Ever wondered why the retirement corpus we need is so large? Often unbelievably so. Is this a mistake in the math, in the assumptions or in the inputs?
In this post, let us a discuss a simple illustration of a retirement calculation in order to understand why the corpus required is so large.
Any calculation requires inputs. For retirement, we require at least 5 inputs. This can be arranged in the following way.
Suppose my current monthly expenses are 30,000. I would need Rs. 3,60,000 a year (excluding loans). Now I assume that I would need 75% of 3,60,000 if I were to retire today.
Sure, I can assume I would need only 50% or 25% too, but since we do not know how the future will pan out, it is always a good idea to be conservative and not assume your expenses will decrease after retirement! Anway, for the purpose of illustration, I will use 75%.
Years to retirement is 30. So I will retire 30 years from now. Similarly, years in retirement is 25.
After 25 years, I better drop dead, because our calculation will assume that the retirement corpus will become zero at the point.
Now, I assume 75% of 3,60,000 = 2,70,000 as my current expenses that would be factored into the retirement calculation.
We are assuming that this expenditure increases year upon year at the rate of 8%. So if the current year is 2016 and my age 30 (I wish!), the expense will increase as shown below, right up to retirement.
This increase in expenses is expected to continue after retirement. This key assumption is the source of all stress associated with a retirement calculation (not me!).
The expenses before retirement and after retirement are mapped side by side.
The ---> After 30 years ----> applies to every row in the above table.
If I retire in the year 2016, I will require 2,70,000 as the annual expense in the first year of retirement. However, I am going to retire 30 years later. Due to inflation, 2,70,000 will increase to 27,16,917 (~ 27 lakhs).
Similarly, the annual expense of 2,91,600 in 2017 will become ~ 29 Lakhs after 30 years in 2047, and so on, as shown above.
Now notice the red rectangle. This represents the annual expenses in each year of retirement. The sum of this is an astounding 21.73 crores (indicated in red above).
If after retirement, I do not intend to invest anything, keep the entire corpus at home (some under the carpet, some in pickle jars etc.), then I would need 21.73 Crores to provide annual expenses for 25 years with the sum increasing at the rate of 8% each year.
However, this is silly. Of course, I would like to invest after retirement. Now, there are two ways I can consider this investment.
A: I only use the post-tax return from the entire portfolio. This is 8% as assumed above. So I invest the corpus in a portfolio which grows at 8% each year (at an average rate of 8%, to be precise). While it grows, I will withdraw the amount I need as annual expenses at the start of each year. After 25 years, the amount will reduce to zero.
This is the basic premise of most retirement calculators, including the freefincal "low-stress" Retirement Calculator which is more comprehensive in terms of accounting for investment avenues.
When such an assumption is made, the retirement corpus decreases considerably. From 21 crores to about 7 crores.
Well, if 7 crores still sounds huge to you, I cannot help. Maybe if you retire early, you can lower your retirement corpus!
The key aspect of this discussion is to realise that retirement planning involves accounting for future expenses with inflation factored in. When pre- and post-retirement expenses are mapped side by side, we realise that there is not much else to do (except to assume unrealistic inputs for more pleasing outputs).
Each month we invest for retirement, we are trying to provide for at least month's expenses (or less) in retirement.
B: Instead of using a single portfolio return, we can use a bucket Strategy. The associated calculator is here: The even lower stress retirement calculator! Those interested can also check out these posts:
Generating an inflation-protected income with a lump sum
Inflation-protected Income Simulator
Once the corpus is determined, the next step is to determine the monthly investment required for an average return assumption (post tax) as in A (above, but before retirement), so that about 7 crores is in hand after 30 years (in this example).
At a conservative 9% portfolio return after tax, about 40,000 is required as a monthly investment.
If one can increase the investment by 5% each year, only about 24,000 is required in the first year. And at 10% increase, only 13,000 in the first year.
End of the day, we all invest what we can, but it is important to understand the impact of inflation. One should use a retirement planner each year to account for changes in one's personal situation.
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Hi Pattu,
The calculations are crystal clear and the monthly investment requirements towards the retirement goal is indeed steep. But I am sure all of us would have contributions to PF/NPS which will provide a portion of the required corpus. In addition, there could also be other income during retirement such as rental income and monthly pension which also adds up.
So after all, we don't need to invest 24,000 per month starting now. It can be slightly lower and that can improve the mood.
1) " But I am sure all of us would have contributions to PF/NPS" is not the point of the post.
2) The low-stress calculator mentioned above factors this in.
Well, I put a modest 8500 monthly PF contribution (employee+employer) on a current balance of 100,000 in EPF account. This gives me a corpus of 2 crores after 30 years. To build the remaining 5 crores, the monthly investment requirement comes down to 10k with 10% step up required every year to build.
So my point about PF contribution and its final corpus makes sense as the required investment comes down from 13k to 10k.
Quite an insightful post.
Interesting to see the sensitivity of investment returns to final corpus left at the end of the 25 years of retirement, given the many years of compounding. Small changes can lead to massive swings in end result.
This seems to suggest a high overweight asset allocation towards equity at young age is mandatory, not just smart.
Brilliant Illustration