Want to be financially free? Do not count on frugality! Worry about sequence of returns risk!

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If you are someone who desires early retirement or you just want to save up enough to ensure income for a few years while you get your startup off the ground, then you probably should have come across* terms like frugality, FIRE, safe withdrawal rate = 4%, savings rate etc. These are some of the lingo tossed about in the so-called financial independence and early retirement (FIRE) forums and communities. Useful as these groups are, I discuss why you should not take their enthusiasm about frugality too seriously else you may risk exhausting your retirement corpus quicker than expected.

* If you have not, good for you. Don’t. You can start off with a clean slate. Planning for early retirement is not different than normal retirement. The math is the same. The assumptions are the same. In fact, contrary to what people think, early retirement requires conservative assumptions than normal retirement.

Don’t get me wrong. These groups are useful when it comes to clarifying and defining your ideas of minimalism, increasing your savings, tips on saving money and use of your available resources efficiently. However, when it comes to handling risk after retirement, many people here seem to think if they spend less (being frugal), they can “manage”.

This is like certified financial planners saying they know everything about money management because they have passed a course or like parents who have just started home-schooling feeling superior to others who send their kids to school.

Before we begin, here are some resources that may be of use to young earners who wish to quit their salaried jobs as soon as possible:

Frugality: The Cornerstone of Personal Finance  ==> My early experiences

Misconceptions about frugality==> It is not spending less, but (organically) wanting less.

Download free E-book: How to retire early in India ==> This is meant as a complete guide.

Is it possible to retire early in India?  ==> Different types of withdrawal strategies are discussed. Pity if you talk about risk, budding FIRE seekers read it as “it is not possible to retire early in India”. Nothing further from the truth! More than possible.

Frugality and me

I am a frugal person by nature. This does not mean I cut back on my needs on purpose. I just have fewer needs, to begin with. As an example: I reluctantly purchased my first mobile in 2006 (because my late father was bed-ridden and wanted to reach me at any time). Since then, I have changed my mobile twice and over the past 12 years spent a total of about Rs. 4500 on them. Nokia 1110 —> Nokia 105 —> Samsung Guru (better voice clarity, but not so great interface). As you may have guessed most of the money went into  Nokia 1110.

I have not deprived myself of an iPhone or Samsung Galaxy. Just never felt the need for them. If I wanted to use internet on a mobile, I use Chrome dev tools and change the device (mainly for testing freefincal) in the browser.

Today I hear about people changing their smartphones once in two years because they have to and less than that because they want to. Nothing wrong that. Money is there to be spent. But if you are going to keep doing that, early retirement will not be so early. There is no free lunch. You can’t have everything.

You MUST plan for normal retirement early in life and start investing asap. You need not plan for early retirement.

The best part and the only reason we could become financially independent within a decade of earning is that my wife is intrinsically frugal too. Even today, she would come and ask, “I need to use the debit card, do we have money in the bank?” for amounts as small* as Rs. 500 or Rs. 1000. My point is, that is her idea of a “big purchase”.

* Should be the case with most people reading this

So make no mistake, we are big fans of frugality because that is our inherent nature. Either you are born with it or embrace it wholeheartedly later on. There is no in-between here.

A frugal existence is necessary for early retirement (unless you earn a super huge salary)

Two reasons:

1: It allows you to invest more. Today I manage to invest 60-70% of monthly income towards all our goals. A few years ago, it was a bit more. You can invest more, not just before saying goodbye to your regular job, but afterwards too.

2: It allows you to withdraw less. When you wish to draw an income from your corpus, a frugal existence goes a long way!

As a corollary: if you were frugal just to become financially free, you cannot change spending habits later on and start splurging!  This is similar to a low-carb, high-fat diet. Once you are on it, you cannot change, else the weight loss will be nullified.

A frugal existence is not sufficient for early retirement (unless you are super rich)

Remember that phrase, “necessary, but not sufficient” from your math textbook? That is what I am talking about.

Again three reasons, but this time not as simple to understand.

