Traditional retirement planning models and calculations rely heavily on the use of assumptions. Most individuals assume long-term post-tax returns of, say, 12% from equity and 7% from debt when saving for retirement. Inflation is typically assumed to be 6%. Such assumptions are known as steady-state assumptions. They generally do not change throughout the individual’s investment horizon (typically 25 to 30 years). But there are a number of issues associated with the use of such assumptions.
About the author: Akshay Nayak is a SEBI-registered investment adviser and a member of Fee-only India, a group of fixed-fee-only advisors. You can contact him via his website akshaynayakria.com.
Firstly, they do not account for a prolonged sequence of flat or negative portfolio returns. They also do not account for real world fluctuations in expenses, inflation rates and portfolio returns. It also leads individuals to erroneously believe that compounding will do the heavy lifting for them rather than their income and savings rates. A very simple and realistic way around this would be to adhere to the assertion of Zero Real Returns.
Understanding Why The Assertion Works
Regular readers of Freefincal would know that adhering to zero real returns implies that post tax returns and inflation nullify each other over the individual’s lifetime. This means that the individual’s money is likely to keep pace with inflation over this period. Retirement calculations are hence redone once a year when planning for zero real returns. Fresh figures are used for all key inputs pertinent to the calculations (retirement age, annual expenses, portfolio values and so on). It therefore negates the need for assumptions regarding inflation and portfolio returns.
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Planning for zero real returns also offers a number of other benefits. It allows flexibility for drastic changes in income and expenses. Such instances usually occur due to major life events such as promotions, childbirth, relocation, death of an earning member and so on. It allows retirement planning calculations to be done without the use of complex mathematical operations. This makes retirement calculations seem intelligible rather than overwhelming. It can also highlight subtle but critical blind spots in the way an individual is planning for retirement. These benefits can be better understood by looking at the hypothetical case study given below.
A Retirement Planned To Zero Real Returns
Mr A and Ms B are a married couple aged 30 and 25 respectively. Their annual take home income and expenses as a couple amount to Rs 40 lakh and Rs 24 lakh respectively. 80% of their expenses go towards discretionary spending. The couple saves 40% of their annual take home income. Their current net worth as a couple amounts to Rs 1.5 crore. The portfolio has a 60-40 split between equity and debt respectively. They have no children at present but expect to start a family within the next one year. Annual expenses post childbirth would increase to Rs 30 lakh. Mr A and Ms B will be getting promoted to major roles in their respective organisations in 2 years time. The demands of Mr A’s new role require him and his family to relocate to a new city. Annual expenses would increase to Rs 35 lakh as a result of the move. But the couple’s annual take home income would shoot up to Rs 70 lakh. Mr A wishes to retire at age 55 and expects to live until age 90.
Planning for zero real returns would stipulate that the quantum of the corpus Mr A requires for retirement would be given as :
Required Retirement Corpus = Current Annual Expenses × (90 – Age at retirement)
But there is a critical nuance to be addressed here. There is an age difference of 5 years between Mr A and Ms B. The retirement corpus being built needs to last for both spouses. Also, the younger spouse is typically expected to live for longer. Therefore life expectancy calculations would be anchored to age 90 of the younger spouse (Ms B in this case). All calculations over the course of this case study are being done from Mr A’s perspective. Life expectancy is therefore taken to be 95 to account for the age gap. For ease of understanding, I will show separate calculations for the following 3 scenarios :
- Present day
- Childbirth after 1 year
- Promotion and relocation after 2 years
Scenario I : Present Day
Annual household expenses = Rs 24 lakh
Current age = 30
Age at retirement = 55
Life expectancy = 95
Years to retirement = 55 – 30 = 25
Years in retirement = 95 – 55 = 40
This implies that the couple requires a corpus worth 40 times their current annual expenses. But not that the couple has an available net worth of Rs 1.5 crore (Rs 150 lakh). This figure can be expressed as a multiple of their current annual expenses. Accordingly :
Current net worth as a multiple of current annual expenses = 150/24 = 6 times (The precise answer would be 6.25, rounded off to the nearest integer which is 6)
This means that the couple needs to build a corpus worth a further 34 times their annual expenses. They currently have 25 years until retirement to build the required amount. This means that the couple needs to invest an amount worth 1.36 times their current annual expenses (34/25 = 1.36) for retirement over the next one year. The figure of 1.36 is known as the investment multiplier. Accordingly : Required annual investment amount = 24,00,000 × 1.36 = Rs 32,64,000
Required annual savings rate = (Required Annual Investment/Annual Take Home Income) × 100 = (32,64,000/40,00,000) × 100 = 81.6%
This highlights a critical issue. The couple saves 40% of their annual take home income. But they are actually required to save 81.6%. This represents a gap of 41.6%. The gap may seem too wide to cover. But remember that the 80% of the couple’s annual expenses go towards discretionary spending. Discretionary spending can be cut to the extent of the additional savings required. This would allow the couple to bridge the gap effectively. In other words :
Annual discretionary spending = 24,00,000 × 80% = Rs 19,20,000
Current annual savings = 40,00,000 × 40% = Rs 16,00,000
Required annual investment amount for retirement = Rs 32,64,000
Additional annual savings required = 32,64,000 – 16,00,000 = Rs 16,64,000.
