Check your progress to financial freedom with this formula!

Published: April 16, 2021 at 10:59 am

Here is a simple formula to check your progress to financial freedom. It can tell you how long you need to be a salaried employee and shift the focus of portfolio review from returns to the corpus worth and, in the case context of retirement, how long would it last. It will work in any spreadsheet application, but with any formula depends on what we put it and how much we appreciate the calculation.

Retirement planning is about answering two questions. One, for a given inflation assumption before and after retirement, and a given overall after-tax portfolio return after return, what is the corpus required upon retirement. A corpus from which we can draw an income each month or each year. This income should grow with inflation each year. The rest of the corpus is assumed to increase at the rate of return assumed and drops to zero only in the year we expect to die.

To appreciate the importance of inflation, here is a simple example: How should I invest to get Rs. one lakh a month pension? This is a step-by-step guide for doing the above calculation: Find out how much you need to retire in 15 mins: build your own calculator!

So the first question is, how much corpus do I need for financial independence after retirement? Even for an actual middle-class existence, this can run into crores! Being a crorepati is not a dream; it is an obligation! See: What is the value of one crore in 2021?

The results can be frightening, which is why we cannot hope to compensate for the shortfall by additional returns. This is why a second income is important! Why you have to start now!

The second question is, with this corpus as a target and for an after-tax overall portfolio return assumption, how much should I inevst? Of course, this is not an independent question, but it helps separate the financial planning process this way.

Please note: When we use the word “retire”, it only means “quitting your regular job”, or “no longer necessary to work every day”. This is not the same as “stop working”. A smart “retiree” should have both passive and active forms of income at retirement. There would be no compulsion to work actively, that is all. Retirement should not be confused with ceasing all activity and annoying the spouse full time.

So what is this formula?

=NPER(real return,-income,corpus,,1)

  • Real Return = (1+ return)/(1+inflation)-1
    • return here refers to the post-tax return on the overall retirement corpus after retirement.
    • Inflation here refers to inflation after retirement.
  • Income refers to the amount required to manage expenses in the first year of retirement. This is equal to current expenses that will persist in retirement after considering inflation between now and retirement. Note there is a negative sign before income in the formula to represent withdrawals.
    • This amount will be withdrawn each year from the corpus. Withdrawals each year will increase at the rate of inflation assume in the real return calculation.
    • The rest of the corpus will grow at the rate of return assumed in the real return calculation.
  • Corpus refers to the retirement corpus.
  • The input between the two commas is optional. If left empty, it is assumed the yearly withdrawals will reduce the corpus to zero.  If you set some value here, the yearly withdrawals will reduce the corpus to that value.
  • The “1” refers to the withdrawals made at the start of the year.

NPER tells you how long a retirement corpus would last (when it would go to zero) if yearly withdrawals are made from it. The withdrawals increase at some rate of inflation, and the rest of the corpus grows at some rate of return. So the answer you get will be in years because that is the frequency of assumed withdrawal.

You can use NPER in two different ways.

  • NPER(real return,-future retirement income reqd, corpus expected at the time of retirement,,1)
    • This is essentially a recheck of the basic retirement calculator. If you entered such a basic calculator that you will retire by age 55 and hope to live up to age 85, then NPER will give you 30 (years) as the answer. That it tells you the duration of your retirement.
  • NPER(real return,-current income required,current corpus,,1)
    • This will tell you how soon can you retire, or it will tell you, if you retire now, how long you can be financially independent.

NPER(real return,-current income required,current corpus,,1) 

Let us call this NPER(current). This version would tell you how close (or I should say far) away from financial freedom. Like most formulae, the assumptions matter and the manner of calculation matters.

The idea of allowing a corpus to grow while you withdraw from it is acceptable for a young earner. As we grow older, we appreciate the need for regular income after retirement. We also need to appreciate the importance of varying asset allocation.  So the withdrawal process assumed in NPER is rather approximate for retirement planning. 

Who should not use NPER(Current)?

  • Those who have just started investing for retirement should not bother with NPER. They will get the answer as 0 or 0.0001 years.
  • Those who are close to financial freedom or those who have already achieved financial freedom should not use it. For example, if I use NPER(current) with my equity MF corpus + direct equity corpus + PPF + NPS, I get 71 years as the answer. I cannot make the mistake of thinking, “Hey, I am 46, my wife is 44, and we can be financially independent until ~ age 100+”.
  • A more rigorous calculation with the robo advisory template taking into account pension income from NPS (80% of the corpus has to be annuitized before age 60 as of now), passive income, dividend income, retirement benefits, guaranteed income for the first 15 years and rest in low-, medium- and high-risk buckets yields a very different answer! It does not change the FIRE status, but the margin of achievement is quite different:  20% more than required and not about 50% more as NPER(current) suggested.

Who should use NPER(current)

  • Those who have been investing for retirement with or without planning for a few years can use NPER(current) once a year. It will tell them how far or how close they are. Since market returns are non-linear, FIRE status will look far and suddenly change overnight. I have seen my NPER(current) double from 5 years to 10 years in a quick span of time. As it increases, we get confidence because we know we are on the right track. Of course, patience is key (clarification for millennials: this means good things will take time).

In summary, NPER is a simple measure to appreciate “where we are” in our journey to financial independence. If we appreciate the underlying assumptions, we can use it as a thumb rule for financial freedom.

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