Avinash Luthria joins the freefincal list of SEBI registered fee-only financial advisors as its 12th member (yet another based in Bangalore) and to mark the occasion, in this guest post, he issues an important warning: *“Real returns, (after inflation and tax), across one’s entire portfolio and across one’s lifetime, will be in the ballpark of zero per cent. **This dramatically changes how one should invest and save”,* and discusses simple solutions to handle this.

Avinash is also a member of Fee-only India: launch of a movement to serve investors and advisors and attended its second meeting in March 2018 at Hyderabad. If you wish to structure your money management goals with Avinash, you can contact him via his website: **fiduciaries.in **Now over to Avinash.

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It’s probably useful to first get a very brief introduction out of the way: I am a Fee-Only Financial Planner & Investment Advisor ( http://fiduciaries.in ). Previously, I was a Partner and one of the five members of the founding team at a Top 5-10 independent Indian Private Equity & Venture Capital fund. In parallel with being a Private Equity investor, in my free-time on Sundays, I was a value-style direct-equity public market investor. I have an MBA (in Finance) from IIM Bangalore and have been a practitioner/student of finance for more than three decades.

Since several readers might find it difficult to accept the assertion above (Zero-Real-Returns), let’s address that before moving on to the *consequences* of the assertion, which are more interesting. A quasi-proof of Zero-Real-Returns would involve too long a discussion about investment theory, history, and psychology, among other subjects. Fortunately, even if the forecast is not precise but is directionally correct, the consequences of Zero-Real-Returns that are mentioned below are still broadly correct. So, I will instead illustrate the assertion of Zero-Real-Returns in an over-simplified manner.

In the illustration below, I have tried to minimize jargon, but there are still a few bits of jargon that the reader cannot skip over: ‘Nominal Returns’ are the returns that we usually talk of in daily life. ‘Real Returns’ are equal to Nominal Returns minus inflation. Real Returns are more relevant, and hence it’s important to think in terms of Real Returns. In the illustration below, I have assumed inflation of 6% p.a. and in case of income tax, a marginal tax rate of 30%.

Let’s assume that the following investment avenues (that correspond with asset classes) have the following, relatively realistic, *future average per annum long-term post-tax returns*:

| Post-Tax Nominal Returns p.a. | Post-Tax Real Returns p.a. |

NSE NIFTY 50 Index fund
| +9.5% | +3.5% |

Residential Real Estate
| +7.4% | +1.4% |

Government of India 10-year constant maturity bond fund | +7.3% | +1.3% |

Fixed Deposits at the highest-quality scheduled commercial banks | +5.0% | -1.0% |

Simple Average of the above Returns
| +7.3% | +1.3% |

Let’s say that Achilles is 30 years old and decides to distribute his net worth equally between these four asset classes. He also maintains this asset allocation proportion for the rest of his life i.e. even when he is 75 years old. His average return over the rest of his life will be the simple average of the numbers mentioned above. So, his post-tax Nominal Returns will be 7.3% p.a. and his post-tax Real Returns will be 1.3% p.a.

This 1.3% p.a. Real Returns assumes that:

- Achilles is always a very good investor who (a) never gets too greedy nor too fearful and (b) does not make any significant mistakes along the way, even when he is 75 years old and
- Achilles does not have much bad luck such as a bad
*sequence-of-returns*during retirement (over-simplistically, sequence-of-returns risk means that a bear market or stock market crash during retirement will have a disproportionately harmful impact)

It would be more realistic to conservatively provide for a few small mistakes and a small amount of bad luck. Doing so will reduce Achilles’ Real Returns below 1.3% p.a. It’s difficult to quantify whether the conservative estimate of his Real Returns is 0.8% p.a. or 0.3% p.a. Instead, we can just approximate that it will be in the ballpark of 0%. As mentioned earlier, it’s not important to be precisely correct in this forecast but to be directionally correct.

Now that we are done trudging through the math, we can focus on the consequences of the Zero-Real-Returns which are more interesting. These are few of the implications of the Zero-Real-Returns and once again, I have over-simplified:

*The corpus that you require to retire is 30 years of expenses:*- The assertion of Zero-Real-Returns allows you to simplify the calculation and treat inflation and investment returns as cancelling each other out. So, in this calculation approach, one can ignore both inflation and investment returns.
- If you and your spouse are 60 years old, you should have savings equal to 30 years of current expenses to be able to retire and
*survive*retirement till the age of 90.__This is a much larger amount than most people think.__

*You should save half of your lifetime salary:*- If you and your spouse are 30 years old, then you have another 30 years of working lives ahead, and a total of 60 years of spending ahead of you. So, you should save an average of around 50% of your post-tax salary over the next 30 years.
__This is a much larger proportion of savings than what most people think.__ - More typical scenarios are also relatively easy to calculate. Let’s assume that you and your spouse are 50 years old and you have already saved half of what you need to save for retirement. You are now trying to figure out the proportion of your post-tax salary, over the next decade, that you should save. This is simple enough to calculate mentally, but the first time you do this calculation, doing it on a piece of paper would minimize errors.

