A formula for your retirement nest egg

I VIVIDLY remember my professor describing a simple formula for calculating the amount of money I would need to retire on: just multiply your annual expenses by 25. I thought I had this whole retirement planning thing figured out. How tough could it be?

The guideline described was the “4 per cent rule”. You multiply the annual cash required by 25, which would let you “safely” withdraw 4 per cent every year and have it last approximately 30 years before you run out of money. So, if you calculated that you would spend S$8,000 a month, you would need S$2.4 million in retirement savings.

It didn’t take long for the harsh reality to set in: That simple multiplication wasn’t going to cut it. Will you end up living until 102 like your great-aunt? Will your investment returns over 30 years of retirement resemble a terrifying roller coaster or be relatively smooth sailing? What about healthcare cost projections in the later decades of your life?

There are just too many moving parts to be able to accurately calculate a minimum retirement sum that would fit a large number of people. More importantly, there are a number of critical assumptions in the “4 per cent rule”: It assumes achieving an inflation-adjusted investment return of 6 per cent every year, that your retirement expenses remain stable over time, and that your lifespan does not go beyond 30 years.

Realising that this calculation method wasn’t sufficient, I set out 20 years ago to create an alternate grid that was more accurate and would provide better results – a model that can be tailored to an individual’s specific situation. We used the same grid for investors who have more than enough money to last beyond their own lifetime, and want to leave a comfortable nest egg for their children and future generations.

First, we tackled the original assumption of an inflation-adjusted 6 per cent annual return. Such a portfolio would need too high an allocation to equities to achieve its target, leading to significant volatility in the yearly returns. Taking out 4 per cent of a portfolio value for living expenses in a bear market would significantly shorten the time till the capital of the portfolio is depleted.

We broadly defined three types of investment portfolios:

• Conservative, targeting 3 per cent returns over inflation;
• Balanced at 5 per cent over inflation; and
• Equity at 7 per cent over inflation.

The number of years until the retirement capital is fully used up reflects the investor’s life expectancy, with a sufficiently large additional margin. The last thing anyone would want is to live additional years after the retirement nest egg is depleted.

Crossing the life expectancy column with the level of risk in the portfolio presents a number that is the multiplier of one’s annual expenditure needs, inflation-adjusted.

An investor who expects to live 20 years in retirement, using a conservative portfolio (3 per cent return above inflation), and who needs S$8,000 a month for all living expenses (S$96,000 per year), would need to accumulate 15 times this amount or S$1.44 million by retirement. They would withdraw S$96,000 the first year, and continue to do so every year, while adjusting the withdrawal up by the annual inflation.

Choosing a less-conservative portfolio strategy means that you would need to accumulate less capital for your retirement needs. However, it also comes with a higher risk of not meeting your retirement goals.

This is why the recommendation is always to choose the most conservative investment strategy. This will ensure that the probability of meeting your retirement requirements is as high as possible. A diversified equity portfolio that targets to last 40 years has a 20 per cent chance of running out of money by year 16, and a 50 per cent chance of running out of money by year 36. Would you take those odds of running out of money in retirement? I wouldn’t – and neither should you.

The last piece of this puzzle is that the targeted investment returns must be achieved with the highest level of confidence possible. In other words, you cannot afford to make mistakes in how this retirement portfolio is managed. A return of 3 per cent above inflation (diversified-conservative) is far easier to achieve than a 7 per cent return above inflation.

For investors who have more than enough assets to last their lifetime, we encourage them to set up a “family multi-generation nest egg”, using the most conservative investment strategy, which targets to build a kitty equivalent to 34 times the expected annual expenditure in retirement.

This set of specifications calls for the accumulation of the largest amount of capital as the retirement nest egg. It does not have an end-life where the capital gets used up, and is thus structured to last forever. When managed judiciously and conservatively, it can be used to provide for future generations of the family indefinitely.

With this portfolio as a safety net, an investor will be able to risk-budget all the other portfolios and assets appropriately, without endangering the family’s well-being.

The writer is head of investments for Singapore at AlTi Tiedemann Global. The views are solely the author’s, and do not reflect the views or positions of AlTi Tiedemann Global or its subsidiaries. This content should not be considered as financial advice.