Thursday, April 27, 2006

What is an acceptable rate of return?

One way of approaching this issue is to consider historical returns. This approach will produce a wide range of answers depending on which asset classes are considered and which time periods are taken into consideration. As an example, an investor who purchased an apartment in Hong Kong in 1996/7 may well still be sitting on a capital loss. In contrast, an investor who purchased in 2003 would have experienced significant appreciation as well as an increase in rent.

While there can be no certainty, equity markets in many countries have managed to provide total returns (dividends and capital appreciation) in the range of 8-12 % pa in nominal terms (before tax). Part of that return has been a result in an increase in price earnings ratios (or other valuation criteria) and commentators have pointed out that there has to be at least some doubt as to whether that trend can continue (or may even be reversed).

Real estate is harder to evaluate, but it seems reasonable to proceed on the assumption that real estate should return an amount equal to its yield plus the rate of inflation. In Hong Kong's current market this would suggest ungeared returns of 7-8% per annum. Historically, the rates of return have varied considerably from this indicative figure, largely by reference to market conditions in the years following the time of purchase. General price inflation is clearly not a complete explanation for property price movements.

A different way of looking at the problem is to work out what rate of return would be required to achieve a financial position whereby the real value of my savings would not decline during my retirement. Putting my current assets, expected savings between now and retirement, the number of years to retirement, my life expectancy and expected annual expenses into one of the many retirement calculators available on the internet shows that a rate of return on investments of about 6.6% per annum is needed to achieve a position where the real value of my retirement savings will not decline after I stop working. Obviously, the numbers can be played with but I tried to be as realistic as possible.

What this effectively means is that I should be looking to achieve a return of at least 6.6% per annum on my investments after expenses and taxes. Any investment which earns less than this is underperforming. Any return above the 6.6% threshold is outperforming. Leaving aside the observation that 6.6% is a fairly low rate of return, this has important implications for portfolio construction and management.

Risks of investing in property

I have allocated a substantial part of the retirement portfolio to property. Property is attractive as a core retirement portfolio position for much the same reason as shares are attractive - an asset class that has the potential to produce a stream of income (net rent) that will rise over time to compensate for the risks of inflation.

Like all investments, property is not without its risks including:

1. property requires a large lump sum - far more than is required for most other asset classes - making diversification more difficult;

2. property is less liquid than many other investments - in adverse market conditions a seller may be faced with a difficult choice of having to wait a long time for a sale or accepting a lower price;

3. properties require maintenance - maintenance costs are not trivial and need to be realistically provided for when evaluating the attractiveness of a property. Also, longer term maintenance may need to include periodic refurbishment;

4. properties have outgoings - maintenance, rates, management fees etc - which must be paid regardless of whether or not the property has been rented out. Also, there is the possibility of outgoings rising faster than rental levels, effectively reducing the net income from the property;

5. properties require active management - either by the owner or an agent appointed on behalf of the owner (for a fee of course);

6. compared to shares, transaction costs are significant - in Hong Kong stamp duty can be as high as 3.75%, agents fees are typically 1% and there will be legal fees as well. Lastly, lenders typically impose stiff penalties for early repayment in the first three years of a loan;

7. deflation is generally considered bad for properties.

Ultimately, property is priced much like many other assets - on the basis of supply and demand. Property though has two different supply and demand considerations - purchase price and rental value. While there is some relationship between the two, a number commentators have suggested that the relationship has become weaker in recent years - particularly for residential property. The other distinguishing feature about property is the fact that no two properties are the same, giving tremendous scope to either negotiate attractive pricing or to be taken to the cleaners (I should write a post about why I would never want to do business with a property developer). This makes it easy to understand the often quoted rule about investing in property - you make your money when you buy.

Silver Update

On 21st April I summarised the reasons why I had invested in silver here . With impecable timing, the CMP Group's Silver Yearbook 2006 was released on 25th April. The key forecast was that after 16 years of deficit (demand for silver exceeding supply), the silver market is forecast to show a surplus in 2006 (supply exceeding demand) of 48.4 million ounces.

