Last Updated on September 4, 2018 at 10:57 am
Given a lump sum, how do we invest it in order to create a reliable income stream that is risk-free and has the ability to keep pace with inflation?
This is the most crucial question that concerns every person who is retired, nearing retirement, or planning for someone else’s retirement (a client or a parent perhaps). Well, at least it ought to be!
The answer concerns everyone since we all have to answer this question at some point in our life.
This post is an offshoot of a discussion with Vignesh Bhaskar in Asan Ideas for Wealth, FB group. Not much information is available on inflation proof post-retirement investment strategies for the Indian scenario. Let us try and discuss this here from time to time.
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Most questions have more than one solution. This is no different. There are many ways of creating a reliable inflation-protected income stream. In this post, I will discuss only one such way.
The best way to do this is via an illustration.
Let us say that I am a retiree, aged 60, with Rs. 30,000 monthly expenses (involving only the retiree and dependents) or Rs. 3,60,000 per year. Perhaps a touch on the lower side.
I make the following assumptions
- Inflation throughout the retiree lifetime: 8%
- Inflation-protected income required for: 25 years That is up to 85 years. Perhaps 30 years would have been better, but let us work with 25.
- Mediclaim: Available. Premium expenses included in the annual expenses.
- Emergency fund: Available. A sum equal to 1 year’s expenses. This is not part of the retirement corpus.
Now we will need to calculate the corpus required
I have assumed that I pay a flat 10% tax on all investments throughout my lifetime. This is indeed an oversimplification. Unfortunately, we will need to use this, as it will be confusing to consider other possibilities.
A post-tax return of 8% may seem a bit unrealistic. However, if a retiree in the 10% tax slab opts for fixed deposits offering 9% for senior citizens (current rates), the post-tax return is about 8%.
Using the annuity calculator, we determine the corpus required
Inputs
Payout required in the first year of retirement: Rs. 3, 60,000
Inflation: 8%
Post-tax return: 8%
Duration: 25 years
Output
Corpus required: Rs. 90,00000 or Rs. 90 Lakhs
If I have an amount close to this or higher than this, I can relax.
What if I have a corpus less than 90 Lakhs? What should I do?
In order to answer this and the question posed in the opening sentence, let us first try to understand why I need Rs. 90 Lakhs given the other inputs.
If I divide this 90 Lakhs into 25 parts, each part is equal to 3.6 Lakhs. This is just the amount I need for meeting my expenses in the first year of retirement.
- I keep aside one part for meeting the first years expenses.
- I then open 24 fixed deposits. Each maturing one year after the other. That is the first FD will mature after one year, the second FD after two years … the last FD after 24 years.
- When the 1st FD (investment = 3.6 L) matures, I will get 3.88L enough to meet expenses in the 2nd year of retirement (here expenses have been inflated by 8%)
- When the 2nd FD (investment = 3.6 L) matures, I will get 4.19L enough to meet expenses in the 3rd year of retirement (here expenses have been inflated by 8%)
- …..
- …..
- When the 24th FD (investment = 3.6 L) matures, I will get 22.8 L enough to meet expenses in the 25th year of retirement (here expenses have been inflated by 8%)
Here is an illustration which explains why I need 90L
Suppose I do not have 90 L. Can I work with a lower corpus and yet mange to generate inflation protected income?
To a certain extent, it is possible. Of course, as must be obvious, one will need to generate a higher rate of return. This implies taking on some risk … with a part of the corpus.
In order to understand this, we will need to discuss about the so-called bucket strategy
The best way to do that is to use the above numbers.
Instead of opening 24 FDs, I can achieve the same result in a different.
- I keep away 3.6L for the 1st year.
- I open 4 FD for 3.6L maturing one year after another as mentioned above.
- This will give me inflation-protected income for the first 5 years in retirement.
- This is called income laddering (also one form of FD laddering)
I invest 18L in an FD that matures in 5 years. Let us call this bucket I
I invest 18L in an FD that matures in 10 years. Let us call this bucket II
I invest 18L in an FD that matures in 15 years. Let us call this bucket III
I invest 18L in an FD that matures in 20 years. Let us call this bucket IV
- Bucket I will mature to 26.44 L. I then split this up into 5 parts, keep one for managing expenses in the 6th year of retirement and use the remaining parts for managing expenses in years 7 to 10 by income laddering.
- Similarly, bucket II will mature to 38.86 L. I then split this up into 5 parts, keep one for managing expenses in the 11th year of retirement and use the remaining parts for managing expenses in years 12 to 15 by income laddering.
- … and so on.
Here is an illustration
In essence, instead of creating an income ladder for 25 years, as mentioned infirst scenario, we create an income ladder for the first 5 years, let the rest of the corpus compound in four buckets, and create new income ladder every five years.
I have assumed that all the buckets compound with the rate of return (8%). So there is no difference between the first and second scenarios. In effect the total corpus needed is the same.
What if, some of the buckets compounded with a higher rate of return?
Can I then not reduce the total corpus required?
Yes, this is indeed possible. Here is a list of different return scenarios. Thanks to Captain Ashok Kumar Anand for pointing out an error in this table. It has now been corrected.
Notice that the returns associated with different buckets have been varied. The first scenario, of course corresponds to the one detailed above.
Notice that as you increase the return in different buckets, preferably the ones which you will need 10, 15 and 20 years later, the corpus required comes down quite sharply from 90 L to 67.5 L
How can I go about achieving this?
Here are some examples
Low risk
Bucket 1 (5Y duration): FDs
Bucket 2 (10Y): Debt ‘income’ funds
Bucket 3 (15Y): Balanced funds (25% equity)
Bucket 4 (20Y): Balanced funds (65% equity)
Medium risk
Bucket 1 (5Y duration): FDs
Bucket 2 (10Y): FDs
Bucket 3 (15Y): Balanced funds (65% equity)
Bucket 4 (20Y): Diversified equity
High risk
Bucket 1 (5Y duration): FDs
Bucket 2 (10Y): Debt ‘income’ funds
Bucket 3 (15Y): Diversified equity
Bucket 4 (20Y): Diversified equity
How to decide what to do?
This is a tough question!
- If I have 90L+ I can afford to choose the no-risk option (all buckets in FDs)
- If I have ~ 80L I will need to take some risk and invest buckets 3 and 4 in high return, tax-efficient instruments
- If I have ~ 70-75L I will need to take much more risk and invest buckets 2, 3 and 4 in high return, tax-efficient instruments. Do I have the stomach for this? If I don’t, I will have to choose a constant annuity from an insurer and my income will have little or no inflation-protection
- If have less than 70L, it is too risky to use buckets. I will have to resign myself to the fate of receiving constant annuity
- Note: This is a ‘all-in’ strategy. That is once you choose the bucket approach, seeking annuity later in life may not (or may!) give you a decent pension. So you will to consider your health into the equation (thanks to Subra for pointing this out). Are you fit enough to manage your own corpus?
What would you do?
Are you doing enough to ensure that you don’t face the prospects of constant annuity?
I apologise for the heavy content of this post. If you have made it this far, thank you! If you need clarifications on any aspect of the post, please feel free to ask.
I have an associated calculator. If you are interested in it, let me know, and I will post the download link.
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