Illustration: Generating inflation-protected post-retirement income

Given a lump sum, how does one generate an income from it? How do we tackle inflation in retirement? Not too long ago, I was under the impression that such questions are asked only by senior citizens.  I soon realized the problem is extremely common.

Many children are trying to optimize income from their parents retirement corpus. Many young (and not so young) people are trying to do the same for their aging relatives.

Budding early retirees  are constantly thinking about retirement planning strategies.

I realized just how popular this issue was when the detailed writeup on how to generate inflation-protected income from a lump sum was published.

This was soon followed up with the  Inflation-protected Income Simulator 

For the past two years, many people belonging to the above-mentioned groups have used freefincal calculators and have written to me about how to go about it.

I generally do not like to publish the queries I receive, as I don't feel comfortable doing that.

However, when I received an email about how to generate inflation-protected income for an elderly couple, I realized that sharing the strategy advised could lead to more ideas as readers are bound to critique it and propose alternative strategies.

With that aim, and with the permission of the person who posed the question of how to  generate inflation-protected retirement income, I would like to share my response to the following problem.

Carl and Ellie from the movie, 'UP' (2009).  Pixar Animation Studios
Carl and Ellie from the movie, 'UP' (2009). Pixar Animation Studios

Inputs
Carl lives with his wife Ellie in a small town. Carl recently retired from his job and received a lump sum of Rs. 35 lakhs with no pension. Ellie is a housewife.

Their children are settled and independent.

Carl and Ellie are both diabetic and do not have any medical insurance. We will assume that they both are medically uninsurable.

Their monthly expenses are about Rs. 10,000 per month (advantage of living in a small town!)

 Objective

Devise a plan for Carl and Ellie to be financially independent in the evening of their lives.

This is how I went about it. Please feel free to share your views and strategy in the comments section.

Calculate Annual expenses:  10000 x 13 = 1,30,000 (13 is used instead of 12 for safety)

Inflation Rate: 8%

Interest rate of instrument in which corpus is invested: 8% (post-tax)

Income up to Rs. 3,00,000 is exempt from tax for senior citizens. Carl and Ellie can manage for 11 years if this limit is never changed. Since it should only increase in the near future, we will assume getting 8% after tax will not be difficult for them.

Using an annuity calculator, we estimate that, if the entire 35 Lakhs is used for income generation, Carl and Ellie can receive inflation-protected income for 27 years.

However, they are both diabetic and don't have medical insurance. So allocating some money towards a medical expense and emergency corpus is the first step.

So we will assume that inflation-protected income is needed for 25 years (that is when Carl turns 85) for  a start.

This is far from ideal, since Ellie is younger than Carl, but this is a good enough starting point.

So they need 32.50 Lakhs for inflation-protected income for 25 years.

This leaves 2.5L a seed money for the medical/emergency coprus.

  • Can we increase this seed money?
  • Or alternatively, can we invest less than 32.5L for income generation?
  • Can we increase the duration over which the inflation-protected income can be generated?

Thankfully, this is indeed possible if they adopt what is known as the bucket strategy.

Carl and Ellie divide the next 25 year period into 5-year capsules.

For the first capsule (1st 5 years in retirement), they ensure inflation-protected income by taking the following actions (using the income ladder calculator)

Keep away 1.3 Lakh  in a bank account to manage first 12 months expenses (1st year in retirement)

  1. Invest 1.3 Lakh in a 1-year FD at 8% to manage next 12 months expenses  (2nd year)
  2. Invest 1.3 Lakh in a 2-year FD at 8% to manage next 12 months expenses  (3rd year)
  3. Invest 1.3 Lakh in a 3-year FD at 8% to manage next 12 months expenses  (4th year)
  4. Invest 1.3 Lakh in a 4-year FD at 8% to manage next 12 months expenses  (5th year)

Total amount required: 6.5 Lakhs

The maturity values of the FDs will correspond to the expenses of the couple increasing annually by 8% ( our inflation assumption).

