By Maya Baltazar Herrera

I decided to devote this week?s column to the rest of the discussion on the magic number?the amount of money you need in order to retire? and how to get there.

We?ll continue from last week using our hypothetical dreamer, let?s call him Jose. Jose thinks he would be spending about 1 million a year, in today?s pesos, when he retires. He plans to retire in 15 years.

From last week, we know that this P1 million a year, with 5 percent inflation will become about P2 million in 15 years. That means Jose will be spending about P2 million in his first year of retirement.

Trust fund baby

Let us now discuss the more precise methods of calculating the magic number. Last week?s back of the envelope method assumes you keep your principal intact. However, that calculation assumes you need the money at the end of the year?which, of course, is imprecise. You can use the table I provide below in order to convert your required annual income into the magic number.

Let us say believes he can earn 4 percent on top of inflation?this means he earns a 9 percent return on an assumption of 5 percent inflation. He takes 26 from the table and multiplies that by 2.08. His magic number is 54. This means he must have P54 million when he retires 15 years from now.

Fast-forward 15 years to retirement, Jose has P54 million and withdraws his first P2 million for his first year expenses. That leaves him with P52 million invested. At the end of one year, he would have earned P4.86 million (9 percent of 52), growing Jose?s fund to P56.86 million. Jose now withdraws P2.1 million, which is about 4 percent of the fund and about 5 percent more than his first year income. Note that his fund has now grown, after the second withdrawal to P54.76 million, which is about 5 percent larger than his original P52 million. This means that his investment income in the second year will be 5 percent higher than his first year income? and will allow him to withdraw an income 5 percent higher next year. This is how Jose will keep up with inflation.

This is the secret to becoming a trust fund baby. Not only should you never spend principal, you must grow principal with inflation.

This means that when Jose is retired, he will only spend the portion of investment income that is in excess of inflation; on his assumption of a 9 percent return and 5 percent inflation, this means he spends the 4 percent portion. In fact, even in years when the investment income is over 9 percent, he should only spend the 4 percent portion. This way, he has a buffer amount to withdraw from in years when investment income is lower than his 9 percent target.

Tweaking the magic number

There are a few adjustments that could be made. First and possibly most important is allowing for catastrophic medical expenses. The older Jose gets, the higher the probability he will require expensive medical care. One way to deal with this is to purchase some sort of pre-paid coverage for life. This is extremely difficult to purchase though and can be very expensive. Also, he would be worried about whether the company is still existent when he needs them.

The other way to allow for this is simply to increase the magic number by an amount that would be set aside for emergency medical expenses. For our purposes, let us assume that Jose believes that about P5 million is enough (this is P2.5 million in today?s pesos). This increases Jose?s magic number to 59. Now, this portion of the magic number will grow at 9 percent since he will not touch it for regular expenses. He will only touch it for major medical expenses. This makes sense as medical inflation tends to be higher than general inflation.

Jose could, of course, reason that this number is too large as he will not live forever. He could consult a table that allows him to estimate how much money he needs depending on how long he will live after retirement. I am providing such a table below. The number of years has to do with how many years you expect to live after retirement. Filipino life expectancy is in the mid-70?s but you should really look at your family history for this.

If Jose estimates he will live about 30 more years post-retirement, this means he multiplies his P2 million requirement by 18,37. This is because he estimates he can earn an investment return that is 4 percent more than 5 percent inflation (a total of 9 percent). This gives him 36.74 and adding P5 million for medical expense, gives him a target of about P42 million.

Next week, we will discuss how to plan out savings.

Readers can e-mail Maya at integrations_manila@yahoo.com. Or visit her site at http://www.mayaherrera.com.