- If you and your spouse are 30 years old, then you have another 30 years of working lives ahead, and a total of 60 years of spending ahead of you. So, you should save an average of around 50% of your post-tax salary over the next 30 years.
*Investment returns cannot compensate for inadequate savings:*- A commonly held view is that if someone does not save enough, then they can compensate for that by taking on more risk and generating higher investment returns. The reality is the opposite of that.
- Let’s say that an individual did not save enough and that they desperately need higher investment returns. Let’s also assume that, wishfully, they try to get higher investment returns by taking on a higher equity allocation. Eventually, after a bear market or stock market crash that persists for a long time, they will find that they cannot hold on to their equity allocation, and will be forced to sell and lock-in extremely poor returns.
__If an individual is desperately in need of high investment returns, then they will not be able to cope with risk and hence, are likely to generate lower returns.__

*Even small costs kill:*- If an individual saves Rs 1 crore and they lose (a realistic) 0.6% of it each year in commissions to distributors of financial products such as mutual funds, then in 30 years, they would be left with the real equivalent of only Rs 83 lakhs.
__So even__*apparently*small costs, cumulated over a long period of time, become large costs and have a huge impact. - Even if one uses Direct Plans (i.e. Zero Commission Plans), all else being equal,
__focus on mutual fund fees and try to minimize them as much as possible__. - A good way to condition your mind to do this is to think of commissions/costs/ fees not in percentage points but in basis points (a basis point is one-hundredth of a percentage point).
- Further,
__every fee/cost above zero should add value to you for that cost to be justified. This is applicable even for annual costs of 0.1 percentage points i.e. 10 basis points.__

- If an individual saves Rs 1 crore and they lose (a realistic) 0.6% of it each year in commissions to distributors of financial products such as mutual funds, then in 30 years, they would be left with the real equivalent of only Rs 83 lakhs.
*There is no room for unforced-errors / blunders:*- Saving 30 years of expenses by the age of 60 is a herculean task for most of us. Any major ‘unforced-errors’ (i.e. blunders) will make this almost impossible to achieve.
- Let’s assume that one invests 20% of one’s net worth in a risky real estate investment and that investment is a failure and the investment gets wiped out. Then during retirement, one will be forced to live with 20% less than what one had planned to.
__The primary way to mitigate this is to sufficiently diversify one’s investments.__

An analogy may make it easier to remember the above rules-of-thumb: Let’s say that you suddenly find out that you have to drive from Mumbai to Pune for a critical meeting, which is four hours from now on a hot summer afternoon. The prudent approach is broadly as follows:

- Check Google Maps to know how long it is likely to take (similar to
*calculating the correct amount that you have to save*) - Excuse yourself from the ongoing less important meeting so that you can leave on time (similar to
*saving enough*) - Just in case you left late, then resist the urge to drive above the speed limit to compensate for it (similar to
*investment returns cannot compensate for inadequate savings*) - Don’t distract yourself by talking on the phone while driving (similar to
*even small costs kill*) - Don’t try overtaking while driving through the tunnels. Also, even though you are short on time, make time to check the air pressure in the tyres (similar to
*there is no room for unforced-errors / blunders*). As we all know, it’s better to reach late, than to not reach at all.

*The views above are my views and do not necessarily reflect Pattu’s views. A huge thank you to Pattu, Ashal Jauhari, Melvin Joseph, Vikram Krishnamoorthy and Swapnil Kendhe for their warm welcome to the small set of Fee-Only Financial Planners & Investment Advisors. This warm welcome from the three Fee-Only Financial Planners mentioned here is the best illustration of Fee-Only Financial Planning being a profession rather than a business. *

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Do join me in welcoming Avinash to our fee-only fold. If you wish to work with Avinash, you can contact him via his website: **fiduciaries.in**

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If this is the quality of advice from the financial planning community, then I have to say that this is a sad state of affairs. A little learning is indeed a dangerous thing. The post seems to ignore so many other factors.

First of all, tax is always paid on realized gains / income and not notional gains. In a buy and hold strategy, the effect of taxation is blunted over long holding periods. Rs 100 invested at 10% over 20 years grows to 672 and the tax on realized gains (@ 33%) would be (672-100) * 1/3 = 190. So the effective rate of return is 8.25% and not 6.66%. (What about inflation? Inflation leads to higher salaries and thus proportionately inreases savings).

Secondly, the world over capital gains gets favorable treatment in contrast to earned income which is taxed at a higher rate. It is less likely that it will be treated / clubbed with salary. This favors investors over workers.

Thirdly, even if the government clubs capital gains under the head salary, progressive taxation reduces the effective tax rate one pays when selling a security. Even for individuals earning 50 lakhs a year under the current dispensation, the effective rate is about 25% or so.

Fourthly, the equity component in a retiree’s portfolio does not have to be zero on the day of retirement [Having a 60/40 stock bond mix is the basis of the 4% withdrawal rule]. The 4% rule coupled with progressive taxation and the FIFO method, means that the effective tax is even lower while allowing the portfolio to grow even more.

While I don’t necessarily disagree with the implications (save 50% of your income, costs matter etc.), the premise on which it is based is broken.

The moral of the story is this. Bad advice and an equally bad advisor can do more damage that inflation, taxes and sequence of returns combined.

It is better to be safe than to be sorry.

Retirement is such a phase of life, where corrective action is a difficult job, usually ends up as regrets .