Although it is not possible to get all the details from the press release (and I am not intending to purchase the yearbook), it appears that the forecast surplus is a largely a product of falling demand for use in photography and jewelry and silverware. A drop in the use of silver in photography represents a continuation of a trend that has been evident for some years and is not a surprise. The predicted fall in demand for jewelry and silverware is (I think) due to the rising price leading to reduced demand.

The supply side includes the forecast sale of 32 million ounces by the Reserve Bank of India which will complete the disposal of the RBI's entire reserves of silver.

It is difficult to draw any conclusions from the press release (there are a wide variety of opinions floating around the internet) . While I have reached the tentative conclusion that the case for a long term investment in silver is intact, I am not as bullish as I was before reading the press release. I am n0w intending to hold my current position and am reconsidering an earlier decision to continue accumulating.

Saturday, April 22, 2006

Risks of investing in shares

I have allocated a significant portion of my retirement savings to shares. The reason for this is simply a case of wishing to secure a stream of income that has the potential to rise over time to compensate for the effects of inflation.

As with all investments, it is worth considering the risks involved in investing in shares.

1. Inflation is higher than the rate of increase in dividends: shares should still do better than bonds or deposits but the real value of the dividend income will decline;

2. Deflation: companies generally do not do well in a deflationary environment. Revenues and operating margins tend to contract faster than expenses;

3. Companies may reduce or cancel dividends: stock selection and portfolio monitoring can address this;

4. Difficulty in acquiring shares that pay an adequate dividend yield: there is not much that can be done about this one;

5. Higher taxes: likewise, there is not much that can be done to avoid the impact of higher taxes and, in any case, I am expecting tax rates to rise in the future;

6. Volatility: this can work both for and against the portfolio. Downward movements may affect dividends and valuations in the short term, but also provide buying opportunities;

7. Rising interest rates; obviously a negative for company earnings and valuations, but again may provide buying opportunities;

8. Foreign exchange risks: matching the currency of the dividends against the currency of anticipated expenditure can go a long way to addressing this issue.

At various times, all of the above risks have had an adverse effect on the returns from equities.

Some of these risks can be addresses through diversification both within a share portfolio and accross asset classes. Others can be dealt with by adopting an opportunistic approach to investing. Some events may require the portfolio asset allocation to be reconsidered - if interest rates rose significantly investing in long dated bonds may be a sound strategy. A number of factors which could affect the stream of dividends are not ones to which there is necessarily a good response. However, these risks are an inescapable consequence of seeking higher real returns over the long term than can be obtained by simply leaving money in the bank.

Friday, April 21, 2006


The price of silver has risen significantly over the last three years. From less than US$5.00 per troy ounce, the price reached a peak of US$14.27 earlier this week before experiencing a very sharp fall. It currently trades at around US$12.62.

Silver is often compared with gold as a "precious metal". While the two metals often move in tanden, silver has historically been more volatile than gold and the current bull market has been no exception. Silver does differ from gold in a number of very significant respects:

1. almost all the gold ever mined is still in existence and generally in a form which can readily be brought to market;
2. the vast majority of the gold mined is brought for investment - only a small proportion is used for industrial purposes. Put differently, this means that gold is valuable because people believe it is valuable (or attractive) not because it us useful;
3. in contrast, silver is largely used for industrial purposes and a significant proportion of it is not recovered after use;
4. notwithstanding the decline in the use of film photography, the demand for silver has exceeded the supply from mining and recyling for most, if not all, of the last decade or so (the deficit has allegedly been met by sales from dwindling stockpiles);
5. the exact figures for supply, demand and stockpiles are uncertain (at least I have had difficulty getting consistent figures from sources I would consider reputable);
6. silver is still viewed as a precious metal by many - reasonable quantities are converted into ingots and coins and sold to investors each year;
7. I have had difficulty getting a clear picture of the amount of silver still in existence but, whichever number is used, the value of the world's stockpile of silver would appear to be less that the market capitalisation of some of the worlds larger listed companies. In a global context, even a relatively small increase in demand from investors could have a material effect on price.