Thus using this income ladder, they can generate inflation-protected income for the first five years in retirement (1st capsule).

The second capsule is from years 6-10.  The necessary amount to adopt the same income ladder strategy can be derived from an investment made at the start of retirement.

That is in addition to the 6.5 Lakhs to manage the income ladder from years 1-5,

  1. A sum of 6.5 L is invested at 8% for 5 years. When it matures it is used to run an income ladder from years 6-10
  2. A sum of 6.5 L is invested at 8% for 10 years. When it matures it is used to run an income ladder from years 11-15
  3. A sum of 6.5 L is invested at 8% for 15 years. When it matures it is used to run an income ladder from years 16-20
  4. A sum of 6.5 L is invested at 8% for 20 years. When it matures it is used to run an income ladder from years 21-25

A total of 6.5L x 5 = 32.5 L

These calculations were made with the Inflation-protected Income Simulator 

Notice that

  • A sum of 6.5L is immediately used up (to run an income ladder from years 1-5).
  • Four sums of 6.5 L is invested for durations of 5,10,15 and 20 years.

Why should the return expectation of the investment for durations 10, 15,  and 20 years be only 8%?

Why can't it be more, by investing suitably?

Yes of course but before stating thinking about equity, we will need to understand that this 32.5L is precious to the couple and there is a limit to the amount of risk that we can take.

So let us assume:

  1.  8%return for 5 years. Suggested banking and PSU based debt mutual fund
  2.  8% return for 10 years.  Suggested:  debt oriented balanced funds
  3. 10% return for 15 years. Suggested equity oriented balanced funds
  4. 10% return for 20 years. Suggested equity oriented balanced funds

What is the investment required for each duration? This can be easily calculated with the  Inflation-protected Income Simulator 

If return expectation was  uniformly 8%, a total amount of 32.5 L was needed.

If return expectations vary as above, only 29 L is needed.

This is significant for Carl and Ellie because out of 35 L, a sum of about 6L can be invested in fixed deposits and kept aside as a medical corpus and emergency fund.

If the actual return is higher than our expectations, inflation-protected income can be generated for more than 25 years.

Perfect!

The corpus in this example was adequate even with a conservative estimate of 8% for all the investments.

What if the total corpus is only 25K?

Assuming 3L is kept away as a medical corpus, can an inflation-protected income be generated with just 22 L instead of the 29 L estimated above?

If Carl and Ellie will have to work with 22 L instead of 29 L, they will have to get higher returns if income must increase by 8% each year.

Unfortunately higher returns either means higher credit risk or higher volatility.

If  22L is the corpus available for investment, for 8% annual increase in income, Carl and Ellie will have to expect

  1.  8%return for 5 years.
  2.  12% return for 10 years.
  3. 14% return for 15 years.
  4. 14% return for 20 years.

How realistic is that? Perhaps they can pull it off, but what if they cannot?

The probability of 'cannot' is too high for comfort. So in such a case they will have to either

  •  lower inflation expectation or
  • find ways to generate constant income in retirement.

Either way the above strategy need not be abandoned in favour of an annuity.

Thankfully lowering inflation expectation is good enough in most situations.

If the income is assumed to increase 5% each year (instead of 8%), only 21.6 L is necessary for the conservative schedule assumed above:

  1.  8%return for 5 years.
  2.  8% return for 10 years.
  3. 10% return for 15 years.
  4. 10% return for 20 years.

Other possibilities can be worked out with the Inflation-protected Income Simulator 

This the main point of this post. The above-mentioned strategy can be used even for low corpuses with a suitably lower annual increase in income, without taking on additional risk.

The strategy will work even with zero inflation or a constant income.

Caution: Lowering the percentage increase in annual income will work for senior citizens. As far as they are concerned, this is any day better than locking the entire corpus in an annuity at the start of retirement to receive a constant income.

People who are planning for early retirement must strive to work with as large an inflation as possible.

They simply cannot risk quitting their job with a 'lower' corpus assuming they will reduce the inflation on their expenses with a frugal existence.

