I thought a pension was unnecessary but age taught me a retirement planning lesson!

Published: February 6, 2022 at 6:00 am

Last Updated on February 12, 2022 at 6:27 pm

I have been making retirement planning tools for more than 11 years now. During this time, thanks to a combination of luck and discipline, I have been able to achieve financial independence. While my risk appetite has increased, I have also become more conservative in planning for retirement. I have come around to see the value of a pension.

I am writing this because a viewer on our YouTube channel asked, “why should I plan with 3% or 4% withdrawal rates? Why can’t I use 5% or 6%?” The answer to this question is quite simple: it is simply too risky. If the returns in the first few years in retirement are poor then it is a recipe for disaster. Even 4% or 3% is far from foolproof. Those who have the time to do so should plan better.

Thanks to how retirement planning tools are designed, my first approach to retirement planning was a simplistic one: You have a corpus (hopefully big enough), say C,  at the time of retirement and it is invested in various instruments. The overall average post-tax returns from all these instruments is, say X.

The inflation expected in retirement is, say Y. Then if A is the annual expense in the first year of retirement, we can compute the number of years an inflation-proof income can be generated as

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The most commonly used form of this formula is to set X =Y. Then if we have a corpus C = 30 times A, the corpus will last for 30 years. The key here is to recognise that we are assuming zero real return. That is, the rate of return and rate of inflation is the same.

Even with an inflation estimate of 6%, this is a quite difficult return to achieve especially after tax. When we are young, it will seem easy ( as it did for me). A few years of experience in the capital market teaches us differently.

In this model of retirement planning, there is no pension involved. The entire corpus is distributed among different buckets – debt mutual funds, equity mutual funds, stocks, fixed deposits etc.  We make regular withdrawals from these to meet expenses and manage the corpus to ensure it does not run out by our lifetime.

There is nothing wrong with this assumption when we are young. As I got older, the risks of this model became apparent. One set of poor returns can destroy the apple cart.

If we divided the first year’s expenses by the corpus (A/C), we get the withdrawal rate. The higher this value, the higher the expenses or lower the corpus. Many people incorrectly believe that a withdrawal rate of 4% is “safe”. This is based on excessive equity exposure (~ 50%)  and does not work for all sequence of returns.  See: Why we need to stop using Safe Withdrawal Rate (4% rule) for retirement planning.

Compared to the ubiquitous 4% estimate, a 3% or 2% withdrawal rate is much safer (more money to play with in the markets!) and a 5% or 6% withdrawal is quite risky  (more risk take with a low corpus).

This is why when developing the robo advisory template, I addressed the following considerations:

(1) A bucket strategy linked to the equity and debt market is essential to beat inflation in retirement. However, the entire corpus should be subject to this. Plan for 15 years of guaranteed inflation-protected income from safe assets (income bucket) while the rest of the money is invested and managed in three other buckets: low-risk, medium-risk and high-risk.  There is an emergency bucket set aside as well for emergencies.

This gives the retiree enough cushion to handle a poor sequence of returns in the first few years of retirement. The other buckets can be gradually shifted to the income bucket to ensure continuous inflation-proof income.

(2) The above strategy is not suitable for everyone. So have red, amber, green kind of system built-in to offer suggestions on who should use a bucket strategy and who should not – the alternative is to buy a pension with most of their corpus.

(3) Factor in income sources from pension or rent so that the retirement corpus required is reduced.

As I moved from my 30s to 40s and now late 40s, I have recognised the value of a pension in a retirement plan. Of course, a pension should not be the main component and only one of the components of a retirement basket (a term coined by P V Subramanyam).

A pension offers some degree of comfort to the retiree that at least some portion of her expenses will always be taken care of. This is known as income flooring. The safest form of income flooring is to plan for pension equity to the expense in the first year of retirement. This is explained in detail here: Creating the “ideal” retirement plan with income flooring!

This of course comes at the price of a much higher retirement corpus. This is why we recommend investors do not adopt extreme solutions (the trivial one based on a withdrawal rate or the ultra-safe income flooring method linked above) and plan with a balanced approach with X years of secured income and the rest of the corpus managed in buckets.

Once our basic retirement planning is firmly in place, we just think our building a diversified retirement basket. This is explained here How to build the ideal retirement portfolio and summarised in this image shared with my monthly stock portfolio updates.

Elements of an ideal retirement portfolio
Elements of an ideal retirement portfolio

I currently hold 60% equity in my retirement portfolio. See: At 46 why are you holding 60% equity for retirement? I would like to bring it down to 50% or so in the next few years.

I am expecting the mandatory 40% pension from my (mandatory) NPS corpus to be approximately equal to my first-year retirement expenses after tax (if I retire early, I will have to re-think but let us cross that bridge later).

If I get close to this expectation, then I can hold on to 50% equity in retirement. This would seem risky but that depends on what the 50% fixed income is worth. It is early days to have a concrete plan on this, but this is how my thinking has evolved.

On the one hand, I have come to appreciate the importance of a pension (I used to dislike the mandatory pension aspect of NPS – not anymore!). Age does that to you!. On the other hand, my risk appetite has also increased. If you had told me “50% equity after retirement” I would have baulked. Now I think it is possible. Financial independence and capital market experience does that to you!.

If we can build a multi-element retirement basket, then our dependence on both a pension and capital market risk will reduce dramatically. The key to all this is time. We have to start planning early. See: How to earn one lakh a month passive income? And How to build a second income source that will last a lifetime.

Life has taught me an important lesson: Never disparage any choice. Time will take you around to see a different perspective and you might embrace that choice.

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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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