In summary, silver is attractive as an investment on supply and demand grounds in spite of the recent volatility. The harder question is whether it is still attractive at current prices.

One problem with silver is that it does not generate any income which makes it a slightly awkward fit for the retirement plan outlined in earlier posts. However, until such time as I retire, I do not need any income from my investments so that issue does not need to be addressed for some years.

Thursday, April 20, 2006

Insurance for when things go wrong

The object of the retirement plan was to preserve the desired standard of living during a very lengthy retirement (30 years or more) with the least possible risk of erosion through inflation. The end product was one that requires a larger sum of capital than is often recommended by financial advisers and a different asset allocation as well.

A plan which involves looking more than 40 years into the future (10 plus years of working and 30 plus years of retirement) has the potential to involve a great deal of uncertainty. Things can, and probably will, develop differently from what is currently anticipated. So what should be done if, or when, things go wrong? The comments below are based on the premise that anything which can reasonably be done to economise on living expenses will have been done already.

I previously mentioned three forms of insurance against things going wrong. These are (in order of preference):

1. Employment: while I have made the case for not relying on employment to fund retirement, the possibility of remaining in or returning to the workforce if the need arises can serve as a form of insurance in the case of emergency;

2. Your home: I made the case of owning your primary residence debt free on retirement. The home also serves as a store of wealth that could be tapped, either through a reverse mortgage or a sale, should the need arise. A sale could done either as a move to living in rented accommodation or to a smaller owned residence;

3. Drawdown of capital: I am not a fan of any retirement plan that relies on drawdown of capital to make ends meet - it is too much like hoping that you die before your money runs out. However, if things get tight it can be done. The money is there and it is better to spend the money than to be forced to eat cat food.

So, three back up plans if things get tight. Actually, living in a high cost city like Hong Kong, there is a fourth form of retirement insurance available - we could relocate to a cheaper place to live. Leaving aside the effect of the cost of moving I would expect this to be the least attractive option as it would result in a significant change in our lifestyle and our social circle at a late age in life.

No pension. No social security.

The fifth and final critical assumption is that no reliance should be placed on either a company pension or any form of social security.

As for company pensions, participation in defined benefit pension plans is being phased out as employers (and investors) wake up to the fact that many companies which offered these schemes have seriously under funded them over extended periods of time. We are starting to see two consequences of the under funding. The first is a bankruptcy risk. When companies get into financial difficulties, the rights of current and former employees to their promised benefits comes under threat. The second is that employers who are now having to deal with the under funding issue are looking for ways to reduce the cost - and the only way to do that is to reduce the benefits to members of the scheme. I would not want to be in a position where my former employer decided to unilaterally reduce my standard of living because it had not made adequate provision in the past. Both of these developments are happening now.

Social security suffers from a similar problem. The social security schemes offered by governments to retired people in many countries are in the process of becoming fiscally unsustainable in their present form due to a combination of demographic factors (an aging population resulting in the ratio of retirees to taxpayers increasing) and historic under funding. The reality is that the governments concerned will need to deal with the problem through a combination of (i) inflation which will effectively reduce the real value of benefits, (ii) making eligibility more difficult (e.g. raising the minimum retirement age, harsher means testing), (iii) reducing the availability of some benefits and (iv) raising taxes generally. The only reason why measures have not been taken to address the problem since it was first recognised (at least in the early 1980s) is the the ballot box. The politicians who have the power to do something will not do anything because they want to get re-elected - a situation which the ranks of aging baby-boomers are likely to perpetuate because they make up such a large percentage of the electorate.

All in all, it does not seem to be an attractive proposition to rely on a system which is financially unsustainable.

Monday, April 17, 2006

Yield and drawdown of capital

The fourth of the five critical assumptions used in preparing the retirement plan relates to the yield on the retirement portfolio and the absence of reliance on drawdown of capital.

