Wednesday, December 23, 2015

Your Money Ratio$

Recently I have been reading this book which I thought is really good for financial planning:

They provide you with advise such as how much you should be saving at every age, how much you should invest, the maximum debt you should get yourself into etc.

Let's get into the details. Assuming you want to retire at age 65, and require 80% of your last drawn income for retirement. How much savings should you have at each age group? The book introduces the capital to income ratio, the savings ratio and the mortgage to income ratio to address this: 

Age Capital to income ratio Savings ratio Mortgage to income ratio Stocks Bonds
25 0.1 12% 2.0 50% 50%
30 0.6 12% 2.0 50% 50%
35 1.4 12% 1.9 50% 50%
40 2.4 12% 1.8 50% 50%
45 3.7 15% 1.7 50% 50%
50 5.2 15% 1.5 50% 50%
55 7.1 15% 1.2 50% 50%
60 9.4 15% 0.7 40% 60%
65 12.0 15% 0.0 40% 60%

For example, at age 35, you and your wife if married should have savings (bank deposits, insurance, stocks, bonds, CPF) that is 1.4 times your total combined annual salary. You should also be savings at least 12% of your total combined annual salary. Your existing mortgage debt should not be more than 1.9 times of your total combined annual salary. Further, you should invest your savings in a 50%-50% stocks to bonds ratio.

The 5% Rule

The way this works is that at age 65, you have 12 times of your last drawn pay as savings. Assuming you earn 100,000 at age 65, you will have 1.2 million in savings. You will withdraw 5% of this savings every year for your expenses. So 5% * 1,200,000 = 60,000. However, earlier we said that we need 80% of our last drawn income for retirement, which means we need 80,000 a year. So where does the additional 20,000 come from? The author suggests that this should come from social security schemes, which in the Singapore case, is CPF life annuity.

Withdrawing 5% of your savings is only a base, and has to be adjusted for inflation. So say for example at age 65, you withdraw 5% of your savings. At age 66, inflation is at 3%, which means now you have to withdraw 8% of your savings to buy the same amount of goods.

To ensure your money doesn't run out prematurely, it is important to keep your savings reinvested. The author assumes you can earn 4.5% real returns yearly on your savings fund, over a 40-year cycle. It is important to note this 4.5% figure is after accounting for inflation. If inflation is 3%, and the financial markets return 7.5%, after accounting for inflation the real return is 4.5%.

I am happy to say that our household met all these ratios, except the 50%-50% stocks to bonds ratio. Currently we are heavier on stocks.

It is important to note that the above is written for an american in mind, how do these ratios change when we consider the Singapore context? This is another piece of research to be worked on.

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