Creating the “ideal” retirement plan with income flooring!

Published: September 6, 2019 at 9:51 am

Last Updated on February 12, 2022 at 6:17 pm

Let us think about it for a moment: What is the ideal retirement plan? One that guarantees income for our lifetime, one that helps tackle inflation and unexpected expenses after retirement. All this with as low a corpus as possible! Yes, that does sound too good to be true. However, we can get close to this situation if there is enough time on our hands. Let us see how to set up an ideal retirement plan with an idea known as income flooring (video example included).

While we are young, many of us tend to look down upon the idea of a pension or an annuity. However, as we age, the idea of guaranteed income each month becomes more and more enticing. However, the problem with a pension is that it fails to combat inflation which is anywhere between 6-8% and unexpected huge/recurring expenses. Also to get a pension a large portion of the corpus should be locked up for life. So the ideal retirement plan should combine the two ideas of constant income and liquid wealth.

This automatically means we cannot aim for minimising the retirement corpus,  but that is fine as long as we have at least ten years to retirement. Most people who are reading this should have considerably more time and should not get scared about what they need to accumulate for retirement. See why: Do not be scared by what you need to accumulate for retirement!

The conventional retirement calculation assumes a corpus X. After retirement, we invest this X in different buckets – low risk for immediate income, medium risk and high risk for future income. You can use the freefincal robo advisory template for the full calculation.

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Now from this X, we keep withdrawing monthly expenses and assume that each year the monthly expenses increase at some rate of inflation (6-8% typically). If we expect to live for say 30 years post-retirement,  the X will reduce to zero at that age. So the retirement planning calculation has two parts: What is X? How much should I invest to get X upon retirement? The robo template will also tell you the asset allocation (how much in equity and how much in fixed income) for each year up to retirement.

Let us redo this calculation with a “minimum guarantee”. Assume we are 55 years of age and the current annual expense is Rs. six lakh. Those younger will have to inflate their current expenses to what it would be at age 55 at say 6% inflation. This is important, but you can do this later.

Now, this annual expense of six lakh will increase each year at say 6%. My retirement corpus is X and I now divide this X into two parts. X = X1 + X2. I will invest this X1 in secure investments (eg. PO schemes) and get a post-tax return of 6% and annual interest = the annual expense in the first year of retirement.

What is income flooring?

We guarantee throughout our retirement a secure income equal to the annual expenses in the first year of retirement. This is known as income flooring. For the current example, X1 is one crore. Now since annual expenses will keep increasing due to inflation, I need some extra corpus to handle this. This extra corpus is X2.

Finding X1 is trivial (6L/6%) and finding X2 is easy enough. The only problem is, X1 + X2 will be a bit more than X from the conventional calculation, but it is far more secure. Also, my equity exposure can be lower (see video below)

Income flooring example

 Pros and cons of the “ideal retirement plan”

Even an idean plan has some disadvantages. In this case, it is a bit higher corpus! So my suggestion would be to use a standard retirement calculator and get started. This is a simple approach:

Once you start investing, you can consider graduating to the robo advisory template for better control of parameters and understanding.  Then after you are confident that you will be able to achieve that corpus of X (crores!) you can try this income flooring approach, check how much you need to invest more and strive towards that. The income flooring approach is likely to be too late for those who are 50-plus.

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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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