It was assumed that a portfolio of shares and property could generate a yield of 4% per annum (after expenses but before taxes) and that this yield should be sufficient to maintain the desired standard of living without the need to draw down capital.

A look at the share market tables for Hong Kong shows that while the average yield across the market as a whole is less than 4%, it is possible to create a portfolio with an average yield of 4% without resorting to the equity equivalent of a portfolio of junk bonds. Likewise, it is possible to acquire residential property in Hong Kong which will show an ungeared yield (after outgoings) of 4%. Of course, the boyant economic conditions of the last few years have made things harder but it is still possible. It is also true that a 4% yield is nothing to get excited over - in more favourable market conditions it is possible to acquire assets which show much better rates of return.

The point about shares and property which I made in previous posts was that the income derived from investments should grow over time to compensate for the effects of inflation. That potential to grow is highly dependent on not spending the capital. There is of course a world of difference between having the potential to do something and actually doing it.

The second part of this assumption is that the retirement plan should not rely on capital drawdown as a means of funding living expenses. There are two sound reasons for this approach. The first is that spending capital will signficantly compromise the ability of the portfolio to withstand the effects of inflation. The second is that if a lengthy retirement is planned (say 30 years or more), then reliance on capital drawdowns is a highly risky strategy. Over an extended time period, even small errors in the rate of return or the estimates of expenses or a single large adverse event can devastate the portfolio beyond repair. No thanks, I'd rather sleep soundly at night.

Retirement portfolio components - property

The previous post summarised the case for shares being one of the key components of a retirement portfolio. The second key component is property.

The rational for including shares in a retirement portfolio is that they produce a stream of income (dividends) that has the potential to increase over time compensating for the effects of inflation. Similar reasoning applies to property - it is an asset class that produces a stream of income (net rental) which has the potential to grow over time.

Property differs from shares in several respects. The first is that historically banks were more willing to lend against the security of property than against the security of shares. While the willingness of banks to lend against shares has improved noticably, the terms offered are generally less favourable in several respects. The interest rate on loans used to purchase shares will be higher, the maximum amount that can be borrowed is usually lower and margin calls are a distinct possibility. All of which makes property much more suitable as a levergaed investment.

Another issue is that property requires more management than shares which can either be viewed as a pain or as part of the challenge. There are outgings to be paid in addition to the mortgage - rates, maintenance costs and so on. There is also the risk of vacancies disrupting the flow of rental income.

The last point to bear in mind is that because of the relatively large sums involved, it is harder to achieve diversification with property than with shares.

Acquiring a property using debt finance set at a level where payments on a prinicple and interest mortgage will be serviced from the rental income can result in an end position where the amount of capital invested at the time of acquisition effectively matures into a debt free property producing an attractive stream of income on retirement. Of course it is necessary to allow for outgoings and the occasional vacancy when doing the maths.

Certainly, there are risks involved. We could experience deflation. Interest rates could rise faster than rentals (or rentals may not rise at all). Still, if an inflationary environment is expected, property remains for me an attractive proposition over the longer term.

Retirement portfolio components - shares

The third of the five critcial assumptions was that the retirement portfolio should be invested mostly in shares and real estate. This post will summarise the case for shares making up a significant part of the portfolio.

Leaving aside a recommended emergency fund which should be in a form which enables ready access without the risk of capital loss, the bulk of a retirement portfolio should be invested in assets that have the potential to produce a return which, after costs and taxes, is greater than the rate of inflation. A different way of looking at the problem is that a retirement portfolio should produce a stream of income which is not only adequate to fund retirement needs now but will continue to produce the same level of income in real (i.e. inflation adjusted) terms over the full duration of retirement (or at least for long enough that it makes no difference).

