dosanomics and financial independence

Raghuram Rajan's dosanomics became quite popular; and he is a smart person. Nominal rate is the sum of real rate and inflation. Therefore, if you take out inflation from nominal rate, what remains is the real rate. 

And real rates are more important than nominal rates. For instance, if you earn 10% on your investment, and inflation during the period was 10%, you have not moved forward; it is a status quo situation. However, if inflation was 11%, you earned a negative return. What it means is that looking at only the nominal rate of return in isolation is not a good idea. Inflation is an implicit tax on your returns. Ignore it at your own peril. That is why we like returns that beat inflation, rather than those that beat a benchmark such as the market index. If we are not able to retain our purchasing power, there is no point in harping about beating the index. If anything is worth doing, it is worth doing well.

So how does the dosanomics fair in terms of our wellbeing?

Mr. Rajan's thoughts:

He explains further:

Is it really so? Let's check out, especially for a retired person.

Let's have a retiree whose annual expenses are Rs.720,000 and assets are worth Rs.10 m. When interest rates are 8%, the retiree earns Rs.800,000; however, with a tax rate of 10%, the net earnings are Rs.720,000. 

Now, if interest rates come down to, say, 6% because inflation moderates to say, 5.52%, the financial equation for our retiree changes. After-tax earnings will be Rs.552 k with a lower tax rate of 8%. Annual expenses will be, nonetheless, higher than Rs.720 k; with 5.52% inflation, they will be Rs.759 k, leaving the retiree with a hole of Rs.207 k. 

Note that for the working people, with active earnings capacity, this may not impact much since annual earnings tend to compensate increase in costs, albeit at different levels.

It will get interesting next year. Even after assuming no change in rates, the hole gets bigger. The assets will be worth Rs.9,531,107. The retiree is clearly worse off.

There are two solutions to this: One is that the retiree should have had much higher assets to start with, which is to say, not to retire so soon. Another is to find an alternative source of income while retired; I guess that happens only by working again. 

This is exactly what someone asked Mr. Rajan:

And this is what he got:

The retiree with annual expenses of Rs.720 k, and with inflation of 5.4%, will have annual costs of Rs.1.2 m in ten years. How much will the earnings be by that year for someone who had assets of Rs.10 m? Not much compared to the costs.

Of course, there is a third solution to the retiree. That is to increase the gap between after-tax earnings rate and inflation. If after-tax earnings are say, 12%, the retiree should be fine. That would be possible only when assets are invested in equities rather than bank deposits. The problem here is that equity returns are not linear, because of which annual drawings may obstruct growth in equity in future years. You cannot rely on only equity returns for retirement, where you require stable earnings.

There is yet another solution: Reduce annual costs. That may be possible when the retiree chooses to live in a smaller, low cost place. 

Whatever the options are, dosaonomics may not be suitable for a retired person. Retirement is a key decision, and it is worthwhile to think about how much assets one should have before taking the leap.

Interest rates are moving downwards.

I would like to call it financial independence, rather than retirement. Whether it happens at 30, 40 or 60, the idea is to have sufficient passive income to be able to finance living costs. Working then becomes optional: you can sit on couch or beach, or take up work that interests you. You can even choose to be busy breathing in, breathing out. Earnings, if any, from such activity then are only incidental, not a requirement.