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 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!)
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)
- Invest 1.3 Lakh in a 1-year FD at 8% to manage next 12 months expenses (2nd year)
- Invest 1.3 Lakh in a 2-year FD at 8% to manage next 12 months expenses (3rd year)
- Invest 1.3 Lakh in a 3-year FD at 8% to manage next 12 months expenses (4th year)
- 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,
- 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
- 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
- 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
- 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
- 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:
- 8%return for 5 years. Suggested banking and PSU based debt mutual fund
- 8% return for 10 years. Suggested: debt oriented balanced funds
- 10% return for 15 years. Suggested equity oriented balanced funds
- 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.
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
- 8%return for 5 years.
- 12% return for 10 years.
- 14% return for 15 years.
- 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:
- 8%return for 5 years.
- 8% return for 10 years.
- 10% return for 15 years.
- 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?