In an earlier post, I talked about life expectancies. If a retirement lasting for thirty years or more is anticipated, the compounding effect of even a relatively low rate of inflation will significantly erode the real value of a nest egg and it will do so at a time of life when options for remedial action are more limited than before retirement. Since the 1920s only two asset classes which are available to the average investor have generally satisfied this criteria over long periods of time: shares and property. Both produce streams of income (dividends and rent) which have increased over time. Certainly there have been periods of time, some lasting for several years, when shares and real estate have declined in nominal terms or in real terms or both. The great depression which started in 1929 is the most severe example during the 20th century. However, a look at any of the charts showing the returns of the various asset classes in the 20th century shows shares and property both providing meaningful real rates of return. Other asset classes such as bonds, deposits or even gold have failed to achieve this. One has to go back to the period from 1880-1920 to find a very prolonged period when bonds produced a better return than equites. Will things be the same in the future? I have no idea.

Are there risks in this strategy? Absolutely (and those risks need to be understood). However, with a safety margin built into the retirement budget, a contingency fund and at least three forms of "insurance" to fall back on, I will sleep a lot easier at night knowing that my hard earned savings and my standard of living were not being devalued by the mere passage of time. I will look at the three forms of "insurance" and the various asset classes in more detail in future posts.

Saturday, April 15, 2006

A debt free retirement?

The second of the critical assumptions in the retirement planning exercise is that a person should have no debt on retirement.

While there is a very meaningful distinction between "good" debt and "bad" debt, the way in which debt is viewed and used needs reexamination once a person leaves full time paid employment. My view is that it is undesirable to have debt once retirement has commenced.

The main reason for not having debt in retirement is safety. Debt needs to be serviced. Interest needs to be paid or it will accrue and compound, increasing the amount owed. Lenders generally expect to get their principle back as well. There are usually two ways in which debt can be repaid. The first is from investment income (e.g. a loan used to purchase an investment propety could be serviced using rental income from the property). The second is from earned income (e.g. a mortgage used to finance the purchase a home would typically be serviced from salary).

If you have been relying on your salary to meet the mortgage payments, the obvious question is where the money will come from to continue meeting payments once the salary stops hitting the bank account each month?

Even if you have been using passive income to service the debt, when you stop working you lose the security of having an alternative means of making payment should there be any disruption to the passive income or, alternatively, if the cost of servicing the loan increases when interest rates rise. People who financed property purchases using floating rate loans (or loans that would move to a floating rate after an initial fixed period) have recently been subjected to rising interest rates (including the traineeinvestor).

Another question to ask is whether the lender will be willing to leave the loan outstanding when you stop working? For most of us, our earned income is one of the things which the bank or other lender will take into consideration when deciding whether or not to grant the loan in the first place. The fine print in the typical loan documentation will often contain a clause giving the bank the right to demand repayment at any time if it thinks that the security of the loan is in doubt - even if the loan was originally granted for a fixed term.

The last consideration is less tangible but still important. People worry about debt just as much as they do about other bills. Why burden your retirement with unnecessary anxiety and stress?

One exception to the undesirability of debt on retirement is the reverse mortgage. Although reverse mortgages have their place in the tool kit of retirement financing they are generally best left as a form of insurance against the unexpected.

Post retirement employment?

One of the critical assumptions used in the retirement plan was that paid employment would not be relied on to help finance retirement. A number of writers on the subject of financial planning have suggested that an inadequate level of retirement savings can be supplemented through paid employment (either full time or part time). I have serious reservations with the idea of paid employment being a necessary part of financing retirement (voluntary working is something else).

The first objection is a question of logic. If you need to rely on paid employment to maintain your lifestyle, can you really be said to have retired? Certainly not if the employment is full time and arguably not if the employment is part time. While retirement means different things to different people, my personal view is that retirement means ending the phase in life when one is forced to rely on paid employment (or self employment) in order to make financial ends meet.

The second objection is a more practical one. Depending on your gender, where you live and a host of other factors your life expectancy could be anything from 70 years to 80 years or more. As you get older, your total life expectancy gets longer. A person who has reached aged 60 could reasonably expect to live to their mid eighties - or longer. Have a look around and ask yourself how many people you know who are still working in their sixties? How many people do you know who are still working in their seventies or eighties? The answer will be not very many.

