Retirement Planning & Financial Independence
The Why, The What and The When with some digression
The Why?
Why is Retirement Planning important for young people?
Simple answer to why it’s important for me — because I find it hard to answer questions like “what would I do if I didn’t feel compelled to earn money for my version of survival?” It becomes a hypothetical question if I don’t even know if I’d ever be able to get there. And my reason for not knowing “if I could ever get there” was that I didn’t know what “there” meant or entailed. It’s easy to get confused by the multiple scenarios that start emerging when you start thinking of a retired life, especially if you are planning an early retirement.
But if you know that it’s a possibility, you can start thinking about what will you do once you don’t have to get up and go to work everyday.
The answer might be to quit and do nothing at all. Time is money after all, isn’t it? And not just in the conventional sense. Planning a retirement is kind of like your current self buying time for your future self.
The answer might be — to try your hand at something different — hiking, painting, writing, etc. — which I like to call the pursuits of spirit. These activities don’t typically cost much, but do not necessarily entail a monetary reward. Financial independence allows you to undertake pursuits whose reward may or may not be financial. Or even material.
The answer might be – to do some other work, which might be lower paying or riskier. Like working at an NGO as a contractual employee, maybe. Or interning with a movie production house. Or volunteering for organizing a sporting event. You’ll get a little money, but whatever you earn it’s all for splurging if you have planned your retirement!
The answer might be – to get up day after day and go to the same place of work you are currently at. That it’s your true calling. Even then there are benefits of doing this planning. Once you have your ideal retirement corpus, you start understanding that you are not doing your job because you need it. There’s no sense of compulsion. Rather, you want to do that work. It gives you a sense of meaning or purpose that you truly value. You might actually start liking your work a little better when you don’t feel encumbered anymore. You might be able to take a few risks which you might not have taken if you weren’t financially independent. You might find the sacrifices that you need to make with your job a little more bearable because now that you are unencumbered and still like it, you are valuing it more than you used to.
A retirement plan is critical if you have a Why. If you don’t have it yet, make a plan and it will ease the search for one.
The What?
I want to start this section by saying that retirement corpus is not dissimilar from The Number (you know, the one you want to hit before you call it quits for good).
The Number, is not your salvation. It’s not the answer to everything. It’s a step in the long game of chutes and ladders. It’s just an answer to an oversimplified question: Ceteris Paribus (all things remaining as they are), how much money do you need to ensure that you can live your life peacefully?
I’ve been reading a lot of articles of late on retirement corpus planning. What I’ve realized that these articles tend to get into complex, and often times confusing, mathematics. When I started to plan my retirement, I approached it exactly the same way. In hindsight, I could have benefited from a simple approach — which just gets me started on my planning. When you are finally ready to take the plunge, step your foot off the gas, want to stop being a cog in the wheel, declare #SYGIGH (I can go on, but I shall exercise restraint here), you should of course undertake a much more rigorous analysis and ensure that you are actually in a good position, financially speaking, to retire.
The approach that I am outlining in this post, is only to arrive at a ballpark figure. As corpus planning is never an exact science (in that you can’t plan down to the last cent), I believe a simple approach should at least help you make a realistic plan so that you know by when can you expect to retire. This will also help you to stay motivated to start saving, start moving along that path, at least. The promise, at the end, is of financial independence.
In very simple terms, how you should be looking at it as follows:
Let’s assume long term inflation forecast is i% and the post-tax rate of return you expect on your corpus is r%.
Footnote 1: Clearly, r needs to be greater than i for there to be any meaningful money left in your bank account in 20 years. Most investment vehicles would help you beat inflation, so whatever combination of debt:equity:gold:real estate exposure you are comfortable with should be fine. Well, not exactly, but for an optimal exposure to each of these you can find plenty of resources.
Next, you don’t want to eat into your corpus for as long as possible, so the smart thing to do is plan a corpus size that allows you to live off the interest alone. That’s your (r-i)% — the spread or return over inflation. This will ensure that your corpus keeps growing at i%, so it’s always inflation adjusted. If you have $1000 in savings today — which buys you 100 big Macs, you’ll always have money to buy 100 big Macs, if your corpus keeps growing at the rate of inflation.
After this, it’s simple. Imagine the life of retirement. What expenses would you have? Be reasonable about it. Include everything that you like in the first run — rent (if you don’t own a house — more on that later) or house upkeep costs (if you own one), internet, mobile phone bill, Netflix, Amazon Prime Video membership, buying books, groceries (This was an after thought. I thought I got all the basics above.), eating out, travel, new clothes, electronics, replacement of white goods (phone, fridge, washing machine, etc.) every 5–10 years, etc. Most of your expenses are running expenses, so that’s easy. For the periodic expenses (travel, replacement of white goods, electronics, etc.), try and annualize these costs.
Crap, I forgot insurance. Thankfully, I asked someone to review before publishing. Not because the list above is supposed to be exhaustive, but because I can now update and fix my model. But this helps me make another point. The plan needs to be flexible. You’ll always be adding things to it till you actually decide to quit. Have faith that it’ll be robust enough to absorb minor things. And after all, you do have to always be prepared to wing it. That does not and should not diminish the importance of planning or deter the planners from planning.
Now, for simplicity, let’s say you need $E per year for your living expenses.
Footnote 2: E can be calculated at today’s cost of things. Because when you take the inflation adjusted return of (r-i)%, tomorrow’s cost of things become immaterial. Rather, you’ve already factored those into your plan.
