Module 11 Personal Finance

Chapter 5

The retirement problem (Part 2)

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5.1 โ€“ Assumptions

We are at an exciting point now. The previous chapter helped us estimate (roughly) the corpus required for one to retire comfortably, without drastically changing the post-retirement lifestyle.

One can argue that certain aspects were overlooked while estimating the post-retirement corpus, which is ok for now because this helps us determine the retirement corpus on a conservative basis.

The idea, of course, is to understand personal finance so well that we can plugin things as we progress and eventually get the corpus number right.

In the previous chapter, we figured that we need roughly 7Cr by retirement; in this chapter, we address the technique to generate the same. It must be quite evident to you by now that to create the retirement corpus by the target retirement year; we need to make investments starting today.

The investments that we make today should ideally spread across multiple assets. This is called the multi-asset portfolio, which includes – fixed deposits, gold, real estate, equities, cash, and cash equivalents. The overall growth that you experience will then be an aggregate across all these assets.

Let me explain a bit more before we get back to the retirement problem. Assume your net worth is distributed across multiple assets –

  • 30% of your net worth is invested in real estate
  • 8% of your net worth is in the fixed deposit
  • 8% of your net worth is from gold
  • 13% of your net worth is in equities
  • Cash is 4%

The numbers assigned are all arbitrary, to drive the concept, so donโ€™t sweat over it ๐Ÿ™‚

Now, each of these assets grows at a specific rate. Needless to say that the growth rates differ for each of these assets. The question is, what is the overall growth given this portfolio of assets?

To answer this, we need to have an expected growth rate for each of these assets.

My long term (10 plus years) growth expectation (CAGR) from these assets are as follows โ€“

  • Real estate โ€“ 8-10%
  • Fixed Deposit โ€“ 6-7%
  • Gold โ€“ 8-9%
  • Equities โ€“ 10-11%
  • Cash โ€“ 0% (in fact cash de grows if you consider inflation)

You can develop your own opinion on the growth rates for these assets by looking at the long-term trends and by developing an idea on their future performance. But here is an advise, when you work with predictions/projections of any sort in personal finance, always keep the number on a conservative basis.

For example, frankly, I know equities, in the long run, will do much better than 11% CAGR, but Iโ€™ll work with a 10-11% range. The advantage here is that you build a future based on conservative assumption, anything better is only a bonus.

Anyway, the overall portfolio growth in the sum product of the weight of each asset and the expected return. Therefore โ€“

= 30% * 10% + 8% * 7% + 8% * 9% + 13% * 11% + 4%* 0

= 8.3%

So as you can see, the combined (diversified) portfolio with multi-assets, generates an overall return of 8.3%.

Of course, change in asset allocation has an impact on portfolio growth. We have discussed this multiple times, wonโ€™t get into that discussion now.

By the way, check this to know how people generally divide their net worth across a diverse set of assets โ€“

The infographic above mainly talks about the HNI and above category; however, if you walk into any financial planning firm, you are likely to get a somewhat similar diversification plan.

While a multi-asset portfolio is highly desirable, we won’t get into that discussion just yet. This is slightly complex, and we are too early in this module to talk about it.

For the retirement problem, we will make one fundamental assumption. The assumption is that we will look at only equity for building the retirement corpus. The exposure to equity is in the form of making systematic investments in a growth-oriented equity mutual fund.

If you do not understand โ€˜systematic investments in a growth-oriented equity mutual fundโ€™, then do not worry. Going forward in this module, we will discuss this in detail.

Since equity is the only asset we are dealing with in this retirement problem, we need to assign an expected growth rate to this asset. I think a 10-11% CARG is a fair expectation, especially when the holding period is long, i.e. more than ten plus years.

So letโ€™s work with this number for now.

5.2 โ€“ The setup

A quick recap of the retirement problem, before we proceed. In the previous chapter, we figured that we need funds to the tune of 7Crs to lead a comfortable retired life. We call this a retirement corpus. We defied โ€˜comfortableโ€™ by ensuring we have at least Rs.50,000/- per month for the 20 years post-retirement.

