Financial Independence, Retiring Early?
Reassess Covid Impact On Portfolio.
Those who have put into place a strategy for ‘financial independence, retiring early’ (FIRE) may be worried about how the current pandemic will impact their portfolios and returns and those who want to get on to the bandwagon may be wondering how to go about it. The following articles provides an in-depth perspective and course of action
Ranbir Singh and Alia Shah in their early 40s and late 30s had always had a dream of exploring the world. Hence, way back in 2016 they decided to retire early and sold their homes in Mumbai to set off on a world tour. At that time the equity market was recovering from demonetisation and was on the verge of a major upswing. Their plan to retire early and travel was unfolding as per their script. Although there were some hiccups in 2018 and 2019, these were manageable and did not perturb them much about their decision. But the world shook up with the corona virus-driven pandemic that led to a sharp downturn in the equity markets, thereby wiping off almost a quarter of their portfolio.
Singh and Shah are like many of the early adopters of ‘financial independence, retire early’ (FIRE) who have now got jittery and are questioning their decision about early retirement. It’s because the ongoing crisis has turned out to be a challenging time for many FIRE adopters and we may see some of the devotees of this strategy going back to job hunting. The pandemic has impacted people and businesses around the world like nothing has ever done before. There’s news everyday about layoffs and furloughs. India is no different. And the stock markets have reflected this unpredictable situation. In March 2020, S & P BSE Sensex tumbled to register a low of 25,639 from its all-time high of 42,274. This fall of 39 per cent was followed by a recovery of 46 per cent from the lows till date.
However, it is still 11 per cent away from reaching its previous all-time high of 42,274 from the current levels. It is not only the equity market that has affected investments. Many FIRE adopters who had parked their money in government saving schemes or fixed incomes are also witnessing a rude shock. To provide impetus to economic growth, the Reserve Bank of India (RBI) lowered the repo rate to its lowest since 2004. It has cut policy rates by around 115 basis points or 1.15 per cent in the last few months and is expected to continue with its accommodative instance. And as a result, the rates on small saving schemes too were slashed for the period of April to June. The interest rates on small saving schemes dropped on an average by over 1 per cent.
As can be seen from the above table, for almost all the popular small savings schemes, the interest rates have been drastically cut for the quarter ending June. Therefore, those who were expecting that their investment in fixed income would help them earn better and remain unscathed should get ready to earn a lot less compared to what they were used to. Both equity in the form of Sensex and fixed income in the form of small saving schemes got negatively affected by the pandemic. This will also have a similar impact on those who are on the verge of retirement or are retiring early with a FIRE strategy in place. With the portfolio of such investors decreasing in value, this article sheds more light on the pros and cons of FIRE and the impact of the pandemic.
Financial Independence, Retire Early (FIRE)
This is a lifestyle movement where people seek financial independence and early retirement. It involves extreme savings and investments that allow investors to retire way earlier than traditional financial plans and retirement plans would allow. The followers of the FIRE movement save almost 70 per cent of their income and invest in such a way that it eventually enables them to quit their jobs decades prior to the conventional retirement age of 60. They live solely on small withdrawals from their portfolios. This model has become quite popular among the millennial generation since 2010. In order to save up to 70 per cent of their yearly income, FIRE followers often begin by staying for several years in the traditional workforce. And once their savings reach approximately 50 times their annual expenses, which for someone with moderate lifestyle works out to about Rs 2 crore, they may quit their day jobs or retire completely from any form of employment. However, the above-mentioned figure is not fixed and would change from person to person.
The above graph would help you understand with the help of a basic formula what your FIRE number is. However, it is to be noted that every person is different and so are his or her expenses, lifestyle, spending habits, risk appetite, retirement year and returns expectations. Therefore, to arrive at your FIRE number, you need to first check for these factors and adjust your expenses for inflation. Further, it is not just your FIRE number but also the withdrawal rate that matters. Post retiring at a young age, FIRE devotees make small withdrawals from their savings to cover their living expenses.
Typically, they withdraw around 3 per cent to 4 per cent annually on an absolute basis. This means, irrespective of inflation and market conditions, they won’t withdraw more than 3 per cent to 4 per cent. If in case in a particular year they fall short to cover their desired expenses, they would rather cut down on their expenses instead of resorting to more withdrawals. Hence, FIRE requires extreme diligence to monitor expenses, maintaining the asset allocation and re-balancing the portfolio periodically.
Variations of FIRE
There are several styles in the FIRE movement:
✓ Fat FIRE: These are individuals with a more traditional lifestyle who save more than the average retirement investor.
✓ Lean FIRE: They strictly adhere to minimalistic living and extreme savings, leading to a far more restricted lifestyle.
✓Barista FIRE: They are the ones who quit their traditional nine-to-five job and engage themselves in some kind of part-time work to cover current expenses which otherwise would erode their retirement corpus.
✓Coast FIRE: They are ones who have a part-time job but also have enough corpus in their retirement kitty to fund their current livin expenses.
