Income portfolio has to be built to meet requirements of changing inflation and expenses later
Not everybody is assured of a pension from an employer, and even if there is a pension, it may not be adequate to meet all the needs in retirement. The corpus built out of savings in the working years is, therefore, invested to create an income stream to meet expenses in retirement. This income needs to last through the retirement years, be stable and adequate to meet expenses and counter the impact of inflation on expenses. But such expectations from retirement income are inherently contradictory to each other, and no one source of income can meet all of them.
For life, but low
The biggest fear or risk in retirement is that of running out of money. “The approach has to be to protect the needs you have for the next 3-5 years in safe investments, so that short-term market fluctuations do not impact you just as you get used to the concept of retirement Beyond that, senior citizens will need to have part of their funds invested in equity or growth assets, which have a higher certainty of beating inflation over longer durations," said Lovaii Navlakhi, founder and chief executive officer, International Money Matters Pvt. Ltd.
A retiree who chooses annuity as a product to invest her retirement corpus will ensure a steady pension for life. However, this assurance comes with the risk of having to deal with a lower income, and that may limit the freedom with which expenses and desires are met during retirement.
Steady, but limited
Popular sources of retirement income include investments such as Senior Citizens’ Savings Scheme (SCSS), bank deposits, post office savings, and others, that now provide returns aligned to market rates of interest. The returns are guaranteed or assured, and in the case of SCSS, it has a higher interest income (8.6% per annum with effect from 1 April 2016) than comparable products. Despite their desirability, the extent to which schemes like SCSS and the post office monthly income scheme (POMIS) can be used to generate retirement income is limited because there are caps on the amount that can be invested in these schemes.
“Depending on one’s cash flow requirement and her tolerance to risk, she can form a financial portfolio comprising of a combination of these products. The tax efficiency of the products will have to be factored in as well," said Amit Kukreja, founder, WealthBeing Advisors.
Adjust for inflation
Assume you have invested in a product that provides a monthly income of 40,000, which is adequate to meet the expenses of 30,000 during retirement. Considering inflation at 5%, the expenses which cost 30,000 to meet at the start of retirement will require more than 40,000 to meet in just seven years. In the 7th year of retirement itself, the income will become inadequate to meet your expenses.
A fixed income product does not consider the impact of inflation on expenses to be met, and will fall short unless the income keeps pace with the impact of inflation.
To earn inflation-adjusted returns, the retiree must be willing to take some risks with investments. “While senior citizens invest in risk averse avenues for steady cash flows, they should allocate a portion of their portfolio in inflation beating products. Allocation of 15-20% of their portfolio to large-cap and balanced equity mutual funds for beating inflation, and debt funds for tax efficiency, is advisable," said Kukreja.
Also, inflation on post-retirement expenses are inching higher as medical expenses form a major part of the total expenses. “It is difficult to meet the need with a single investing option as inflation and medical expenses bring a change in your required income. Keeping your money ahead of inflation and investing in instruments that beat inflation on a post-tax basis is a bigger challenge in the golden years," said Dinesh Rohira, founder and chief executive officer, 5nance.com, a financial advisory portal.
Heed the tax
The post-tax income is what will be available to the retiree to spend. Pension, whether received from an employer or from an annuity, interest income earned on bonds and deposits, rental income are all taxable. “While selecting investments, seek products that have higher returns not in absolute terms but on a post-tax basis. Liquidity or lock-in is another factor one needs to keep in mind. SCSS, where a person over 60 years can invest a maximum of 15 lakh and earn 8.6% per annum quarterly is a good start if one has no other income. The idea is to maximise the tax-free returns of 5 lakh per annum with instruments that give higher returns but which are taxable," said Navlakhi.
Some income earned, such as rental income, are allowed to be adjusted before calculating the income chargeable to tax. The amount of rental income charged to tax is lower than what is actually received, and this improves its post-tax yield.
Mix and match
There is no one source of retirement income that can balance all these features that are essential for a satisfactory retirement income.
The efficient way is to create a retirement income portfolio that will generate multiple income streams, each of which meet one or more of the desired characteristics.
“For a person retiring at age 60, the retired life can be around 30 years, considering the increase in longevity. The effect of inflation is to be considered for this 30-year period. You cannot ignore equity even during this phase. Depending on the comfort level, you can choose to have 15-25% of the retirement corpus in equity. After 10 years, this can be slowly shifted to debt products." said Melvin Joseph, founder, Finvin Financial Planners.
Some products will bring assured income for life, but given the low returns, use these only to the extent required to meet mandatory expenses such as health and insurance, loan repayments, if any, taxes and such. Over time, as retirement progresses, add more of such income to meet most expenses since retirees will prefer assurance and simplicity.
“The single biggest worry of large outflow at this stage is medical expenses. A health insurance policy taken in the working years will ensure that the exclusion period of pre-existing illnesses is over. However, beyond the policy, there may be a need to earmark a corpus for medical purposes—a combination of liquid funds, bank deposits and possibly a pharma fund, could be a solution," said Navlakhi.
Depending upon each individual’s preferences and the stage of retirement, the feature of retirement income that is most relevant will vary. In the early stages, when expenses on leisure are likely to be high, some proportion of the portfolio needs to be invested for better returns. In the later years, the focus will be on predictability and simplicity.
The income portfolio in retirement has to be built and modified to reflect these preferences.