The article investigates if you can retire in India with only 25x your expenses saved as retirement corpus.
Why is real return important for investing?
Inflation, as we discussed in our detailed article on inflation recently, increases the future value of goals to unexpected levels. We can use the rule of 72 as a convenient mental shortcut to understanding the impact of inflation.
The rule says: Rate of doubling * Time in years = 72
Rule of 72 lets us quickly calculate the impact of inflation over time. For example, using the rule, we can see that:
the purchasing power of money halves every ten years at 7% inflation. For example, one crore worth today will be worth 50 lakhs in 10 years and 25 lakhs in 20 years
a lump sum payout, say from an insurance plan, is worth around four times less in today’s money if received in 20 years
if you need one lakh/month in living costs in the first year of retirement, that will be two lakhs/month in ten years and four lakhs/month in twenty years
The above examples show the danger of linear thinking when money is involved especially in retirement. For example, any goal planning that ignores the effect of inflation will lead to inevitable failures when it is time to spend the money. Similarly, investing in insurance plans that give a fixed return over life will lead to getting smaller and smaller amounts in real terms that will be useless in the later years of retirement. The actual calculation is an application of the compounding formula like this:
Cost after N years = Cost today * (1+Inflation) ^ Time
Here is a table that applies the above rule:
For example, at 9% inflation, a goal ten years away will increase by 2.37 times. If the cost today is ₹10 lakhs, after ten years, it will be ₹23.7 lakhs.
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Defining real return
Given that we need to keep track of inflation while investing, the real return is a convenient tool to subtract the effect of inflation from the nominal portfolio returns.
Return over inflation, i.e. real return, is calculated as
The second formula is a bit less accurate but is simpler to understand and calculate.
Real return during the retirement period depends on:
real return assumptions of each asset class in the retirement corpus. Typically this will be equity, debt and cash. Many others will have real estate and gold in their portfolio
the asset allocation for each individual expense goal based on the horizon. We are creating one single goal for the expenses in each year of retirement using the same concept described in this post: how to get SIP amount for a goal with multiple payments
the glide path for each of the individual goals
inflation in the accumulation phase (when you are saving for retirement) and in the post-retirement phase
The SWR is the amount withdrawn from the portfolio in the first year of retirement
this amount is increased gradually by the prevailing inflation rate every year after that
We will assume that the first year’s withdrawal is a value between 1% and 5%. The withdrawal amount will be increased by inflation of 7% every year. As a practical example, we will take
starting portfolio of one crore
₹2.5 lakhs expense in year one; 2.5 * 1.07 = ₹2.675 lakhs expense in year two etc.
since SWP is a standing instruction, we will edit the withdrawal amount in the mutual fund portal once a year to adjust for inflation
Start
₹ 1,00,00,000
Withdrawals ⬇️
–
Year 1
₹ 2,50,000
Year 2
₹ 2,67,500
Year 3
₹ 2,86,225
Year 4
₹ 3,06,261
Year 5
₹ 3,27,699
If we assume a real return of zero, i.e. the portfolio grows at the same rate it is withdrawn from, a lot of our retirement calculations become very simple. With zero real returns, the starting retirement corpus divided by the expenses in the first year of retirement is the number of years the corpus will last. It is that simple.
A 1 crore corpus growing at 7% will therefore support a 2.5L SWR (growing at the same 7%), for 100/2.5 = 40 years.
If the real return is more than zero, that is if the portfolio grows faster than inflation, then the number of years it will last will be more. Conversely, if the portfolio is very conservative, the real return will be negative and it will last lower than in the previous case. We have discussed these points before as well:
We will assume the following as the retirement portfolio
Equity: 4% (large-cap domestic stocks)
Debt: -3% (short duration < 1-year T-Bill or money market)
Asset allocation: 60:40 constant
We see that the real return of the portfolio is:
Real return = 0.6 * 4% + 0.4 * (-3%) = 1.2%
We have covered the 1.2% real return case in the above table which shows that if SWR is 3% or less, the portfolio can easily last 40 years or more. There if you are planning to FIRE for 40 years, a 3% SWR with a 60:40 equity:debt portfolio is a good option with these assumptions.
If the SWR is higher than 4%, there is only a limited chance that the portfolio will last longer than 30 years.
This result was a portfolio with a fixed asset allocation, a bit like a unified portfolio. In a future article, we will see how a portfolio whose risk component is gradually reduced with time lasts in retirement against various SWRs.
FIRE aspirants as a test of if they can FIRE or not
If you get a large lump sum amount from a sale of a business or property or an insurance payout that is invested for retirement corpus
If you decide to leave your job to start a business, you can see how long your current lifestyle can be maintained
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This post titled How long will your money last if you retire today? first appeared on 18 Sep 2022 at https://arthgyaan.com