Impact of Pandemic on FIRE Portfolio
As discussed earlier, the virus pandemic has had a significant impact on the economy, equity as well as the debt market. As investment is made either in equity or in debt or in a combination of both and thus would have affected the FIRE portfolio too. To understand the extent of the impact, we carried out a study wherein we have taken an example of a person aged 30 who is planning to retire early with three retirement age possibilities – 40, 45 or 50. Further, we have assumed possible portfolios of 100 per cent equity, 75 per cent equity and 25 per cent debt, 50 per cent in equity and 50 per cent in debt, 25 per cent in equity and 75 per cent in debt and 100 per cent in debt. For illustration purpose we have taken S & P BSE Sensex as a representative of equity and S & P BSE 10 Year Sovereign Bond index as representative of debt.
We have also assumed the annual income to be Rs 12 lakhs of which 70 per cent (Rs 70,000) would be saved and invested in the possible portfolios on a monthly basis and 30 per cent (Rs 30,000) would be the monthly expenses. Further, while calculating the retirement corpus we have assumed pre and post retirement inflation rate to be 7 per cent with postretirement expected rate of return at 10 per cent and life expectancy up to 100 years age.
As can be seen from the above graph, no matter what your portfolio strategy is, you are not able to reach your targeted retirement corpus of Rs 2.07 crore. This suggests that you should either increase your retirement age or curtail your expenses further the during retirement period.
The above graph clearly shows that a portfolio with 100 per cent equity was about to achieve its target retirement corpus of Rs 2.81 crore but the pandemic’s impact pushed it below its target level. Here, you can continue with your investment. Possibly it would be wise to adopt tactical asset allocation than strategic asset allocation.
The above graph clearly highlights a perfect example of the power of compounding – when a person diligently invests, he can surely create wealth. And that wealth is not defined by how much rate of return he earned but rather how much time he stayed invested. In the above graph, almost all the investment strategies helped reach the targeted retirement corpus. Apart from 100 per cent debt, all other possible portfolios were able to accumulate much more than the targeted corpus. Even by taking low risk and investing 100 per cent in debt, one would have been able to achieve the desired corpus. This also dictates that no matter what your risk appetite is, you can certainly achieve the desired corpus target. Hence, keeping the retirement period a bit ahead is ideal for achieving the FIRE goal.
In the above illustration we observed the impact if you are retiring during the time of the pandemic. Further, it is also crucial to understand how your FIRE portfolio would turn out if you are starting your investment as of now. To understand this impact what we have done is to reverse the returns. For instance, if our period of study is from April 2019 to March 2020, we reverse whatever monthly returns the investment avenue generated. This is popularly known as the risk of sequencing returns. The below table would help you understand the same.
Therefore, in this way we would try to find out the impact of the pandemic on the FIRE portfolio if you start investing now (as of March 2020) as well as study the impact if you retire in the next 10, 15 or 20 years.
As can be seem from the above graph, it would be really difficult for you to retire in the next 10 years. Therefore, it is advisable that you should either defer your retirement further or curtail your expenses during retirement. To retire in the next 10 years, you will either need great returns or high investment amount.
The above graph illustrates that people following moderate to aggressive investment strategy were able to achieve their FIRE goal but conservative investors seem to be struggling to achieve their target. Hence, it is advisable to either defer the FIRE goal or increase the risk tolerance level to at least moderate. Further, if you wish to stick with your existing risk tolerance level, consider investing a higher amount to achieve your FIRE goal.
The above graph clearly shows that an investor with whatever strategy he adopts is able to achieve his FIRE goal and that is the case even if he is a conservative investor. Further, moderate to aggressive investors are able to accumulate quite a lot than the targeted retirement corpus of Rs 3.78 crore.
Portfolio Management Measures
Save your FIRE portfolio from the pandemic. As we have observed from our illustration above, the pandemic has surely impacted your FIRE portfolio if you already have one. However, those with their FIRE goal approaching in 20 years were comfortably able to achieve their target irrespective of the risk tolerance level. But they did miss locking gains when the markets were overvalued. So, now the issue is about how you should manage your FIRE portfolio. It would be more appropriate for you to manage it tactically.
This means that you should enter and exit from equity and debt depending upon equity market valuation and economic dynamics. Many mutual fund houses uses price to earnings multiple of frontline index to gauge the attractiveness of the equity market and accordingly do their asset allocation. We at DSIJ follow a combination of equity and debt market indicators to understand where to invest.
As you can see in the figure above, our proprietary equity sentiment index was able to give us the right calls. Based on the present economic situation and market dynamics, we recommend investing in equity, though not aggressively. Therefore, investing tactically and moving from equity to debt and vice versa would give your FIRE portfolio an added advantage.
Conclusion
The concept of FIRE is no doubt very alluring but it is also quite tough to achieve. It demands extra diligence and disciplined and constrained spending. Also, people who possess a splurging habit would find it difficult to achieve a FIRE goal. Even those who wish or are planning to retire early in about 10 years should either reconsider their retirement age or shed more out of their pocket. This holds true even for conservative investors. Also, we have observed that if you are planning to retire in the next 20-year period, you can do it easily irrespective of investment strategy and risk tolerance level.
Further, to get most out of your FIRE investment portfolio, we recommend adopting a tactical asset allocation strategy. This would not just help you achieve your targeted retirement corpus but also provide the right buffer to maintain your desired lifestyle post-retirement. The ongoing crisis, we believe, will lead more people to be well-prepared for the future. In our example above, Singh and Shah were geared for such a ‘black swan’ event and had set aside five years of their cash expenses in fixed income in case of a sustained downturn. In addition to this they had also decided on a conservative annual withdrawal rate of only 3 per cent of their portfolio.