1: Unexpected recurring expenses. If you have a one-time expected expense now and then you can use your corpus or your emergency fund to handle it. If you have unexpected or unanticipated expenses that recur (say monthly), you will start withdrawing more and more from your corpus after quitting your regular job and risk running out of money sooner. Those below 30 may not appreciate it as much as older readers would do.

This is the reason I started a poll on Facebook Asan Ideas for Wealth: When did you first start thinking about FIRE? Fire-seekers in their 30s are likely to be a bit more balanced in their views while planning for retirement than those in their 20s.

You may want to be frugal and keep your expenses lower. But remember that life must let you be frugal. Many young earners seeking FIRE (financial independent and early retirement) fail to understand this. They think they can generate a nice fat 3-4% return above inflation and be as frugal as possible.

2: Lower reward, not just from equity but also fixed income in future. That is lower than what you project after early retirement now. See: Should I expect lower returns from equity in future?

This might reduce inflation from your present expenses, but it would be pretty brave to assume an real inflation of lower than 6% in India for the next 10-15Y at least. The good part is, disappointing returns will prevent you from retiring early! Better that risks pan out before you retire!

3: Sequence of returns risk. This is the most important reason and in combination with unexpected expenses can wreck havoc.

What is a sequence of returns risk?

As recently shown in Sensex Charts 35 year returns analysis: stock market returns vs risk distribution, even after 25 years, Sensex in the past has returned single-digit returns. That is, the return sequence over such 25-year periods was quite poor.

Want an actual example? Watch this:

How is this a risk in early retirement? Well, this is a risk for any goal.

Consider the most popular thumb rule used by budding early retirees:

If my current annual expense is X then a corpus of 30X will last me for 30 years.

For example, a monthly expense of Rs. 30,000 or annual expenditure of Rs. 3.6L will need a corpus of 108 lakhs).

That is I take the 108L and invest it in a portfolio that should give me say a return of R% year on year. I keep withdrawing money for expenses. This expense can increase year after year at an inflation rate of R%.`

Say you invest the corpus in a portfolio of stocks and bonds that gives you a net post-tax return of 8% year on year. Your corpus will last for 30 years if the inflation in your expenses is 8%.

That is the real return (excess return above inflation) = zero. In other words,

a corpus of 30 times annual expenses will last for 30 years with zero real return

The problem is that this 30X thumb rule holds good for 0% return and 0% inflation; 4% return and 4% inflation and 8% return and 8% inflation. What is the difference? The risk necessary to achieve 8% net portfolio return after tax is higher than 0% or 4%!

This means as you expect higher and higher returns from your corpus in the withdrawal stage, you subject the plan to both

(a) unexpected recurring expense risk and (b) sequence of returns risk.

Suppose your 60-70% stock portfolio encounters a -40% stock market crash. This means for one year alone (say 8th), the net portfolio return is about -21%. Even if the net return is 8% for all other years, the corpus will only last for 23years. Seven years worth of corpus destroyed by one terrible year.  If the -21% return had occurred in the very first year, 8 years worth of corpus would have been destroyed. This is known as sequence of returns risk. Will post more realistic examples soon

Early retirement sequence of returns risk example

It is perhaps ironic that people who claim to be frugal in life are not frugal when it comes to return expecations! I have seen articles with 4% real returns!

What early FIRE seekers must recognise is, ten years after retirement, your portfolio return could be 12%. Great achievement, but if it includes even one negative return year, you will run out of money sooner than expected.

Consider this: If each year your portfolio return is 8%, then CAGR after 30Y is also 8% (obviously!).

Suppose you get 8% for first 7 years, -21% in the 8th year and then 10% in the remaining 22 years, the effective CAGR is 8.3%. A bit more than what you had in mind when you first calculated. You will still run out of money in 26 years. Four years earlier than expected because of a poor sequence of returns. A clear case of operation, successful, but the patient is dead.

FIRE seekers would do well if they understand that the return projections in a calculation are year on year returns and single bad year can derail their efforts. Please don’t tell me, you will somehow escape those bad years. That is plain stupid.

