I made a mistake : Fixed returns can lead to Early Retirement

Several months ago, I had stated to my wife, quite brashly if I may add, that debt-like returns would not find any place in our retirement portfolio.  I have been in a tearing hurry to grow our retirement corpus and I thought that the slower growth rate of debt-like investments, when compared to equity based investments, was something I could not tolerate.  In fact I was so convinced about my logic, that I even posted a blog entry justifying my position.  I could not have been more WRONG!!  However, like all good things, ones financial strategy is also never 100% right, and there is always room for improvement.  I have now realized my mistake, and made room for some more fixed income into our retirement portfolio.  There is one key recent investment opportunity though that triggered my change of heart.  If you are a keen follower of personal finance, then you already know what I am talking about!  Yes, I am of course talking about ...

... tax free infrastructure bonds.  But before I get into the details, here are some related thoughts.  The biggest fear I have with building a retirement portfolio is taxes.  Taxes can take a huge bite out of my withdrawals from the retirement portfolio when I eventually need the money!  I cannot afford to pay anywhere from 10% to 30% of my withdrawals to the government.  Unfortunately there are only a few ways in which you can protect your retirement portfolio from taxation.  Your EPF and PPF contributions follow the EEE concept.  This means that the money going into PPF/EPF is not taxed, it grows tax free, and is not taxed when you withdraw the money.  However, there is a maximum limit to how much money you can save this way.  PPF maxes out at Rs1Lakh per year (was Rs70,000 earlier; increased to Rs1Lakh since Dec'2011)  EPF is limited to 10% of your basic salary if you are a salaried employee.  My next target is typically the long term capital gains route.  Currently long term equity capital gains are taxed at 0%  So you can stash all of your retirement portfolio into equity based investments, and withdraw them via SWPs (Systematic Withdrawal Plans) without worrying about taxes (assuming naturally that you have held these investments for more than a year)  However, the first problem with this approach is that equity based investments tend to be high risk, and you do not want to be withdrawing from your equity portfolio in a market downturn.  Also with the new proposed DTC (Direct Tax Code) around the corner, this benefit might be withdrawn at any time.

Dividend income is the other possibility.  You can currently invest a large part of your retirement income in dividend yielding equities (either through directly buying high dividend yielding stocks, or through dividend mutual funds) and live off the yearly dividends that they generate.  However, though dividend returns are currently not taxed, that could also change once the DTC is approved.

I am not aware of any other means currently to protect your retirement withdrawals from the taxman.  In this scenario, the announcement of the tax free bonds came as a welcome relief, and really perked my interest.  Back in 2003, the government of India had announced RBI relief bonds at 6.5% tax free interest.  Unfortunately at that time I was not focused on my retirement planning.  As I learned more about the taxation policies, I began to realize that there were very few avenues to save money, and build a portfolio that could generate sustainable and predictable yearly returns, without paying a fat share to the government.  The US allows for investments via ROTH IRAs.  This structure, allows you to channel your investments (upto a limit of course) through it such that your withdrawals are tax free.  The ROTH IRA is basically a TEE structure.  The money going in is already taxed, but once inside the structure, it can grow tax free, and can be withdrawn tax free.  This is a powerful method to rapidly grow your investments.  In India the only TEE structures are life insurance policies, ULIPs, and pension plans.  Pension plans and traditional endowment policies are typically linked to fixed return instruments, and hence their returns tend to be low.  ULIPs are no different from long term MF investments from a taxation perspective.  India currently does not provide a formal TEE structure like the ROTH IRA. 

Therefore when the tax free bonds were recently announced, I was pleasantly taken by surprise.  I mentioned to my wife the moment I noticed this investment avenue that we should take full advantage of it.  I had completely forgotten my earlier statement that I would never include debt-like instruments in my retirement portfolio!!  The opportunity to lock in tax free returns of over 8% for 15 year periods was too good to pass up.  I will not get into the details of the tax free bond offerings from NHAI, PFC, HUDCO and IRFC here.  You can easily find tons of literature describing the various aspects of these bond offerings on the internet.  Suffice it to say that guaranteed pre-tax returns of upto 12% per annum (for folks in the highest 30% income bracket) were too mouth watering to pass up.  Obviously several people thought the way I did.  The HNI allocations of all these bond offerings were over-subscribed within days.  Fortunately all of them had separate allocations for retail investors like you and me.  There was a limit of Rs5L per bond offering in the retail category, which I thought was high enough for most retail investors.  In case you had more money available to invest, you could have spread 20L across the 4 offerings, and a total of 40L if you and your wife applied separately.  At 8.6% tax free returns, you can generate ~Rs29K per month tax free for the next 15 years guaranteed!!  This is possibly the highest guaranteed returns post-tax that you can generate across any existing TEE schemes. 

