There are many variables in planning for retirement. Which makes it difficult to plan without doing some specific numbers. So I’ve decided to do a very simplified example in Spain and see the results.
An example of how to calculate your FI number
Meet Teresa. She has just graduated from university, she is 22 years old and has no debt. Not having debts at this age is very common in Spain but a luxury in other countries so in a certain way she is in a good situation.
I won’t ignore unemployment in Spain though. This is a specific problem in our country for young people. So during the first year after her degree, Teresa works as an intern and she is not able to save anything. She manages to stay out of debt though.
Net worth at age 23: 0
In the second year after finishing university she finds a job with a salary of 23k (about 1,500 net euros per month). Let’s say in Madrid or Barcelona. These are her monthly expenses:
- Rent: 900 euros. She is going to live alone in an studio. It includes utilities.
- Transport: 60 euros. Approximately the price of a monthly pass in Madrid or Barcelona.
- Everything else: 540 euros. Food, gym, restaurants, etc.
- Total: 1500 euros
If you move any variable, take into account its impact on the others. For example, if it seems crazy to get 23k where you live, consider that your rent will probably be lower as well.
Net worth at age 24: 0
Terehas lived to the fullest this first year of work but has not saved anything. To build Teresa’s plan, we will need more information. The problem is that it is information about the future and we need to estimate it.
The planning questions
How will your salary change?
She believes it is reasonable for her salary to increase by 5% per year on average. There will be years with no raise and others with a significant on (promotions or new job)
How will your expenses change?
For a 24 years old, Teresa spends a lot of money. Although she doesn’t want to cut back, she believes she can maintain that average level of spending for years. The categories will change depending on her personal situation but the total will remain the same.
It won´t rise with inflation either, but I think this is still a conservative estimate. If Teresa finds a partner, she could reduce her housing expenses dramatically. She could also optimize her spending on “others”, for example.
How much will you spend when you retire?
She doesn’t want to count pennies in retirement (who does?) but believes that by spending 2,000 euros a month on average she can have a good life. Taking into account the 4% rule, Teresa’s FI number (the money she needs to retire) will be 25 times her annual cost of 24,000. That is 600,000 today, and we will adjust it with inflation to calculate it in the future. This gives us a baseline.
We estimate that she will rent for life and that she won’t have equity linked to a house.
What will inflation be?
We have no idea, especially for such a long period. The best estimate I can make is 2% on average.
How much will your investments grow?
Let’s assume that your investments return 6%. In our calculation, inflation is 2%, so the real profitability of your savings would be 4%. For simplicity, we consider that when she withdraws she doesn´t pay taxes.
The Vanguard IE0032620787 indexed to the S&P500 (in euros and with dividend accumulation) has an annualized return of the last 10 years of more than 10%. We could also say that the profitability is 7% and she pays taxes (between 19% to 23% on gains) when withdrawing but it would be less conservative.
Everyone has their own opinion regarding returns. Some people think that 6% is very high and others that it is very low.
What income will you have during retirement?
Teresa does not trust public pensions and she believes that she will have no income.
I don’t think this is a bad assumption, although I do think it is very conservative and that it would not be crazy to end up having some income: private lessons, consulting, inheritance, job in a summer camp … there are many options. Although it is also truth that assuming that you will have no money coming in takes away any pressure to look for paid activities: you might prefer to volunteer in something interesting instead of being paid for doing something you are not as passionate about.
At 55 she would have a net worth of 1.2 M€ with her last salary being lower than 80k
If Teresa retires at just 55, she could follow the 4% rule and spend around 4,200 euros per month. She could also be more conservative and spend about 3,150 (3% rule). We are considering inflation so these 4,200 would be about 3,622 today (well over the 2,000 that Teresa had).
The equity increases exponentially while inflation increases the number If linearly[/caption]
The graph shows how impactful is the combination of compound interest and keeping constant expenses while your salary goes up. It starts slowly but accelerates quickly.
55 years may seem too late for many and very soon for others. Personal circumstances play a very big role.
Seeing the number can help us make better decisions. If it seems too late, maybe you should ask yourself how you could improve your income to reduce your expenses. If you think you’re not going to put up with that long in your job, maybe it’s worth it to delay financial independence and switch to a job you like better.
We will do a second part about this case playing a little with the estimates.