Many of you will be surprised to see the title of this post. After all, isn’t this something that all financial planners, be it in real life or through online, have drilled indelibly in our brains? I mean we could all do it in our sleep, right? You just take your current annual expenses, decide how much would still be applicable at the time you retire, use inflation figure that you deem fit, apply the compound interest formula and arrive at the desired figure. To make it even clearer, see below:-
- Current annual expenses is 6 lacs.
- 80 % will apply at retirement, so relevant expense = 6 lacs x 80 % = 4.8 lacs
- Retirement is 20 years away and this expense will grow at current inflation rate of 8 %
- Therefore application of compound interest formula will give us the first year retirement expense as 22.37 lacs.
But hang on – are we really going to spend 22.37 lacs a year adjusted for future inflation? If that is so and I assume a Zero real interest in my corpus, then my corpus calculation will be something shown below:-
- Yearly expenses in the first year of retirement = 22.37 lacs
- Number of years in retirement = 30 years
- Real rate of return = 0 %
- Corpus needed = 22.37 x 30 = 6.71 crores
Of course, if we need to have this corpus then so be it. But are we missing something here? Yes, we are missing something really big because we are doing this just by the numbers without understanding the context of the life situation which is really the important understanding to have.Not clear? Let me give you some examples then:-
- Ravi has just started work and lives on his own in Bangalore. His expenses are 20000 Rs a month and he will probably work for the next 30 years. Traditional way of calculating his expenses in the first year of retirement will give us an amount of 24 lacs.
- Ravi has now worked for 10 years and lives in Bangalore with his family, which includes his wife and 2 children. His current expenses are 12 lacs per year. We can take it that he will retire in 20 years as before. In the first year of retirement his annual expenses can be projected to be 56 lacs.
- Ravi has now worked for 20 years and is due to retire in 10 years time. With the college expenses of his children he now spends 24 lacs per year. If you take his projected expenses annually in the first year of retirement it will now seem to be 52 lacs.
- Ravi has now worked for 25 years and his children are settled now. His expenses have now reduced to 15 lacs a year with both children being away. He will retire in 5 years and the projected annual expenses in the first year of retirement will be 22 lacs.
Can you understand what is happening here? Different life stages have different expense levels and if we project on the basis of it we will get very different results. In 1 Ravi has not started a family so his expenses cannot be taken as being representative. Neither are 2 or 3 and the closest figure that can work is probably 4. Of course in this case 1 and 4 have similar results but that is only a coincidence which is fortuitous.
So the happy news is if you are 40 and your financial adviser is asking you to project your expenses and working out a huge corpus, he is most probably wrong. We need to calculate the corpus needed in a different manner, the current methods are clearly useless in terms of practical application.
Junk all the retirement calculators which tell you to do your calculations on the above basis. We need a much better way of doing it and there is one available. We will discuss it in the next post.
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