Getting a guaranteed pension after retirement and beating inflation after retirement has traditionally been two extreme solutions in retirement planning. In this article, we explain how these solutions can be combined to build a robust and nearly fool-proof retirement plan.
In the former, we talk about buying an annuity from life insurers for a guaranteed pension (link points to basics of annuity with available options) with most of the retirement corpus. In the latter, we consider how to use a part of the corpus for inflation-protected income and how to save some of it and invest some of it to beat inflation in the future. See for example I am 30 and wish to retire by 50 how should I plan my investments?
The two solutions have traditionally been polar opposites with good reason. Pension-seekers do not have much of a corpus to with. Inflation-beaters have the luxury of a large corpus.
Today, we are in a position to discuss a solution where both approaches can be combined because more and more young earners are investing for their future instead of saving. They are likely to be inflation-beaters upon retirement.
The combined approach is known as income flooring. Let us understand this with an example.
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Suppose our monthly expenses in the first year of retirement are Rs. 50,000. We buy an annuity so that our monthly pension = Rs. 50,000 (after tax!). This will take care of all our monthly expenses (hopefully) in the first year of retirement.
From the second year, inflation has to be accounted for. Assuming it is about 6%, the expenses will increase as shown below. Since the pension takes care of of a part of the expenses for life, we only need to handle the rest via prudent bucket strategy management.
| Years in retirement | Monthly Expenses | Monthly Income needed from buckets |
| 1 | 50,000 | – |
| 2 | 53,000 | 3,000 |
| 3 | 56,180 | 6,180 |
| 4 | 59,551 | 9,551 |
| 5 | 63,124 | 13,124 |
Please note that the above are monthly expenses and the monthly income needed from buckets will become big quickly as we see below.
Considering how the expenses in the latter years of retirement increase, “should one use an income flooring option and waste money in an insurance annuity?” is indeed a valid question.
The answer to this depends on the individual. When we are young, we assume we will be investing 50-60% of the corpus in equity after retirement. However, as we age we tend to mellow down.
An income flooring guarantees a certain amount of income for life and psychologically it can play a big role. Planning for income flooring is not necessary for those who are in their 20s and 30s but become an important consideration in their 40s and 50s.
When I was young, I thought a pension was unnecessary but age taught me a retirement planning lesson! Today, my risk appetite for equity is considerably higher. I would love to invest 50% of my corpus in equity all through my life, but to do this, the corpus should be high enough and I would like to ensure at least of my expenses are guaranteed with a pension. Hence the income flooring idea. In my case, I have to annuitize 40% of my mandatory NPS and this would be my natural income floor.
Income Flooring Example
We shall consider an income flooring example using screenshots from the freefincal robo advisory tool where this option has just been added*
* New users of the robo tool will get this option by default. We shall send the updated tool to existing users for free in the next couple of days. Please ensure the email [email protected] is added to your contact list (in Gmail you can create a filter so that this email is never sent to spam) so that you receive the update.
The tool can handle three sources of income (pension, rent etc.) while computing the retirement corpus. If the total income from these sources is higher than the annual expenses in the first year of retirement then the income flooring option will not be invoked.
We shall consider a 30-year old wanting to retire by age 50 and hoping to live until age 90. We shall assume 7% inflation each year before retirement and 6% after retirement. The inputs used in the freefincal robo advisory tool are shown below as screenshots.
The income flooring option can be seen below. The user wanting to use this option should choose “yes” and decide what percentage of income (= expenses) to “floor” with a pension. The expenses are in turn decided by current expenses (Rs. 45,000 in this example).
So the user can decide say 80% of the current expenses are essential and can floor that much. Or as a matter of safety, she can also decide to floor 125% of current expenses( at the time of retirement after accounting for inflation).
The retirement corpus required is shown above: Rs. 8.66 Crores. The monthly investment amount required (increasing 10% a year, see the first screenshot) is Rs. 66,070 (this includes EPF contributions). The asset allocation schedule to be followed is shown below.
In case the income flooring option is not used, the required corpus is lower – Rs. 6.6 Crores. Today when our networth is low, this is likely to seem like a big saving. However, after a few years of investing it would seem eminently achievable.
The investment required for this option is also obviously lower – Rs. 50,500. The asset allocation schedule to be followed is shown below.
Naturally, the price of more safety is a higher cost (higher corpus and more investment required). Young investors can wait until they are 40+ to decide if want to use income flooring or not. By this time, their income would be higher and their risk appetite tempered with market volatility.
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