Last Updated on August 23, 2019 at 10:29 am
Avinash Luthria, SEBI Registered fee-only investment advisor explains why one should not retire early in India (or US or elsewhere) based on the so-called 4% retirement rule (explained below). I respect Avinash’s approach to investing especially his realistic views on risk and reward.
Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI Registered Investment Adviser (RIA) at Fiduciaries. He was previously a Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore. His articles have appeared at Business Standard, Mint and The Ken. See: publications You can read his previous guest articles here:
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Misconceptions about Early Retirement
The biggest misconception about early retirement is that you can retire at the age of 40 or 50 with a corpus that is 25 times your annual expenses. You cannot! Many people are optimistically misreading the 4% rule. And the 4% rule is itself optimistic. But let’s start at the beginning.
Amateur version
There is an amateur view which is more common in high inflation countries like India. The amateur view on this topic goes something like this. Let’s assume that I want to retire, and I have a corpus of Rupees 1 crore. I can get 5.5% post-tax interest on this, which is Rupees 5.5 lakhs per year. If Rupees 5.5 lakhs per year is sufficient to meet my annual expenses, then I can retire with a corpus of Rupees 1 crore. And I will be living of the interest and I won’t be touching the principal so my corpus will last indefinitely. As I mentioned earlier, this is an amateur view. It suffers from what is called ‘money illusion’ which is a confusion between nominal returns and real returns. Nominal returns are what we talk about in everyday life for example, the 5.5% post-tax returns that we can earn. Nominal returns minus inflation is called real returns. So, 5.5% nominal returns minus say 5% inflation is equal to 0.5% real returns. Since this view is extremely amateur and is completely wrong, let’s not spend any time on it here.
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The 4% Retirement Rule
The next refinement on this thinking is what is often called the 4% rule. Firstly, the 4% rule is not really a rule. It is just called ‘a rule’. The 4% rule was based on a study in 1998 which said something like this: “Let’s say that you have a corpus of Rupees 1 crore. In your first year of retirement, you consume 4% of your corpus as expenses. That is Rupees 4 lakhs. In the second year of retirement, to maintain the same standard of living, you consume Rupees 4 lakhs plus inflation. Let’s say inflation is 5% so you consume 5% more which is Rupees 4.2 lakhs. And so on. Historical data shows that if you invest half your corpus in equity and half in bonds, then your corpus is very likely to last for 30 years”.
4% is equal to 1 divided by 25. So, in the first year of retirement, you can withdraw one-twenty-fifth of your corpus. Another way of saying this is that your corpus has to be equal to 25 times your annual expenses in your first year of retirement. So, if you are 60 years old and you plan to retire today and you want your money to last till you are 90, then you need to have a corpus that is equal to 25 times your annual expenses.
This is already a big leap forward from the amateur version that we discussed earlier. The 4% rule says that your corpus will not last indefinitely. It will last only 30 years.
Misunderstanding the 4% Rule
Unfortunately, a lot of people including a lot of popular personal finance bloggers outside of India did not bother to understand the 4% rule. This includes many people outside of India who have written books about financial planning. They latched on to one bit of the 4% rule, that your corpus has to be equal to 25 times your annual expenses in the first year of retirement. They then said that if you are say 40 years old and you have a corpus that is equal to 25 times your annual expenses, then you can completely retire. Please note the word ‘completely’. Some of them did not bother to understand what the 4% rules says. Others at least understood that the 4% rule was talking about a finite period of time of 30 years. But they said, don’t worry, if the corpus can last for 30 years, then it can last till infinity. The trick that these so-called experts are playing is to use the term the 4%-rule and then use the partial-credibility that this rule has to claim something completely different and completely absurd. The problem is that many people are making life-changing decisions based on this nonsense. This is one of the reasons that I am making this video/article.
The 4% rule did not say that if you have a corpus of 25 times your annual expenses, then you can retire at the age of 40. Or even at the age of 50. It was talking about an age of around 60 when you are ok if your corpus is completely used up in 30 years.
As I mentioned the 4% rule was based on a study in 1998. Today, no competent financial planner goes by the 4% rule. The 4%-rule is optimistic for several reasons. Let’s look at only three. First, it looked at only US data and the US was one of the best performing stock markets over the last 120 years. The 4%-rule fails in many other developed countries, let alone developing countries which are even more unpredictable. Second, the study that it is based on ignored taxes. Third, due to the current high equity valuations, what worked in the past may not work in the future.