You cannot get single-digit returns from equity after 20-25 years without having a few negative return years. During those years, you cannot stop withdrawing from your portfolio! If the first few years after quitting your job, returns are poor, it can destroy your plans once and for all. You can play this game and see for yourself: The Retirement Bucket Strategy Simulator

Frugality and early retirement

How to handle a sequence of returns risk in early retirement?

1: Do not aim for real returns! That is portfolio return higher than inflation. This means simply too much risk. Yeah, it also means, you will have either postpone FIRE or have a side income afterwards.

2: Work with -2% real return or at best 0% real return but also work more with debt or bonds. I designed the robo advisory template to cough up higher debt allocation if one retires earlier! This is completely opposite to what you might read in early retirement blogs. Better to be safe than sorry. I would recommend a 40-50% equity allocation for early retirement, not more. If you cannot retire early with 40-50% equity, you are not ready to retire early, period. You cannot cope sequence of returns risk.

3: You must be able to generate inflation-protected income for at least the first 15 years of retirement. This is my “thumb rule”. I cannot back this with backtesting though (I soon will). Those 15 years gives you some time to recover from bad returns. This also means you have to tactically and aggressively manage the portfolio. That is, say, you expect 10% return on equity and one year you get 15%, you book profits to debt and protect that extra sum.

If you do this right, you can live off debt for 15Y at any given time -in the 1st year of retirement or 10th year. This should be the ultimate goal of a good bucket strategy. Try the simulator linked above. You will get some nice insights on how to handle this.

4: Set up an annuity ladder If possible, guarantee some income all your life with an annuity. Suppose your initial expenses are about 4 lakhs a year, buy an annuity to cover say, at least half your expenses immediately upon retirement. After 10Y or so, buy another annuity at a higher rate (because you are older), and hopefully lower taxes. Rinse and repeat. This annuity ladder will give you peace of mind. Of course, this means you need a good corpus to start with and more tax outgo.

5: Do something you love and earn a little money off that. This way you do will not withdraw for the first few years and do not need an annuity ladder for say 10-15 years. This gives you time to let the corpus grow untouched. Do not take on more risk though!

Advisor risk in early retirement

Not many financial advisors understand and appreciate sequence of returns risk and may ask a client to take on too much equity after retirement. This can be disastrous. Never ever get post-retirement planning advice from commission based (aka fee-based) advisors. Even if you get advice from a fee-only planner, double-check and understand the pros and cons yourself.


To conclude,

Frugality is necessary, but not sufficient for FIRE. Know-how of managing “sequence of returns risk” is essential and possibly even sufficient for sustained FIRE

Download free E-book: How to retire early in India

What is your financial freedom strategy? How do you plan to handle a sequence of returns risk?

You can also tweet your response to @freefincal

Do share this with FIRE communities. I would be curious to know how they react!

Do share if you found this useful

About the Author M Pattabiraman author of freefincal.comM. Pattabiraman(PhD) is the author and owner of freefincal.com.  He is an associate professor at the Indian Institute of Technology, Madras since Aug 2006. Pattu” as he is popularly known, has co-authored two print-books, You can be rich too with goal based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management.  He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. Pattu publishes unbiased, promotion-free research, analysis and holistic money management advice. Freefincal serves more than one million readers a year (2.5 million page views) with numbers based analysis on topical issues and has more than a 100 free calculators on different aspects of insurance and investment analysis. He conducts free money management sessions for corporates  and associations(see details below). Previous engagements include World Bank, RBI, BHEL, Asian Paints, TamilNadu Investors Association etc. Contact information: freefincal {at} Gmail {dot} com (sponsored posts or paid collaborations will not be entertained)
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  1. Absolutely brilliant, no doubt about it. Retirement is not a simple equation as made out by many experts. You have rightly brought out so many angles to it, each one is on target and affects overall returns and hence standard of life. Since equity carries risk, asset allocation needs to factor this higher risk. Thanks for brilliant write up.