The next step is to figure out how one can generate a retirement corpus. Remember, we are starting our journey to save for retirement today, and we have 25 years to build this corpus. Twenty-five years is 300 months.

For now, we will rely upon investing in an equity mutual fund, in a systematic way to generate this retirement corpus. To solve this problem, we need to make a few assumptions. They are โ€“

  • We have a steady job which pays us a salary every month
  • We are employed until the year of our retirement
  • Our primary savings vehicle is regular investments in equity mutual funds
  • We get yearly hikes in our pay
  • Every year we will increase the investments in equity mutual funds by 10%
  • The increase in savings happens every January

I know many of you may be concerned with these assumptions here, especially about the job and the hikes, but then, thatโ€™s an underlying assumption, without which we cannot proceed ๐Ÿ™‚

So how do these assumptions translate to action? Here is how it looks โ€“

Let me explain this table. The very first row reads like this โ€“

It is January, and Iโ€™m making my very first investment of Rs.5000/- today. I won’t be touching this investment until I retire, which is 25 years away or about 300 months away.

The 2nd row reads similar โ€“ Its February, Iโ€™m making the 2nd savings installment for the year, i.e. Rs.5000/-. Retirement is now 299 months away.

I want you to recognize the fact that the โ€˜months awayโ€™ can be looked at from a different perspective. If you realize, these are the number of months during which your money can grow. For example, the very first installment you make has the luxury to build (or compound) for 300 full months. The next month’s savings can grow only for 299 months, 3rd installment has only 298 months to grow. So on and so forth.

Now, the 5th and 6th assumptions state that we are increasing the savings rate by 10% every January. ย This means, if we are starting with Rs.5000/- for year 1, the 2nd year we bump this up by 10%, hence for the 2nd year we invest Rs.5,500/-.

This is how it looks โ€“

The month counting continues the same way. For example, the Rs.5,500/- investment we make in the 2nd year January has only 288 months to grow or compound.

I hope you get this flow for now.

So what happens after you make these investments? Well, as per the assumption, each of these monthly investments we make, grows at 11% CAGR (compounded annual growth rate), for the respective months.

For example, the very first investment that we make, i.e. Rs.5000/- gets to grow at the rate of 11%, for 300 months. So what would be the value of this investment at the end of 300 months?

Well, by now, you should recognize that we can apply the concept of the future value of money and get the answer. The future value of money formula is โ€“

Future value = P*(1+R)^(n)

Where,

Principal (P) = Rs.5000

Growth rate (R) = 11% per annum

Time (n) = 300 months. However, this formula considers time in years. Hence we need to express 300 months in years, therefore 300/12 = 25

= 5000*(1+11%)^(300/12)

=Rs.67,927/-

Let us do this for the 2nd installment as well; everything stays the same except for the time component โ€“

= 5000*(1+11%)^(299/12)

=Rs.67,339/-

This is how the table looks โ€“

Now, if you add up all the future values, you get the corpus accumulated for your retirement. Before I show you the number, what is your guess? Does Rs.5000/- as the starting amount make the cut? Do you think it gives you the target corpus of Rs.7Crs?

If you are doubtful, then you are right. It does not cut the mark. It’s way off the mark โ€“

 

So what should we do? How do we ensure we reach the target retirement corpus? Well, we can do three things โ€“

  • We save for a much longer period, say 30 or 35 years. However, this may not be viable as we wonโ€™t have a sustainable source of income for these many years
  • Increase the rate of return, maybe from 11% to 14%, but then is like robbing yourself of your future. So we wonโ€™t commit this sin
  • Increase savings, this means a frugal life today for a comfortable and financially independent life tomorrow. This is an option we can work with this.

So from saving Rs.5000 per month, let us bump this up to say Rs.15,000/- per month. Here is how the numbers stack up โ€“

There is a significant improvement, but still not close to the 7Cr mark. We can try this with Rs.20,000/-

As you can see, starting at Rs.20,000/- per month, we get close to the 7 Cr mark, which upon retirement will yield us Rs.50,000/- per month for 20 years.

