‘Can I invest in such a way that my capital is protected?’ is a question that many ask. Especially those who are retired, or about to retire. The answer is contextual. The term capital protection can take two meanings depending on how we use it. In this post, I discuss the disadvantages of capital protection, when one should do it and what are the alternatives.
Protection against erosion: In its simplest and most popular form, if I have invest one lakh today, the investment should not erode that capital. Or in other words, the capital invested should be intact at all times (protected against loss). Capital protection against erosion is essential in certain situations and is easy to achieve.
Protection against loss in value: Rs.1 lakh today will still be Rs. 1 lakh twenty years from now. However, its value or what we can buy with it would be considerably less. As you know, this is due to the effect of inflation. Capital protection against inflation is essential but not easy to achieve after retirement. A part of the corpus must be able to fetch a real return to enable this and real returns imply taking on volatility. Real return refers to excess return above practical inflation after taxes. How much volatility exposure a retiree should take on is, however, debatable.
I have suggested some guidelines earlier on when erosion protection is essential and when value protection is possible: When should senior citizens purchase an annuity?
The problem in both cases is inflation and sudden changes to lifestyle resulting in recurring expenses.
If my corpus is too low that I cannot afford to take on risks, I am forced to protect my capital against erosion and completely unprotected against inflation (loss in value).
If my corpus is comfortably large, then I can combat inflation and ensure that it outlives me.
The danger is when it is neither too small nor too large (these limits are arbitrary!), then it is a see-saw between erosion protection and inflation protection and if one gets it wrong, it can be a problem.
Can these two protections be combined?
If the retirement corpus grows year after year by an amount which is exactly equal to the amount we withdraw for expenses, then we have achieved capital protection and value protection. This is known as a perpetuity. An illustration can be found here: Is it possible to retire early in India?
Achieving this in a country with high inflation is quite difficult and if there are sudden withdrawals, the plan will go phut.
In response to Generating an inflation-protected income with a lump sum, Mr Lakshminarasimma had asked an interesting question which made me write this post:
assuming only you and your wife are there and you have 90 lakhs after doing all marriages college education of your children. also assuming you have physical and mental strength
put entire 90 lakhs in FD, get monthly 55k post tax as interest at 8%, manage 35k expenses and some 15k keep putting in mutual fund. keep 5k as reserve
in this way your capital is protected, you manage monthly expense, also you invest still in share market like subra says.
Will this work? Can capital and value protection be combined by investing the corpus in risk-free assets, live off part of the interest and invest the rest? Let us find out.
Assuming for a moment it is possible to find a risk-free instrument that offers 8% return before tax (at 10.3%)* for 20 years (it is not possible, but please humour me for argument’s sake), this how it will pan out ideally!
* It should be 20.6%, making things worse but will not change the main idea.
Assuming a conservative inflation rate of 6% (unrealistic), within 9 years, the expenses will overtake the interest from the “risk-free” instrument – notice how risky this really is!! And we have assumed for 20 years, there will be no unknown expenses!!
Capital protection is possible after retirement, but at what cost?!
So what should be done? In this case, the initial withdrawal rate is 4.67% (12 x 35,000/90,00,000). This is pretty decent and the retiree can afford to stomach some volatility. Using the Four Simple Retirement Planning Tools (app version coming soon), one can find out that 90 Lakhs, at 8% inflation and a net portfolio return after tax of 7% can last for 19.6 years (after which it will be exhausted)
There are many ways to achieve this comfortably. Using the ideas discussed in deciding on asset allocation for a financial goal, suppose I decide to invest 70% in risk-free fixed income and 30% in say, equity-oriented balanced funds (which I consider as 100% equity).
I expect 6% post-tax from the fixed income instrument (reasonable for now?) and 9% from the equity balanced funds (conservative?)
Then 70%x6% + 30%x9% = 6.9% Which should be enough.
This is a comfortable situation owing to the availability of 90 Lakhs and expenses (initially) only 35K a month. The trade off between capital protection and volatility is easily achieved.
If I had only 80L, then for the above assumptions, the corpus will only last 17+ years. To make it touch 20 years, I will have to obtain more return. Meaning, I will have to take on more volatility.
With decreasing corpus or higher expenses, the trade-off will become harder and harder until I cannot take on any risk.
For example, suppose I had only 50L, my monthly expense is 25K then I will need about 10% return from the portfolio after tax to make the corpus last for 20 years with 8% inflation.
And how will I get this 10% return?
Fixed income 50% with 8% expectation after tax and Equity 50% with 12% expectation. Is this reasonable? Not in my book. A single market crash and I ruined. In such a case capital protection is mandatory!
So to sum up, sometimes capital protection is dangerous, and sometimes necessary. Sometimes one can balance between safety and volatility and sometimes one cannot! Check out the following posts to get a better understanding of the ideas discussed here: