How falling interest rates and lower equity returns can affect a retirement plan

Published: May 23, 2020 at 10:21 am

Last Updated on February 12, 2022 at 6:16 pm

With the repo rate at its lowest, fixed-income investment rates which were already heading south over the last few years are likely to stay there and move down further in future. Equity returns have been consistently heading lower and lower too. This can destroy all financial plans especially retirement which does not come with a “second chance” attached to correct mistakes. Why the market crash and rate cut must be used as a wake-up call lower our return expectations and make up for it!

If you thought 15-year Nifty SIP returns crashing to 8% (51% reduction since 2014) is only “temporary”, think again! On 5th Jan 2020, well before the crash, we had reported, Ten-year Nifty SIP returns have reduced by almost 50%.

Senior citizens who complain about falling rates today, had about 17 years to prepare for this when PPF rates fell from 12% to 9% between Jan 2000 to Mar 2003. That was the wake-up call India was transitioning to a market-driven economy. Someone who is 65 today still had a few years back then to recognise the direction in which India was headed.

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Yes, hindsight makes it all seem obvious and the above-statement was not particularly kind. However, some foresight is essential in money management and we cannot afford to change our calculation inputs when the evidence is staring right at us. One person’s hindsight is another foresight – at least it ought to be.

Those who have never had any kind of market exposure before retirement do not have much a choice and must resign themselves to less than inflation returns (even if they are in the 0% tax slab) and reduce their lifestyle. See: Why have we not seen a retirement crisis in India?

Imagine a 30-year old who starts planning for retirement in 2010. Equity was tax-free then, PPF was 8.5% and that amazingly prudent organization called EPFO effectively bankrupted itself by offering 9.5% in 2010-11 (and got it down to 8.25% next FY). This is the singular reason for the prompt payment in interest that the organisation has managed these days! (#sarcasm) See: Delay in EPF interest payment: Is there a loss to subscribers?

In 2010, if someone assumed 12% returns from equity  (let alone 10%) they would be dubbed “conservative” and “scared”. These could typical assumptions made then:

  • Anticipated post-retirement rate of interest 7.00%
  • Current expenses per month (annual/12) 25000
  • No of years you expect to work 25
  • Expected inflation throughout lifetime 6.00%
  • Estimated years in retirement 30
  • The average rate of interest expected from all asset classes 10.00%
  • The annual increase in monthly investment you can manage 5.00%
  • Amount invested so far (end of the current year) 100000
  • The average rate of interest for this amount 8.00%
  • Monthly investment needed as % of current expenses 71.53%

An asset allocation of 60% equity with 12% (tax-free return then!) and 40% fixed income and 8% tax-free returns would mean a 10% overall portfolio return in 2010. Notice even with these nice assumptions the monthly investment needed is 70% of the current essential annual expenses that are likely to persist after retirement.

Now, let us assume our 30-year old is scared about retirement and decides to invest 100% of his then monthly expenses = 25,000 into retirement each month. From just one Lakh in 2010, his retirement corpus grows to more than 57.8 Lakh in 2020.

However, the overall portfolio growth is only 7.5% instead of the expected 10%. This is because his equity investment made only 7% and was 50% of his portfolio while fixed income returned about 8%.

As an aside, these numbers are actually on the higher side. As noted recently, Crash destroyed my 12-year equity MF gains( but this is time to invest more!) and My retirement equity MF portfolio return is 2.75% after 12 years! For my current asset allocation, the overall return is 6% (3% from equity and 9%+ from NPS)

In 2020, our 30-year old has become a 40-year old. His current essential annual expenses that are likely to persist after retirement are Rs. 55,000. Life did not follow the excel script of 6% inflation which does not account for a change in lifestyle.

At 30, he thought he could work until 55. At 40, he has had enough and wants to quit by 50 or might be thrown out by then.

With only ten years left to retirement, even 40% exposure to equity is a touch on the risky side. With 9% post-tax return expectation from equity (how times change!) and 7% from fixed income, the expected portfolio return is still 7.8%!

These are new assumptions and result:

  • Anticipated post-retirement rate of interest 6.00%
  • Current expenses per month (annual/12) 55000
  • No of years you expect to work 10
  • Expected inflation throughout lifetime 6.00%
  • Estimated years in retirement 30
  • Average rate of interest expected from all asset classes 7.80%
  • Annual increase in monthly investment you can manage 10.00%
  • Amount invested so far (end of current year) 5780669
  • Average rate of interest for this amount 8.00%
  • Monthly investment needed as % of current expenses 163.62%

The monthly investment now is 163% of 55K and this should increase at 10% a year! If he does manage to work gainfully until 55, then the investment amount (other things being the same) would drop to 90% of 55k – still a tall order.

What went wrong?

Admittedly this an exaggeration. Not in terms of the numbers assumed initially or after 10Y but because we assumed the original retirement plan was not reviewed for ten years. If this is you, then it is a wakeup call! There are other problems like not accounting for lower equity exposure with age which can be corrected (see below)

Even if we had reviewed it each year, the effect of falling interest rates and lower equity returns would mean only one thing: we need to increase the investment amount. The only difference is, time would not be lost with an annual review.

When we try to convince an audience to start investing in equity, we have to assume equity will beat fixed income and equity exposure would mean a lower investment amount than a 100% debt portfolio

If after 10-12 years equity underperforms fixed income then the only way out is to increase the investment amount falsifying our original claim. Yes, equity can and might move up suddenly and overnight the situation can change, but that would be leaving things to chance.

Young earners will have to lower return expectations and increase their investments right away to prevent this from happening to them. The only reason I am still financially independent is because of this. I have been using 10% equity for at least 5-6 years now.

It would be much harder for 40-somethings to suddenly start investing more.  This is the sad reality of decreasing rates. Changing times always affect a generation. Senior citizens with inadequate savings have been suffering for more than a decade now. While things get worse them, the assembly line of life is all set to attack the 50-somethings. We need to pay heed to these warnings or we would be next.

Lower expectations alone are not enough. The right asset allocation with age (how equity is varied) is important and how the retirement corpus is managed also matters today. The freefincal robo advisory template not only uses conservative pre- and post-retirement assumptions, but also uses a conservative bucket strategy to minimise the risk of varying economic conditions and sequence of returns.

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Pattabiraman editor freefincalDr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over ten years of experience publishing news analysis, research and financial product development. Connect with him via Twitter(X), Linkedin, or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation promoting unbiased, commission-free investment advice.
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