Tuesday, December 1, 2009

The Arithmetic of retirement

The first issue one needs to sort out when contemplating retirement, particularly when you are unlikely to get a pension, is the amount that needs to be saved by the time you retire. Lots of investment advisers have written reams on the subject. Amongst the first things that they mention is a cautionary statement about inflation.

It is evident to everyone that the fact that you need Rs.6 lakhs per annum (say) today to maintain your current lifestyle does not mean that ensuring a cash inflow of Rs.6 lakhs per annum after the date of your retirement will satisfy your needs. You have to factor in the increase in monetary expenditure on account of inflation and at 6% per annum (say) your requirement may well be around Rs.11 lakhs if you retire in 10 years. This fact is abundantly underscored in all existing literature. The problem, however, is that they seem to think that the Gods of Inflation would take pity on a poor retired person and bring inflation to a screeching halt upon retirement. Most advisers seek that you plan for Rs.11 lakhs per annum rather than Rs.6 lakhs per annum but seem to conveniently ignore that fact that costs will keep increasing and in another 10 years time, post retirement, you would be trying to meet an expenditure of Rs.20 lakhs with an income of Rs.11 lakhs.

A rough and ready method for calculating your monetary needs for retirement is to divide the annual funds requirement at the time of retirement by the difference between your expected rate of return and the estimated inflation rate. To illustrate, if your expenditure at the time of retirement is expected to be Rs.11 lakhs; expected return on your money is expected to be 10% and expected inflation rate is expected to be 6% divide Rs.11 lakhs by 0.04 to derive the required savings at the time of retirement. Thus Rs.2.75 crores would take care of your retirement provided your estimates of expenditure, return and inflation rate hold good.

The above calculation actually ensures that you can live off your savings in perpetuity. A cautionary word, however, is required here. Post retirement, you will find that your first year’s return is Rs.27.5 lakhs while your estimated expenditure is Rs.11 lakhs. The excess amount is to be re-invested in order to ensure that future inflationary increases are taken care of. In case you feel flush with what you consider to be excess returns and blow up the money you may live to rue the fact. The model works under the assumption that your initial expenditure is as estimated and, in every subsequent year, you spend no more than your previous year’s expenditure increased by the expected inflation rate. (Well! The real world does not operate as elegantly as the world of maths. Inflation rate will keep fluctuating from time to time. As long as you stick to your expected life style you should be OK).

You can readily see that you may actually require lesser money since you do not really think that you are immortal. If you want a more accurate method for computing your financial requirements adopt the following.

1. Calculate your inflation adjusted rate of return as [(1 + expected rate of return) divided by (1 + expected inflation rate)] minus 1. For our example, this would be (1.10/1.06)-1 which would be .037736.

2. In Excel, use this rate for return, the number of years you expect to live post retirement and your annual expenditure at the time of retirement in the PV function. For our example, this would be =PV(0.037736,20,1100000), which would give you a result of about Rs.1.5 crores.

It is apparent that when you fund only 20 years of the future the amount required is far lesser. If, however, you happen to outlast the expected lifetime you could end up totally destitute. Please remember also that the expenditure level has to be maintained for the same lifestyle and the excess re-invested.

Thus, when you plan for retirement, ensure that you underestimate your returns (also ensure that it is post-tax returns!), overestimate your expenditure, inflation as well as longevity. You can always find a way to spend the excess cash but doing without what you consider are your needs may not be a palatable option. If, however, you estimate so conservatively that a lifetime of saving is not enough, prepare to enjoy a lifetime of working!


  1. Dear Suresh,

    Excellent analysis coupled with a simple style of explanation & no complicated formulas!

    You may even consider sending it to some Business column.

    Cinema Virumbi

  2. I think you have left out the tax component..unless you plan to safely divide the corpus with spouse/child.!

    1. Not exactly! The intention was to use the post-tax interest rate as 'expected rate of return'! Did not make an explicit reference, that is all!

  3. Not sure where my comment disappeared...Anyway...It's rather fascinating to see how you have shifted from your usual style of writing and ventured into Post Retirement Financial Planning...Guess the 50th Birthday Celebration got you thinking :) Nevertheless , Honest and Informative post :)

    1. Comment moderation on, Soham! So, comments appear only after I publish them.

      Btw, this one is an old post - as far back as 2009 :) So, it has nothing to do with my 50th B'day :)