My eye-opening retirement audit

Do you know the annual investment return you need to reach your financial goals?

Until today, I didn’t. But reading the work of my new colleagues Mark and Shani has made me realise how important this is. In fact, it’s the second step in forming a successful investing strategy. It comes long before picking individual investments, which is where I used to start.

Feeling a bit of shame, I decided to work out the required rate of return on my retirement portfolio. As I only started my first Australian job recently, about 98% of my retirement savings are in my self-invested UK retirement portfolio. My Super balance is tiny. But all going well, it will make up most of my pot by the time I retire.

I mentioned earlier that working out your required rate of return is step two of setting a sound investing strategy. Step one is setting a goal. The goal for this portfolio is to provide for a happy and occasionally indulgent retirement. To attach a number to that goal, I used the four-step approach Mark outlines in this article. Here’s what I came up with.

Setting my retirement number

Step 1: Tax and savings adjustments. I am currently on around $100,000 per year. Adjusting for a lower tax and Super burden in retirement takes the amount I need to maintain my current lifestyle to $70,000.

Step 2: Adjusting for future savings or costs. I am going to keep my other costs flat as I expect to still be paying rent. We already travel a fair amount, so I doubt this will increase when I retire.

Step 3: Salary adjustment. I didn’t adjust my future salary. Even though it is likely I still have some salary growth ahead, I’m just not sure how I could predict it. I would also be fine having my current quality of life during retirement (I bet everyone says that).

Step 4: Calculate my required portfolio size. Based on a 4% yearly withdrawal to fund $70,000 of living costs, the amount I need to reach is $1.75m in today’s money.

Where am I now?

I started by converting my UK pension balance to Australian dollars and adding it to what I have in Super. Please don’t laugh at my Super balance, I’m new here!

So, my starting point is $31,544.58 at the age of 29. The number I want to hit by 65 is $1.75m in today’s dollars. Add in my future contributions and I have everything I need to figure out my required annual return. Well, everything except my assumed inflation rate.

Inflation’s scary impact

When we invest, we forego spending today in the hope that our money will grow and give us more spending power in the future. Inflation fights against this.

Imagine that over a period of 20 years, you want to turn every $1000 in your account into an amount that would buy $3000 worth of goods today. If there is no inflation, you would simply need $3000 by that point – an annual return of 5.6%. But inflation means that tomorrow's $3000 won’t get you what $3000 buys today. You therefore need a higher return on your investments.

As you can see, small changes to the assumed rate of inflation can take your required return from reasonable to very aggressive. You could spend a whole year discussing how to predict inflation rates and be no closer to doing it well. But you do need to factor it in.

For my calculation, I went for 5% in case central bank targets of 2-3% are too optimistic. We’ve had 15 years of super low interest rates and some of the world’s biggest economies are up to their eyeballs in debt. That probably makes me sound like a gold bug, but I just want to avoid a nasty surprise.

Working out my portfolio’s required return

Here are the numbers I put into my calculation:

$31,500 starting value
$1,750,000 target value in 35 years
5% assumed inflation rate
$9500 annual contributions (my current amount)

When you are putting in your contributions, make sure to account for the tax you will pay on them. $9500 is my after tax amount. Here’s how it looked in Morningstar Investor’s required return calculator:

joseph-pension-calculation

Sheesh. A required annual return of 14.0%. No wonder there is a red warning sign next to the number - it’s just unrealistic.

Putting your numbers into a pension calculator and getting a high required return or low projected portfolio value doesn’t feel great. When this happens, you have two options:

Make the goal easier (reducing the target amount or give yourself more time)
Contribute more money

For me, option two looks like the way forward. I’m not sure I want to work beyond 65 and I don’t want to reduce the target amount. To contribute more, you can either save more of what you already earn. Or you can try to earn more and save a similar percentage.

I recently started a new job, so it’s unlikely my earnings will rise again in the short-term. But it might be very realistic for you. I wrote about three ways you can increase your income without working more in my article ‘Are you too focused on investing?’.

Here is how contributing more to my portfolio reduces the returns needed:

$400 per month extra contribution = 12.8% required return
$600 per month contribution = 12.4% required return
$800 per month contribution = 11.9% required return

$600 extra per month would be doable. But that only cuts my required return to 12.4% per year, which is still too aggressive. What else could I do? My next idea was to commit a large chunk of any future bonuses or other windfalls to my retirement pot.

Let’s say I manage to save the extra $600 monthly for the next year. I also manage to contribute an extra $10,000 from a bonus or other windfall. My new starting point (assuming flat returns in the meantime) would be $58,000 with 34 years left to compound. The required return is still 12%. I played with the numbers more and found that I would need a starting balance of $200,000 to get my required return down to 10%.

At least I have two potential saving graces.

Number one, I didn’t factor in any salary increases. Even for me, that’s pessimistic. Number two, my assumed inflation rate was aggressive. If it does settle at a level of 3%, my required return falls to 11.7%. Or 9.6% if I contribute that extra $600 each month.

My situation probably looks far from ideal. But I am where I am. What matters most is having a plan to bring your goals within reach. Praying for low inflation doesn’t count, so I guess I better start working on that promotion.

Here are some articles that might help you plan your retirement investments: