CPF on FIRE: CPF LIFE, what’s the optimal approach?

CPF on FIRE is a series that takes a deeper look into Singapore’s Central Provident Fund (CPF) Scheme and see how they do or do not contribute to a financial independence journey. As each Singaporean and Singaporean PR must contribute a large chunk of their monthly income to CPF, this is a hot button topic for everybody. I’d like to dive deep and dissect it to give an objective assessment of the scheme from a financial independence and early retirement perspective.

Update (25/12/2018 12:00PM SGT): As pointed out by Adriel in the comments section (Thanks for the heads up!), the original post had the ERS amount incorrectly at 2x the FRS, however the correct amount is 1.5x the FRS. This has been fixed and it impacts the result of the withdrawal rate analysis.

The CPF LIFE Scheme is a life annuity scheme that provides Singapore Citizens and Permanent Residents with a monthly payout for as long as they live.

CPF Website

As CPF members, when we turn 55, our CPF Ordinary Account (OA) and Special Account (SA) balance will be combined and transferred into a CPF Retirement Account (RA) for the purpose of the CPF LIFE. This amount is locked in until the age of 65 – when we will start receiving the CPF LIFE Payout. The amount you receive each month from CPF LIFE depends upon the value of your Retirement Account.

Since this is government-mandated, CPF members don’t get to choose whether we want to participate in CPF LIFE or not. However, what we DO get to choose are:

1. The amount of money we want to convert into CPF RA for CPF LIFE: Basic Retirement Sum (BRS), Full Retirement Sum (FRS) or Enhanced Retirement Sum (ERS)?
2. The payout plan – how we’d like the payout to be made: Standard Plan, Basic Plan, or Escalating Plan?

All of these options seems pretty complex and intimidation but that’s why I’m here!

As the main goal of our FIRE journey is essentially the same – to derive enough income from our savings and investments to cover our living expenses – we should take a look at all of these options to determine our optimal choice.

This is how I’ll be breaking it down:

• The role of CPF LIFE in your retirement plan.
• What’s the best choice for retirement sum?
• What’s the pros and cons of FRS vs BRS?
• Which is the best payout plan?
• Conclusion: The optimal choice & the FIRE approach

Sounds good? Makes sense? OK! Let’s get started!

The role of CPF LIFE in your FIRE plan

For a very good breakdown on how you should look at your CPF LIFE and the role it should play in your general retirement plan, InvestmentMoats has a very good section on that in his post breaking down the CPF LIFE.

Essentially, we should not be looking at CPF LIFE as a total retirement income replacement in old age, but rather a “income floor” which will help counteract the effect of market volatilities on our investment portfolio. As CPF LIFE payouts are guaranteed and predictable, it could be a god-send during times where market returns are volatile or takes a nosedive. It can help us weather the storm and reduce our reliance on withdrawing from our investment portfolio when market performance is not favourable.

Within our FIRE plan, we should already have a target withdrawal rate in mind that we believe will last our entire lives. That could be 4%, 3.5%, 3% or even lower. With CPF LIFE, you know that you will be receiving an additional stream of income, guaranteed by the Singapore Government, when you reach the age of 65.

This income will supplement your withdrawal – you can either continue withdrawing the same amount from your portfolio and take CPF LIFE payout as a bonus to live a more luxurious lifestyle or you can elect to reduce your portfolio withdrawal at the same amount you are receiving payout from CPF LIFE, thus reducing your withdrawal rate and reducing the chance of depleting your portfolio value within your lifetime even further.

Now that we know how we should be thinking about CPF LIFE, let’s dive into assessing choices we should be making with regards to CPF LIFE to optimise its output.

Should we choose the Basic, Full, or Enhanced Retirement Sum?

Depending on the amounts we have in our OA and SA at 55, we will either qualify for the Basic Retirement Sum (BRS), Full Retirement Sum (FRS) or the Enhanced Retirement Sum (ERS). Here’s what each of those look like for those turning 55 in 2018 (Source: CPF LIFE Website):

Each of the sum will entitle you to a different monthly payout from the CPF LIFE, so which one makes the most sense in terms of value? Here’s the monthly payout for the above retirement sums when you turn 65:

OK… but how should we analyse these payouts? How will we know if these are good or bad payout rates?

Well with everything in the FIRE community, we should be assessing these with the same lens as the “Safe Withdrawal Rate.” The baseline is always 4% and if these constitute a better withdrawal rate (more than 4%) then they are a great deal.

So compared to the total value of the “investment” – or “retirement sum” in this case – what kind of withdrawal rate do these payouts represent?

I’ve made assessment by calculating the withdrawal rate using the CPF RA balance at age 55 (which unsurprisingly gave a really good rate.) However, since we do not receive the payout until we reach the age of 65, the correct assessment should be based on how much that CPF RA balance could have grown in those 10 years between age 55 and age 65.

So I calculated using 2 different scenarios:

1. Assuming the CPF RA balance grows at 4% (the base rate for the CPF RA)
2. Assuming that instead of putting money into the CPF RA, we invested it at a return of 8% p.a.
3. Assume the investment returns a higher average of 10% p.a.

Based on a rate of return of 4% p.a. all three of the options provides a withdrawal rate of more than 4% which means that they are all very good deals from a withdrawal rate stand point.

Even once we increase the rate of return to 8% p.a., all 3 retirement sums manages to stay above 4% withdrawal rate.

Only once we ramp up the investment returns to 10% p.a. does the payout from the FRS and ERS drop below the 4% mark. And even then, the withdrawal rate hovers above 3.5% withdrawal rate.

What this shows is that, from a withdrawal rate standpoint, all 3 retirement sum options offers a pretty solid payout.

However, if you really want to optimise the output per dollar, because the payout doesn’t scale linearly between BRS, FRS and ERS (payout for FRS is less than double of BRS even though the amount of required balance is double) you get better bang for the buck with the BRS option.

But before you jump on the BRS option, there are a few drawback to the BRS option which you should be aware of.

The Pros and Cons of the BRS

At the face of it, you may get better payout per dollar by opting for the BRS option over the FRS, however in order to opt for the BRS, you’ll have to make some sacrifices:

1. You must have a property to pledge.
2. Your property must have a residue value equal to or higher than the BRS amount.
3. You will need to pledge your property.
4. Properties that have been pledged cannot be sold or transferred.

However, the benefit of the BRS option is that if you have more than the BRS within your CPF, and you pledge a property, you can withdraw the rest of the amounts out of your CPF account to use. Here’s a simple scenario:

1. BRS Amount Required: S$85,000
2. Balance in CPF RA: S$170,000
3. Property Pledge: S$85,000
4. Amount that can be withdrawn from CPF: (2) – (1) = S$85,000
5. If you had opted for FRS you would have to leave the entire S$170,000 inside the CPF RA.

If you have better use for your CPF monies than leaving it in the CPF account to earn CPF interest, then you might want to opt for this option.

However, given that the FRS option still pays out more than 4% of your portfolio after a 8% p.a. return on your FRS amount over 10 years. I’d elect for the FRS option and not pledge my property.

Now that we know the most efficient retirement sum to aim for, let’s take a look at the different options we have for how the payouts are distributed.

Standard Plan, Basic Plan or the Escalating Plan?

Similar to the options for the retirement sum, there are a total of 3 different payout plans that you can select before the payout starts at the age of 65:

Here’s how the initial payout amounts compare between the 3 options for the FRS:

Let’s assume that we are assessing these plans based on how it will directly benefit us while we are alive instead of after we are dead. This means we can rule out the Basic Plan as the main purpose for that is to pay out less and leave more for our children. If that is important for you, the Basic Plan may be for you, but otherwise it’s not a good choice if you want to use the payout while you are alive.

OK, so let’s do a proper comparison between the Standard Plan and the Escalating Plan. How do we best compare the two? Well, the best way I can see is to find out the breakeven point.

