Retirement Planning: Addressing Key Challenges
Retirement Planning, though prevalent in the western world since long, is a relatively new phenomenon in the Indian society. The joint family system where a son took care of his parents, obliterated the need for retirement planning. A competent son used to be the best investment Indian couples made for retirement.
However, this has changed with the advent of urbanization, employment-led migration, nuclear families and rising aspiration levels of young Indian couples. Retirement planning has become a necessity in Indian society today.
Retirement Planning typically consists of two phases –
1. Accumulation Phase
2. Distribution Phase
Accumulation Phase, as the name suggests, is the period before retirement, when a person accumulates or builds the corpus for his / her retirement, known as Retirement Corpus.
Distribution phase is the period after retirement when the accumulated retirement corpus is invested in a manner that assures safety of capital, liquidity and a regular, guaranteed stream of lifelong income that can grow with inflation.
While enough literature is available on the accumulation phase, not much has been said about the distribution phase. We shall primarily deal with the Distribution Phase in this article.
The Indian retiree faces some challenges while investing for the distribution phase -
1. Generate post-tax income that is enough to cover expenses, regular and ad hoc, from guaranteed sources
2. Make sure that the income grows at a pace enough to cover inflation
3. Mitigate the Reinvestment risk in an environment where interest rates are declining
4. Ensure that one doesn’t run out of money during the lifetime i.e. there is enough capital at all times to keep generating required income
THE CONUNDRUM - SAFETY OF CAPITAL, GUARANTEED INCOME, LIQUIDITY, REINVESTMENT RISK & INFLATION
The most important thing for a retiree is to never run out of capital. Income can be generated only if there is enough capital. Capital erosion due to exogenous factors such as volatility in market, credit defaults, etc. can be dangerous. A considerable part of the investments in Regular Income portfolio thus need to be in non-market linked instruments that provide safety or guarantee of capital like government sponsored savings schemes/ bonds, fixed deposits, post office instruments, etc.
On the flip side, such non-market linked instruments do not allow the capital invested to grow in line with inflation and hence may be insufficient to meet income needs in future. Also, such fixed income bearing securities are inflexible i.e. one cannot increase or decrease the cash inflows frequently. Plus, they can also be illiquid i.e. have fixed lock-in periods and are also susceptible to reinvestment risk in a declining interest rate scenario.
I know a person who had enough money in bank deposits yielding 7.5% p.a. three years ago, to take care of his monthly expenses (his income was 125% of the expenses at that time). He is in a precarious situation today as the deposit had to be renewed at 5.5% recently. His income has fallen by ~27% - for no fault of his – while expenses are up by ~12%, leaving a gaping hole of 18% per month. This is what falling interest rates can do in an inflationary environment.
Market linked instruments such as debt mutual funds do help in managing issues on growth, liquidity, flexibility and reinvestment risk to some extent. Though they are subject to market volatility, they provide scope for capital growth, a careful selection of the right funds can help mitigate these issues.
In a falling interest rate scenario, they tend to appreciate in value (as bond prices rise) and compensate for the loss in yields / coupon for some time and to some extent. For instance a debt mutual fund with yield to maturity of 7.5% and modified duration of 3, will appreciate by ~6% if yields fall to 5.5%. This can partly compensate for the loss of income. Also, debt mutual funds are highly liquid, allow the investor to benefit from rising bond prices and allow flexible withdrawal options through the Systematic Withdrawal Plan (SWP) route.
A balanced approach is thus needed to allocate between such fixed income bearing, inflexible yet safe instruments, and, market linked instruments such as debt mutual funds.
BEATING INFLATION – A DUAL APPROACH CAN HELP
The biggest challenge for retirees is to make their retirement savings last a lifetime in an inflationary environment. Your retirement corpus may be enough to meet your expenses today. But what about 10 years from now? At an inflation of 4% p.a., a monthly expense budget of Rs. 1 lakh today will grow to Rs. 1.48 lakhs in 10 years and Rs. 2.2 lakhs in 20 years. Assuming that you retire at the age of 60 years, by the time you turn 100, you will need a monthly income of Rs. 4.8 lakhs to meet your expenses at this rate of inflation.
Look at it from another angle - if you have a retirement corpus of Rs. 2 crores - invested at 6% p.a. - and withdraw a monthly income of Rs. 1 lakh growing at 4% p.a., you will run out of money after 20 years. How are you going to manage the rest of your life?
This conundrum can be resolved by bifurcating your investment in 2 parts – Regular Income Portfolio and Growth Portfolio. While Regular Income portfolio provides liquidity, regular income and safety of capital, the Growth Portfolio takes care of inflation and reinvestment risk.
The Growth portfolio is generally invested in hybrid dynamic asset allocation mutual funds that invest in a combination of equity and bonds, the allocation between the two being managed dynamically in line with market valuations. This allows the fund to participate in the upside of equities while protecting the downside to a great extent.
Historically, such funds have given an upside capture of 55%-60% and downside capture of 45-50% w.r.t equity indices. Over medium to long term, these strategies have managed to beat inflation handsomely, generating returns similar to equities at half the volatility.
The Growth portfolio can be used to replenish the Regular Income Portfolio whenever the latter falls short of capital due to higher income withdrawals (needed to meet higher expenses as a result of inflation). By adopting this approach, one can have a safe, liquid and flexible regular income generating Retirement Portfolio that also provides for inflation and capital appreciation.
HOW DOES THE DUAL APPROACH WORK?
Tough times and evolving needs demand a dynamic solution. Being fixated on a few government-sponsored savings schemes or generic retirement plans will not help you realize your retirement goals. One size doesn’t fit all. A tailor made, well-planned, well-diversified and dynamic approach, such as the one shown above, is the need of the hour. Last but not the least, nothing beats regular reviews of the plan or portfolio. The only thing that is constant in markets is “Change”. Why shouldn’t your plan change too?
STEPS IN RETIREMENT PLANNING - SUMMARY
Author: Alok Agarwala
Published: Investor's India Magazine, August 2020 Edition