Let's have a look at some of the reasons why participation in the work force declines as people age:

1. for many people in these age groups, not working is a personal choice. This is great if you can afford it;
2. as people age, factors other than choice start to affect ability to work. Some people have difficulty keeping their skills up to date - with the pace of change of technolgy and the increasing internationalisation of the workplace, keeping skills current is an issue that many will face all through their working lives;
3. some employees are working in industries where remuneration is at least partly linked to seniority - the longer someone has been in a job, the more they get paid. While these structures are breaking down under the realities of economic life, some people just find themselves priced out of the job market;
4. there have been a number of studies that have shown that older workers are not as quick, adaptable or as dynamic as younger workers (although experience often acts as a balance). A logical consequence is that employers may prefer to hire younger workers;
5. mental and physical health deteriorates as we age. It's a fact of life. An inevitable consequence is that the ridiculously long hours that are often demanded will eventually prove too much for most of us (and not just for those whose jobs involve physical labour).

While demographics in many (if not most) developed economies may help create more opportunities for workers in retirement (in particular baby boomers), this is a somewhat risky assumption to rely on for two reasons. The same demograpic factors that may create an increased demand for older workers also dictate that the supply of older workers will also be higher. It also has to be remembered that immigration, offshore outsourcing and technology developments are also potential ways of alleviating any shortage of workers in the years ahead.

Putting the proposal differently, do you really want to be forced to work to stay afloat financially in your 60s, 70s or even 80s? What happens if you cannot find a job? What happens if you are no longer capable of working well enough to keep a job? Lastly, do you really want to have to get out of bed in the morning instead of enjoying yourself?

Don't misunderstand. I am not suggesting that working in retirement is a bad thing. There are many good reasons why a person may wish to work either full time or part time once they "retire". But to rely on full or part time employment as an essential part of a retirement plan strikes me as a very risky proposition.

Five critical assumptions

The three step retirement calculation described in previous posts contained a number of assumptions (some expressly stated, others implicit) and some conscious elections. These include:

1. that paid employment will not be relied on in retirement;
2. that the mortgage and other debt should be repaid before retirement;
3. that retirement assets (or at least most of them) should be invested in shares and real estate;
4. that retirement assets will produce a yield of 4% per annum (as distinct from a return of, say, 8%) and that only the yield will be used to fund retirement. Put differently, not only should capital not be drawn down against to fund living expenses but it should be allowed to grow over time;
5. that neither a company pension nor government welfare can be relied on to fund a retirement.

The assumptions mentioned above are different in whole or in part from those that many financial advisers use when offering financial advice. Although I make no claims to expertise or qualification as a financial planner, I have serious reservations about a number of matters that are often relied on in preparing a financial plan. Although these assumptions will have the effect of materially increasing the amount of savings needed to adequately fund retirement, given the consequences of running out of money after leaving the workforce, my own preference is to err on the side of caution and avoid unnecessary risks.

Retirement calculation - step three

The previous two posts considered firstly an evaluation of a person's current financial situation and second an estimate of how much would be needed to fund the desired standard of living without being in paid employment. The third and final step in the retirement calculation is to produce a plan to get from point A (now) to point B (retirement).

In our example, we assumed that an income of HK$40,000 per month would be required and calculated that a 4% rate of return would require a lump sum of HK$14 million to achieve this (HK$12 million to produce regular income and HK$2 million for one off events). The 4% has been based on the fact that in current market conditions it is possible to construct a portfolio of shares and properties that will produce a net yield of 4% before tax. The expected yield is a rather critical assumption and contains some further implicit assumptions or elections which will be examined separately.