Zero Real-Returns
I earlier wrote that one should assume zero post-tax real returns for one’s entire portfolio over one’s lifetime. So, your corpus does not grow in real value of money. Hence if you are retiring at the age of 60 and you want your corpus to last till you are 90, then you need a corpus that is equal to 30 years expenses. Or your corpus should be equal to 30 times your expenses during your first year of retirement. Another way of saying that you can spend one-thirtieth of your corpus in your first year of retirement. Let’s say that you are 60 years old and your corpus is Rupees 1 crore. In that case, you can spend one-thirtieth of Rupees 1 crore which is Rupees 3.3 lakhs in your first year of retirement. This amount is lower than the Rupees 4 lakhs indicated by the 4% rule.
Let’s look at two variants of early retirement. First, let’s say that you want to completely retire at the age of 50. In that case, you need a corpus that is equal to 40 times the expenses in your first year of retirement. This is so that your corpus will hopefully last for 40 years.
Another variant is, let’s say that you have a corpus that is equal to 30 times your annual expenses and you are 50 years old. You cannot completely retire but you could semi-retire. What I mean is that you could shift to a lower stress and lower salary role which just covers your expenses. So, you are not using the corpus that you saved for retirement. That corpus grows at the rate of inflation and when you fully retire at the age of 60, you still have a corpus that is equal to 30 times your annual expenses. At that point, you can start eating into your corpus.
Mitigating Sequence of Return Risk
There is scope for someone to misunderstand what I mean. It sounds like I am recommending a variant of the 4% rule and the difference is that I am saying that you can spend 3.3% of your corpus in your first year of retirement and an inflation-adjusted amount in the next year and so on. So, this sounds like a 3.3%-rule. But that is not what I am recommending. What I am recommending is more nuanced than that.
Let’s say that you are 60 years old, you have just retired, and you have a corpus of Rupees 1 crore. You hope to be able to spend Rupees 3.3 lakhs during your first year of retirement. Let’s say that 30% of this corpus is invested in equity so that is Rupees 30 lakhs invested in equity to protect you against unexpected high inflation. And the rest is invested in completely safe investments so that is Rupees 70 lakhs invested in safe investments to protect you against the risk in equity.
Purely for the sake of this illustration, so that we don’t have to complicate the calculation with inflation, let us imagine that one month after you retire, the stock market crashes by 50%. Now your Rupees 30 lakh investment in equity is down to Rupees 15 lakhs. The safe investments stay at Rupees 70 lakhs. So, your net worth is now Rupees 15 lakhs in equity plus Rupees 70 lakhs in safe investments which is a total of Rupees 85 lakhs. This is 15% less than the Rupees 1 crore that you had on the day of your retirement. What you now have to do is reduce your annual expenses by 15% compared to the Rupees 3.3 lakhs that you had been planning to spend. Your non-discretionary expenses like rent won’t change.
So, the reduction in your discretionary expenses like entertainment or vacations could be much higher – maybe 50% or 75%. And it has to stay that way till the stock market recovers in real value of money. This could be years later or decades later or even never. It is difficult to make such a large reduction in expenses, but one might just about manage to. And that is why for such a person, they have to limit the proportion of their net worth that they put in risky assets such as equity and real estate. I have covered this in slightly more detail in a webinar for IIM Bangalore alumni
The approach that I described is a way to mitigate what is called the sequence of return risk. And this concept is largely based on the insight of William Sharpe, a Nobel Prize Winner in Economics. William Sharpe has provided the concept and I added the zero real returns approach as a layer above it to provide specific numbers.
Summary
In summary, firstly, if you have a corpus that is equal to 25 times your annual expenses, you cannot completely retire at the age of 40 or even at 50. Claiming otherwise is based on a misunderstanding of the 4% rule.
Second, the 4% rule is itself optimistic and today no competent financial planner goes by it.
Third, when you completely retire at the age of 60, you need to have a corpus that is equal to 30 times your annual expenses.
Fourth, if you have a corpus that is equal to 30 times your annual expenses but you are 50 years old, then you can semi-retire and you should continue to earn a salary which is enough to cover your expenses till you completely retire at the age of 60. And finally, if during retirement, a stock market crash reduces your net worth by say 15%, then you have to reduce your standard of living by the same amount.
Video version (use headphones)
Avinash Luthria is Founder, Fee-Only Financial Planner & SEBI Registered Investment Adviser (RIA) at Fiduciaries; He was previously a Private Equity & Venture Capital investor for 12 years and has a flagship-course MBA in Finance from IIM Bangalore; He writes about Financial Planning & Investing in Business Standard, Mint, MoneyControl, The Ken, VCCircle etc ( https://fiduciaries.in/articles/ ); Views expressed here are of the author and do not necessarily reflect the views of FreeFinCal
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