5.3 โ€“ Are you serious?

Saving Rs.20,000/- a month, that too as a starting amount may sound crazy to many, especially for people who are just starting their careers. After all, youโ€™ve just started your career, started seeing a steady cash flow, and you are expected to park the bulk of it for retirement?

How fair is that?

Before it demotivates you any further, let me tell you. It is not all that lousy ๐Ÿ™‚

Let me make an assumption here; if you are starting your career now, then probably you are 24 or 25 years old. This means you have a long runway before you retire. Even if you retire by 60, you mostly have 35 years to retire.

Out of these 35 years of service, even if you invest for 30 years, you will be placed much better. You can choose to start with Rs.10,000/- per month. Check the snapshot โ€“

Starting your career early, gives you two powerful levers to operate โ€“ time and money. You can start with a small amount and build on it, eventually, it will yield you a similar result.

What if you are in the middle of your career and you are looking at retirement sometime over the next 10 or 15 years? Well, unfortunately, you do not have many options expect to save large chunks of your cash flow.

But remember, this entire conversation is an oversimplification to help us get started. There are many angles to this story. For example, you may acquire property by inheritance, which earns you a rental income for the rest of your life or you can get a huge lump sum amount at retirement, thanks to PF and stuff. This retirement amount gets parked in a savings account or a fixed deposit, which gives you yearly cash flow.

The objective of this module is to help you solve this puzzle so that you can plan your financials efficiently for yourself and your family.

5.4 โ€“Next step

Irrespective of the lump sum cash or a yielding rental property landing up in your lap by retirement, investing in equity is something that you cannot miss. I firmly believe that ‘equity’ as an asset class will outperform all other assets and shine through. Equity has to be a part of your long term portfolio.

The best way to gain exposure to equity is by investing in mutual funds via a systematic investment plan. Of course, there are many other variants and techniques for this.

Given this, over the next few chapters, we will deep dive into mutual funds and get a thorough understanding of mutual fund investing. This discussion will include things like developing a mindset for mutual fund investment, building a mutual fund portfolio, goal-based portfolio, fund analysis, direct vs regular, growth vs dividends, etc.

Once we understand mutual funds, we will steer our way to learn other critical components of personal finance such as life insurance, health insurance, pension funds,ย  EPF, ETFs etc.

So as you can imagine, we have a long learning path ahead ๐Ÿ™‚

Key takeaways from this chapter

  • In a multi-asset portfolio, the aggregate portfolio return is the sum product of the asset weight and the assetโ€™s expected returns
  • Equity exposure is a critical component in long term wealth creation
  • Investing small amounts of money regularly leads to a massive retirement corpus

 

 

55 comments

  1. Kunal G says:

    I have read all of your varsity modules!
    I’m eagerly waiting for the mutual fund education. There are a lot of mutual funds out there and which makes it confusing to know where to park our money into. And how much tax do we have to pay for the interest we receive every year.

  2. Punith says:

    Hi Karthik,

    You have listed the importance of savings and investing your savings in a very effectively manner, The point I wanted to add was we even have PF’s which will also add a significant contribution to our final corpus – Do you like to and any points on the same.

  3. Govil Bhole says:

    The only drawback of Varsity is that you have to wait eagerly for the next chapter. I wish you can start like Binge reading in varsity!! ๐Ÿ™‚
    Great content Sir!!

  4. Mohammed Jidin MP says:

    Personal Finance is a much needed subject on wealth creation. Zerodha understood the need for such module and presented it in a simplied manner. Hope this module will covers all the relevant asset classes. Keep going Zerodha.

  5. DILIP says:

    Sir, Thanks a lot for nice explanation.

    There are 2 sheets are already available , however rest are not.

    With Regards,

  6. Satyam says:

    Thanks Sir, for sharing these insightful information. You are doing a great job. Keep going..