No wonder I had to admit my mistake, and change my retirement investment philosophy.  My only regret at this time is that I could not free up enough capital to invest in this tax free offering.  If there are more tranches of such offerings in the future, I fully intend to watch out for them, and plan upfront to free up some more cash to invest in such risk free and tax free opportunities.  Did you capitalize on this opportunity for your retirement portfolio?  Such no-brainer opportunities do not come very often!  It would be interesting to know how many of you participated in this bond offering.  Let me know.

How much home loan can I get? (Part II)

In the Part I of this post, I had described a seemingly well set couple; Gaurav and Sneha, planning to buy their first home.  They had taken all the right steps in budgeting their home loan eligibility and are ready to take the plunge into home ownership.  Their financial planner approves of this step, and has given them the go ahead.  However from an early retirement aspirants perspective, they are making a huge mistake, that will potentially ruin any chances they might have of exiting the financial rat race early.  Where did they go wrong?  Isn't owning your own house a good financial milestone?

For starters let us look at some "role models" to see how they spend their money.  To help with this discussion, I will pick people that you have most likely heard of (unless you live in a cave) Let's start with William Henry Gates III, or Bill Gates to you and me.  He lives in Medina, Washington in a home that is approximately valued at US$150M.  In the 2011 Forbes Wealth rankings, Bill is estimated to be worth US$56Billion.  Next, we will profile his close friend and legendary investor, Warren Buffett.  Warren lives in Omaha in his 50+ years old home, that is probably valued at US$1M.  Warren's networth is estimated to be US$50Billion.  Picking an Indian name next, let's talk about Lakshmi Mittal, the steel magnate and CEO of ArcelorMittal who is known for his ostentatious displays of wealth.  Worth a whopping US$31Billion, Lakshmi owns three prime properties on the "Billionaire's Row" at Kensington Palace Gardens that are collectively worth US$1.2Billion.  Speaking of ostentatious, closer to home, we have our own Mukesh Ambani estimated to be worth US$27Billion.  He has just finished construction on his dream home in Mumbai called Antilia, which is considered the worlds most expensive single family home in history costing an estimated US$1Billion.  So what is the common thread in all of these numbers?  Clearly all of these folks (with the exception of Mr Buffett) like to live large and have the money to be able to afford it.  However, even in the most extreme case in the above examples, the amount of money "invested" in the primary residence is not more than 4% of their overall networth.  These business leaders with their enormous spending ability, choose to spend an extreme of 4% (and on average less than 1%) of their networth on their primary residence.

Now lets contrast that with Gaurav and Sneha.  They are just starting off on their careers, and by no means do they consider themselves rich and wealthy.  In fact they are firmly entrenched in the category of the new middle class in India.  However, with their goal to purchase a flat worth Rs52 lakhs, their networth would have to be Rs 13Cr, if they want to match up to the 4% primary residence spending guideline from above!  Clearly, by this metric they are spending much more than their means, on this new flat purchase.  Now I have picked the extreme examples from above, to really up the contrast on spending strategies.  In reality, given the extremely high networths of the individuals I have considered it is not surprising that only a very small portion of it is spent on their primary residence.  However, it does illustrate the point that many times we over-estimate our spending capacity based on our ability to maintain the cash flows required to fund the expense. 

Like I described in my earlier post on Compound Interest 101, the initial years when saving/investing for a financial goal are crucial in terms of corpus growth.  In the early days of Gaurav's career, his networth will primarily grow based on the quantum of his savings.  Only after his corpus has reached a significant amount, will the power of compounding take over and continue to power future corpus growth.  In this crucial early period of his career, when Gaurav should be saving and in turn investing aggressively, he is choosing to block up as much as 50% of his net take home income (not to mention the 15% down payment on the home) in his primary residence.  Now the primary residence can be considered an asset as well (most financial planners do that) since it does have value, and is not a depreciating asset.  However, since it is your primary residence it will not bring in any income on its own.  The value of this asset might increase, but this is only a notional or paper growth in assets, since there is no way for you to monetize this asset, unless you sell your house (but then where will you live?)  Reverse mortgages are slowly finding popularity in India, but this is a step that you will only take once you are deep into your retirement years. 