Due to the fact that the Escalating Plan starts out paying much less than the Standard Plan but increases over time, the Stand Plan is better if we don’t expect to live long after the payout starts – so we want to get more money early. However, if we expect to live really long after the payout begins, the Escalating Plan could be better as the payout increases over time!

If we can answer the question: “When does the total amount paid out by the Escalating Plan overtake the amounts paid out by the Standard Plan?” it will help us understand how long we’d have to live past the age of 65 for the Escalating Plan to be worth it.

To make this assessment, I’ve graphed out the cumulative payout amounts over time between the 2 plans using both the FRS and the BRS option. Here’s the result:

The result is quite surprising. Initially we’d think that hedging against inflation with the Escalating Plan sounds like a great idea!

However, as you can see from the chart, it takes about 310 – 320 months after turning 65 for the Escalating Plan to overtake the Standard Plan in terms of cumulative payout – for both all 3 retirement sums!

This means that in order for the Escalating Plan to start being a better option for you, you’d have to live past 90-91 years old! Plus this says nothing about the opportunity cost of foregoing a larger payout up front.

If you happen to pass away at 90 years old, you’d have been better off selecting the Standard Plan. Although the converse is also true, if you live to be a 100, then the Escalating Plan absolutely makes sense.

However, I don’t know about you, but I’m not super confident that I’d live past 91 years old; and if I happen to, I’d take that as a bonus in and of itself.

So verdict here: If you would like to make sure that the CPF LIFE Payout is adjusted for inflation and you think you’ll live to be more than 91, go with the Escalating Plan. Otherwise, stick with the Standard Plan.

Conclusion: The optimal choice & the FIRE approach

OK so after all that analysis, I believe the optimal solution is clearly:

1. Make sure you contribute to CPF until you reach the FRS. The BRS comes with drawbacks regarding pledging the property and the tradeoff isn’t worth it. Although the ERS still offers a good payout, it’s not as worth it from a value per dollar standpoint, plus it will take you a lot longer & you’ll need to top-up your CPF voluntarily to accumulate enough CPF balance to hit the ERS when you could be investing that money instead – so I’d opt for the much easier to achieve FRS here.
   [Updated 29-Apr-2020]: I did further analysis to compare ERS against investing and found that it is most likely better to upgrade to ERS compared to investing, so if you’re interested, do read that post in detail!
2. Elect for the Standard Payout Plan and skip the Escalating Plan unless you are very confident you will need the inflation hedge AND that you will definitely live past 91 years old.

Keep in mind that the CPF LIFE is meant to provide a minimum amount of money to allow you to cover your basic needs in your old age. It is not meant to provide you a luxurious lifestyle. As FIRE adherents, I will recommend looking at CPF LIFE simply as a bonus, something that will help supplement your portfolio income / withdrawal from your portfolio once you turn 65.

(You can read up on how CPF LIFE payout fits into my withdrawal strategy for retirement in my latest post.)

If your 4% withdrawal rate have you withdrawing S$6,000 from your portfolio each month, and CPF LIFE pays you S$2,000 each month once you turn 65, then that means you can reduce your withdrawal to just S$4,000! That changes your portfolio withdrawal from 4% to just 2.67%!

That practically ensures that your portfolio will never run out of money – and likely grow much larger as you reduce your withdrawal. Or, if you so choose, you can maintain your withdrawal at S$6,000 and live luxuriously with the extra S$2,000 income from CPF LIFE. The world is your oyster!

I think that’s the best way to think of it, a great safety net for us FIRE folks, basically guaranteeing that we can take some risk with our withdrawal rate, maybe increasing it to 5% while knowing that when we do turn 65, we will begin to get an additional income stream to reduce our withdrawal rate from our portfolio.

As always, I’d like to know what you think. Let me know if this makes sense for you or whether you agree, disagree or have a different take on it in the comments below!

You can also follow & shout at me on twitter if you want to have a conversation by tweeting @firepathlion!

Until next time! Thank you for reading!

FPL

Other readings on CPF LIFE:

• CPF Life: Is it a worthwhile investment? by Life Finance