Your retirement corpus (C) is supposed to generate E at the rate of (r-i)% annually. So,
C*(r-i)/100 = E
=> C= (E*100)/(r-i)
That’s it. Plug your numbers in. Arrive at your number. Start planning how you’ll get there.
Typically, I assume that a corpus will generate 1–1.5% spread over inflation. But I also tend to be cautious in my models. If it earns a higher spread, you can take an additional trip that year. Or you can buy that gadget that you’ve been wanting to buy. If you really want to splurge, buy popcorn at the movies during interval!
But if you use 1–1.5% inflation adjusted return on your corpus, your corpus should be simply between 70*E to 100*E.
Footnote 3: This way of calculating your corpus makes it easy for you to know when you can retire — whenever you get to 100E. Most other form of retirement corpus calculation start backwards from the age of 60, which has it’s own value, but it’s a different problem from the one that we are trying solve.
The When?
This is the last step. Look at the past trend of your income and it’s growth. Try and project that going forward. Look at how much of your income you’ve been able to save. Project your saving rate going forward as well. You can build a simple model that will take you to a point where your cumulative savings will reach C. That’s your when.
If your C’s too little, and you are already there or can get there soon, great news! You can also feel free to add more expenses. Sounds awesome, doesn’t it! It’s unlikely, but it happens sometimes — for example, if you are an investment banker with 5+ years of work-ex without a super extravagant lifestyle. Or if you live like a hermit.
If the C’s too much, take a knife to your expenses. Think on what all you can cut without feeling too bad for not having it. Tweak the calculations and arrive at a C that you can reach in a reasonable amount of time, if that’s what you want. If you don’t want to reduce expenses, you’ll have a very long retirement horizon. But this information is still useful, right? At least now you know that you need to keep your foot on the pedal. More importantly, hopefully you also understand the “why am I doing this to myself?” a little better now. Knowing something more about yourself and your situation than you knew yesterday seems like a good thing.
The Promised Digression: Buying a House vs Renting
People buy houses for a variety of reasons. Most of those are beyond the scope of this article. But if it’s an entirely financially motivated decision, it’s not always obvious who wins the Buying vs. Renting bout. Here’s why:
In the calculation above, let’s assume that E is your annualized expense inclusive of rent. If we assume R to be the annual differential between rent and the upkeep cost of an owned house, in case you own a house, your retirement corpus (C’) becomes
C’ = (E-R)*100/(r-i) or, in the above assumption, 70 to 100 times (E-R).
For simplicity, let’s assume r-i = 1%. Then, C = 100E and C’ = 100(E-R).
This implies that (C-C’), the additional corpus needed on account of not owning your home, is equal to 100R.
Hence, you can buy a house for 100R for it to be a corpus neutral decision. Basically, you either buy a house for 100R or add 100R to your corpus and keep paying the rent from the spread over inflation that you earn on the corpus.
Footnote 4, the usual list of pros and cons of buying vs renting also apply here.
Footnote 5, your assumption regarding the return you expect over inflation might be different. If you expect a 2% higher than inflation return, for example, the value of corpus-neutral house that you can buy is 50*R.
Footnote 6, it is assumed that the house is not an investment since you’ll be living in it. How the real estate appreciates is rendered irrelevant by this assumption.
Now coming to the real dilemma that this poses and the reason for the digression.
More often than not, a 100x multiplier on the annual rent is going to make buying a house the right choice. A simple reason for this is that the way we are calculating the retirement corpus, we assume that we are going keep living the way we live for a million years. Till perpetuity really. If mankind becomes immortal in our lifetime, you will still be good with this model.
So effectively, you are building a corpus that will let you pay the rent for all of eternity. When you decide to buy a house, on the other hand, a chunk of money goes into the house now but reduces your corpus requirement.
Does that mean you should buy the house? Similarly, should you buy a life time Netflix subscription? Unfortunately, the answer to that is slightly complicated.
First up, let us understand the limitations of this way of thinking:
- We don’t factor in a life expectancy
- As corollary to 1, we don’t target having no money in our account when we die to fulfil some poetic fantasy
- As corollary to 2, we plan to leave behind good money when we die
- It might however be a sound buffer to have in case you need a major surgery or if you need to buy a nice car when you are close to popping
Basically, this approach in some sense gives you an upper end estimate of your corpus. Think of it as something that helps you meet your needs (factored in to E) and leaving a healthy buffer for exigencies or for other people to inherit.
Alternatively, if you want to arrive at a more reasonable estimate of your corpus (the lower end, in which you will be left with little to no money in the end), it looks something like:
Let x = (1+i)/(1+r)
Complex C = x*E*[x^n-1]/[x-1]
Where, n is the number of years you think you got left.
In the example above, assuming you have 40 years ahead, inflation is estimated at 6% and post tax return is estimated at 7%, then:
Complex C = 34E (approximately)
While this seems rational, we had to estimate a lot more things than previously. Also, these are not in our control. Return over inflation is. Well, more in control at least. The probability of these estimates being correct over a 40 year horizon is also very low. Also, while you’ll be left with 65% of Complex C in your account by the end, it would barely be 2x of your annual expenses at that time. Given that you started with 34x, that’s cutting it too close.
In this scenario, however, following from above, a house worth 34R or 34 times your post retirement annual rent expectation would be corpus neutral.
That house just got much less fancy.
In summary, you can plan for your Corpus to be somewhere between the C and the complex C. That should ensure that you not cutting it too close and also bring the retirement horizon a little more closer.
And don’t forget to also find an answer to your Why while you are at it. Without a strong enough why, none of this is of any real value. The maths is fun, no doubt, but it’s not a theoretical problem that we are trying to solve, is it?