In summary, though Gaurav is eligible to take on this level of financial commitment, once he signs the home loan papers, he might as well kiss any hopes of early retirement goodbye.  Once the home loan documents are signed, he has tethered himself to the bank, and for the foreseeable future (25 years is his home loan tenure) will work 33% for the govt (assuming he is in the 30% income tax bracket), another 33% for the bank (since he will be paying off 50% of his take home, or 33% of his gross income, towards EMIs) and only the final 33% for himself.  In effect for every 3 days of work that Gaurav puts in (and I am sure he works in a high stress environment to be able to command such a high salary) he only gets paid for 1 day (since the remaining 2 days worth of income is taken by the govt and the bank respectively)  Gaurav will have to continue slogging away at work, and the situation will most likely get tougher for him, if his wife Sneha were to choose to stop working (since her income is also accounted for in the home loan eligibility computation)

For early retirement aspirants, the conventional thought of paying around 45%-50% of your take home income for home loan EMIs is a non-starter.  I am not suggesting that you should not buy a home.  Just realize that your primary residence, is a paper asset that does not bring in any monthly income, and though it appreciates in value, the gains are only notional.  I would recommend a much more conservative 15-20% of your net take home salary to pay for any home purchase, leaving plenty of monthly income in hand for aggressive savings and investments.  Particularly for folks early in their careers, aggressive savings is critical to unlock the power of long term compounding of wealth.  Dial down your first home purchase aspirations and give yourself a shot at quick financial freedom and early retirement.  Else follow conventional guidance, buy the best home your money can buy, and commit yourself to decades of daily grind in pursuit of financial freedom. 

How much home loan can I get? (Part I)

Buying a home in India, or for that matter anywhere in the world, is a big decision for most people.  It is most likely the single biggest purchase you will ever make in your lifetime.  Gone are the days when one used to save for a lifetime, before finally being able to afford a small home towards the end of your career.  Today India is growing by leaps and bounds, and the average home buying age in India is dropping every year.  The Associated Chambers of Commerce and Industry of India (ASSOCHAM) estimates that the average age for home buyers in the 1980s was 55-58 years in India.  In stark contrast, since 2000, the average age for first time home buyers for personal use has dropped to 30-38.  Many first time buyers are either just married, or many times choose to buy a home even before marriage.

In most Tier1 cities in India, the trend I see these days is that once a person graduates from college and begins working, the first big ticket purchase they consider is a car, and the second one is a house.  In most Indian families, even after the children start working they typically continue to live with their parents and siblings.  After a few years of working when they are 25-28 years of age for boys, and a couple of years younger for girls, the thoughts turn towards owning a home.  Guys typically prefer to buy a smaller new home (maybe a 1BHK) just prior to getting married, so they can move in as soon as the wedding is done.  The other alternative is to buy a bigger new house (upto a 3BHK) so the newly weds can have their privacy, while still living with their parents.  Girls on the other hand might typically wait to get married, and then right away begin the search for a home, since the joint income of the husband-wife couple is more than enough to afford a good home.  Many times the quality and size of home you currently live in, or plan to buy soon, can be a critical factor in influencing the choice of life partner, with families preferring to create marriage alliances with their social and financial equals (as measured by the size and quality of their dwelling!) 

Buying a home in India can also be a very emotional decision, heavily influenced by family, friends, peers and the unique social environment we live in.  Peer pressure plays a big role here as you see your friends and colleagues purchasing homes.  There is also a desire to show that you have "arrived" and the best way to do so, is buy purchasing the biggest house you can afford.  A nice upscale colony, with a fancy clubhouse, tennis courts, gymnasium, walking/jogging track etc helps in setting the bragging rights, even though you may have to pay a stiff monthly maintenance fee for several of these amenities that you probably never use!

Of course we always rationalize to ourselves that surely we deserve the best house we can afford.  We want to provide the best living conditions for our parents given that they have sacrificed so much for use.  We want our kids to have the best amenities, and access to swimming pools, tennis courts, basket-ball courts, play areas, etc, since we did not have that luxury when we were growing up.  The list of reasons is endless, and I am not debating right or wrong.  I had the same thoughts while we were trying to figure out where to buy a home ourselves.

