Last Updated on February 12, 2022 at 6:23 pm
Ajay writes, “Dear Pattu Sir, I am 28 years old and wish to retire by 50. I have designed a simple retirement plan with EPF and a Sensex index fund, 50% each. I arrived at my corpus using an online retirement calculator. Can you please review the assumptions made in the calculation and let me know if I am on track to retire by 50?”
These are the following inputs and assumptions used in the retirement calculation. Age 28; Retirement age 50; Life expectancy age 80; Monthly expenses Rs. 40,000; Current corpus is practically zero; Inflation: 6%; Return on investment is 12%.
According to the calculator, if we assume 100% of current expenses will persist in retirement (some expenses will stop, but new ones will crop up, so we can assume this), Ajay needs to invest about Rs. 44,500 each month to accumulate the necessary retirement corpus of Rs. 5.2 crores by age 50.
Although life expectancy may be a bit higher than assumed, it is a reasonable assumption. So is the inflation estimate. Over the next 22 years, inflation should be lower than 6% unless the economy derails. Hopefully, that will not happen.
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Unfortunately, there is a complete disconnect between the assumed asset allocation (50% EPF and 50% Sensex index fund) and the assumed return of 12%.
Even today, this return estimate is incorrect for the assumed asset allocation. If we expect a 12% return from Nifty (this is probably today but less so in future) and an 8% return from EPF (again, this is fine for the present but not the future), the current portfolio return assumption is
(50% x 12%) + (50% x 8%) = 10%
Unfortunately, it is unreasonable to expect the EPF to continue giving 8% return after 22 years or equity to provide 12% returns.
I would recommend expecting 7% from EPF and 10% from equity. These are current estimates and need to be revised in yearly reviews when the retirement calculation has to be re-evaluated with fresh inputs and assumptions.
So, unfortunately, this means the current portfolio return assumption should be
(50% x 10%) + (50% x 7%) = 8.5%
So this naturally increases the monthly investment – which is already more than the monthly expenses. Also, one cannot hold on to 50% equity until age 50.
This has to be reduced progressively, and therefore the portfolio return will also reduce. If we do not factor this into our plan today, we will fall short of the retirement corpus.
Using a single fixed return in a retirement calculation is the single biggest drawback of most online calculators. We can do so much better by paying attention to details.
Let us now redo the calculation using the freefincal robo advisory tool with the following modifications (remaining assumptions stay the same):
- Life expectancy: 90 years
- Increase in monthly investment each year: 10%
- Inflation before retirement: 7% and after retirement 6%
The retirement corpus increases to Rs. 6.16 Crores, but the monthly investment required is only Rs. 33,750 increasing each year at the rate of 10%.
The recommended change in asset allocation and the corresponding change in overall portfolio return is shown below.
The equity allocation is gradually reduced from an initial 60% equity (10% more than what Ajay had in mind) to 29% at age 50.
Even though the equity allocation reduces, the initial investment required is lower because of the assumed 10% increase in investments each year. This is reasonably possible with regular income hikes, bonuses and promotions.
Out of the total corpus of Rs. 6.16 crores, 5% is kept aside for emergencies. Out of the remaining corpus, 29% is set aside for equity, and the rest is fixed income distributed among four buckets.
- An income bucket with 47% of the remaining corpus for guaranteed income for the first 15 years in retirement. During this time, investments will be made in the following three buckets.
- A low-Risk bucket with 24% of the remaining corpus for income from year 16 to year 25 in retirement. The low-risk bucket will have an asset allocation of 30% equity 70% debt during the investment period (years 1 to 15 of retirement).
- Corpus from a medium risk bucket with 15% of the remaining corpus will provide income from year 26 to 33 in retirement. This bucket shall have an asset allocation of 50% equity and 50% debt during the investment period (year 1 to year 25)
- Corpus from a high-risk bucket with 8% of the remaining corpus will provide income from years 34 to 40 in retirement. This bucket shall have an asset allocation of 70% equity and 30% debt during the investment period (year 1 to year 33)
- The buckets will be actively managed to reduce risk during this investment period via rebalancing and profit booking from one bucket to another. To understand how this works, try this: The Retirement Bucket Strategy Simulator.
- After 15 years, the low-risk bucket will be turned into 100% debt and provide income for about ten years. After that, the other buckets will also be progressively used.
In summary, Ajay should be wary of online calculators due to their simplistic assumptions and focus on reasonable returns expectations, variation of equity in the asset allocation and how the retirement corpus will be deployed in different buckets to combat inflation. We believe he is on track to retire by age 50 as long as he can stick to the investment schedule mentioned above.
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