  7. Ram says:

    Agreed with Govil, Karthik its like I get up everyday with the expectation that you will upload a new chapter but I have to go with despair every day. Karthik please………….! ๐Ÿ™‚

  8. Pritesh Jadhav says:

    Hi Karthik thanks for all the knowledge and wisdom that you are sharing with us.But I would like to ask a naive question With SIPs we are building our retirement corpus or some goal purchase like luxury car after 20 years.But our investments will be attracting LTCG @10% suppose my goal amount is 1Cr in 20 years I can build that at nearly 7K per month at 15% CAGR my total investment will be 16 lakhs which means I will gain 84 lakhs so how is tax calculated on such investment is it calculated yearly or only when I have to do redemption does it mean that at 10% I will be paying 8.4 lakhs on the wealth that I built slowly and working very hard or is there any smart way around.Also how is indexation benefit availed is it applicable for all investments or only selected types of investment??
    And last but not the least thank you team Zerodha you have amazing apps and services varsity,kite,coin and many more๐Ÿ˜๐Ÿ˜๐Ÿ˜

  9. Shiva Teja says:

    May i know how many lessonns there are going to be in this module , also the number of modules you are going to make ?

  10. Sanu says:

    Is there a way to label my mutual fund investments with goals? For e.g. Aditya Birla Sun Life Frontline Equity Fund – Direct Plan – Growth—> House, Nippon India Low Duration Fund–> Vacation etc. This would really help track our investments based on different goals

  11. Vibhor says:

    Hi

    Similar to other modules, can we also have a downloadable pdf available for ‘Personal Finance’ module ?

    Thanks

  12. Abhishek says:

    Hi Sir,

    Any reason on why to increase sip by specifically 10% every year or was it just an example?

  13. Kumar A says:

    Your retirement corpus calculation is not correct. You have not escalated current monthly expenditure 50k with inflation rate to get expected monthly expenditure when person retires. You assumed same expenditure at retirement age and then taken inflation rate for post retirement period. Secondly, post retirement if one invest the retirement corpus in bank @7% then inflation at that bulk amount will be taken care by this bank interest. Thirdly, you are expecting that after life span is over the person will leave a big amount to his nominees. Whereas the value of retirement corpus will be reduce drastically from 7 Cr, if you consider as diminishing balance and will become zero after his demise. For safety life span can be taken 5 year more if felt by anybody.

    • Karthik Rangappa says:

      Kumar, I’m aware of all these points. It is just that I dint want to complicate the retirement problem at the start of the module. The idea is to introduce different concepts and then revisit the problem again for better understanding. For this reason, in the chapter, I’ve mentioned that the solution is an oversimplification.

  14. Abhishek says:

    Hi Sir.
    Can we trust mutual funds for such a long time and put big chunk of our income in such schemes for this long?

    • Karthik Rangappa says:

      Yes, they are all highly regulated entities. So far there have been no bad incidents in the MF industry, so we all hope for the best ๐Ÿ™‚

  15. Kumar A says:

    Thanks Karthok. I understand & appreciate your point.

  16. Kumar A says:

    * Karthik

  17. Vivek says:

    Hi Karthik,

    Great work with all the modules. I couldn’t find the link to download the corpus estimation excel sheet. Can you please share the link here.

    Thanks

  18. Vivek says:

    Thanks for your response. I’m looking for the excel file to check the accumulated corpus values with different initial conditions. I understand the PDF will only be published after the completion of the module.

  19. Sumanth says:

    Hi,
    Don’t you think that the corpus of 7Cr will also keep growing year over year? And considering the growth rate of 8.3% illustrated in this chapter (with the asset allocation) will generate 58L annually. Whereas the requirement at the first year of retirement is barely 20L. So, the return of 38L is added back to the corpus of 7Cr. Isn’t it a very conservative (or safe) approach to build such a huge retirement corpus which also seems to be impractical? In my opinion, 3Cr corpus is good enough to generate 25L returns and after expenses of 20L still has a surplus of 5L which goes back to the corpus. Am I wrong in my assumption?

    • Karthik Rangappa says:

      Sumanth, yes, that matters and there are other angles to this as well. I’ve kept it straight forward for now, as we develop more and introduce more concepts, we will reintroduce the retirement problem and rework on it. This chapter is to just kick start the thought process.

