When calculating the FIRE number, one rule of thumb is to simply multiply your annual expenses in the first year of retirement by the number of years of retirement. The number of your retirement years, in effect, becomes your expenditure cover multiple.
If your annual expenses in the first year of retirement are ₹10 lakh and you intend to be in retirement for 40 years (assuming a retirement age of 50 and life expectancy of 90 years), you’d need a cover of 40 times, which translates into a FIRE number of ₹4 crore.
But what if you decide to retire earlier and the number of your retirement years is longer? Do you need a higher or lower cover multiple than the number of years in retirement?
A study co-authored by Rajan Raju and Ravi Saraogi goes beyond the basic thumb rules of calculating corpus cover and the rate at which funds can be withdrawn for income during retirement, digging deeper into what can be considered as a safe corpus cover for early retirees.
An analysis using the Monte Carlo method involves running simulations on inflation and market return data over a 20-year period to project a safe withdrawal rate for the retirement corpus. The withdrawal rate can be used to determine the corpus cover required vis-a-vis the first year of expenses – the higher the expense multiple, the lower the withdrawal rate and vice-versa.
The study has some interesting findings. It shows that the required cover multiple ends up being slightly lower than the number of retirement years when the number of years in retirement is sufficiently long.
Early retirement cover
Saraogi, co-founder of Samasthiti Advisors, explains that when the retirement period is longer, the compounding process becomes more powerful, and the sequence of return risk is lower because the portfolio gets more time to recover from any bad sequences of returns.
For example, if a person has to spend 50 years in retirement, he or she requires a corpus that is 48 times the expenses in the first year of the retirement period. The required cover multiple varies across a range of post-retirement periods (see graphic).
In the example of someone retiring at 40 years with a 50-year post-retirement period, the safe withdrawal rate for income in the first year works out to 2.1%. The withdrawal rate in subsequent years will be influenced by the impact of market returns on the portfolio as well as inflation pushing up annual expenditure. Hence, such an analysis is aimed at finding the safe first-year withdrawal rate or the corpus cover multiple to the first year’s expenditure.
Also read: Plan to retain your Employees’ Provident Fund balance after retiring? Read this.
Keeping FIRE alive
But what if the retiree not only wants the corpus to last over the post-retirement period but also keep its value intact in real terms – after adjusting for inflation? In that case, the cover multiple will rise steeply.
Taking the same example forward, when the individual retires at 40, with 50 years of post-retirement, the cover multiple required is 65 times the expenses in the first year of retirement.
The cover multiple increases because the corpus needed is much larger to take care of withdrawals and retain the value of the corpus in real terms over the retirement period. Due to the larger corpus size, the withdrawal rate slips to 1.5%, allowing a larger part of the corpus to remain invested and compound.
The simulations consider returns from a 50:50 equity-debt portfolio over the past 20 years. Even if the post-retirement period increases, the expenditure cover multiple remains stable at 65. Saraogi said this is not uncommon.
“International studies also show that there is a floor level safe withdrawal rate for certain combinations of inflation and projected returns on the corpus,” he said. “The multiple number will change if we change inflation assumptions. In our case, we have taken 4% inflation to calculate the real value of the retirement corpus at the end of the retirement period. For other combinations of inflation, we may not arrive at a stable solution like 65 times. This is a peculiar case, where a combination of 4% assumed inflation and projected return is giving a stable solution in simulations.”
Takeaways
The table above can be used to plan your FIRE or early retirement corpus. If your current age is below the target retirement age mentioned in the table, you would need to factor in the impact of inflation (let’s say 5% inflation rate) on your current expenditure.
For example, if your current age is 30 and you want to achieve FIRE by 40, you should inflate your current expenses by 10 years and then use the expenditure cover multiple in the table to arrive at your required FIRE corpus.
When it comes to planning for FIRE or retirement, it is prudent to be slightly conservative because there are many uncertainties that can never be fully factored in – in terms of both market and economy-linked variables.
Remember that no simulation or analysis can be 100% foolproof. The analysis comes with a 95% success rate, which means there is still a 5% probability of failure.
The safe withdrawal methodology accounts for various combinations of inflation rate and returns based on past data to simulate what withdrawal rate or expense multiple would be ‘safe’ to start one’s retirement journey. The simulations use past data, while inflation and return on investment in the future may still vary.
“Often, we have seen clients erring in terms of overestimating portfolio returns due to recency bias or underestimating the impact of inflation when calculating their retirement corpus,” said Vishal Dhawan, founder of Plan Ahead Wealth Advisors.
Also, the retirement calculations in these analyses don’t account for unplanned spending like medical expenses. For medical expenses, an adequate health insurance cover can be taken, or a separate medical corpus target can be created in one’s financial planning.
Higher education costs for the children are not accounted for either. These costs would vary widely, depending on the chosen stream of education, public or private college, domestic or overseas education.
Also read: How this dentist is saving for his retirement and his son’s education