Let us take the example of 29 year old Gaurav who is married for a couple of years now to Sneha and is soon planning to have kids and start a family.  This is of course a fictitious example, but helps to illustrate my point better.  Before Gaurav and Sneha decide to have a child, they would like to purchase their first home.  They would like to go for a 3BHK, since 3 bedrooms would give the family enough space and privacy once they have a child.  Since both Gaurav and Sneha are salaried employees, they expect one set of parents (either Gaurav's or Sneha's) to stay with them almost throughout the year, to help with taking care of their child.  A good apartment complex near the upcoming outer peripheral road would be a good place to invest in a home, since there are several new developments happening in that area.  Good schools are expected to come up there soon, and both their offices are also within a 10Km radius.  The first thing Gaurav does is search online for how much home loan can he get given their combined joint monthly income.  Gaurav and Sneha are very disciplined and do not spend extravagantly.  They do not have any personal loans or student loans and pay off their credit card bills promptly.   Their joint monthly take home income is Rs 80,000.  Gaurav and Sneha approach a leading bank to negotiate a pre-approved home loan so they can decide on the budget for their dream home purchase.  The bank informs them that they typically sanction a maximum EMI of 45-50% of the net take home salary, and encourages them to jointly apply for the home loan to maximize the total loan amount.  Also since they dont have any other personal loans, or credit card debt, and their credit rating is impeccable, the bank agrees to extend the eligible monthly EMI to 55% of their take home pay.  This means the bank estimates that Gaurav and his wife can comfortably pay a monthly EMI of Rs 44,000.  After all the bank manager also has home loan disbursement targets to meet, and a young couple with a strong employment history is an ideal customer for the bank. 

Gaurav decides to maximize the tenure of the loan to further bump up his overall loan eligibility.  The maximum term with this bank is for 25 years.  The home loan interest is a floating rate of 10% per annum.  Based on these parameters, Gaurav is eligible for a home loan of Rs 44 Lakhs (I used the home loan EMI calculator available here at ApnaPaisa) Since the bank will only fund upto 85% of his loan, his maximum budget can be Rs 52 Lakhs with the 15% margin money of Rs 8 Lakhs being Gaurav's responsibility.  Gaurav and Sneha are overjoyed by this and sign up for the pre-approved home loan.  They can now buy a flat of their choice upto a maximum budget of Rs 52 Lakhs.  This is a fairly conventional storyline, and is repeated hundreds of times across various banks in India. 

So what is wrong with this story?  Well nothing much, if you are counting on a conventional financial plan, with traditional milestones of marriage, family, owning a home, working hard till the age of 60-65, and finally leading a happy retired life.  But this does not work for early retirement aspirants.  In my next post we will dissect this case study from an early retiree's perspective, and see why this plan cannot co-exist with thoughts of early retirement. 

Inflation in India

Inflation is a much maligned but sometimes poorly understood phenomenon that has the most significant impact on any personal finance plan.  Particularly in a emerging country like India, inflation can be so rampant as to be the fundamental parameter that influences all investing decisions.  Inflation is usually defined as a rise in the general level of prices of goods and services in an economy over a period of time.  In the words of noted economist Sam Ewing, it is the reason why you pay $15 for the $10 haircut that you used to get for $5 when you had hair. 

First it would be instructive to look at inflation in a mature developed economy like for example the US.  In recent years the US has not experienced significant inflation levels, with the inflation rate hovering around 3-4% for the last decade.  The following is a chart from Wikipedia that shows the US CPI Inflation over the last century.

Over the last couple of decades since 1990 US inflation rates have been relatively stable and low.  Inflation rates of around 3-4% seem very comfortable and makes financial planning over the long range, a tad bit easier.  The interesting thing is that in the 70s inflation was very high averaging in the high single digits, and peaking at 15%.  My key takeaways from this graph are that even in a mature economy inflation if not controlled can go up significantly, and also the variability in the inflation rate cannot be avoided particularly over timeframes that range over decades (like hopefully my retirement days)

Now lets contrast this against the inflation rates seen in India.  I found this historical annual CPI inflation data on the Worldwide Inflation page.

As you can see inflation in India since the mid-70s has averaged around the 10% mark.  The 1999-2005 period in recent memory is almost like a "Golden" period from an inflation perspective, characterized by low levels of inflation, and possibly the resultant bull market.  However, the recent high inflation rates that many of us are complaining about, is just a return to the mean that our parents struggled with through the entire earning careers.  The early-70s seem an aberration due to the events of the time like the India-Pakistan wars, and more importantly the oil-shock of 1973-74.  Before that the mean seems to hover around the 10% mark.  There is not much point looking at inflation data prior to the 50s since the conditions in pre-independence colonial India were very different and lessons learnt from that period are most likely not applicable today.  My key takeaway here is that the India has always worked with a high inflation rate of 10% and I don't see the norm changing in the near future.  Periods of low inflation (in the low single digits) are few and rare, and should be taken advantage of, as and when they occur.  In the meantime, we should be looking back to the age-old methods used by our parents to combat high inflation rates.

Here are some, at first glance non-intuitive, but extremely sane financial decisions that I have seen people make as a result of the prevailing high inflation environment.

We tend to stock up on non-perishables as we know the same product is going to cost more next month.  In these times of rising incomes, people have more purchasing power, and I routinely see them buying large quantities of soaps, cosmetics, house-hold cleaning agents, even grains, biscuits, basically anything that is non-perishable and can be stored for a month or longer.  Every super-market you walk into, you can see sales on bulk non-perishable goods, and people willing to buy these bulk products (for example a pack of 5 soaps, that will probably last a family of 4 for 3-4months) knowing fully well that the same item will cost 5% more in a few months.

