The Salary Trap

Retired Indian Army major Dhyan Chand died alone and poor on Dec 3, 1979. He was an Olympic Gold medal winner not once, but three times. Awarded the Padma Bhushan, his statues stand in Vienna, New Delhi, and Medak. His birthday is celebrated in India as National Sports Day. Yet Dhyan Chand died alone and poor, away from media glare[1,2,3].

“But that won’t happen to me,” Venky, an IT pro, says confidently, “I am a software professional, earning a good salary, and the IT boom doesn’t appear to be slowing down anytime soon … even if there seems to be a temporary setback just now”.

The second part may be true, Venky, but the same technology revolution that is giving you high salaries will also lead you to Dhyan Chand’s end unless you take the proper steps right now. You may not have realized how the following two factors interact:

1. Salary income stops more or less entirely at retirement, approximately at age 60, but the technology revolution has pushed life expectancies much beyond retirement age.

2. The savings you have been putting aside (At least, I hope you have been saving. Have you been living off your credit card instead?) in bank accounts or fixed deposits will, in the long term, be crushed by inflation.

These are fairly well-known facts, but taken together they will likely lead you to a penniless future. It may be hard to visualize how they interact, so let’s build a numerical picture of your financial life. Although it will still be a simple model, I hope it will drive home the point of this article.

I will first explain some basic principles, then describe the model, and then chart its behavior.

Real Money

Because of inflation, one cannot directly compare the value of money in different years; instead, one uses real money value that discounts the effect of inflation. For example, if the rate of inflation is 10% per year, 100 Rupees today are equivalent in buying power to 110 Rs next year, or 260 Rs in ten years. A better way to look at this is to say that if you hide 100 Rs in the mattress today, its real value will shrink to 62 Rs in 5 years, 38 Rs in 10 years, 15 Rs in 20 years, and 6 Rs in 30 years!

Money is like mothballs: it evaporates with time. At 10% inflation, its half life is about 7 years.

That is, Ct Rupees t years in the future are equivalent to Cr Rupees today, given 100r percent inflation per year:

image001

Notice, for positive inflation r (prices going up), Cr is always less than Ct.

Compounded Annual Growth Rate (CAGR)

The same exponential behavior, but accretive rather than evaporative, can occur for your investments too. This is parameterized by the Compounded Annual Growth Rate or CAGR, and your money will grow from A0 to At in t years for a CAGR of 100c percent per year according to the next formula. Note that the power term is positive here.

image002

However, after taking inflation into account, your investment in real Rupees grows in t years to only Ar,

image003

Notice that whether the investment grows or shrinks in real terms critically depends on c being larger or smaller than r.

The Financial Model

We build a simple financial model of Venky’s salaried life:

Every year, Venky earns a salary, pays 30% income tax, spends 60% of his remaining salary, and saves the rest. One year’s savings plus any earnings during the year from his earlier investments are ploughed back into next year’s investments.

With time and hard work, Venky’s salary grows. His expenses also grow as he starts a family, but he lives within a budget of 60% of post-tax salary. After reaching middle age, his salary plateaus (See Peter’s Principle[4]). After a satisfying career, he reaches retirement age. He retires and then starts living off the earnings coming from his investments, managing his expenses within the same budget that he had in his last year of salaried life.

When his expenses exceed earnings, he has to eat into the capital. Eventually he and his wife run out of money — or this world.

That was a simplified description of the financial model. If you want all the gory details, see the last section, The Detailed Model.

The Trap

So now, using the financial model, we are ready to spell out the salary trap Venky can get into.

Figure 1 is a detailed chart of annual values of salary, expenses, investment earning, yearly investments, and net worth (clbal), when all savings are put in bank fixed deposits (6% CAGR post-tax). Starting salary of 5 (all values are in units of Lakhs: Rs.100,000) grows to 500 in 45 years (don’t laugh – ask your elders how much their salary changed in 45 years). Salary stops at age 60, but expenses continue their upward trend. Amount of investments is labeled net worth: it peaks to 25 crores (One crore is 100 lakhs) at 60, then declines steadily. Venky runs out of money at age 70. Values for every fifth year are given in Table 1.

