A friend asked me this question: "I currently have an asset allocation of 60% equity and 40% fixed income. My retirement is many years away. Why can't I continue to hold 60% equity after retirement too? In fact, all my life?". Since the answer is not a simple "yes" or "no" and since it can illustrate certain aspects of reviewing the strength of a retirement corpus before or after retirement, let us discuss this with the aid of an example.
Consider a 30-year old whose current average monthly expenses (that will persist after retirement) are about Rs. 30,000.
We will assume that she will invest in 60% equity and 40% fixed income (debt) up to age 60 and retire on her 60th birthday.
Post-tax return expected from equity: 10%
Post-tax return expected from fixed income: 7%
Each year, her total monthly investment say is, X% of her monthly expenses (X to be varied as below). Sixty percent of this goes to equity and rest to fixed income until she stops earning.
This is only an illustration. Realistic asset allocations should be changed for most people as retirement nears. Hopefully, this post will serve as an example as to how this change has to be made to decide equity exposure post-retirement.
No rebalancing is done and she lets the equity and fixed income corpus grow without interference.
Post-retirement interest rate (post-tax) assumed = 7% (30 years from now, this seems like a safe assumption)
Inflation = 6% (probably an underestimate, but please play along. You can always use different numbers)
Example A She invests 30% of her monthly expenses each year.
This represents an annual increase in monthly investment of 6%.
At the time of retirement, the fixed income corpus is about 29% of the total corpus.
Now she rebalances at sets equity = 60% and fixed income = 40%
Now, at 7% return and 6% inflation, she asks, What is my (rebalanced) fixed income corpus worth?
Or in other words, if she wishes to generate an income to meet monthly expenses that increase each year at the rate of 6% (assumed inflation), while the rest of the corpus grows at 7% p.a. how long will the fixed income corpus last?
Using the Four Simple Retirement Planning Tools, the answer is: approx. 6 years.
Now to put this into context: If she wants to generate safe income from 40% of the total corpus while 60% of it is invested in equity, then after 6 years, she will have to dip into the equity corpus.
Is this a sound strategy? NO in my opinion. That large a corpus is exposed to significant risk with redemptions necessary from the 6th years onwards. If there is a huge crash either within 6 years or even later, her financial security in retirement will be under threat.
So if she invests only 30% of the monthly expenses, she cannot afford to have 60% equity exposure after retirement.
In fact, I don't think she can have any equity exposure. Her initial withdrawal rate
= annual expenses (first year in retirement)/Total corpus = 7%.
This is extremely high.
Even if she invests the entire corpus at 7% and withdraws money for expenses increasing at 6% a year, it will only last her up to age 75 (15 years) - not bad, but not great either.
This is the classic catch-22 situation in retirement planning:
Take some risk (equity exposure) and stand of chance of becoming financially insecure sooner vs Take no risk (buy an annuity) and lose the battle of managing inflation and lifestyle creep.
In my opinion, many financial advisors in India are not qualified to handle this kind of situations and tend to offer crappy solutions like SWP from balanced funds or monthly dividend options without recognising risks.
Example A She invests 50% of her monthly expenses each year.
All other parameters and actions being the same, 40% of the final retirement corpus will last close to 10 years if an inflation-protected income is drawn from it.
Now, can the rest of the corpus (60%) be exposure to equity after retirement? It now has about 10 years to grow (hopefully untouched).
Question is, is there a need for any equity exposure?! Even if the entire corpus earned 7% return with withdrawals increasing at 6% p.a. it would last for 26 years.
So the equity exposure necessary is only about 10-25%. This is a fantastic place to be in and is the result of systematic investing for 30 years before retirement.
High(er) equity exposure (not necessarily 60%, but even 40%) is a cat-on-the-wall kind of situation and requires active management to reduce risk.
Example C She invests 100% of her monthly expenses each year.
No prizes for guessing the results here. If she invests as much as she spends (I strongly recommend this and practice 2 to 2.5X expenses), then she needs no equity exposure at all after retirement and therefore can afford to hold 60% equity after retirement (Does that make sense?)
If she invests 100% of the corpus at 7% and draws income increasing at 7% p.a. it would last her 62 years!!!
If she invests 40% of the corpus at 7% and draws income increasing at 7% p.a. it would last her almost 21 years!!!
So now she has the luxury to invest the rest in equity. With minimal risk management, she can happily grow that part of the corpus and leave behind a sizeable estate to her loved ones.
Please note: The scenarios depicted here are simplistic and only try to answer "how much equity exposure can I have after retirement?".
You can use this calculator to punch in your own numbers.
Download the how much equity can I have after retirement calculator
Note: The sheet does not exactly answer this question. It only tells you the number of years one can be drawn an inflation-protected income from the fixed income portion of the corpus. From this, it is up to the user to draw inferences about equity exposure based on the risk profile of the corpus and their risk appetite. It is not an easy question to answer.
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Hi Pattu, this risk is actually very well understood and articulated in the west and referred to as the sequence of returns risk. Broadly the conclusion they proffer is that negative returns at the beginning of the withdrawal phase have a much greater impact on the length of time the corpus will last, in contrast to negative returns towards end of retirement phase. Hence they recommend a portfolio with lower volatility to mitigate this risk.
Yes, I am aware of this. The retirement bucket strategy simulator and the even lower stress retirement calculator! discuss this. I do not agree with their approach and conclusions. I think it is quite risky be it in the US or here. Of course, their job is to make the most of a meagre corpus, but it is like walking on a wire.
Pattu sir,
when we change the age to 40, i get the error as below
Amount needed in first year (1st payment)
Years payment can be made #VALUE!
That is up to age #VALUE!
I did not understand the relevance..
please explain
Sorry, Guru. Corrected and re-uploaded.
Hello Sir
I have a question on Re-balancing .If i have a pure equity fund and a debt fund with same fund house, Do i have an option to switch the some profits earned directly from equity fund to debt fund ? are such facilities available for investors ?
Thanks Pattu. This is eye opening, as it clearly establishes the link between the pre-retirement deeds to the post retirement possibilities 🙂
Now, I will come back to my favorite question - can I maintain the fixed income part of the post retirement corpus in the debt part of a balanced mutual fund? What is the downside of such a strategy?
Thank you. That observation is spot on as usual. Fixed income in balanced fund alone seems quite risky to me. I would see a balanced fund as a pure equity fund.
That you would want to see balanced fund as a pure equity fund is well understand. And this is perfectly fair from a risk-reward side of the equation.
But the fixed income part cannot be ignored either (with this significant 25% or so allocation).
Basically, if I need X amount for my fixed income allocation and that is 'comfortably' met with debt part of the balanced fund - where does the 'risk' arise from? Fund house goofing/turning up? running away/scam? OR doing a shoddy job of managing the debt side?
In part and IMO, there is absolutely no clarity on what the fund houses are actually doing and making out of the debt portion of a balanced fund. I would really like to see a clear segregation of the debt and equity side stats and being bench-marked separately for a clearer picture.
Thoughts?
postscript: and this leads to the perfect heading for your next article "Why can’t I invest in 60% equity all my life?! - via a Balanced Fund" !!! 🙂