Our lives run according to a financial script.
- Equip yourself with skills to earn money
- Earn money
- Retire on your savings
Retirement is often called the ‘golden period’, because you’re independently wealthy and without the need to work. It is the only time in life, the theory goes, when you have both money and time on your hands. So planning well for retirement is an essential step in your financial life. Unless you plan to work forever, that is.
In this post, we will see how you can estimate your ‘retirement point’.
The ‘retirement point’, for the purposes of this post, is defined as the point at which you can stop working without fear of your wealth ever running out.
Step 1: Understand the concept of ‘real growth’
We often make the mistake of performing money calculations in absolute terms. As an example, let’s take a man whose house doubled in value in a period of five years. He is apt to feel happy about his return, and he thinks that he has doubled his wealth. He may think that he’s ‘twice as rich’ today as he was five years ago.
But is he, really?
His wealth may have doubled when measured in monetary terms, but has his wealth grown? Has his purchasing power grown?
We sometimes forget to take away inflation and tax from our gain calculations. An inflation rate of 10% and a capital gains tax rate of 20% means that what our investor thought was a 24% annualized return is ‘only’ worth 12%. So in real terms, his wealth has grown only at a rate of 12% per year, which, over five years, is a total increase of around 50% (instead of the 100% that he thought it was).
So if we have to put it into a formula:
Real Growth = Paper Growth – Inflation – Taxes
Step 2: Estimate your annual retirement expenses
This ought to be the easiest step of all, provided you keep a reasonably good record of where you spend your money today. It is good practice to assume that your retirement expenses will be at least as high as your expenses today, adjusted for inflation. In practice your retirement should be significantly cheaper, but there’s no harm in assuming the worst case scenario.
(There are some types of retirements that are lavish, but here we will assume a plain old ‘vanilla’ style retirement.)
Step 3: Work out your ‘safe withdrawal rate’
Armed with the concept of ‘real growth, the math of retirement savings becomes simpler. Our aim is to accumulate a certain amount of wealth which will outstrip inflation and taxes by high enough a margin to pay for our lifestyle.
The ideal retirement is that in which you’re only spending the ‘growth’ part of your wealth so that your wealth does not diminish forever. That way, not only will you have a comfortable retirement, but you will also pass on a significant amount of wealth to your descendants.
The question, then, is this:
What is a safe annual withdrawal rate that I can use on my wealth to ensure that it will never diminish?
Research on the financial landscape of the United States has concluded that 4% is a ‘safe withdrawal rate’. That means if you can restrict your yearly withdrawals out of your retirement nest-egg to 4% of the total amount, your wealth will never diminish.
So if you have one crore in invested net worth today, you can withdraw an income of 4 lakhs this year without having to fear that you’re biting into the principal. Why does this work? Because in the United States, over the last hundred or so years, a balanced stock and bond portfolio has returned 4% in real terms on average.
Does that mean it will remain 4% into the future? No.
Does that mean that the 4% rule will work for India? Again no.
Peeping through the other hole
Sometimes it helps to read a problem backwards. Instead of asking what is a safe withdrawal rate, I think we should ask this question: How much do I think my wealth will beat inflation and taxes by, over a long period of time? In other words, what real growth figure are you comfortable with for your wealth?
Risk-averse investors may say that they are confident of their wealth returning just 1% after inflation and taxes. Riskier investors may push for 4% or even 6%. Safe investors may settle for 0%, content to stash their wealth into fail-safe assets and watch it track inflation, never beating it but never trailing it either. Some investors may even settle for negative returns in some scenarios.
Let’s work through a few examples:
1. If you settle for a 1% withdrawal rate, your wealth will last for 100 years even if it delivers a real real return of 0%. It will last forever if it delivers a real rate of return of 1%.
2. If you settle for a 2% withdrawal rate, your wealth will last for 50 years even if it delivers a real return of 0%. It will last forever if it delivers a real return of 2%. Anything less than 2% and you’re biting into the principal. Anything over 2% and you’re adding to your nest-egg.
3. If you settle for a 3% withdrawal rate, your wealth will last for 33 years at a 0% real return. At a 3% real return rate, your wealth will never diminish.
And so on.
Step 4: The ‘Retirement Point’
Whether you’re at the retirement point in your life or not depends on three variables:
- Your total investible wealth
- Your annual expenses
- Your safe withdrawal rate
The retirement point in your life arrives when your yearly expenses become equal to x% of your amount of total investible wealth, x being your safe withdrawal rate. If you have five crores in investible assets and your safe withdrawal rate is 2%, then your retirement point is at the 10-lakh-per-annum mark. If your annual expenses are under that amount, you’re already at the retirement point. If they’re not, you have some way to go yet.
How the three variables interact
We can think of our individual retirement points as being fluid on a curve determined by the three variables defined above. If you’re in the accumulation phase and you wish to calculate how much investible wealth you need before you can retire, you can plug in your annual expenses and your chosen withdrawal rate to arrive at an estimate. If you’re wondering whether what you have accumulated is enough to retire on, you can plug in your preferred annual expenses and safe withdrawal rates to see if you’ve made your mark yet or not. Given two of these variables, the third can be worked out without much hassle.
A final, one-paragraph example
If I want a retirement in which I’m able to spend 10 lakhs every year (inflation adjusted), and if I’m comfortable with a safe withdrawal rate of 1%, I will need to accumulate an investible surplus of 10 crore rupees. On the other hand, if I’m willing to take on more risk and push my withdrawal rate to 4%, I need an investible surplus of ‘only’ 2.5 crores. If I’m willing to make do with an income of 5 lakhs every year at a withdrawal rate of 4%, I can retire on 1.25 crores, whereas if I want to pull my withdrawal rate down to 2%, I will need 2.5 crores before I can retire.
Over to you, now. What measures do you use to plan financially for your retirement? What is the most challenging aspect of planning for retirement, in your opinion? And how do you combat it?