Investment portfolios are constructed to meet future liabilities. Such liabilities range from buying a house and paying children`s tuition fees to creating endowments and meeting post-retirement lifestyle. Several investors in the recent past have asked us about post-retirement portfolios. The question is: How should one create a post-retirement portfolio that generates monthly cash flows?
This article discusses the retirees` need and the desire to generate monthly cash flows. It also explains investment avenues available to non-pensioners to generate income that replicates pension payoffs.
It is true that retirees have to match their expenses with appropriate income. But it is moot if they necessarily require monthly cash flows from the investment portfolio to enjoy their desired post-retirement lifestyle.
Suppose an investor receives a pension of Rs 5,000 a month. This approximately equals receiving cash flows of Rs 65,000 a year on a deposit of Rs 8.60 lakh carrying 8% interest. Essentially then, those who receive pension income already have bond-like cash flows. Creating a portfolio that generates monthly income would only mean even greater exposure to bonds as an asset class.
This is not true for non-pensioners. They have to generate some monthly cash flows to replicate pension payoffs. Their portfolios have to, therefore, carry sufficient bond assets to generate the required monthly income.
Now, asset allocation is essential for lifecycle investment. This means that even retirees should have some allocation to equity-like cash flows to generate higher returns. Otherwise, their portfolio will suffer from inflation risk. This is because bonds pay nominal interest rate and, hence, do not protect the retiree-investors from rising price levels.
It is important to understand that a post-retirement portfolio should contain assets that generate income as well as capital appreciation. The monthly cash flows would then come from interest, dividends and through sustainable withdrawals from the investment portfolio.
Investors have several ways to creating a portfolio generating monthly income. Many prefer Post Office Monthly Income Scheme (POMIS) offered by the Government. The problem is that POMIS by itself cannot provide the required total monthly cash flow because of an investment cap of Rs 0.45 million for each account. The investment cap translates into approximately Rs 3,000 a month based on the interest rate of 8% a year.
Investors can consider annuities along with POMIS. Such products can be purchased from insurance companies, which entitle the annuitant to receive stable cash flows through their life time. Of course, annuities are priced off the interest rate prevailing at the time of purchase; higher the interest rate, higher the cash flow that the investor will receive for the amount paid to purchase the annuity.
Besides, investors have Monthly Income Plans (MIPs) offered by asset management firms. Such funds predominantly invest in bonds and money market instruments to make monthly payments. These funds will be exposed to price risk to the extent the portfolio has exposure to short-term and long-term bonds and to equity.
It is important to note that fixed deposit with banks is not considered, as they do not provide investors with monthly cash flows. Some investors even take exposure to high dividend-yield stocks to generate monthly income. The problem is that such investments suffer high downside risk, unlike POMIS.
Conclusion
The urge to receive monthly cash flows from investment portfolio is high among retirees. This article shows why pensioners should resist this urge, as pensions have bond-like cash flows.
Non-pensioners should consider annuities, POMIS and MIPs as part of the investment repertoire to replicate pension payoffs. The proportion of the portfolio to each product would depend on investors` desired post-retirement lifestyle and risk tolerance level.
Even post-retirement portfolio should carry optimal allocation to equity and bonds, if not other asset classes. Such a portfolio would help retirees enjoy inflation-adjusted post-retirement lifestyle.