Real estate has seen a crazy spiral of inflation driven price increases.  There is a mad rush to acquire property due to the fear that the same house or plot of land will appreciate between 15-20% in a year, pushing it out of your spending capacity.  Builders and property development firms take advantage of this phenomenon by launching huge developments with 100s and nowadays 1000s of flats, with the firm belief that they will be able to find customers to lap up these offerings.  The average joe is in a rush to buy property to "lock-in" today's price, since he/she knows that in as little as 5-7years the same property will cost double the price.

Wages are caught up in an inflation driven spiral as well (economists call this cost-push inflation) as employees clamor for higher wages in order to maintain their lifestyles in a high inflationary environment.  This in turn drives up costs further, and adds to the cycle of inflation.  The new Gen-X and Gen-Y employees have become used to this environment and typically expect wage increases in the double-digit percentages.  This expectation (which has been met in recent years) leads to unhealthy financial decisions that are dependent on future expected wage hikes.  The younger generation is willing to make bigger purchases, most times leveraging on loans, expecting to be able to repay them with future wage increases. 

It makes financial sense in a high inflation environment to accumulate (or hoard) products and assets.  In addition to hoarding what you can afford with your current wealth, most folks begin to leverage by taking loans to accumulate assets beyond their current means.  The thought is that the high inflation environment will continue, and future loan re-payment will be with a de-valued currency that is progressively easier on the borrower. 

Health care costs continue to spiral, making it difficult to estimate insurance premiums and how much insurance cover to purchase.  Insurance firms increase annual health care premiums, and keep releasing products with higher insurance limits, and more innovative schemes like top-up insurance products with high deductibles.  There is also a brisk trade in life insurance policies since the term insurance that you bought 5 years ago for Rs 10 lakhs cover, no longer seems adequate today simply because of the de-valuation of currency due to inflation.

Finally, retirement plans are most impacted, since any form of fixed retirement income (PPF, NSC, FDs etc) is typically not inflation indexed and hence doomed to failure.  Equity and real estate are probably the only forms of inflation indexed investments that can combat the high prevailing inflation rates.  And predicting a retirement corpus to enable early retirement becomes a herculean task to estimate with any reasonable degree of accuracy.  

The positives in this story are that, high inflation environments have existed before in mature economies, and are fairly typical in other emerging economies even today.  We should be looking for strategies for wealth management and growth that have worked in these environments in other countries, and adapt and apply them within the Indian context today.  This would be the right approach since, "The middle class learn from their own mistakes, while the rich learn from others mistakes!"

Is 1 Crore enough to retire on in India?

If you had Rs 1Cr (approx USD $200,000) would you be able to retire right now in India? If you need to meet retirement expenses over 30 years, would Rs 1Cr suffice?  How much can you spend monthly, if you need the Rs 1 Cr corpus last over 20 years.  To understand these and several related questions, read on.
Similar to the 1 million dollar mark (USD $1M) as a financial milestone in the US, in India in recent times, 1 Crore (Rs 1Crore) is the magic figure that is often talked about.  It is not as small as 1Lakh which is somewhat easily achievable these days, but not so far out that it is completely out of reach for the diligent and disciplined saver.  So lets say that through hard work, patience and discipline (or by winning the lottery) you have achieved the goal of having a total accumulated corpus (networth) of 1Crore.  By total corpus, I mean the total amount you have in liquid investable assets like bank accounts, Mutual fund investments, FDs, stocks, etc.  I do not want to include your primary residence as an asset, since you need it in your retirement days to live in.  Any additional real estate equity (if you are lucky enough to have it) can be included in the total corpus, as long as you realize that the entire corpus will need to be utilized to generate income once you have retired. 

Now the big question is Is 1Crore enough to retire on in India?  Can you use this corpus to fund all your expenses and never have to work again?  If you had 1Crore Rupees right now, could you give up your job right at this moment, and retire?  Now this is a very tough question to answer, since it depends on several factors that will be unique to your situation.  It is dependent on how many years you need to spend in retirement, do you have kids?, what are your monthly expenses?, do you plan to leave a inheritance for your kids, your health etc.  Since I cant tailor this article for all situations, I will instead assume a range of expenses, and compute the probability of a 1Crore corpus enabling retirement.

