We cannot fight inflation after retirement by protecting our nest egg!

Published: May 12, 2021 at 10:55 am

We had recently discussed why we need to stop using Safe Withdrawal Rate (4% rule) for retirement planning. Many readers seem to be under the wrong impression that it is possible to fight inflation after retirement while ensuring the principal (nest egg) does not deplete. Here is why this is wrong.

Let us reproduce the example discussed in the safe withdrawal rate discussion. Suppose you have a corpus of Rs. one crore upon retirement. You invest in such that it gets you 7% overall return after tax every year in retirement. This is far from an easy achievement, but let us play along. Assume that the inflation is 7%. That is your expenses will increase each year by 7%. No sudden increase in expenses is accounted for.

So the one crore is invested, and each year, you withdraw an amount equal to current annual expenses from it. Let us assume your expenses in the first year of retirement are Rs. 4 lakh. Now the withdrawal rate in the first year of retirement is 4%, that is 4 lakh divided by 1 crore = 4%.

In the second year, the expenses are Rs. 4.28 lakh (7% inflation), and the corpus after the first year withdrawal, has grown by 7% to Rs. 1.0272 Crores (Rs. 102.72 lakhs). The withdrawal rate in the second year of retirement is 4.28/102.72 = 4.17%. We discussed in the previous article how the withdrawal rate keeps increased and the idea of a safe or sustainable withdrawal rate is a reference only to the initial withdrawal rate (first year).

Many readers have argued that this reasoning is wrong. According to them, the corpus earns a 7% return each year and the inflation is also 7%. So this means the retiree is only withdrawing the interest and the principal or nest egg will always be one crore and protected. This way the withdrawal rate is always 4%.

On the face of it, this seems right does it not? Not quite.  Suppose I invest Rs. one crore in a product that gives me a 7% return each year. The first year I will get 4 lakhs as interest which I will use as expenses. In the second year?

I need Rs. 4.28 lakh for expenses. Will this product give me 4.28 lakh in the second year, Rs. 5.24 lakh in the fifth year and so on? Or will it give the same Rs. 4 lakh each year? Obviously no. In order to handle inflation, we need to dip into the principal. There is no other way.

Yes, there are increasing annuity products available. That is, you pay the one crore to a life insurer and they will pay you a pension for life that increases each year. The catch is, the rate of increase is only 3% (before tax!) and the interest rate for this option would be much lower than the interest rate for the constant pension option. This option is unsuitable in more ways than one.

If the retiree wants to protect the capital, then they cannot aim for higher income in the future and keep pace with inflation. If they want to keep pace with inflation, then they will have to dip into the nest egg. There is no other way. To reiterate, this 4% SWR rule refers only to the initial withdrawal rate.

Also beating inflation is not the only goal in retirement. The retiree will have unexpected expenses and also discretionary expenses. There should be ample buffer in the corpus for these. That is why I keep

Think of retirement income distribution as running a marathon. The goal is not to win but to finish the marathon. A retiree having high expenses or a low corpus will have a high initial withdrawal rate. This is like a person starting a marathon at high speed. They are unlikely to finish.

Just like correct pacing is essential to complete a marathon, retirement income distribution requires as low an initial withdrawal rate as possible. It is not much of an analogy but you get the picture. If we withdraw too much too soon, the corpus will run out.

Young earners and early retirement aspirants should focus on not only building a large nest egg, but they must also plan out their retirement bucket strategy and how they are going to tackle the sequence of returns risk. If this is in place, the initial withdrawal rate can be kept under control. See: Can I Retire With Rs. One Crore Today?

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

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