In one of my earlier articles, Retirement Investing - I : The Accumulation Phase, I mentioned that the amount an individual requires for retirement can be given as follows :
Required Corpus = Current Annual Expenses * Years post retirement
In other words, someone who wants to retire at say age 55 with a life expectancy of 90 would need a corpus worth 35 times their annual expenses at age 55 for retirement. This formula is given based on the concept of zero real returns. It assumes that long term post tax portfolio returns would be equal to the inflation rate experienced by an individual over their lifetime. Such an assumption may seem overly conservative. Some may even call it illogical. But the concept of zero real returns is backed by prudence and sound logic. And this is what I am going to throw light on in this post.
To set the stage for the concept of zero real returns, we first need to understand what real returns are. When assessing investment returns, we tend to look at nominal returns from products in our portfolio. Nominal returns are the returns we talk about in everyday conversations. For example, assume a mutual fund in an individual's portfolio has generated a return of say 10%. This is the nominal return of the fund.
But nominal returns do not account for the effects of taxes and inflation. Therefore we need to look at real portfolio returns in order to holistically assess performance. Real returns are given by the formula in the graphic below.
In the graphic above, the term nominal rate refers to post tax portfolio return. To understand how real returns are calculated, look at the illustration below.
Pre tax portfolio return = 10%
Tax rate = 30% or 0.3
Post tax portfolio return = 10 (1 - 0.3) = 10 (0.7) = 7% or 0.07
Inflation = 6% or 0.06
Post tax real return = [(1 + post tax portfolio return)/(1 + inflation rate)] – 1
= [(1+0.07)/(1+0.06)] – 1
= 0.0094 * 100
= 0.94%
The resultant figure of the real return calculation can be interpreted as follows :
Real return < 0% : Purchasing power is lost
Real return = 0% : Purchasing power is maintained
Real return > 0% : Purchasing power is increased
Therefore the real return figure is what we really need to look at to get a realistic understanding of how our portfolios are doing. A long term non negative real return would be acceptable (albeit very hard to achieve) when investing for our goals.
The assertion of zero real returns states that post tax portfolio returns over our lifetimes would be equal to inflation. The approach therefore allows us to ignore inflation and investment returns. To understand the logic behind the concept of zero real returns, look at the illustration given below.
Consider the case of an investor who falls in the 30% tax bracket. He invests 25% of his portfolio in each of the following asset classes :
1. A Nifty 50 index fund
2. Fixed Deposits in the safest of large scheduled banks
3. Debt mutual funds
4. Residential real estate
He maintains this asset allocation (25% to each of the 4 asset classes) over the long term. Headline inflation is assumed to be 6%. Assumed post tax returns from each asset class are given below :
Nifty 50 index fund = 9%
Fixed deposits = 5%
Debt mutual funds = 7%
Residential real estate = 6.5%
Average post tax portfolio return = 6.875%
Accordingly, real returns from each of these asset classes (using the real return formula discussed above) are given as follows :
Nifty 50 index fund = 2.83%
Fixed deposits = - 0.94%
Debt mutual funds = 0.94%
Residential real estate = 0.47%
Average real portfolio return = 0.825%
The resultant average real return figure of 0.825% means that the individual's portfolio is expected to beat inflation by 0.825% over the long term. But this is based on the following assumptions :
1. The investor is rational and never becomes overly greedy or fearful.
2. The investor does not commit any unforced investment errors throughout their journey.
3. The investor does not face a prolonged bear market or market crash for the entirety of their post retirement period.
These assumptions rarely turn out to be true in the real world. Therefore it is virtually certain that the real returns enjoyed by the investor would be lower than calculated. But it would be hard to precisely estimate the quantum of the reduction. It would hence be prudent to assume that real returns from our portfolios over our lifetimes would be zero.
The assertion of zero real returns comes with the following implications for investors :
1. Assuming a life expectancy of 90 years, we would require a retirement corpus worth current annual expenses * (90 – intended age of retirement). For instance, a 55 year old individual who wishes to retire today would face a post retirement period of 35 years. They would therefore require a corpus worth 35 times their current annual expenses for retirement.
2. Assume an individual begins investing for retirement at age 30 with an intended retirement age of 60. In such a case, they would need to invest an amount equal to their current annual expenses each year for retirement. This usually implies a savings rate of 50% of their lifetime post tax income for retirement. Those who start investing for retirement after 30 would have to maintain an even higher savings rate. The same is true for those who aspire to retire before age 60.
3. There is no scope for unforced investment errors when building our retirement corpus. Examples of such errors include :
A. Concentrating exposure to a single product or asset class
B. Investing in unregulated products such as cryptocurrencies
C. Investing in complex, high cost products such as PMS, AIF, investment cum insurance policies, regular plan mutual funds etc
The primary way to mitigate this risk is to diversify our investments across asset classes. We must invest in simple, regulated products that are easy to understand.
4. Higher investment returns cannot compensate for inadequate savings. Individuals may try to make up for not saving enough by using a higher equity allocation. This may increase expected returns from the portfolio. But a subsequent market crash and/or prolonged bear market can decimate the portfolio. Most individuals may not be able to psychologically cope with such an eventuality. They may then reduce their equity allocation. They are therefore likely to generate lower investment returns over the long term.
5. It is vitally important to be conscious of costs when picking products for our portfolios. Small costs compounded over long periods of time would significantly reduce the value of our investments. For instance, regular plans of most large cap mutual funds in India charge an expense ratio of 2% per annum on average. Investors are constantly pushed to purchase such funds. Compare this to direct plans that charge a more reasonable 1% per annum on average.
The incremental cost of 1% in case of regular plans would result in 26% of the investment being lost over 30 years. We must therefore focus on keeping investment costs and fees as low as possible.
To understand the underlying calculations for retirement planning using the zero real returns approach, have a look at my earlier article, Retirement Investing - I : The Accumulation Phase (linked at the beginning of this article). But I hope that it is clear by now that the assumption of zero real returns is very much logical even though it seems overly conservative or illogical. We therefore have enough reason to abide by the assumption when charting out our retirement calculations.