Financial Independce, Retire Early [FIRE] has become the aim of each and every youngster for various reasons. Vicki Robin and Joe Dominguez published their book Your Money or Your Life in 1992, which popularized the idea of achieving financial independence rather than spending the best days and years of your life working in a 9-5 to make money. The most common reason why people aim for FIRE is the daily pressure on the job. The current stress due to COVID situation is definitely working as a fuel for FIRE seekers.
Last week, One of my friend lost his livelihood to the current crash in job market. He has been one of those diligent saver/ investor that at his age of 37, he is able to accumulate a corpus of 33x of his annual expenses without any large liabilities due in foreseeable future. This has drawn him to the thought about hangging up his boots and living life as he pleases on his portfolio income. He has seen many articles talking about retirement corpus to be 30x of the annual expenses and the 4% withdrawl rule to sustain in retirement on portfolio income.On the back of this conversation, I agreed to put together some numbers for him to make an informed decision.
“30 times the annual expenses with 4% withdrawl rate, One can sustain the retirement on portfolio income alone.”
I have earlier also written about the points of retirement planning including the steps to Calculate the required corpus, Adjust for Lifestyle inflation, Create a Core & Satellite Portfolio based on your risk appetite & risk capacity.
My friend was of the opinion that if he will take the withdrawl rate of 3% conservative to preached 4%, He can surely sustain his retirement. He was not aware of the other pointers around this thumb rule so he wanted to understand the same in details. The 3% withdrawl means that If we have a portfolio of 100, we will take out 3 for the expense and the reminaing money stays invested. For the exercise, we assumed the inflation to be 6% and return on investment as 7.2% (Equal to 40yr Govt of India bond). We calculated the balance at the end of each year as below and continued the same for next 60yrs. [Ignoring the liquidity requirement & Tax impact for now.]
|Year||Portfolio||Withdrawl [For Expenses] @6% Inflation||Returns@7.2%||Balance End of the year|
|1||100.0||3.0||7.0 = 97*7.2%||104.0|
|2||104.0||3.18 = 3*(1+6%)||7.3= |
The orange/amber line in the chart represents the expenses, which continues to grow @6% inflation. At the end of 60th Year, It grew to almost 100 in itself due to exponential growth. The blue line represents the size of the portfolio, which continues to grow for next 30 years but the annual withdrawal amount grows higher than the return on portfolio and it start to deplete the portfolio. At the end of 42nd year, It depletes completely. This means you can survive for next 42years, at 3% withdrawal rate with portfolio size of 33x annual expenses. People retiring at the age of 60 +/- 2 can survive till the age of 100yrs but retiring early at the age of 37 can create a RISK OF LONGEVITY.
The next thing we analysed is the possibility of addition of investments with some risk but higher possible returns. The returns of such portfolio will be non-linear (varying from +ve to -ve), we can not simply use the mean return to draw a chart similar to above. Hence, I had set up a Monte Carlo Simulation to find out the impact of volatility. Over the 10,000 simulations I looked for success rate of >=95% such that Portfolio survives upto the 60yrs of age with 3% withdrawal growing at a 6% rate of inflation. This had helped us creating the minimum return required at a given risk/ volatility. [Chart Below]
Monte Carlo simulation can be done on excel itself for limited variablitiy, If interested to look at the file then drop an email to us and we will be happy to share the workings.
You can see as the risk/ volatility in portfolio increases, we need the higher returns to get 95% success to sustain 60yrs in retirement on portfolio income with 3% withdrawal. At 0% volatility, we need roughly 8.4% return in portfolio which is pretty difficult to get in the current scenario. At 5% volatility, we need returns just shy of the 10% and at the 20% volatility returns required is north of 15%. We need to make sure, the returns of the portfolio should be in the region higher than blue line for given risk of volatility.
Before you suggest that equity investing can give you the higher returns, let me quickly remind you that the annual mean return of equity index in India has been 11% over last decade+ with the volatility of annual returns of ~20%.
Using the concept of Asset allocation & Modern Portfolio Theory, we mixed the different asset classes using the Corr & Cov matrix along with their expected returns & volatility. We backtested the portfolio and it worked as desired, though as always future is unknnown. We reduced longevity risk of early retirement by inducing some volatility in the Portfolio. Though we come to conclusion that if he want to stay prudent, he should continue to look for the alternate employement and defer the complete dependency on Portfolio income by 3-5 years at the least. This would help him reduce the withdrawl value as well as number of years in retirement and create some buffer for unseen emergencies.
Let me leave you with these thoughts to ponder upon. Do you know the amount you need to be financially independent? Will it survive the required number of years? Have you backtested it? If not, then do it sooner than later and Keep Investing!!