So you have finally realized that it is high time that you start investing for your retirement. And to help you with your planning, you have decided to make use of free-online-retirement-calculators.
The beauty of online calculators is that it is very easy to input a few numbers and see the results instantly. But the ease and convenience of using an online retirement calculators, should never undermine the importance of retirement calculations.
What I mean to say here is that just because of it is easy and you are using a few text-bookish assumptions,it does not mean that the magic number thrown up by the calculator is sacrosanct. And in most of the cases, it might not even be correct. You should always question it. Always.
Think of it. Are you willing to blindly follow an action plan set up (for the next 25-30 years) by an online calculator? Are you willing to take a risk on something, which will give you money to survive for 20-30 years after you have stopped earning? Its a big bet and requires you to take a really big leap of faith. And ofcourse, it is very scary.
Just imagine that a calculator tells you to save Rs 2 Crores (Crs) by the age of 60 years. And you diligently save and invest and somehow manage to accumulate Rs 2 Crs by the time you reach 60. Feels great.
Now when you started investing in your 30s for this corpus, the online calculator had an inflation assumption of 5%. In reality, it turned out to be 6%. Another assumption made by calculator was earning 8% annual returns on the corpus after retirement. In reality, things changed and safe bank FDs, where you had decided to park most of your money started giving just 5% annual return. The result…is that you are screwed. And screwed when? When you hit the age of 70 or 75. You have exhausted your corpus, not because you did not stick to your investment plan. But because situations changed and assumptions in your retirement planning calculator, did not remain completely valid in future.
Seems scary to run out of money at 75. It’s just like you run out of oxygen when you are doing deep sea diving and are 100 feet deep in water!
I am not saying that one should not use retirement calculators at all. All I am saying is that it is very important to understand that ‘Assumptions’ play a very big role in all retirement calculations.
Now these assumptions are also of 2 types.
First are the assumptions about the ‘Uncontrollables’. Things you cannot control. Some examples of these are assumptions made for return percentages, inflation, etc. You can do nothing to control these factors. You can only hope that your assumptions remain as close to reality as possible over the years.
Second are the assumptions about the ‘Controllables’. These are the factors which you can control atleast partially (if not fully). Some examples are your starting investment amounts, yearly increase in investments, etc.
In this post, I will simply focus on the assumptions we make about the Uncontrollables. And more specifically, lets focus on assumptions about the returns we expect to earn from our investments over the accumulation phase of retirement planning.
Now do this small 15-second exercise:
Close your eyes and think of a number (in percentage), which you think is most popular when people discuss about the expected returns from MF investments.
Thought of it? Great.
Personally, I have heard numbers ranging from 15% to 25%. Though I would personally love to get 25% annual returns, the fact is that it is not going to happen. No matter what anybody says, earning 25% every year is impossible. An annual return of 25% means doubling your money every 3 years. We need to be realistic and stop listening to brokers and agents.
So if 25% is bull shit, then is 15% fine? Honestly, it seems achievable. And there have been funds, which have done even better than that in past.
So is 15% a good assumption to make when doing retirement calculations?
It might be. I personally think that it is manageable in the long run. But common sense says that when I am making assumptions for future, I should be cautious.
These days, many people are talking about margin of safety (MoS). But mostly these people are using the term MoS, when discussing about individual stocks and value investing. But I feel that margin of safety is something, which should not be restricted to investing in stocks alone. It should also be considered when planning for your retirement.
But what is happening is that when it comes to personal finance, there are many who just blindly expect MFs to deliver 15% to 20% for next 25-30 years! I am not saying that it cannot be done. But I can bet that it will not be achieved by 99% of those who claim that it can be easily achieved. And I can bet my entire retirement corpus on it. 🙂
So lets come back to our case study:
Now 15% can be done. But when calculating the corpus needed for my retirement, I will take a much lower number. Say 12%. This straight away gives me a buffer of 3% to be wrong. So even when I am investing with 12% assumption, it is possible that luck favors me and I manage to earn 14% return. Will I mind it? Not at all. I love positive surprises. And who doesn’t?