What do you think?

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23 thoughts on “Illustration: Generating inflation-protected post-retirement income

  1. bharat shah

    i think , the income ladder buckets concept is the answer to inflation proof income in retirement years for having limited resources. only problem is management of investments,a little risky than fixed income instruments in increasing age years and sometimes a lone of couple lived behind, particularly in case where no trustworthy is available .

    Reply
    1. pattu

      Yes I agree. The couple should be able to manage the investments on their own or with the help of a trustworthy relative or professional.

      Reply
  2. bharat shah

    i think , the income ladder buckets concept is the answer to inflation proof income in retirement years for having limited resources. only problem is management of investments,a little risky than fixed income instruments in increasing age years and sometimes a lone of couple lived behind, particularly in case where no trustworthy is available .

    Reply
    1. pattu

      Yes I agree. The couple should be able to manage the investments on their own or with the help of a trustworthy relative or professional.

      Reply
  3. Deep

    The above approach is very conservative.For 32.5 lk corpus with annual spending of 1.3 lk .i would suggest 29 lk be kept in equities through a mix of index and diversified equity fund,the rest in liquid fund.Since 2004 the sensex has never returned a negative 3 yr rolling return .Please refer http://www.hdfcfund.com/Calculators/SensexRollingReturnsCalculator.aspx?ReportID=C208C983-C4A5-41B4-B245-CB77C8D2EDC3.The volatality risk as measured by standard deviation will always be there in equities but let us not overplay it.The total market capitalization of bse today stands at around 1.5 trillion usd up from about 120 billion in 2002-03 ,please refer http://www.bseindia.com/markets/keystatics/Keystat_maktcap.aspx?expandable=0,which means the market today is far more deeper or in other words market size is huge compared to global as well as domestic liquidity.As usual i stand by my aggressive equity allocation recommendation.

    Reply
    1. pattu

      This approach is too risky. A single market crash will devastate the couple. They can never recover.

      Reply
  4. Deep

    The above approach is very conservative.For 32.5 lk corpus with annual spending of 1.3 lk .i would suggest 29 lk be kept in equities through a mix of index and diversified equity fund,the rest in liquid fund.Since 2004 the sensex has never returned a negative 3 yr rolling return .Please refer http://www.hdfcfund.com/Calculators/SensexRollingReturnsCalculator.aspx?ReportID=C208C983-C4A5-41B4-B245-CB77C8D2EDC3.The volatality risk as measured by standard deviation will always be there in equities but let us not overplay it.The total market capitalization of bse today stands at around 1.5 trillion usd up from about 120 billion in 2002-03 ,please refer http://www.bseindia.com/markets/keystatics/Keystat_maktcap.aspx?expandable=0,which means the market today is far more deeper or in other words market size is huge compared to global as well as domestic liquidity.As usual i stand by my aggressive equity allocation recommendation.

    Reply
    1. pattu

      This approach is too risky. A single market crash will devastate the couple. They can never recover.

      Reply
  5. ashalanshu

    Bucketing is OK. controlled Eq. exposure through hybrid fund is also OK but after 8-10Y from here on wards, the couple may not be in a good health condition to check and manage MFs so by that time say age 70-75, we w'd have to return to safety of debt - means lower return.

    Thanks

    Ashal

    Reply
    1. pattu

      Yes, agreed. With some luck at that time, they would have a reasonable corpus to provide a constant income at least a little higher than their expenses at that time.

      Reply
  6. ashalanshu

    Bucketing is OK. controlled Eq. exposure through hybrid fund is also OK but after 8-10Y from here on wards, the couple may not be in a good health condition to check and manage MFs so by that time say age 70-75, we w'd have to return to safety of debt - means lower return.

    Thanks

    Ashal

    Reply
    1. pattu

      Yes, agreed. With some luck at that time, they would have a reasonable corpus to provide a constant income at least a little higher than their expenses at that time.

      Reply
  7. austereseeker

    Food inflation is more like 20%, sir. And 10,000 pm is not enough for one person. Plus expenses would increase in retirement-- more time so more travel, more family functions and social obligations, etc.

