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Thursday, October 20, 2016

Retirees need not only Invest in Bank FDs

You are happy that you have saved diligently and along with other retirement dues from your employer, you have accumulated a decent corpus to retire on.

You think that all your financial worries are over and you can now look forward to a happy and peaceful retired life. Wake up and get real!

The first thing to note is that with increasing life spans, you and/or your spouse are in all likelihood set to live for another 3 decades. The money has to last till then.

Secondly I hope over and above this corpus, you have adequate medical insurance cover for both of you and in addition a decent amount as a buffer in medical emergencies, because otherwise these situations could eat into your corpus.

Thirdly, are you planning to invest all your money in fixed deposits or bonds because you want your capital to be protected? You think the interest earned is more than sufficient for your needs hence you will be comfortable throughout your lifetime?

Once again I urge you to get real. 25-30 years retirement life spans will be common.

 Longer life spans will mean that the Retirement corpus will have to last longer.  In a country like ours, where the rates of inflation are almost equal to the interest rates or sometimes even higher, this is an impossible task. So what is the solution? The retirement corpus needs to be divided into two parts. The bigger portion goes into FDs or some such interest earning products. These would earn returns, enough to fulfill your expense needs.  

The smaller portion is invested into equity; either stocks or equity mutual funds. This investment should continue for the better part of the decade so that short term fluctuations are ignored and over time the corpus grows at a decent rate. As time passes your expenses increase and you feel the need to add to your income.

By then the equity fund grows to an extent that it can be dipped into and you can sell some of it to add to your Fixed Deposit portfolio.

Let me illustrate this by an example. Let us say you retire today with a corpus of Rs. 1 crore. You invest all your money in Fixed Deposits. Assuming an interest rate of 8% , you can earn Rs. 8 Lakh per year. Accounting for income tax it should be around Rs. 7 Lakh. Let us assume that your present monthly expense is Rs. 35,000. So on an annual basis you require Rs. 4.20 Lakh, but you are getting Rs. 7 Lakh which is way more than the money you require for your living expenses. You can invest in your FDs in such a way that non cumulative option is used only to the extent you require income and the rest could be invested under cumulative option. A very happy state of affairs indeed!   As the years roll by, inflation causes your expenses to increase and at some point in time you will convert your cumulative FDs to non cumulative.

The effect of inflation is relentless and even after this there will come a time when you will find that your interest income is no longer sufficient to meet your expenses and you have nothing to fall back on. From now on, you will have to dip into your capital to meet your expenses.

An inflation of 8%, doubles your expenses in 9 years. You will fall short way before that. Is this a risk you are willing to take? I hope not. So lets work with the solution cited above. You have Rs. 1 crore. Lets say you invest only Rs. 70 Lakh in FDs and the rest of the money in equity funds. Even Rs 70 lakh will generate more than Rs 5.5 lakh income (a little over Rs. 5 Lakh after tax), so you consider investing some FDs under cumulative option. Now your expenses don't double all of a sudden after nine years but they increase slowly over the years. As they increase you can convert the cumulative option to non cumulative.

This should work for a few years depending on how the expenses increase. By the time this income becomes insufficient, we can expect that your equity corpus increases substantially (If the corpus earns 12% return, it doubles in six years and your Rs. 30 Lakh will become around Rs. 60 Lakh). It is now time to partly sell the equity corpus and add the sale proceeds to your fixed deposits, thus increasing your income as per requirement and also leaving sufficient investment in equity for it to repeat the feat. Please understand that the assumptions made for inflation and returns from FDs and equity are all in the practical realm but the figures would change from time to time. The most tricky assumption is on the equity performance and I would be the last to hazard a guess on the returns over a fixed period of time. The main aim of the article is to caution the reader of the perils in making an all FD portfolio post retirement.

The risk of running out of money far outweighs the risk of investing in equity. The example I have given should be taken as a broad guideline to follow. If you are not confident of being able to execute this process by yourself, you are better off consulting a financial advisor.

A few words of caution

Your retirement corpus is sacrosanct. Be wary of "get rich quick" schemes because there is never such a thing as a "free lunch". This amount is also not meant to be spent on funding your son's business or spending lavishly on your child's wedding. These events are to be planned for in advance and separate funds to be accumulated for that.

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