I will also assume for the purposes of this example that you can generate a 12% annual rate of return on your invested retirement corpus.  This should be the average rate of return across your asset allocation which could be in rental real estate, MFs, direct equity stock holdings and dividends, FDs, PPF etc

Another key factor we cannot ignore is inflation.  Many times people forget to factor in this destroyer of wealth.  I will go with an 8% inflation rate, since these days we are subject to rampant inflation, and I think it will take several years if not decades for the inflation rate to cool off. 

With these basic assumptions let us first start with a simple example wherein you have accumulated Rs 1 Crore, and are now ready to retire.  You estimate that your annual expenses will be Rs 6Lakh (Rs 50,000 per month)  Can you fund your entire retirement expenses from your retirement corpus?  Let's do the math and see how this works out.  I have plotted the total corpus and the increasing annual expenses (since we have a 8% inflation rate) in the graph below, with the total corpus on the left axis and the annual expenses on the right axis. 

Notice that in the early years your corpus keeps increasing since you are getting 12% investment returns, while you are not withdrawing much for your annual expenses.  Your total corpus peaks in your 16th year of retirement at Rs1.6Cr !! Unfortunately for you, your annual expenses are also growing at the rapid 8% inflation rate.  So in your 16th year of retirement you will need Rs19 Lakh to fund the same lifestyle which you could afford in your 1st retirement year at only Rs6 Lakh.  Your annual expenses now keep increasing and make a significant dent in your total retirement corpus.  From the 16th year onwards your corpus steadily decreases and finally runs out completely in the 26th year.  So basically for this situation, you can fund a retirement of only 26 years.  If you are in your 60s, then potentially 26 years should be sufficient to cover the remainder of your (and your spouses) life needs.  Mind you, that you will not have any corpus left at the end of 26 years to pass on as an inheritance to your heirs.  However if you are in your 50s, you could be cutting it close since in 26 years you will be in your mid 70s, which would be a terrible time to run out of money!

Finally, continuing to assume a 12% investment return rate, I show below how long your retirement corpus will last for different inflation rate assumptions and annual expenses.  I start with Rs3 Lakh annual expenses (or Rs 25,000 monthly expenses) and keep increasing the annual expenses to as much as Rs 7 Lakhs (or Rs 75,000 in monthly expenses)  For each of these cases, the height of the bar, shows how many years you can assume the Rs 1Cr corpus will last. 

The blue bars assume an inflation rate of 8% and the red and green bars assume 9% and 10% inflation rate respectively.  Naturally as the inflation rate goes up, your total corpus runs out faster.  This table will help you pick an inflation rate you are comfortable with, and assess if you can retire with the Rs 1Cr corpus.  For example if you are in your 50s and want to be conservative in your inflation rate prediction and go with 9%, then you should target monthly expenses of Rs 25,000 or lower (Rs 4 Lakh annual expenses) to ensure that your corpus will last for atleast 30 years (which is what you will need, to ensure you have money well into your 80s)

I hope this table will help you figure out if Rs 1Cr will be enough to fund your retirement dreams.  You would be surprised at how little Rs 1Cr can fund in monthly expenses if the inflation rate continues to remain very high!

Compound Interest 101

Compound interest is the single most interesting and critical factor that impacts all projections of investment growth, retirement corpus accumulation, loan EMIs and payback tenures, etc.  For a concept that is so fundamental to financial theory, compounding can be exceedingly difficult for the average person to understand and fully appreciate.  This is fundamentally because with compound interest, the total corpus grows or declines in an exponential manner.  It is widely believed that the human mind has difficulty comprehending exponential behavior.  For example, Albert Bartlett a US scholar, once commented that "The greatest shortcoming of the human race is our inability to understand the exponential function".  In economics the exponential growth model is also known as the Malthusian growth model, after the Reverend Thomas Robert Malthus, who authored "An Essay on the Principle of Population", one of the earliest books on population growth rates.

Let us look at a few examples to better understand the power of compounding and its implications to financial planning.  We will start with a simple goal of saving up Rs30 Lakhs in 25 years.  This could be a financial goal that you take up to fund your retirement, or maybe plan for your child's higher education.  Assuming a 12% annual rate of return, you would need to invest Rs20090 annually to achieve this goal.  So far this is just basic mathematics, and is the kind of computation any financial planner, or online financial calculator can do for you.  Here is a pictorial representation of how the corpus would grow over the 25 years, finally reaching a value of Rs30 Lakhs at the end of the 25th year.

Now here are some interesting observations that are a direct result of the nature of compounding.  I have labeled them as Compound Interest Observations (or CIOs)

CIO1: The first thing I'd like you to notice is how exactly your total corpus grows over time.  The exponential nature of the curve above leads to some interesting results in terms of the rate of growth of your corpus over time.  This result may not be very evident when you look at the above curve, so let me show you the same curve in percentage terms below. 

