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Planning To Retire Early To A Lower Cost Destination?

|Includes: SPDR Gold Trust ETF (GLD)

I wouldn't blame you if you did! One of the primary reasons for those wishing to retire abroad is to take advantage of the cost-of-living arbitrage. Indeed, many retirement destinations in the world offer a good value for the U.S. dollar and not surprisingly, Americans unable to finance their retirement in U.S. are opting for such locations. This is, in a way, seeking alpha in retirement living! I originally wrote this article for a select group who wished to retire in India after working for 10-20 years in the U.S. So, the references in this article pertain to India and INR as currency. However, the principle is relevant to any country - you only need to substitute the name of the country and its currency to get the picture!

In such cases, a common question arises for those who have substantial portion of their retirement assets invested in another currency where they earned their income or wealth. The question is: How much should one withdraw from the asset base during the first year of early retirement in a new country? Subsequent years' withdrawals are assumed to be pegged to inflation so it is the first year's withdrawal that determines the success or failure of a retirement portfolio. But here is the problem. For those whose assets are largely in USD and are going by fairly exhaustive studies on safe withdrawal rates (SWR) must consider that such SWRs are based on historical inflation rates in U.S. For a 65-year old U.S. based retiree, an SWR of 4.5-6% is recommended by many financial advisors for a 30-year retirement horizon based on 90%+ likelihood of portfolio survival (I know some of you may want 99% or even 100% probability, but such simulation-driven probabilities are not meaningful in the real world filled with other uncertainties. Once the probability crosses 80%, I am okay with it for all planning purposes). For 40-year old really early retirees, the SWR is estimated at 3-3.5% for U.S. living based similar probability of portfolio survival. However, the U.S.-influenced SWR for a person living in India needs a closer look. Those working in India (or planning to work) till retirement for 10-20+ years on a full time job fortunately don't have to face this question as they will accumulate substantial INR-based assets in India from gainful employment, which are largely pegged to inflation in India.

A complicating factor in this analysis is the theory of interest rate-exchange rate (IR-ER) parity. Broadly, this states that the difference in interest rates (and hence, inflation) between two free-market economies (U.S. qualifies, India increasingly so) would be reflected in the forward exchange rate movements that run counter to interest rates to neutralize any arbitrage opportunities. The premise is that savvy market operators and arbitrageurs will continually exploit such differential return opportunities and transfer capital between the two countries such that forward exchange rates will neutralize any such advantage compared to spot exchange rates. In an increasingly integrated world where large sums of money move in and out of global capital markets, it is reasonable to assume that the IR-ER parity theory will hold. Sure, for the near term, there are capital controls and restrictions in India where there could be significant anomalies (recall in 2007 and early 2008 where $1 exchanged for as low as INR 37 and recently as much as INR 56 - and all through this exchange rate rollercoaster, the interest rates in India were much higher than U.S.). I believe these short-term anomalies cannot be taken as guidance for a 30-50 year retirement planning horizon. Still, there remains a nagging question in the minds of retirees in India with sizable retirement assets in another country. What if, there are significant deviations from this IR-ER parity theory for substantial periods of time (say, 10 years)? After all, IR-ER parity is just another economic theory (like Efficient Market Hypothesis) even though it holds up to logic. Can we pin our hopes on a multi-decade retirement based on an economic theory just because it sounds logical?

I have wrestled with this question and found no satisfactory solution even after extensive web searching and talking to personal finance experts. Finally, I developed this method for retirement modeling purposes. Bear with me as it involves some leaps of faith - whether those leaps are too large for your comfort is for you to decide. I started with a compromise that once a person reaches the age of 65, whether in India or U.S., the SWR should be treated as same, because of the following reasons/assumptions:

* Shorter planning horizon for a 65-year old compared to 40-year old early retiree, so there is less time for inflationary differences between U.S. and India to cause as much damage.
* I assumed that it is unlikely for a 65-year old India retiree to reach the age of 95 compared to a U.S. retiree at the same age. Assumptions on mortality are not pleasant, but even if this assumption is not true, I hope that some portion of the retirement living or medical costs will be borne by retiree's children if push comes to shove. Of course, Social Security can add a nice chunk to the income, and even a $800 check can mean a lot as it can cover a month's living expenses in some places. Moreover, the medical costs are lower in countries like India, so bearing at least some of the old man's expenses may not be that difficult for children working in the U.S.
* I assumed that India retirees will have at least 30% of retirement assets in India, so local inflation is addressed to some extent. This further suppresses the impact of inflation differences over a 30-year horizon. It is important for every retiree abroad to have a portion of his assets in the same currency to hedge near-term inflation risk.

The next problem is to arrive at the India-based SWR for an age 40 retiree, who still needs to brace 25 years of Indian living before the above assumptions on SWR parity at age 65 holds true between U.S. and India. Here, I made another leap of faith. Instead of divining what the interest rates and inflation rates between U.S. and India are going to be over the next 25 years, I will simply increase the SWR annually by a certain fixed percentage to compensate for relative differences between U.S. and India inflation. Note that the SWR already accounts for U.S. inflation, you are only covering for differences between U.S. and India inflation rates. You can plug in your own number but I assumed 3% as the annual increase in SWR. So, if I take 4.5% as the SWR for a 65-year old retiree in India, and compound backwards using 3% annual raise, I get an Indian inflation adjusted SWR of 2.15% for a 40-year old retiree in India for the first year. If I do the same using a 2% fixed rise in annual SWR, I get the Indian inflation adjusted SWR of 2.74% for the same 40-year old retiree in India. So, upon return in the first year, a 40-year old retiree can withdraw 2.1-2.7% of his assets and increase the withdrawals annually with local inflation. Some may assume this as nothing more than adding 2-3% to U.S. inflation rates to arrive at Indian inflation rates, but in reality it is not that simple. There is an underlying assumption that some of Indian inflation is being hedged. There are several reasons why people may choose to have up to 70% of their assets in a developed country that allows global investment opportunities where they lived in the past instead of countries like India where the investment opportunities are largely local. There may also be other reasons to do this, especially if you don't want to 'put all eggs in the same basket' without experiencing the long-term economic and political stability of your retirement destination. An alternative would be to put at least 20% of the assets in a Gold ETF (NYSEARCA:GLD) or its equivalent in your retirement country, to protect against such risks. Withdrawals can be opportunistically timed against needs and local economic conditions. Early retirement is not for the timid, but for those who venture to explore what may be the 'last arbitrage' (retirement in a lower cost of living country) in a challenging investment horizon, this may prove to be a better choice.