How to plan for your retirement: Part 1

During your working life, you need to save and accumulate a sufficiently large corpus which can meet the income needs of your retired life. Unfortunately, many investors in our country do not give much importance to retirement planning until the later stages of their working career. We will discuss retirement planning in this two-part blog post.

Why is retirement planning important?

• In a joint family, financial security of all family members was ensured by the earning members. In nuclear families, you need to have a retirement plan for financial security after retirement.


• Employees covered under pension plans of their employers continue to receive income after retirement. However, vast majority of Indians do not get pension after retirement. You need to create your own pension like cash-flows from your investments.


• Average longevity is increasing and retired lives are getting longer. You must also ensure financial independence of your spouse, if he or she survives you. One must have sufficient savings or investments to ensure regular income for a long period of time.


• You should factor inflation in your retirement planning. Your living expenses will keep increasing over a long period of time. Your retirement corpus should be able to generate cash-flows to meet inflationary expenses.


• You may be forced to retire early due to a variety of factors like involuntary retirement, ill-health, to take care of ailing family members, etc. It is prudent to begin retirement planning early in life, so that you are better prepared to face unforeseen financial challenges.

Financial independence

The most important objective of retirement planning is to maintain financial independence. How do you achieve financial independence? If income from your assets is enough to meet your expenses, you are financially independent. You should understand what we mean by “assets” here. Assets are investments which generate returns or income for you. Examples of assets are mutual funds, bank FDs, stocks, bonds, property let out on rent, etc. The house in which you and your family lives, you/your spouse’s gold jewellery which you plan to use or gift to your children/ grandchildren, your vehicle for personal use, etc. are assets which do not generate any income from you.

In this blog post, we will refer only to the assets or investments which generate cash-flows for you. If your assets do not generate sufficient income to meet your expenses either due to inflation or due to excessive withdrawals, then at some point of time, you will lose financial independence and will have to depend on others e.g. children, grandchildren or other relatives.

How to plan for retirement

• You should estimate how much expenses you will have post retirement. If you have a home loan and plan to pay it off fully before retirement, you do not have to budget for EMIs. If you are paying school or college fee for your children and expect them to begin their working careers before your retirement, then you can exclude those expenses. Some of your current expenses (e.g. food, utilities, fuel, salaries for staff, maintenance and servicing, etc.) will continue even after retirement. Many people expect their expenses to be considerably lower after retirement, but based on our experience you should expect that most of your expenses except home loan EMIs and children’s educational expenses continue even after retirement.


• You should factor inflation in your retirement planning. Let us assume that you plan to retire in 20 years and your current living expense, excluding the ones that will go away post retirement (e.g. home loan EMI, children’s education, etc.), is Rs 50,000 per month or Rs. 6,00,000 per year. Assuming 4% inflation, your annual expense will be around Rs. 13,00,000 per annum (Rs. 13 lakhs per annum).
  
  You can explore this retirement calculator to understand it better!


• How much should you accumulate? After retirement, you should have a conservative risk profile. You should not expect more than 5 – 6% annual pre tax return on investment (ROI). Assuming your effective annual tax rate is 12.5% (e.g. you are Rs. 12.5 to Rs. 15 lakhs income slab)your post tax return will be 4 – 5%. If you need annual income of Rs. 13 lakhs, then you need to have a corpus of Rs 2.6 – Rs. 3.2 crores assuming 4 – 5% withdrawal after taxes every year. Here we have assumed that you have no other source of income other than your investments. If you have other sources of income after retirement e.g. rental income from let out property, pension, income from professional services (e.g. consultancy) etc., you can reduce that from your expenses to calculate income need from investments.


• In the above example, we have assumed that you will leave your entire corpus as an estate (i.e. as an inheritance) for your loved ones e.g. children, grandchildren, etc. and will live only off the returns. If you want to leave a smaller estate or no estate at all, then you can make bigger withdrawals from your corpus. In that case, you can manage with a smaller corpus. However, you should be mindful of the fact that, if your withdrawal rate is higher than the ROI, then your corpus will keep reducing in value over time. Your withdrawal rate should be such that your corpus does not go to zero in your and your spouses’ lifetime. We will discuss this in more details later.


• So far, we have discussed about the impact of inflation after your retirement. Since your expenses will keep increasing after retirement, you will need more income in future years. How can you get more income from your investments, despite withdrawing regularly to meet your expenses? The answer is capital appreciation. You need to have a percentage of your asset allocation in equities even after retirement. Historical data shows that equity as an asset class can give superior inflation adjusted post tax returns.


• The next question will be“how much equity should you have in your asset allocation after retirement?” Your equity allocation will depend on your risk appetite, your corpus and income needs. As a general guideline, one may refer to the Asset Allocation Rule of 100. The Rule of 100 suggests that your equity allocation should be 100 minus your age. So when your age is 65, you should have 65% of your assets in fixed income and 35% in equity. Here are suggested asset allocations for different ages post retirement based on Rule of 100.
  
  

Suggested reading: What is asset allocation and why it is important?

Conclusion of this part

One aspect of retirement planning that we have not discussed in the post is lifestyle because lifestyle needs varies from individual to individual. However, lifestyle considerations are very important in retirement planning. Your retirement plan should enable you maintain your lifestyle even after retirement because lifestyle is very difficult to change.

Our objective in this post was to give you some general guidance about how you can think about retirement planning. You should consult with your financial advisor in determining how much you need to save and invest in order to meet your retirement goal. In the next part of this series, we will discuss how you can go about your retirement planning with mutual funds. For now you can read this why you should start investing early in mutual funds for your retirement planning.