Sunday, January 10, 2010

Be well planned for early retirement

The trend of retiring early is catching up, thanks to increasingly demanding working conditions and ample savings and investment avenues. The emerging trend has also got a boost from the expansion in self employment opportunities in the services sector, which has emerged as the driver of the Indian economy.

Recently, around 101 Indian Air Force pilots applied for early retirement citing suppression, emotional and medical grounds as reasons for their untimely decision. This trend of getting retired early in life is not limited to government organisations but has spread to professionals working in the private sector as well.

So, how feasible is the idea of early retirement? Can an urban professional save and invest in a manner that will enable him to retire in mid-40s without fretting over the next payment of his home loan installment? While searching for an answer, we at ET Intelligence Group worked on various scenarios of income, savings and return on investments. Read on.

SCENARIOS: Every working professional has his own reason for seeking an early retirement. For some it’s the boredom of modern office that pushes them to consider it, for others it’s the calling of their passion that becomes irresistible after a time. However, dreams can’t be realised if not backed by resources. So, for our analysis, we built three scenarios of income or salary. They are further divided in three savings and investment style that yields vastly different corpus at the end of the planning horizon (see the chart below). For simplicity let’s assume that a professional starts his career at the age of 25, and he wishes to retire at the age of 45 from job.

The person will have to draw a savings-cum-investment strategy with a 20-year planning horizon. Fresh out of university and living on a shoe-string budget, means lower savings. But as he progresses in life and realises the responsibilities that lie ahead and the desire to retire early, he progressively increases his savings. We have assumed that in the first 10 years of the career he saves 25% of his savings and raises it to 40% by the time he turns 35. Further, we also assume that in the first period the salary increment is 20% p.a., which declines to 15% p.a. in the second half of the working life. The assumption is based on the belief that in the first few years of career, professionals usually do job hopping to improve their earning but later they tend to settle down in a comfortable job.

Now let’s divide professionals in two sets. First: who earns less per month but has no big-ticket financial burden such as home, education and car loans to repay. Second: Those professionals who draw bigger salaries but are saddled with financial commitments in the form of monthly installments toward at least one major loan. Let’s assume that a professional in the first case starts his career at the age of 25 with a monthly salary of Rs 20,000 per month. The second professional, however, is luckier and draws a salary of Rs 40,000 in his first, but higher income in turns induces him to buy a house on loan which comes with an EMI for 20 years.

THE EXPLOITS: The summary of the results of the calculation is shown in the adjoining chart. If say Mr A starts his career with a monthly income of Rs 20,000 and his income and savings grow as assumed above, his corpus would grow to Rs 4.6 crore at the end of 20th year, i.e., when the person turns 45. The calculation is, however, based on the assumption that the person takes risk and invests in riskier but rewarding assets, such as, equity. In case he sticks to traditional investment avenues, which yield annualised returns of 8%, the corpus would be Rs 2.4 crore at the end of 20th year.

In comparison, Mr B who began his career at Rs 40,000 per month but is saddled with big loans would be able to build a nest egg worth Rs 9.35crore at the end of 20th year, provided the investment grows at 18% p.a. Now the next question to ask is whether the nest egg is sufficient for the person to retire at the age 45. This depends on the combination of the following factors – the person’s expenses, the expected recurring cash flow from the corpus, the postretirement plans of the individual and inflationary expectations in future. For instance, Mr A’s expenses are around Rs 36 lakh per annum in the 46th year and are likely to grow at the rate of 5% per annum due to inflation.

In comparison, an investment of the entire corpus of Rs 4.6 crore in fixed deposit will yield him fixed annual cash flow of Rs 37.4 lakh assuming an 8% yield. So initially, the investment income will sustain him, but as the second chart shows as time passes, investing in fixed deposits only will lead to a shortfall as its doesn’t provide protection against inflation. He has two options to fill this gap. Choose a post-retirement activity, which is both fun and yield a regular income. The other option is to invest a part of the corpus say 50% in high dividend yielding stocks.

Dividend payout from companies grows in tandem with growth in profits and provides a good hedge against inflation. In our calculation we have made two assumptions— the initial dividend yield on equity portfolio is 2.5% and that future dividend growth is 15% per annum. The results are plotted in the chart below. It shows that dividend income has the potential to not only fill the gap but also provide a surplus as time goes by.

CONCLUSION: As the above calculations show, theoretically it’s possible for a typical middle class professional to retire early, but it can never be guaranteed. To be successful in his plans, the individual should have generous income, a frugal lifestyle and highly and should be focussed in his savings and investment strategy. Some luck would also help as it not easy for an asset class to deliver to 18% returns over a 20-year period, though not impossible as many stocks have shown in last 20 years. The entire project would, however, be like a breeze if the person inherits a fair amount of wealth or post-retirement activity turns out to be financially lucrative.

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