  20. Sumanth says:

    Hi Karthik,
    Thank you for the clarification. Look forward to understand the other angles and concepts

  21. Narana says:

    Hi Karthik,
    Most of the expenses (school fees, clothes, shoes, electronics, restaurants, vacations, fuel) go down after retirement. Also inflation is not applicable for every product. If we closely observe, mobile phones, TVs, Laptops, clothing, shoes, cars and for many things , prices have not increased since 2005. Rather reduced. I agree on food inflation but that’s not more than 10%-15% of total costs. So, will it not make sense to calculate retirement requirements taking a inflation of not more than 1%-2%. Even if we are at par with USA in next 20 years, just look at the cost of things in USA. Its not that expensive. If some one is able to buy a house for retirement in 30s and 40s, shouldn’t such retirement targets scare him than help him…..My question is should we reduce the targets for retirement?
    I am in mid 40s and would like to start trading in options . I want to become more of an option writer. Just finished 4 modules on Analysis, Futures and Options . Tonnes of thanks to you. Taking full advantage of COVID situation. I am NIT passout ECE, working in Sales and Marketing. A doubt keeps coming in my mind , whether its a right age to start Option Trading ? Even if I am able to make 1Lacs/month , that would not be able to replace my current income. Suppose I religiously trade in options for next 2-3 years, is it possible to generate a net income of 2L-3L/month after few years? How much investment is needed to generate this level of income ? Will it make sense to sell a flat and plot ( which is any way seems to be dead investment) and put it into options ?
    rgds/Narana

    • Karthik Rangappa says:

      Narana, of course, it makes sense to factor in inflation and a lot of other parameters before factoring in retirement. The one that I’ve put up here is to help start the train of thoughts. We will revisit this topic when we have sufficient knowledge of various components that make up a retirement plan, guess I’ve mentioned it towards the end of the chapter as well.

      As far as options writing is concerned, all one needs is a month like April to wipe out all gains made along the year. Its very tricky and can be really hard to replace your main source of income unless you do it with a ton of capital and have a significant amount of risk management. Selling your property for this is a really bad idea. Even if its a dead investment, your capital is safe, with options, that can also get wiped out in a month ๐Ÿ™‚

  22. Narana says:

    Thanks for the advise. I may start with a small capital of 15Lacs for 1 year and then see how it goes.

    • Karthik Rangappa says:

      Good luck, Narana! Hope this works well for you. Let me know if you have any questions with regard to options trading.

  23. Divyam says:

    1)why do u believe equity as a class will outperform all others?I have seen lot of graphs which say the gsec bonds have over 25 years done almost as well or better then nifty?
    2)dor retirement calculation,we should convert all our calculation to money we will require to earn by end of working life-because in 20 years to retirement it can still give significant interest?

    • Karthik Rangappa says:

      1) Over a long period, equities have always outperformed. Of course, this was challenged in recent times when even the 10-year SIPs went -ve.
      2) Yes, but we have no insights into the interest rates, right?

  24. Divyam says:

    Sir,but asa rule we should never extrapolate the past to the future.There has to be independent reasoning to predict future trends?

  25. Gaurang Joshi says:

    I did not get this —-
    = 30% * 10% + 8% * 7% + 8% * 9% + 13% * 11% + 4%* 0
    = 8.3%
    How you got it..Please explain..

    Still the excel sheets used in above chapter are missing…Kindly upload those excel sheets for easy reference…

  26. Shubham says:

    Although, I already know what are these things mentioned in this chapter but i just loved the way you have explained it in so simple language.

  27. Rani says:

    Hello Sir,

    Heartfelt appreciation your superb initiative for spreading financial literacy.

    AS we are talking about retirement problem, what do you think about NPS. NPS also gives 50k additional limit under 80C and can have equity portion upto 75 %.

    Isn’t it must to have in portfolio?

    Are there any drawbacks to it.

  28. Sachidananda Pradhan says:

    I do not get it how did you calculate the total growth rate to be 8.3% ?
    It happens to be 5.71% ?

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