The basic calculation is to take (i) the estimated amount which can be saved each month (or year) and (ii) an estimate of the return that can be earned on investments and work out how long it will take to accumulate the required lump sum. An alternative approach is to work backwards - taking the number of years to the planned retirement date and work out how much needs to be saved each month. Many financial advisers use a rate of return bewteen 8-10% for planning purposes. There are many financial calculators avaiable on the internet that can be used to do a simple calulation. Alternatively, a spread sheet can be set up to produce a more personalised calculation.

The next step is to take a look at the outstanding mortgage (and any other debts) and see if the scheduled payments will result in the mortgage being paid off before retirement. If the answer is "no" then either an additional amount will need to be set aside to pay off the residual balance before the onset of retirement. Alternatively, the monthly payments could be increased to pay off the mortgage sooner.

The last step (as with all parts of the planning process) is to ask if there is anything else that may affect the plan that can be readily forseen?

As mentioned, the three step process contains a number of implicit assumptions or elections. It also leaves open the question of how the starting capital and the savings should be invested. These points will be addressed in the next series of posts.

Retirement calculation - step two

The second step towards preparing a workable retirement plan is to evaluate what financial resources will be needed to fund the desired lifestyle when when you no longer work full time. This calculation comes in three parts.

1. how much income will you need? A review of current expenditure is a good starting point. However, things will be different in retirement. The mortgage will be paid off (hopefully). You may not have to spend as much on work related expenses (e.g. clothes). On the other hand, you will have more time for recreational activities and may expect spending on things like travel and dining out to increase. Also, medical insurance may currently be subsidised by your employer. A buffer should be added to the budget to allow for contingencies.

2. how much needs to be set aside for one off events and other contingencies? Will you still be supporting your children hrough school and university after retirement? Do you anticipate having to contribute to the cost of your children's wedding(s)? Anything else? A small contingency fund?

3. how much will need to be invested in non-income producing assets? This includes your home (unless you rent), furniture, car etc.

The income figure needs to be grossed up to allow for taxation and capitalised to produce a lump sum. If a before tax income of HK$40,000 per month is required and an assumption is made that assets can be invested in a manner that will earn 4 per cent per annum, then it follows that a lump sum of HK$12 million is required (approximately US$1.5 million).

The cost of one off events involves a bit of guess work, but could be anything from zero to a seven figure sum (in Hong Kong dollars) depending on individual circumstances. As an example, if you are still spending money on children and have to set aside money to cover the last few years of schooling and a university degree then this needs to be provided for. A lot obviously depends on which school and which university the children go to. Assuming good quality schools and a good quality university, the cost could easily be about HK$1 million per child. Let's assume that these one off costs work out at about HK$2 million in total.

Lastly, the non-income producing assets including the family home, furnishings etc need to be added up. In a place like Hong Kong where real estate is expensive, It would be easy to spend HK$7 million (US$900,000) on a modest sized flat and furnishings.

In this example, the grand total comes to HK$21 million (about US$2.5 million). For most of us that is a huge sum of money that would be difficult to accumulate in one person's working life. In another post, I will revisit this calculation and look at why the number needs to be so high.

Thursday, April 13, 2006

Retirement calculation - step one

The first step in preparing a workable retirement calculation is to evaluate the current financial position.

A distinction needs to be made between assets and liabilities.

Assets are essentially things which either produce income or which can be viewed as store of value and which can ultimately be looked to as a source of funding in retirement. I realise that this is different from the way an accountant would look at the world, but for our purposes, the test of an asset is whether it will contribute to financing your retirement.

Shares, bonds, mutual funds, property, bank deposits and cash all meet this description. So will pension plan assets and some collectables (art, wine etc). Most cars, furniture and other chattles should not be viewed as assets for present purposes - they do not produce income and they are not a store of value (they cost money to maintain and depreciate in value over time). It has been argued that a person's primary residence is not an asset. I disagree with this view and will explain why I regard an owner occupied residence as an asset in a future post.

Liabilities are future obligations which can be measured in monetary terms. Debt (mortgage, credit card etc) is the most obvious example of a liability. Other examples are accrued but unpaid expenses. An example of the latter in Hong Kong is personal income tax. Hong Kong does not operate a "pay as you go" tax system. Employees are paid their gross salary and get an annual tax bill from the government (payable in two intstallments). Every month that an employee is paid, an obligation to pay tax in the future builds up as a liability.

