Saturday, October 3, 2009

Catholic Retirement: Wisdom of the Proverbs

"Wealth quickly gotten dwindles away, but amassed little by little, it grows." - Proverbs 13:11

Wisdom of the Proverbs
The wisdom of the Scriptures is really amazing. It is full of timeless truths, and this verse from the Proverbs about wealth is no different. You can imagine two people with very different circumstances. The first won a million dollars in a lottery and the other, over his entire working career, amassed a savings of a million dollars. What kind of mentality would the former have when he cashes that million dollar cheque? Maybe, "I'm going to treat myself to a nice vacation, buy a sports car, spread a bit of the wealth to my close friends, etc." There is absolutely nothing wrong with any of the above, but the frame of mind is to spend, and to spend quickly. At the end of the first year, he may have spent a good 20-30% of his fortune. On the other hand, the latter understands the hard work it took to save up that one million dollars. He is not going to spend a good chunk of it in one setting.

The Proverbs is not commenting on the morality of the speed of obtaining wealth, but it is simply stating a fact. When money is obtained in a short timespan, chances of it being spent quickly is higher. On the other hand, if it is saved over a long period of time, it will grow. It speaks more about human nature than anything. Saving requires discipline and once obtained, it stays with you for the rest of your life.

Catholic Retirement...Well, Really, It's Just Smart Retirement!
So, how do we apply this proverb to our investments? What is the way of Catholic retirement? In my spare time, I have built a spreadsheet that plans out my retirement. It is like one of those retirement calculators that you can find on bank websites, except better! :) Please download it if you'd like. You'll need to enable macros in Excel for this to work, but don't worry, no viruses here! Let's go through it line by line.

First, what do the colours mean? Yellow denotes an entry box. If the cell is not yellow, you don't need to touch it. Some of the colours I put in there just highlights certain things.

1. Right at the top, we have our biggest enemy: inflation! One of the main reasons why we cannot afford not to invest is because if our money is stagnant, the value of it actually decreases over time. Everyone can recall how something used to be so much cheaper when they were kids! The historical inflation rate in North America for the past few decades is somewhere between 2 to 3%. I've put in a default 2.5%.

2. The second entry box is the growth rate of our investment. This is the average growth you are expecting to see in your investment per year. For reference, a CD (certificate of deposit [or GIC - guaranteed investment certificate in Canada]) usually returns about 2-3%, because it typically matches inflation quite closely. Therefore, CDs usually give an illusion of increasing the value of your money, when in fact, it is remaining constant, at best (due to the canceling effects of inflation). Depending on which years you take an average, the S&P 500 index will return anywhere between 8-12%. I don't believe that is good enough. My goal is to get 20-30% returns consistently year-after-year. You will soon see how much difference a few percent make!

3. The third entry box is how much money you intend to add to your retirement investment each year while you are still working. 10-20% of your before-tax income would be a good start.

4. The fourth entry box is how much money you already have in your investment.

5. The fifth entry box is your estate value (in today's dollars), or how much money you want to leave your family/friends/charity of choice.

6. The sixth entry box is your current age.

7. The seventh entry box is your final age, or how long you're expecting to live. To be safe, I have put 85 so we ensure the chances of you running out of money is low.

8. The eighth entry box is the fun part. It's how many more years you want to work before you retire...Go ahead, have some fun...put in 5 and see what your investment needs to do for you to achieve that goal...freedom 35...not impossible to achieve!

9. Now we have our first non-entry box. The "age of retirement" box just shows how old you will be at your retirement.

10. The next box is the "years of retirement". It shows how long your retirement will last.

11. Here, this box shows how much your investment is worth at retirement. Whatever numbers you have chosen, it does look pretty big, doesn't it? That is the power of compounding, my friend. Your money will work harder and better than you will ever work for yourself! And that is the reason why you're reading this blog!

12. The 12th box shows your estate value in the "future" dollars. The value of the money is the same, but the magnitude of the number is larger due to inflation.

13. After retirement, some people choose to move their investments into safer vehicles (e.g. bonds). I do not necessarily agree with that strategy, but it is understandable. So, how much do you expect your investment to return (after inflation)? For simplicity sake, if you expect it to be 10%, just minus the inflation rate from 10%. So, if you are using 2.5% as your inflation, enter 7.5%.

14. If your retirement investment is in some tax-deferred plan (such as 401(k) or IRA [RRSP in Canada]), you will get taxed as you withdraw money. If it's not in a tax-deferred plan, you probably still have to pay taxes on capital gains. Enter in the tax rate at which you expect to be taxed.

