting The Results

We must remember that the percentage calculated above pertains solely to the retirement goal. Other goals will have their separate savings targets. We must then look at our actual annual savings rate. If the actual savings rate is lower than the RSP it means we are unable to save enough for our retirement. If both metrics are broadly in line with each other, it means we are largely on track for retirement. But it also means that we may be unable to save enough (or anything) for any other goals we may have. Finally if the actual annual savings rate is significantly higher than the RSP it means we can invest enough for retirement and also any other goals we may have. This is the best case scenario.

In the instant case, the individual spends 45% of their annual income ([18/40]×100 = 45%). This means their actual annual savings rate is 55%. The RSP is 57.5%. Strictly speaking, the individual is unable to save as much as they need to for retirement. But the actual annual savings rate is broadly in line with the RSP. This means that they are broadly on track for retirement. But they may be unable invest enough for other goals.

Closing Thoughts

The above calculations and interpretations may make goal planning numbers look daunting. Let me be the first one to admit that. But these calculations look daunting only because they are meant to. If they don't, it can mean one of two things. It could mean we have a very high savings rate (at least 60% of post tax income). This implies that we are able to invest enough to achieve our goals. If not, it means we are not doing the calculations right.

Doing these calculations would help those who are on track further validate what they have done so far. Those who may have fallen behind would at least receive a wake up call. Those willing to take action may then still have enough time for course correction. So these calculations and interpretations have something on offer for all those planning for retirement.