One issue which needs to be considered carefully is the valuations to put on the assets and liabilities. For some items it is easy - a quick look at a bank statement can show the outstanding balance on a credt card and the amount of money on deposit. Shares can be valued by looking at the closing prices. Other assets can be a bit more challenging - property is illiquid and, as each property is unique, determining an exact value often involves elements of comparing recent prices of similar (but not identical) properties. While an exact number is not essential, realistic numbers are essential if the exercise is to be useful.

The difference between the total assets and the total liabilities is a person's net worth. The personal balance sheet (assets and liabilities) and the net worth figure are the starting point for preparing a workable retirement plan.

As a working example, we will use the following assumed information:

1. ownership of a residence worth HK$7 million with and outstanding mortgage of HK$5 million due over a remaining term of 16 years;

2. other investments of HK$1 million divided among a small share portfolio (HK$320,000), a retirement scheme (HK$180, ooo) and bank deposits (HK$500,000);

3. no other debts or assets which would be relevant for present purposes.

A three step retirement calculation

Planning for the financial aspects of retirement is essentially a matter of creating a plan to get from one's present position to the position which is expected or desired on retirement.

The first step is to determine the current financial position. This is usually a simple exercise in adding up the value of assets and deducting the value of liabilities.

The second step is to determine the desired financial position on retirement. This is a more difficult exercise involving assessing three key variables:

1. how much income will be needed on retirement and where will that income come from?

2. in addition to assets dedicated to producing income, how much money needs to be set aside for one off events or other contingencies?

3. how much money will be invested in assets which will not be used for 1 or 2?

The answers to the three questions will determine how much money needs to be accumulated to achieve the desired financial position on retirement.

The third step is to figure out how to bridge the gap between the current position and the desired position.

If all this sounds simple, it's not. The next few posts will look at each of the three steps involved in preparing a financial retirement plan and identify some of the difficulties in producing a plan that will be successful.

Sunday, April 09, 2006

Why save?

Unfortunately it is not a retorical question. I am continually amazed at the low level of personal savings in many (mostly western) countries - in some countries the savings rate is close to or even below zero. Don't people (as a group) actually think about how they will sustain their standard of living once the paychecks stop coming in?

Traditionally there have been four alternative sources of funding a person's retirement:

1. government (i.e. the taxpayer);
2. employer (either by contributions made during the term of employment or promises to provide at a later date);
3. family members (typically children);
4. personal savings.

There has been enormous coverage of the demographic factors that will make it increasingly difficult for goverments in a number of countries to continue to provide the same level of retirement benefits (including health care) to future retirees as are enjoyed by current retirees. Even if the current level of retirement benefits can be considered adequate (not even close in my view), my expectation (which I believe is widely shared) is that the value of such benefits will materially deteriorate in the future.

There has also been commentary about the widespread underfunding of company sponsored defined benefit pension plans. Since I do not get to participate in one of these, this is not an option for me anyway.

Reliance on family members? No thanks. While traditonal in many cultures, I would prefer to rely on my own efforts rather than impose a cost on my children.

That leaves personal savings as the only viable (or available) alternative.

The conclusion seems unavoidable. Either I rely on myself through savings or investment or face the prospect of a declining standard of living once I leave full time employment.

Mission Statement

The decision to join the blogging community is most likely symptomatic of my first mid-life crisis. In any event, I have set up this blog for a number of reasons. The most important is to impose some discipline on my personal financial planning and money management. While I have managed to make a reasonable start towards saving for my eventual retirement, there have been significant deficiences in my progress to date. Budgeting has been weak (when done at all) and investing has been done in a manner that gives new meaning to the concept of "random walk" investing. Putting my investing and other ideas down in writing should help clarify my thinking. Failing which, I get to look back and wonder what on earth was I thinking.