First lets focus on the red line at the mid-point of your 25 year investment plan.  At the 12.5 year mark, your corpus only amounts to 20% of your final savings goal!  So even though you have completed 50% of your investment timeline, you have only achieved 20% of your investment goal!  Next lets focus on the second red line at the 20 year mark.  At the 20 year mark you have completed four-fifths or 80% of your investment timeline, and still your corpus has only reached a little over 50% of your savings target.  It is only in the last 5 years that the power of compounding really kicks in and catapults your investment to the final 100% target.  The key takeaway here is that even though you are steadily investing Rs20000 annually, and the rate of return is also a steady 12% annually, the corpus growth is heavily weighted to the later portion of your savings timeline.  In the early years a very small amount of the corpus will be built up, while towards the end as you near your goal, the corpus grows rapidly.  This simple effect has profound implications on the impact of variations in investment ability, or investment return on the final corpus accumulated.  As a case-study, this example clearly reveals why many people get frustrated with their savings progress.  In the early stages of savings, the corpus growth is much slower (20% corpus in 50% time, 50% corpus in 80% time) and it is only much later that you can finally start seeing the magic effect of compounding.  This effect many times leads to people giving up on their savings goals, since they are not able to see a proportionate increase in their corpus for the effort they put in (in the form of annual investments) during the early years.  However, this example clearly shows that you need the patience to complete your investment timeline, to truly reap the rewards of compounding.

CIO2: The next point to closely observe is the yearly increase in your corpus.  I have plotted the yearly increments in the total corpus for this example below. 

Notice that in the first few years the annual increase is only around Rs20,000 to Rs40,000 per year.  Whereas after the 15th year, the corpus grows by more than Rs1 Lakh per annum.  This just reinforces the observation from the previous case wherein the rate of growth is hardly worth mentioning in the initial years, but the yearly increase is spectacular in the last few years of your investment timeline.

CIO3: Next lets look at how the yearly growth that is described above, is actually achieved.  In the plot below, I show 2 lines.  The blue line is the percentage contribution of your own investment to the yearly increase above (remember you are putting in Rs20K every year which will show up as an increase in corpus every year, but is really your own money) and the red line is the percentage contribution from the investment returns (at 12% per annum) to the yearly increase.

Observe that in the first 3 years, over 70% of the yearly increase is coming from your own investment adding up to the corpus.  The increase from investment returns is less than 30% in each of the first 3 years.  This is why it is so critical to continue with your investment plans in long range products like ULIPs and insurance endowment policies well beyond 3years, since in the first 3 years, most of the "growth" is really your own money being returned to you.  The cross-over occurs at the 6th year in this example, where both your investment of Rs20K and the investment returns are almost the same.  Beyond this point, the investment returns steadily keep increasing and from the 20th year onwards, account for more than 90% of the yearly growth.  At this time, your yearly investment of Rs20K becomes negligible since almost all of the yearly growth is powered by investment returns.

CIO4: The final observation I will make in this article is to drive home the point from CIO3.  The graph below shows the percentage of your money (the annual Rs20K that you are investing) in the actual corpus that is available every year.

You will notice again that in the initial few years the percentage of your money in the total corpus is high.  For example at the end of the 3rd year, ~80% of the total available corpus is your own money! (the Rs60K that you have invested in the first 3 years) Investment returns at the end of the 3rd year form only 20% of the overall corpus.  Even after 10 long years, the total corpus comprises only 50% of investment returns with the remaining 50% being your own investment money.  This again highlights the need to stay invested in long range products almost to the end of their lifetime, since during the early stages most of the corpus is your own money, with a low percentage of investment return based money. 

I hope this article sheds some additional light on how compounding actually works, and allows you to better envision some of the implications of the way compounding grows your investments.  No wonder Albert Einstein said "Compound Interest is the 8th wonder of the world.  He who understands it ... earns it ... He who doesn't ... pays it"

Household Savings Rate

Earlier this month I had stated my intent of saving 85% of our family take home income.  I am still unsure if I can achieve this aggressive savings rate, but I am pretty sure that over the last few months, our savings rate should be around the 50%-60% levels.  This got me wondering as to what the average household savings rate is across India/World.  So I went searching for this data, and here is what I dug up from GFMAG.

I have reproduced the following table from the above site here for convenience. 

The shocking statistic for me was that across the world over 2decades of time the annual average household savings rate maxes out at 20%, with the most common savings rate being in the mid to high single digits.  Now of course the need to save could be different in different countries.  Typically countries that have a higher proportion of social security, should have lower savings rate since there is less of a drive to save for a household, as the government is expected to provide support post retirement. 