But if I start investing with a 15% assumption, and I end up with returns of 13%, I will have trouble in my retirement years. And that is what I don’t want.
So with assumption set at 12%, lets do some number crunching. I will only share the findings and not the exact calculations to keep it simple.
Also, I will be tweaking the 2nd and 3rd scenarios for different rates of returns within the investment life. This is to bring these calculations closer to reality. So for theory and comparative background, you can read the 1st scenario. But focus more on 2ndand 3rd scenarios.
Scenario 1:
Current Age = 30 years
Retirement Age = 60 years
Accumulation period = 30 years (60 – 30)
Starting yearly investment = Rs 60,000 (~ Rs 5000 monthly)
Expected Average Annual Returns = 12%
Planned Annual Increase in Investments = 3%
Simply put, the expected rate of return in this scenario is 12% for the entire 30-year period.
The result is a corpus of Rs 2.31 Crores at the age of 60 years.
But lets make this more interesting. Lets split this 30-year investment period into 4 sub-periods:
- Period 1 – when age between 30 and 40 years
- Period 2 – when age between 41 and 50 years
- Period 3 – when age between 51 and 56 years
- Period 4 – when age between 57 and 60 years
Now an important point to note here is that returns earned in each of these four periods can be different. But in this first scenario, the returns have been put uniformly as 12% for all four periods spanning 30 years. The scenario is summed up in table below:
As already mentioned, this is a good theoretical scenario, which assumes that returns over a 30-year period will be about 12%. Though it is theoretically correct to assume an average figure across a long period, I still feel that later years (after the age of 50) are way too far in future to be predicted correctly.
So to create a more realistic scenario, it makes sense to reduce the return expectations in later years.
Lets try to do this in second scenario.
Scenario 2:
A slightly more realistic assumption in later years is depicted in table below. The impact of lower returns is that one ends up with a lower corpus at the age of 60.
You might say that this exercise is just like assuming a lower than 12% rate of return for the entire 30 year period. And you are right in saying so. But its tough to make people believe that even MFs can give lower returns than 12% in later years. Just try telling this to someone who is already convinced that MFs will help him reach his retirement targets with ease, and you will understand what I mean.
We need to understand that the situation after 30 years is very far off in the future. And we have absolutely no way of knowing what will happen then.
Today, a return of 15% might look like normal. But we can never be sure whether the same 15% will be a normal thing in 2040 or not. It’s possible that the new normal might be 20%. And it is also possible that the new normal might be 12%. No one knows.
But when calculating our retirement corpus in future, it’s prudent to make assumptions of returns on the lower side, and those of inflation on the higher side.
So this 2nd scenario stands as follows:
Current Age = 30 years
Retirement Age = 60 years
Accumulation period = 30 years (60 – 30)
Starting yearly investment = Rs 60,000 (~ Rs 5000 monthly)
Annual Average Returns = Varies in 4 different period as shown in table above
Annual Increase in Investment = 3%
Retirement Corpus = Rs 1.60 Crores
That’s a cut of almost Rs 70 lacs!! (Rs 2.31 Cr – Rs 1.60 Cr).
Is this it? Can it get any worse than this?
The answer is it might. Lets take up the 3rd scenario now.
Scenario 3:
I know you will abuse me for such a pessimistic 3rd scenario. But here it is:
The returns in future keep going down to 5%. So between 30 and 40, returns are 12%. The next 10 years see a return of 10%. And the remaining 10 years see 8% in initial years and 5% in latter years. And the corpus? It comes to a paltry(!) Rs 1.27 Crs.
Sounds horrible. Right? Just a few percentage points lower in later years and the portfolio (as well as you) end up getting screwed!
Can you take this risk? The risk of having lesser money than what you expected after 30 years of investing?
I would not want to be in such a situation. And for that, if it means lowering my expectations and investing more, then so be it. I will do it as much as I can within my limitations.
