SEBI-registered flat fee-only advisor Swapnil Kendhe explains the pitfalls of conventional retirement planning calculations.
About the author: Swapnil is a SEBI Registered Investment Advisor and is one of the sought-after advisors on the freefincal fee-only financial planners’ list. You can learn more about him and his service via his website, Vivektaru. His story: Becoming a competent & capable financial advisor: My journey so far.
As a regular contributor here, he is a familiar name to regular readers. His approach to risk and returns is similar to mine, and I love the fact that he continually pushes himself to become better, as you see from his articles:
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Here is how the FIRE or retirement corpus is calculated conventionally. You take a few assumptions, such as
- Inflation – 7%
- Equity Return – 11% (4% real return)
- Debt Return – 6% (-1% real return)
- Asset Allocation – 50:50 Equity: Debt (Different advisers take different asset allocation assumptions, but that is not important for the discussion in this article.)
- Portfolio Return – 50%*11%+50%*6% = 8.5% (1.5% real return)
- Retirement Age – 45
- Life Expectancy – 90
- Years in Retirement – 45 (Life Expectancy – Retirement Age)
You then use the present value function in Excel to calculate the retirement or FIRE corpus. PV(rate, number_of_periods, payment_amount, [future_value], [end_or_beginning])
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FIRE or Retirement Corpus = PV(((1+Portfolio Return)/(1+Inflation)-1), Years in Retirement, -Annual Expense, 0, 1)
With the above assumptions, the FIRE corpus number you get is approx. 34 times annual expense at age 45. For the simplicity of discussion, let’s keep children’s higher education, marriage and other goals outside the scope of discussion.
Debt returns are closer to the general inflation in the economy. The actual inflation we face is higher than that. So, even pre-tax debt is unlikely to match inflation. Since debt products are also heavily taxed, the post-tax debt return could be 2% less than the inflation.
If we rerun calculations assuming post-tax debt return to be 2% less than inflation, the FIRE corpus number we get is approx. 37 times annual expense at age 45.
37X appears to be a reasonable FIRE corpus number at 45. But even 37X may not be adequate for 45 years in retirement. Here is why.
All FIRE or retirement corpus calculations assume –
- Perfect behaviour by the investor.
- Fixed inflation-adjusted withdrawal from the portfolio.
- A linear rate of growth of portfolio and inflation.
But in the real world –
- Investors don’t stick to the plan – No investor runs the fixed assumed asset allocation throughout retirement. Often, investors don’t even understand assumed portfolio management in the corpus calculation.
- There is excess withdrawal risk – Retirees don’t withdraw a fixed inflation-adjusted amount from their corpus assumed in retirement corpus calculation. Retirees aren’t even aware of the withdrawal their portfolio can support. There is always the risk of excess withdrawal that the portfolio can not sustain.
- There is the sequence of return risk – All retirement calculators assume linear portfolio growth and inflation throughout retirement. But neither portfolio grows at an assumed average rate nor inflation grows at a linear rate.
Negative portfolio returns at the early stages of retirement could cut down the life of the retirement portfolio. Withdrawals during bear markets can deplete the portfolio rapidly. Markets may recover subsequently, but there would be a smaller base to benefit from.
- Investors underestimate their expenses – 30, 40 or 45 years is a long time. We don’t know what the world will look like in 20-30 years; what would be part of our necessary expenses?
You may upgrade the house during retirement or spend significantly on renovating the existing house. Perhaps you would move to a richer neighbourhood, and that would increase your lifestyle expenses. Your friends getting richer also adds to your lifestyle expenditure.
Expenses may reduce with age, but there could be unexpectedly big expenses. You may have to support your kids or close relatives/friends during retirement. Your kids could be settled abroad, and visiting them even once in a year could be a big drain on your portfolio. Geriatric care could be expensive.
Investors who don’t actively track their expenses underestimate their expenses.
- There is Longevity Risk – All retirement corpus calculations in India assume a life expectancy of 85 or 90. Many of us will live till 95; some may even touch 100.
- There could be cognitive decline – Many of us will face cognitive decline later in retirement, which severely affects portfolio management and financial decision-making skills. You may have to annuitize a part of your retirement corpus at around age 70 to deal with dementia and longevity risk. The death of the spouse who manages money also exposes the surviving spouse to serious financial mistakes.
There are many unknowns in retirement planning. Suppose you want to make allowance for all these unknowns in FIRE or retirement corpus calculations. In that case, assuming that the post-tax real return from retirement corpus in retirement would be closer to the inflation you would face is safer. In this case, the retirement or FIRE corpus would be an annual expense in the first year of retirement*years in retirement.
A 25X or 30X corpus is insufficient for FIRE at age 40 or 45. But it is a good enough corpus to leave the highly stressful job crushing your soul and do something of your own or change your profession.
P.S. You don’t have to do anything fancy to achieve FIRE. Follow the financial goal-planning approach. Use simple and low-maintenance products on equity and debt sides, stay closer to your target asset allocation, and focus on your primary profession. The more financial success you achieve in your primary profession, the earlier you can achieve FIRE.
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