Though countries like India and China are not listed in this survey, I would assume we would naturally have a much higher savings rate since our government does not provide any kind of social security whatsoever. 

In any case, the fact that the average savings rate is much below my 85% target, gives me a lot of confidence.  On average, people do not retire early, and continue to work into their late 60s.  For me to be able to retire in my 40s, I need to be doing something that is not the average, and I hope my aggressive savings rate will make the difference when compared to the average joe.

Savings Rate or Investment Returns?

I see several articles and energy spent on figuring out how to maximize ones investment returns.  There are tons and tons of websites dedicated to guiding you on how to increase your stock market returns, or to find the best loan rates, or the highest FD rates.  Yes, I believe all of this is important, since you wouldn't want to be stuck with a less than optimal investment return, when better returns are available for the same product and risk profile.  However, the key realization you need to have is that, investment returns are not in your control.  You can try your best to increase your returns by a few percentage points, but for the most part you have no guarantee that this will happen.  Also, going for increased returns always goes hand in hand with a higher investment risk that you will have to take on. 

Instead I propose that you should spend your energy in figuring out how to increase your savings rate.  For starters this is completely in your control, so you can decide and implement any savings strategy, as long as you have the discipline for it.  Also most times I have found that a small increase in your savings rate, can easily offset any lower investment returns that you might see.

Here is a table that illustrates this principle.  I have calculated how many years it would take to save up 10 times your annual salary, if you make 0% to 20% returns (on the Y axis of the table), for different savings rates from 10% to 90% of your annual income (on the X axis of the table)

The first row is the simplest to understand, since it assumes 0% returns, or the equivalent of taking all your savings cash and keeping it in a bank locker.  Therefore, in this case, if you save 10% of your annual salary, it will take you 100 years to save up to 10times your annual income.  As you increase your savings rate, the number of years reduces proportionately.  If you are able to save 50% of your annual income, you can achieve your 10X target in 20years.  However, in real life, nobody keeps their money in a bank locker with 0% investment returns (unless it is black money!)

So lets take the example of 8% annual returns. In the current scenario of high interest rates, it is easy to achieve 8% investment returns by simply investing in low risk debt instruments (like FDs, MIPs, etc)  In this case, if you are able to save as little as 30% of your annual income, you can save up 10 times your annual salary in 16.9 years.  This may seem like a long time, but if you start at the age of 25, by the age of 42, you will have 10X your annual salary in your investment portfolio.  That is a very strong position to be in!  However, if you are not willing to wait that long, you can increase your savings rate to 50% (save half your annual income)  This will help you reach your goal in just 12.4 years.  Again starting at age 25, you would have met your goal at the young age of 33!  Clearly this illustrates the value of increasing your savings rate.

If you are willing to take on more risk, you can aggressively invest in equities, real estate, and these days even in gold.  Assuming an aggressive investment returns of 12%, you can see from the table that 30% savings will help you reach your target in 14.2 years, while an increased 50% savings rate will help you get there in just 10.8 years. 

This should clearly drive home my point that though investment returns are a good thing to chase after, an increased savings rate is a more powerful tool (and completely in your control) to help you reach your retirement corpus accumulation target.

Early Retirement Killer : Inflation

The single biggest obstacle I foresee to any plans for early retirement is inflation.  Yes, I believe this is a bigger challenge than even accumulating a large enough corpus in the first place to enable retiring early.  India continues to reel under the pressure of rampant inflation, ranging from 8% to 10% in recent times.  The inflation rate is not the same across the various components of my expenses.  In particular there are three areas that seem to have persistently high levels of inflation that show no signs of letting up.

Health care:  The cost of medical care, hospitalization, routine doctors visits, and medicines, continues to go up at what feels like an ever quickening pace.  Health care premiums also continue to shoot up at the same pace, as insurance companies have to raise rates to remain viable. 

Education:  Learning, which should ideally be accessible to every single person, also seems to be becoming more expensive everyday.  Tuition fees from nursery and day-care, to higher education professional degrees are becoming prohibitively expensive. 

Real Estate:  In India real estate has always been expensive, but in recent times, has seen a phenomenal increase in per sqft rates.  Everyone wants to own a piece of real estate, and the increased demand is resulting in continually increasing real estate prices. 

The key challenge I see going forward, is that I will definitely need access to health care and education (for my kids) and potentially also buy real estate (either for my self, or as an investment for rental returns)  But due to steep inflation rates in these areas, (and certainly my salary is not increasing at the same pace) I am getting priced out of the market.  In other words, as time goes by, I will be able to afford less and less, in the health-care, education and real estate space. 

Do you feel the same way? and do you have any suggestions on how to deal with this?