This amount can be sourced through a cut in discretionary expenses. Therefore : Reduction in discretionary expenses diverted to annual savings = Rs 16,64,000
Permissible annual discretionary spending = 19,20,000 – 16,64,000 = Rs 2,56,000
At the end of the year equity generates a return of 9% post tax. Debt generates 7% post tax. Accordingly :
Weighted Average Portfolio Return = (60%×9%) + (40%×7%) = 5.4% + 2.8% = 8.2%
Scenario II : Childbirth After 1 Year
Before getting into the calculations, major changes in the couple’s realities must be highlighted. Their annual take home income has now grown to Rs 44 lakh (10% higher than the previous year). Their annual expenses have increased to Rs 30 lakh. Mr A and Ms B are now aged 31 and 26 respectively. This means they now have 24 years left until retirement. Their current net worth is now Rs 198 lakh. Underlying calculations for the portfolio value are given below :
Portfolio value at the start of year 1 = 1,50,00,000
Annual investments for year 1 = 32,64,000
Post tax portfolio return for year 1 = 8.2%
Portfolio value at the end of year 1 = 1,50,00,000 + 32,64,000 + 8.2%
= Rs 1,98,00,000 (The precise answer would be 1,97,61,648, rounded off to the nearest lakh which is 1,98,00,000)
Accordingly :
Current net worth as a multiple of current annual expenses = 198/30 = 7 times (The precise answer would be 6.6, rounded off to the nearest integer which is 7).
The couple now needs to build 33 years of expenses over the next 24 years. Accordingly :
Investment multiplier = Number Of Years Of Expenses Required/Years To Retirement = 33/24 = 1.375
Required annual investment amount for retirement = 30,00,000 × 1.375 = Rs 41,25,000
Required annual savings rate = (Required Annual Investment/Annual Take Home Income) × 100 = (41,25,000/44,00,000) × 100 = 93.75%
This indicates a gap of 53.75% between available savings and required savings. Underlying calculations for required additional savings for the year are laid out below : Available annual savings = 44,00,000 × 40% = Rs 17,60,000
Additional annual savings required = 41,25,000 – 17,60,000 = Rs 23,65,000
The additional savings required would once again have to be sourced through a cut in discretionary spending
Annual discretionary spending = 30,00,000 × 80% = 24,00,000
Reduction in discretionary expenses diverted to annual savings = Rs 23,65,000
Permissible discretionary spending for the year = 24,00,000 – 23,65,000 = Rs 35,000
At the end of the year, equity as an asset class remains flat (no returns for the year). Debt earns 6% post tax. Accordingly :
Weighted Average Portfolio Return = (60%×0%) + (40%×6%) = 0% + 2.4% = 2.4%
Scenario III : Promotion And Relocation After 2 Years
Let us first understand the changes in the couple’s realities for this year. Their annual take home income has now grown to Rs 70 lakh as a result of their respective promotions. Their annual expenses have increased to Rs 35 lakh. Mr A and Ms B are now aged 32 and 27 respectively. This means they now have 23 years left until retirement. Their current net worth is now Rs 245 lakh. Underlying calculations for the portfolio value are given below :
Portfolio value at the start of year 2 = 1,98,00,00
Annual investments for year 2 = 41,25,000
Post tax portfolio return for year 2 = 2.4%
Portfolio value at the end of year 2 = 1,98,00,000 + 41,25,000 + 2.4%
= Rs 2,45,00,000 (The precise answer would be 2,44,99,200, rounded off to the nearest lakh which is 2,45,00,000)
Accordingly : Current net worth as a multiple of current annual expenses = 245/35 = 7 times. Notice that the net worth multiple has remained constant in comparison to the previous year. This is a natural consequence of the low portfolio return in year 2 owing to the 0% return from equity.