15. This box shows you how much money you will withdraw from your retirement funds during the first year of your retirement.

16. This box shows how much actually gets into your hands after Uncle Sam takes his cut.

17. Finally, this is the inflation adjusted amount, or in other words, what the value is in today's dollars. If you intend to be spending $40000 per year in your retirement, you would want this number to be $40000.

Now that you have entered in all your info, click on that "Optimize for Retirement" button at the bottom. You will need to have macros enabled for this button to work. Otherwise, it'll just do nothing. What this button does is it find out how much money you can withdraw per month based on the data you have provided.

I will confess now: this spreadsheet is not entirely flawless. Many things change over the course of your lifetime, including inflation rates, tax rates, etc., etc. This sheet only provides you a constant value for these things. If you want to be on the safe side, enter a larger number for inflation and taxes. Having said that, this sheet will probably suffice in showing what actions you need to take in order to achieve your retirement goal.

Now, Let's Have Some Fun!
So now that you have become familiar with the spreadsheet, let's play around with some numbers to see what our retirement is going to look like.

The Young Father
So, let's take someone similar to myself, in his 30s with a young family and some savings. For our numbers, let's use...
Inflation: 2.5%
Contribution per year: $5000
Present investment value: $20000
Estate value: $0
Final age: 85
Current age: 30
Remaining work years: 30

I've left out the investment growth value so we can play around with that.
Investment growth rate: 3% --- Value at Retirement: $293,559
Investment growth rate: 9% --- Value at Retirement: $1,008,230
Investment growth rate: 15% --- Value at Retirement: $3,824,020
Investment growth rate: 20% --- Value at Retirement: $11,838,816

Whoa! What a difference! I did not select these numbers randomly. 3% is a typical return for a CD (or GIC). 9% is an average return for the S&P 500. 15% is considered a very good long-term return for any fund. 20% is what I believe a smart individual investor can achieve the long-term.

As one can see, the investment value grows exponentially as your growth rate increases. If the young father has a return of 9%, he will have $1 million when he retires. If, on the other hand, his return is 20%, he will have almost $12 million! That's a 12-fold increase in value for a 2-fold increase in growth rate! So, here we have it. Don't settle for less! You want to increase your growth rate as much as possible!

The Early Bird
Now that we have established the importance of growth rate, let's look at our time horizon. For our numbers, let's use...
Inflation: 2.5%
Growth rate: 15%
Contribution per year: $5000
Present investment value: $0
Estate value: $0
Final age: 85

Let's change up the age and number of working years and assume that we work until 60 years old. This represents how early we start our retirement savings.
Current age: 20, Remaining work years: 40 --- Value at Retirement: $10,229,769
Current age: 30, Remaining work years: 30 --- Value at Retirement: $2,499,785
Current age: 40, Remaining work years: 20 --- Value at Retirement: $589,051
Current age: 50, Remaining work years: 10 --- Value at Retirement: $116,746

The Early Bird, starting at age 20, saves up $10 million dollars for his retirement, while the late starter, at age 50, is only able to save $116K. The late starter is going to have a really tough retirement living on government pensions! Again, for compounding to work its magic, it needs time! The difference of 10 years can prove to be life-changing! If you can afford to work a few more years, your retirement can be a lot more enjoyable!

The Super Saver
Let's see how the contribution amount affects the final value your retirement funds.
Inflation: 2.5%
Growth rate: 15%
Present investment value: $0
Estate value: $0
Current age: 30
Final age: 85
Remaining work years: 30

Contribution per year: $1000 --- Value at Retirement: $499,957
Contribution per year: $3000 --- Value at Retirement: $1,499,871
Contribution per year: $5000 --- Value at Retirement: $2,499,785
Contribution per year: $10000 --- Value at Retirement: $4,999,569

There's sometimes a slight misconception amongst investors that the more one contributes to one's retirement funds, the better. That is true, but to a lesser effect than the previous two factors. The value of retirement grows linearly with the contribution amount. $1000/year contribution yields a final value of $500K, while a $10000/year contribution yields a $5 million final value. So, yes, it is true that it is better to contribute more, but its effects are less pronounced than if you spent some more time increasing your returns by 1 or 2%, or if you start your retirement savings a year or two earlier.

The conclusion is threefold:
1. Increase your returns!
2. Start early (or work a little longer)
3. Increase your contribution (but don't put too much emphasis on this).

Since this is a blog about investing, we will focus on conclusion #1 in future posts. It's actually not that difficult...don't get fooled by the myths perpetuated by the investment industry. The individual investor has many advantages over fund managers and yes, even Warren Buffet. We'll explore these a little later on!