An expense multiplier is a better way to crack how much you need for your retirement as different families have very different expense behaviour
How much money we need to retire at age 60 can be answered in many ways. I wrote earlier (you can read it here: bit.ly/2ruHEtK) that you need eight times your annual income at age 60 to retire comfortably. Plenty of people wrote back to say that a more useful benchmark will be an expense multiplier rather than an income multiplier. An expense multiplier is, in fact, a better way to crack the same problem because at the same level of income, different families will have very different expense behaviour. I know families that don’t know where their money goes and others who have tiny expenses because of their chosen lifestyle. An expense multiplier assumes that you know how much you spend. Many families are clueless of their annual expense number—money comes in and money goes out. So get a hold on how much you spend in a year as a first step.
How much do you need? At age 60, you need 18 to 35 times your annual expenses to retire with the lifestyle you are used to. If you are spending an annual Rs12 lakh at 60, you need a retirement corpus of Rs2.2 crore to retire if you plan to eat up all the money and leave nothing for heirs. If you want to leave the entire corpus to your children, the same annual expense will need a corpus of Rs4.2 crore. If you plan to leave half your corpus, then you are targeting a corpus of around Rs3 crore. The younger you are today, the larger will be the corpus in the future, but the multiplier remains the same. You can inflate your current annual expense at an inflation rate of 6% to arrive at what you will be spending when you are 60 and then use the multiplier to see the face of your corpus. Hope it scares you into starting to invest right away.
Why this wide gap between the two numbers? There are two products in the retirement market we can use to do the math: an increasing annuity and an increasing perpetuity. Both assume that your annul expenses grow at a certain rate. I’ve taken an inflation number of 6% a year. In the annuity model, nothing comes back and your corpus exhausts at age 99. You hand over your retirement corpus to the annuity provider, and I assume you get an amount that increases by 6% each year till age 99. If you die before that, the money is not refunded to your heirs. I used the calculators on http://financeformulas.net/ to do the math. The other product is an increasing perpetuity. This is a product that gives you an infinite stream of income that also grows at 6% from a given corpus. Or, for the purpose of this piece, I can assume that on death, the corpus returns to the heirs.
You need to assume a possible rate of inflation and a rate of return on your retirement corpus to make this projection. Here is the interesting thing. The difference between using a 7% and an 8% return over the retirement period is double for the perpetuity. This means that you need twice as much money if you stay conservative with a 7% future rate of return (on an assumption of 6% inflation) than you would need if you nudged up the return to 8%. If I use a 7% future rate of return, then my annuity multiplier jumps to 21 times annual expenses at 60, and 70 times for the perpetuity. In rupees this means a 7% rate of return will need a corpus of Rs2.5 crore for the annuity and Rs8.4 crore for the perpetuity. I can use a higher 10% return number but it is better to be conservative in future return projections because post-retirement there are very few degrees of freedom left in reworking the math. Our takeaway is that we must target a real return of 2%. This means, whatever the long-term inflation trend line is, you must target a return of 2 percentage points over that. If inflation in India falls to a 4% trend line, then use a 6% return rate. The problem with this model is that India’s annuity market is undeveloped and good products are hard to find. Most people end up managing their own money using a mix of financial products.
How should you use this rule of thumb? First, remember that this is a rule of thumb. This means that it is a crude approximation of what you will actually need. For instance, if you plan to work beyond 60, then the corpus needed will shrink. If you have other sources of post-retirement income, say rental income, then the corpus needed is less. If you are working with a financial planner and can target a real return of 4%, that is a return that is four percentage points over the trend inflation rate, you can target a lower corpus.
I was speaking to a leading financial planner last week and she flagged an interesting behaviour change in her clients. More people are now worried about their retirement than the education and marriage of their children, she said. Sure they remain as prominent goals, but the over-fixation of providing for the children is now getting moderated by a pragmatism about funding their own retirement. Put retirement at the top of your goal set because whatever method you use—income or expense multiplier—the retirement corpus is a large number. The faster you start targeting it, the better it is. Don’t wait to get a large monthly surplus to begin. Begin with what you can and then keep topping it up. But start now.
Monika Halan works in the area of consumer protection in finance. She is consulting editor Mint and on the board of FPSB India. She can be reached at firstname.lastname@example.org.
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