The couple now needs to build 33 years of expenses over the next 23 years. Accordingly :
Investment multiplier = Number Of Years Of Expenses Required/Years To Retirement = 33/23 = 1.43
Notice that the investment multiplier has increased in comparison to the previous year. This is because the couple still need a further 33 years of expenses as they did last year. But they now have one year less available to build the amount. Traditional retirement planning calculations reliant on steady state assumptions would not capture this fact. Therefore
Required annual investment amount for retirement = 35,00,000 × 1.43
= Rs 50,05,000
Required annual savings rate = (Required Annual Investment/Annual Take Home Income) × 100
= (50,05,000/70,00,000) × 100
= 71.5%
This indicates a gap of 31.5% between available savings and required savings. Underlying calculations for required additional savings for the year are laid out below:
Available annual savings = 70,00,000 × 40%
= Rs 28,00,000
Additional annual savings required = 50,05,000 – 28,00,000
= Rs 22,05,000
The additional savings required would once again have to be sourced through a cut in discretionary spending
Annual discretionary spending = 35,00,000 × 80%
= 28,00,000
Reduction in discretionary expenses diverted to annual savings = Rs 22,05,000
Permissible discretionary spending for the year = 28,00,000 – 22,05,000
= Rs 5,95,000
This should give readers a reasonably clear idea with regard to how retirement planning calculations are carried out when planning for zero real returns.
Key Implications When Planning For Zero Real Returns
The case study and scenarios discussed above highlight a number of critical implications for individuals. Notice first that the required annual savings rate in all 3 scenarios is at least 50% of annual post tax income. This would be true for most individuals. It is consistent with one of the fundamental stipulations of the Zero Real Returns model. It states that individuals must save at least 50% of their lifetime post tax income for retirement. Monthly and savings rates of 20%, 30% and so on would therefore be nowhere close to enough for a comfortable retirement.
In the instant case, the couple is required to save 81.6%, 93.75% and 71.5% of take home income respectively across each of the three scenarios. Figures like these may make it seem like the Zero Real Returns model is overly conservative. Some may even say that the model is fundamentally flawed. But if anything is fundamentally flawed here it is the couple’s lifestyle. Notice that their annual expenses increase by at least Rs 5 lakh a year. Also 80% of their annual spending is attributable to discretionary reasons. The disproportionately high annual savings requirements are a natural consequence of both these facts.
Notice that the gap between the required annual savings rate and the couple’s actual savings rate is the lowest in Scenario III. This is because the couple’s take home income increases significantly there. This implies that a constantly growing income is a vital enabler of a comfortable retirement. A growing income and low discretionary spending represent two critical levers for anyone looking to enjoy a comfortable retirement. They are most effective when employed in parallel to each other.
Individuals may try to rationalise not being able to save enough for retirement by running overly aggressive portfolios. This sees them set high return expectations from their portfolios. But high investment returns cannot compensate for inadequate savings. Individuals may try to make up for not saving enough by using a higher equity allocation. This may increase expected returns from the portfolio. But a subsequent market crash and/or prolonged bear market can decimate the portfolio. Most individuals may not be able to psychologically cope with such an eventuality. They may then reduce their equity allocation. They are therefore likely to generate lower investment returns over the long term.
The couple here is planning for retirement at age 55. This is the norm for most retirees. They start saving for retirement at age 30 which is quite an early start. But the required savings rates are still daunting. And the challenge becomes that much more steep for those looking to retire early. Such individuals need to invest between 2 and 3 times their annual expenses each year for retirement. It is therefore a trivially small number of people who are likely to possess the financial and behavioural capacity to retire early.
Parting Thoughts
The resultant figures of calculations when planning for zero real returns may seem scary. Some may even lose their motivation to invest on seeing such figures. But the only reason they are scary is because that is just what accurate retirement planning calculations are meant to be. If the resultant figures of a retirement planning calculation don’t scare us, it means either of the following two things :
- The calculations are inaccurate
- We live an inherently frugal lifestyle and hence are able to comfortably invest enough for retirement.
And if such calculations are going to scare those saving for retirement, the fear is best realised today. There would still be enough time to change course and implement corrective measures. But to rise to the challenge, we must first wake up to reality. And planning for zero real returns would help us do just that.