Retirement Planning: What To Keep in Mind

Here are options to keep in mind while doing your retirement planning.

The steps for retirement planning are by themselves pretty simple. You need to estimate your post-retirement cash flow requirements, and thereby the corpus you need. You need to think about what kind of investment mix (debt, equity, real estate) you will be comfortable with. Once you have done these two, you need to identify investment opportunities and begin investing.

However, the difficulty lies in envisaging a future that is decades away. You don’t know how much inflation will erode your savings, and you don’t know what risks lie over the horizon. Not least among the risks are regulations and government policies. The last 3-4 union budgets, for instance, have made debt mutual funds far less attractive than they were. Those who relied on them have been hit and have had to review their plans. Here are a few things to keep in mind while planning:

Your Lifestyle: One primary consideration to keep in mind is the kind of lifestyle you wish to lead after retirement. For instance, do you plan to travel extensively? If so, you need higher cash flows, as travel is expensive. Are you planning to move to a Tier-3 or Tier-4 town? Rents may be lower but you may need to travel often to a larger city, especially for medical needs.

Health Factors: This is another thing you need to consider – your state of health and family history. These can vary considerably from individual to individual. While general averages are useful, you need to look specifically at your situation and that of your spouse.

Review Regularly: Finally, bear in mind that retirement planning is just that – planning. You need to review your plan regularly. And after you retire, you need to review it every year. Some of the assumptions you may have made might no longer be valid. Or, the tax laws might have changed. Actual inflation may be higher or lower than anticipated. Maybe an attractive investment opportunity may come your way – like the tax-free bonds that were offered a few years ago.

The Right Age to Start Planning

A good time would be between 40 and 45. This is when salaries would have grown to healthy levels, and the children would still be in school. As a result, couples would have investable surplus at this stage in life. Even modest investments made at this stage, driven by the power of compounding, will grow handsomely over the next 15-20 years, and will help immensely in building the corpus you need.

But keep in mind that while incomes will continue to grow after 45, two things tend to happen. First, you may need to fund your kids’ college education, which could be expensive. Second, you will have fewer years for your investment to grow before you begin tapping into it.

If you have the luxury of doing so, it will be very useful to finish paying off your loans by the time you hit 55.

Investment options for an ideal retirement portfolio

It is best to have a mix of equity, debt and real estate. The return on debt investments tend to hover only marginally above the inflation rate. As a result, they don’t grow significantly in real terms. While debt generally tends to be safer, the value of bonds can fall as well.

This is where equity comes in – it can boost your corpus and can provide a rate of return that is higher than inflation. It can make your portfolio grow in real terms. But it comes with a downside risk too. However, in the long term, equities (especially large cap stocks and mutual funds) tend to perform well. At an earlier stage, equities can be very useful when you are building your corpus. Bull markets and bonus issues can really boost your corpus in a way that debt investments cannot. And you can always prune your equities exposure as you approach retirement.

Within equities, investing in stocks will call for deeper understanding of specific companies, and may be difficult. Fortunately, mutual funds (especially large cap schemes) offer a more practical alternative. Mid cap and small cap stocks tend to be more volatile that large cap ones.

Real estate has an important role to play too, even though it is illiquid. Although the annual returns from real estate (in form of rent) seldom exceed 2% of the current market value, it is the piece of your portfolio you will turn to in the event of an emergency. If you – God forbid – suddenly find yourself in need of tens of lakhs or a crore, real estate can help you.

As far as annuity is concerned, I am not a fan. That is because of the way it works:

The fund manager takes your money and invests it in debt and equity. Let’s say that he generates a return of 8.5% (it could be more) from your money. He keeps 2% for his expenses and profits, and gives you 6.5%. On the other hand, if you were to manage your own portfolio prudently, you could generate 8% to 9% from it. Why give away that precious margin to the annuity fund manager? Besides, the 6.5% you receive from your annuity investment is likely to be inefficient from a tax perspective.

It is therefore critical to construct a good portfolio and to review it from time to time. There is no alternative to doing the research yourself, as financial advisors are often influenced by the commissions they get. Advisors are a good source of information and opinion, but you must make your own choices. In this context, websites like Moneycontrol, Myiris and Value Research can be useful. There are several independent websites where you can look at performance of funds and stocks. They also offer good comparative analysis.

Estimating your post retirement cash flow

Given the way inflation has been eroding the value of the rupee, this is the most difficult part. Also, because a 6% inflation, just to use an example, does not necessarily mean that your expenses will also grow at 6% too. It could rise faster, and for a good reason.

The official inflation rate is based on a typical basket of goods and services. As you grow older, the basket of goods and services you consume may change. Take doctor’s fees, for instance, which takes a larger share as you age. A specialist to whom I was paying Rs 400 per visit a couple of years ago is now charging Rs 700. This increase is far higher than the inflation rate.

On the other hand, the prices of large televisions and nice-to-have appliances might not have risen very much. But the frequency at which I buy such appliances reduces with age. Thus, the inflation rate a retired couple actually experiences may be different from the government’s rate.

While you certainly must prepare a spreadsheet of your best estimate of your cash flow requirements, it would be useful to compare your estimate with what senior citizens and retired people you know actually spend.

Another way is to compute the required corpus based on your cash flow requirements if you were to retire today, and then to double it. Why? Because, one half of the corpus will generate the cash flow you need, while the other half ensures that your corpus continues to grow with inflation.

Let’s say you estimate that you will need Rs. 1 lakh a month if you retire today. That makes it 12 lakhs per year. At 8% returns, this works out to a corpus of 1.5 crores. If you double this to 3 crores, you will generate 24 lakhs in the first year. From this, you draw 12 lakhs the first year, and the remaining 12 lakhs goes back into the corpus.

Next year, you will draw 12 lakhs plus 8%. This goes on year after year, and your cash flow will grow by 8% every year. Even if inflation touches 8%, you will continue to receive the same amount every year in real terms. Healthcare cost is a major concern in the senior years and can lead to unexpected expenditure. This is where equity and real estate come in. With above-inflation returns, equity can help you navigate surprises. And in an emergency, you have the option of liquidating your real estate.

Rent from property is an important component of your cash flow. If you peg the rent to inflation, your rental income will not be eroded by inflation.

Bequeaths & wills

Bequeaths tend to be more expensive than settlements. They have higher transaction costs (which your heirs will have to bear). Settling properties in the heirs’ names when you are alive, reduces the transmission cost significantly. But then, the income arising from the flat will no longer come to you. As is obvious, there are moral hazards here. A key consideration will be the outlook of your heirs and their disposition towards you.

Comparing Options

I believe we should compare options only on a post-tax basis. Pre-tax comparisons can be misleading, and you could find yourself short of money because of it.

As far as reducing risk is concerned, it should primarily be to the extent of eliminating speculative and high-risk investments. It should not go to the extent of eliminating all equities (be it shares or mutual funds). Some amount of equities would help beat inflation and meet emergencies.