    Reply
    1. pattu

      Food inflation is only one component of overall inflation. You do any planning with 20% inflation. It simply too high. Expenses depend on lifestyle. I was asked to plan for 10K monthly expenses and I did.

      Reply
  8. austereseeker

    Food inflation is more like 20%, sir. And 10,000 pm is not enough for one person. Plus expenses would increase in retirement-- more time so more travel, more family functions and social obligations, etc.

    Reply
    1. pattu

      Food inflation is only one component of overall inflation. You do any planning with 20% inflation. It simply too high. Expenses depend on lifestyle. I was asked to plan for 10K monthly expenses and I did.

      Reply
    2. Jayadeep Purushothaman

      whether 10K per month is not enough depends on where you are and what your lifestyle is - there are places in the country where you can lead a very descent life with 10K. In fact if they can produce some descent food(eg: sufficient coconut for their own use and pepper/cashew to sell in Kerala), you don't really need even 10K.

      Reply
  9. Vin

    Is it a good idea to start the bucket strategy outlined in the article as soon as one reaches 60 (and has atleast 3 years of working life left ahead) ? Or is it good to wait till active work life is over and then start the bucket strategy with more earned corpus ?

    Reply
  10. Vin

    Is it a good idea to start the bucket strategy outlined in the article as soon as one reaches 60 (and has atleast 3 years of working life left ahead) ? Or is it good to wait till active work life is over and then start the bucket strategy with more earned corpus ?

    Reply
  11. Piyush Khatri

    I have met lot of people approaching their retirement. Most of them are heavily depended on their provident fund and gratuity (Low income group), Some of them are heavily invested in Real Estate (High income group). And very few have nothing to show.
    I don't really believe in equity as a income generator after retirement. I have met 240 people in person last month in 6 different cities (A corporate program). A diverse income group of 6500 monthly to 2,50,000 monthly.
    Only 4-5 people out of them invested in MF or equity. I have seen few program on TV as well, where expert are advising Mutual funds as peanuts to monkey.
    You will not become a expert of mutual fund by following ratings of research house. Even people who do research in those firms are young CFA's, who has more of a ego to beat their fellow analyst rather than genuine concern for a layman.
    I am trying to aware people, mostly aged people approaching their retirement about Post office savings. It is easily assessable and reliable for them.
    I would not hesitate to advise a person in their sunny days to invest in equity, though he should have surplus corpus to do that. I would not let him compromise with his/her daily needs.

    Reply
    1. pattu

      It is horses for courses, Piyush. A person who has started investing for retirement quite early with significant equity exposure, is likely to have a decent corpus. Such a person (only such a person) can afford to have good equity exposure after retirement too.

      Reply
  12. Piyush Khatri

    I have met lot of people approaching their retirement. Most of them are heavily depended on their provident fund and gratuity (Low income group), Some of them are heavily invested in Real Estate (High income group). And very few have nothing to show.
    I don't really believe in equity as a income generator after retirement. I have met 240 people in person last month in 6 different cities (A corporate program). A diverse income group of 6500 monthly to 2,50,000 monthly.
    Only 4-5 people out of them invested in MF or equity. I have seen few program on TV as well, where expert are advising Mutual funds as peanuts to monkey.
    You will not become a expert of mutual fund by following ratings of research house. Even people who do research in those firms are young CFA's, who has more of a ego to beat their fellow analyst rather than genuine concern for a layman.
    I am trying to aware people, mostly aged people approaching their retirement about Post office savings. It is easily assessable and reliable for them.
    I would not hesitate to advise a person in their sunny days to invest in equity, though he should have surplus corpus to do that. I would not let him compromise with his/her daily needs.

    Reply
    1. pattu

      It is horses for courses, Piyush. A person who has started investing for retirement quite early with significant equity exposure, is likely to have a decent corpus. Such a person (only such a person) can afford to have good equity exposure after retirement too.

      Reply

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