Another assumption, which I have made in the above scenarios, is that every year, I am increasing the annual investment by just 3%. Though I have done extensive analysis of how you can become really rich by increasing you annual investments by 10%, the fact is that it is easier said than done.
Our salaries might get a 10% hike every year. And assuming a 6% inflation, we should theoretically have no difficulty in increasing our investments by even more than 10% every year. But no matter how well we plan, there are bound to be unforeseen, additional and recurring expenditures arising every year. A big electronic purchase which was pending for last few years (though even such purchases can be planned wisely), foreign trips (Yes. Trips can be planned too), unnecessary luxuries, etc.
And that is the beauty of expenses. The expenses have a bad habit of beating income increases every year. 🙂
A 3% increase is not recommended and is in fact very low. We should target a higher percentage every year. But since the theme of this post is pessimism, lets keep the annual investment increase at just 3%.
So till now, we have discussed that it’s an interesting (and useful) exercise to expect lower returns in later years of investment lives. So what should one do?
Suppose we take the corpus accumulated in 1st scenario as the target. That is, we need to have Rs 2.31 Crs at the age of 60. And for returns, lets take the expected rate of returns from the 3rd scenario:
- 12% in Period 1 (30 and 40 years)
- 10% in Period 2 (41 and 50 years)
- 8% in Period 3 (51 and 56 years)
- 5% in Period 4 (57 and 60 years)
So assuming that we need Rs 2.31 Crs at the age of 60, and with above given expected returns, how much should be the monthly investment?
That is the question, which we need to answer to complete this case study.
Now here, there can be two ways of achieving it.
First is where you start with a higher initial monthly investment (>Rs 5000 per month or Rs 60,000 annually) and increase it at the above discussed low rate of 3%.
Second is to start with Rs 5000 monthly investment (Rs 60,000 annually), but grow your contributions at a higher rate every year.
Here are the details of the first option.
Scenario 4:
As you can see the table above, you need to start with a monthly investment of Rs 9100 instead of Rs 5000 (as in Scenario 1) and then increase your annual investments by 3% every year to reach your goal of Rs 2.31 Cr.
But what if you want to start with the same Rs 5000 every month? That brings us to the second option.
Scenario 5:
In this option, you can start with a monthly investment of Rs 5000. But then you will have to increase your annual investments by 8.5% every year to reach your goal of Rs 2.31 Cr, given the lower return expectations set in 3rd scenario.
Now lets try to take another view.
I know the post is getting quite long. But please hear me out for some more time.
I am sure many of you would be saying that as soon as we approach the last decade before retirement, we should theoretically start moving away from equity MFs (the only one capable of giving 12%-type returns). But problem with moving away from an equity biased portfolio by the age 60 is something related to medical advancements! Yes. Don’t be surprised. Please hear me out.
What I mean to say here is that our generation has a higher probability of living upto 90 and 100 years of age than any of the previous ones. So if you completely move out of equities by 60, you will still have 30 post-retirement years to earn something on your already depleting portfolio. Isn’t it?
And I am sure to hurt many retirement planners when I say that even after reaching 60, one should keep a significant percentage of overall corpus in equity MFs. But having said that, consideration also needs to be given to a person’s risk appetite and not just the logic of higher life expectancy, which I gave above. But I guess that discussion is best left for some other day.
So that’s it for this post. Hope I was talking some sense in this post. 🙂 Please note that I have made return calculations in straight line (using % mentioned as expected returns). In reality, stock markets and mutual funds have volatile returns. One year might give 40% and other might give (-) 20%. And there can even be instances where there is Zero growth for 5 straight years! Almost anything can happen.
The impact of case studies like these is that I am slowly but steadily lowering my return expectations. And this consequently, forces me to increase my contributions slightly with every such lowering-of-expectations-exercise. So think about what you just read above. And if you have some really high Buffett-type returns expectations from your investments, its time to get realistic about it. It is your retirement after all, not Warren Buffett’s. 🙂
Thank you very much for the detailed analysis.
Thanks Sushanta 🙂
a lot of “real” possibilities and expectations. makes a lot of sense .
appreciate your efforts !!