Friday, August 31, 2018

Retirement Planning - how much is enough ?

source : economictimes.indiatimes.com


By Dhirendra Kumar 
A few weeks ago, I wrote about how conventional wisdom on retirement savings is condemning Indian savers to old-age poverty. During decades of retired life, inflation destroys the value of your savings relentlessly. Many people find that their savings are not enough. Eventually, at some point, they realise that they are running out of money. Nothing is worse than a long period of old age, where an old couple gradually loses prosperity and then faces poverty. Yet, all around us, we can see many senior citizens in a similar situation. 




                                                                                           How can you prevent this from happening to you? 





   

                                                                                            The first half, which I have written about in detail earlier, is about saving enough during one’s working life and investing this money in equity-backed mutual funds. It sets the stage for a financially comfortable old age. 

 
Miles to go before I sleep !
  
The second part, which is the outcome, is deriving income from these savings once retired life begins. If you have appreciated what I’ve been saying about inflation, then this should be self-evident: you must spend, at most, only that part of your investment returns which exceed inflation rate

    
This is another way of saying that you must preserve the value of your principal. However, you must preserve the real, inflation-adjusted value of your money, not just the nominal face value. Please read the preceding paragraph again, carefully. It’s possibly the single most important input to having a financially comfortable old age. So how do you do this?   

Suppose you retire today with a Rs 1 crore corpus. If you put the money in a bank fixed deposit, a year later, it will be worth Rs 1.07 crore. So you would have earned Rs 7 lakh, which you can spend, right? Not really. 

Assuming a realistic inflation rate of 5%, if you want to preserve the real value of your principal, you must leave Rs 1.05 crore in the bank. That leaves you with Rs 2 lakh to withdraw and spend over a year, which is Rs 16,666 a month. 


   
   
  
                 


                                              
Is that enough?  


For a middle class person, surely not. It could be a little worse with some banks, and it could be a little better with, say, the Post Office Monthly Income Scheme, but basically, this is roughly the calculation.  

It’s important to understand that with fixed deposits (and similar investments), this calculation does not change even when interest rates rise because inflation and interest track each other closely. The real (inflation-adjusted) interest rate is not going to be more than 1.5-2% at best. 

If you need Rs 50,000 a month, you need about Rs 3 crore. Of course, at that level of income, tax also has to be paid. So, about Rs 30,000 a year will go as tax. This is the best case scenario. In practice, it’s often worse, as there have been times in the past when the interest rate has been below the real inflation rate. 
Moreover, income tax on deposits has to be paid whether you realise the returns or not. There can be a situation when the interest rate barely exceeds the inflation rate and the income tax on the interest is effectively reducing the real value of money. 
The situation is very different in equity-backed mutual funds. Unlike deposits, these are high-earning, but volatile. 



In any given year, the returns could be high or low, but over five to to seven years, or more, these comfortably exceed inflation by 6-7%, even more. 

For example, over the past five years, a majority of equity funds have given returns exceeding 17%, with about a fourth crossing 20%. The returns may have fluctuated, but that’s something the saver has to put up with for getting rid of fear of old-age poverty. 

In such funds, one can happily withdraw 4% a year  and still have a big safety margin. Besides, there is no income tax and the capital gains tax is 10% on actual withdrawals. Effectively, for a given monthly expenditure through equity funds, you need just half the investment that you would in deposits. So, for a monthly income of Rs 50,000 a month (or Rs 6 Lakh per annum), Rs 1.5 crore (4% of 1.5 Crore is Rs 6 lakh per annum) will suffice. 


Even now, only a small (but growing) number of people have begun to understand and appreciate this idea, and started implementing it. They tend to be those who have used equity funds as their savings vehicle anyway and are used to ignoring short-term volatility in the interest of long-term gains.  

El Dorado


Unfortunately, most retired people are still looking  for the non-existent safety that fixed deposits provide and end up facing hardships as they grow older.                                         


Notes by me : This Rs 1.5 Crore is for a person retiring today in 2018. If your are retiring after 10 years, then multiply this figure by 2 (assuming 7% inflation, the expenditure will be double by after 10 years)





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