image004

Table 1: 60% Spending, 6% CAGR

year Salary Tax expense invest earning reinvested Net Worth
26.0 5.8 1.7 2.4 0.0 1.6 1.6
30.0 10.8 3.2 4.5 0.5 3.6 12.6
35.0 23.3 7.0 9.8 2.1 8.6 44.0
40.0 50.3 15.1 21.1 5.9 19.9 117.7
45.0 108.6 32.6 45.6 14.4 44.8 284.2
50.0 234.5 70.4 98.5 33.3 99.0 653.9
55.0 344.6 103.4 144.7 70.4 166.9 1340.0
60.0 506.3 151.9 212.6 132.1 273.9 2476.2
65.0 0.0 0.0 342.5 116.8 -225.6 1721.6
70.0 0.0 0.0 551.5 16.5 -535.1 -260.4
75.0 0.0 0.0 888.2 -203.2 -1091.5 -4478.3
80.0 0.0 0.0 1430.5 -634.7 -2065.3 -12644.0
85.0 0.0 0.0 2303.9 -1433.7 -3737.6 -27632.2

The values of 25 Crore net worth, 5 crore annual salary sound unreal. It is better to look at real values that are discounted for inflation. Figure 2 shows the chart for real net worth – a much more believable peak of about 88 Lakhs at retirement. Notice that after 45 years of toil, the nest egg is less than 5 times Venky’s final salary.

image005

Now let us see the effect of investments giving higher yields: 10%, 12%, 14%.

Figure 3 charts real net worth for these CAGR values as well as 6% CAGR for comparison with Figure 2. As the CAGR rate increases, you can afford to live increasingly longer – at 14% CAGR your net worth keeps climbing rather than shrinking after retirement.

image006

Table 2: Real Net worth for different investment strategies

year 0.6 cagr 0.10 cagr 0.12 cagr .14 cagr
26 1.5 1.5 1.5 1.5
30 7.8 8.4 8.7 9.0
35 17.0 19.6 21.1 22.7
40 28.2 34.6 38.7 43.3
45 42.2 54.8 63.2 73.4
50 60.4 81.9 97.1 116.7
55 76.8 110.6 136.1 170.4
60 88.1 136.7 176.0 231.9
65 38.0 98.9 153.4 236.6
70 -3.6 61.1 128.6 242.1
75 -38.1 23.2 101.5 248.8
80 -66.9 -14.6 71.9 256.7
85 -90.8 -52.4 39.4 266.3

“Wait, this was with spending 60% of my post-tax salary, that is just 28% of my salary going into savings” Venky says, “I just need to be more frugal, even though I may have a hard time keeping my wife happy”. Well, let us see what the model does with 30% spending and 6% CAGR.

As Figure 4 shows, being more frugal increases peak real net worth so that Venky will run out of money at age 84 rather than age 70. But remember, frugal living may also enhance lifespan. It appears that the problem still remains; Venky has not escaped the trap.

image007

Summary

Be aware of the salary trap. Even high salaries don’t allow escape from the trap (unless, perhaps, you reach a really high rung of the corporate ladder). Here are the main points:

* Money evaporates like mothballs.

* Income from salary won’t last you much past retirement unless you do one of:

– Live a life of debauchery and die soon after retirement.

– Live very frugally all of your life.

– Invest a reasonable amount of savings such that on the average you beat inflation by a good margin.

* Arrange to generate passive income, especially after retirement.

* If your investments cannot beat inflation, it helps to continue working past retirement.

References

[1] Dhyan Chand.   http://www.webindia123.com/personal/sports/dhyan.htm

[2] Dhyand Chand.  http://www.indianetzone.com/9/dhyan_chand.htm

[3] Dhyan Chand.  http://www.indianexpress.com/oldStory/22333/

[4]. Peter’s Principle.  http://en.wikipedia.org/wiki/Peter_Principle

Appendix: The Detailed Model

The model calculates the effect of savings, if any, being put into investments at the end of each year.

Investments made in the year = Year’s income – year’s taxes – year’s expenses.

Annual income comes from two sources: Salary and returns on prior investments. We ignore your winning the lottery or a large inheritance from an uncle who had run away to Brazil, as being too improbable to count on.

Salary generally increases with age. This is modeled as a linear growth in real money terms, with an additional inflation multiplier.

image008

100s is yearly percent increment in salary in real money

100s’ is the inflationary increment component, typically s’ is less than r, the inflation rate.

An additional complication is that real salary doesn’t keep increasing throughout the employment. It generally stops growing when an individual hits a plateau (see Peter’s Principle[4]). So the factor s would have one value in early years, and a different value in later years. After retirement, of course, St becomes zero.

Thus we have different curves for salary for the three periods defined by the following four points in time:

t0 = starting age = 25

t1 = start of plateau = 50

t2 = retirement. = 60

t3 = death = 85

Salary that comes into your hands is after deduction of income tax. I have used a simple, proportional 100u percent tax rate for each year. T = uS.

Next, we need to model the expenses. I use a simple model for expenditure, and it emulates a conservative, prudent approach to spending: Expenses are modeled as 100e1 percent of post-tax salary until retirement and then hold the real expense steady in value thereafter. Rate of inflation is 100r percent per year.

image009

image010

Next, we come to investments. Although one would make different kinds of investments with different tradeoffs of risk and return, I have clubbed it all into a single average investment, with an average CAGR of 100c percent after taxes.

Thus the final iterative formula becomes,

Capital at year t+1

image011

image012

Ct can also be called net worth. After taking inflation into account, it becomes Rt, real net worth.

Parameter Values

The following parameter values are used to generate the figures used in this article:

Inflation rate = 10%.

salary real increment rate = s = 5%

salary inflation rate s’ = 5%

expense rates, percentage of post-tax salary:  e1 = 60%, 30%

income tax rate = 30%

Inflation rate taken at 10% is probably higher than the historical long term average, but I believe that conclusions based on comparison of other rates with inflation rate will not be materially affected by the specific value of inflation rate.

Perl Script

#!/usr/bin/perl -w

# The Salary Trap

############################### Debugging ############################

$PrintDetailed = 1;

############################## Input Parameters ######################

$t0 = 25; # AGE childhood stops

$t1 = 50; # AGE salary growth stops

$t2 = 60; # AGE salary stops.

$t3 = 85; # AGE heart stops.

$TaxRate = 0.30; # tax on salary

$Sal_starting = 5; # in Lakhs per year

$Sal_increment = 0.08; # yearly increase in real money terms t0 .. t1

$Sal_inflation = 0.08; # salary inflation per year t0 .. t2

$Spend = 0.6; # spend this fraction of post-tax salary

$Exp_inflation = 0.10; # yearly inflation in expenses t0 .. t3

$Money_inflation = 0.10; # overall inflation rate

$CAGR = 0.12;

###################### State Variables ###############################

$t = 0; # current year

$inv = 0; # current investments

$sal = 0; # current salary

$exp = 0; # current expenses

$maxsal = 0; # max real salary

$maxyear = 0; # max real salary in this year

######################################################################

# initialize all state variables

sub do_init

{

$inv = 0;

$t = $t0;

$sal = $Sal_starting;

$exp = 0;

$maxsal = 0;

$maxyear = 0;

}

# compute salary

sub do_one_year

{

my ($s, $e, $i, $tax, $savings, $x, $realsal, $realinv);

# $s is salary multiplier, $e is expense multiplier

$t++;

print “year $t opbal $inv “;

if ($t <= $t1) {

$s = (1 + $Sal_increment) * (1 + $Sal_inflation);

} elsif ($t <= $t2) {

$s = (1 + $Sal_inflation);

} else {

$s = 0;

}

$sal *= $s;

print “salary $sal ” if $PrintDetailed > 0;

$tax = $sal * $TaxRate;

print “tax $tax ” if $PrintDetailed > 0;

# consume $Spend of post tax salary upto retirement

# stay at that level with correction for inflation post retirement

if ($t <= $t2) {

# Expenses tied to salary upto retirement

$exp = ($sal – $tax) * $Spend;

} else {

# continue the expense from previous year

$e = (1 + $Exp_inflation);

$exp *= $e;

}

print “expense $exp ” if $PrintDetailed > 0;

$i = $inv * $CAGR;

print “invest earning $i ” if $PrintDetailed > 0;

$savings = $sal – $tax – $exp + $i;

print “invest $savings ” if $PrintDetailed > 0;

$inv += $savings;

print “clbal $inv ” if $PrintDetailed > 0;

# $x <= 1, discounting for real value

$x = ($t > $t0)? ((1.0 + $Money_inflation)**($t0 – $t)) : 1.0;

#print “year $t, discount $x\n”;

$realsal = $x * $sal;

# remember the max salary in real money terms in this life.

if ($maxsal < $realsal) {

$maxsal = $realsal;

$maxyear = $t;

}

$realinv = $x * $inv;

print “real bal $realinv “;

print “\n”;

}

sub do_one_life

{

do_init;

while ($t <= $t3) {

do_one_year;

}

}

sub dump_params

{

print “Tax rate $TaxRate “;

print “Expense $Spend “;

print “Salary incr $Sal_increment “;

print “Salary inflation $Sal_inflation “;

print “expense inflation $Exp_inflation “;

print “Rupee inflation $Money_inflation “;

print “\n”;

}

############### main ###########################

for ($CAGR = 0.06; $CAGR <= 0.14; $CAGR += 0.02)

{

my $x;

do_one_life;

$x = $inv / ((1 + $Money_inflation)**($t – $t0));

print “CAGR $CAGR “;

print “real net worth $x “;

dump_params;

}

print “# max real salary $maxsal year $maxyear\n”;