  2. Dear Sir: An excellent article. Gives valuable insight. Pl do train some people who can do hand holding for those who are not financially savvy and not skilled enough to use your various tools. That will generate lot mor values out of your efforts.
    Do run some articles for traing children in money management.

  3. Another awesome article pattu.. I am a early retiree/financial free and my plan was to keep 15 yrs worth of expenses in debt and remaining(35x) in equity. Is that what you were also referring to in point 3 of above article. I also actively manage asset allocation based on the market state with a Conservative bias.. Need to play further with your tools on the sequence of return risk, which calculator of yours will help help me play with sequence of returns? Thanks in advance .

    1. Thank you. The debt corpus should be able to provide income increase each year by 6-8% for 15Y. You can play with the bucket strategy simulator linked above. I am making more.

  4. A great write up as always
    I am actually doing this and quite confident that my solution will work out. Now I experience this freedom every morning when I don’t have to wake up with the alarm and that dreaded feeling on Mondays to face office politics and the bad boss. Now I work on projects that I love without worrying about the income, I am getting healthy, I eat less (no more emotional eating when I was associated with corporate life), lost weight and cholesterol. Spend quality time with family. Also now I run marathons and travel frugally wherever Indian rail goes and tasting so much variety of cuisine that real India has to offer. I am a foodie too.
    Hence I would like to propose this solution for this disease called Sequence of return Risk (SRR) in an early retirees life.
    I am myself doing this for past 5 years(FI’ed at age of 42)
    ie to Use IRR of your portfolio as the real return to gauge if SRR can bite you badly.
    For example assuming if my FI portfolio is 1cr(25x the expense) expense 4 lac, as long as my portfolio IRR is above 4%(tax and inflation adjusted, real return), I can live on this till perpetuity.
    Now this assumption goes under water if I cannot generate a real 4% return in a bad year. in that case, I am having a debt/bonds/fds/ppfs for 3-5 years expense to meet my expenditure during those times. Historically the situation gets better in 3-5 years of drawdown. One can try to simulate it also with the historical data.
    This provides a Lakshman Rekha to an early retiree for not crossing it ie not to consume more than, what can get replenished.

    The worst scenario is to come back to workforce doing some barista jobs, I like driving so might well drive people around(uber or ola) till it improves.
    SRR is dangerous as you rightly pointed out but this can be tamed.
    I hope more people can realize this and enjoy the true freedom that FI brings in.

  5. Dear Professor,

    Thank you for all the insightful posts and observations, which are actually based on mathematical analysis – really invaluable.

    I have been planning for an early retirement. I would get a government pension with an inflation linked DA component once I take early retirement. In my case, the pension that I would be eligible would fully meet my day to day household running expenses. I have made provisions for the children education and marriage expenses, plus a sizeable amount (20 X Annual expenses) as contingency. As I dont intend to touch this contingency corpus, do I need to worry about sequence of returns risk as long as I maintain the right Equity-Debt balance (re-balanced every year ?)

    It is THE right answer to problem that you are referring to .
    Making a provision for 50% of expenses by annuity will relieve lot of pressure on retirement corpus to perform optimally,ALWAYS..
    I appreciate your insight in personal finance issues,it is typically fitting for someone like me,a born & brought up middle class ,intending to have middle class mentality,despite having funds to upgrade .
    HOPE & PRAY FOR THE BEST,BUT ALWAYS BE PREPARED FOR THE WORST ,is my mission statement shared in my family in all aspects of life.
    It is natural for me, because I am ANAESTHESIA SPECIALIST DOCTOR,nobody understands this mission statement better than us ,because we always deal with life,to support it, while it is being subjected to ULTIMATE STRESS to life survival..
    enjoyed your write up, Sir
    Keep it up
    All the best,Sir

  7. Thanks for your service to humanity.
    However, most of average IQ people like me could not understand any of your articles, at all. So much of Maths -brain breaking. Gone through many times but could not get the actual point/calculation procedure.

    It will be better if you do financial advice, so that we can get the final advice to one’s need. Or else please publish atleast of top 10 usecases so that we can pick up one close to it. Hope you will reply to this.

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