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How to build a DREAM retirement fund
Retirement in the general terms refer to the end of working life of an individual, called in other words in organised sector as superannuation. While planning for a happy retirement is a necessary part of the financial life of an individual, there are two phases involved in the process.
1. Accumulation phase
2. Withdrawal phase
Accumulation phase is the period in the working life of the individual when s/he is working and regular contributions are being made towards the retirement corpus. This should be done as per the strategy charted out in a well-drafted financial plan in consultation with a financial planner.
Though a lot of importance is given to accumulation phase, managing the withdrawals in such a way that the individual does not outlast the corpus is equally important. Planning for the same should be done from the stage of financial plan construction only, however scope for correction and adjustments can be provided as the period of forecasting and assumptions are very long.
There are retirement products available in the market in form of annuities of insurance companies, which are designed in such a way that there is a regular periodic payment for the holder instead of one lump sum payment. These annuity plans may be good option, the only shortfall being that the investments and withdrawals are not customised and are not related to the replacement ratio.
Government of India has taken cognisance of the fact with New Pension System coming up; this system also has a mandatory requirement of purchasing an annuity from 60 per cent of the accumulated corpus at the time of withdrawal. Thus it becomes clear that withdrawal management is important and should be done in such a way that there is a steady flow of income to the individual to provide for expenses during the retirement period.
It is challenging to customise the corpus withdrawal schedule for every individual at the institutional level and thus the onus to manage the income from corpus lies on the individual herself/himself and it should be done in consultation with an expert like a certified financial professional, who is equipped to manage the corpus in terms of longevity and other factors like return optimisation and tax efficiency.
The writer is working with Financial Planning Standards Board India (FPSB India) in the capacity of Vice Chairman and Chief Executive Officer. The views expressed here are personal, and do not necessarily represent that of the organisation. FPSB India is the sole marks licensing authority for the CFP marks in India, through agreement with US-based FPSB Ltd.
How to build a DREAM retirement fund
The timing of withdrawals also plays a very important role in deciding the return generated on the invested sum of money, for example, a corpus invested primarily in debt products may be affected by the movements of interest rates which are a function of macroeconomic factors. The other factors that go into deciding the management of corpus are following:
1. Risk
Though it is advisable to invest the retirement corpus in risk free investments like government securities or post office deposits, some risk can be incorporated in the portfolio looking at the risk appetite and financial position of an individual which can optimise returns.
2. Return
High returns will be difficult to chase with the money in retirement corpus, however it must be ensured that the best possible return as per the decided risk category is generated through proper investment. As retirement is a long-term process, continuous monitoring is required to keep the risk and return in the desired bracket.
3. Inflation
Inflation is a very important factor in retirement as the expenses are taken from the corpus, the return is going to be hit by inflation and this should always be kept in mind while calculating the requirements for the future and inflation adjusted returns should be used.
4. Tax efficiency
Certain avenues of investment are more tax efficient than others, and senior citizens enjoy special tax benefits which are promulgated every year in the finance bill. Investment in options like PPF which have EEE status can be beneficial along with other schemes for senior citizens which are announced from time to time.
It is a notion that retirement planning ends at retirement and money from corpus may be withdrawn passively in the retirement phase; if this is followed one may forego benefits which can accrue to the corpus if managed actively in consultation with a financial planner.
Post retirement expense requirement needs to be forecast as it will decide two things:
a. The amount to be invested during the working life and
b. The amount which may be withdrawn periodically later
The corpus accumulated for the purpose of retirement needs to be spent according to a well-drafted strategy. As an example if an individual has Rs 1 crore accumulated in her/his retirement corpus and s/he wants this amount to last for 25 years then on an average s/he needs to spend 4 per cent of the corpus every year as per the wisdom guided by conventional mathematics. But the requirement is not going to be the same as there would be inflationary pressure on the expenses and on the other side the invested corpus will be able to generate some returns as it would be invested in some low risk asset classes during the period.
How to build a DREAM retirement fund
Analysing the same, one would say that getting 4 per cent of the corpus every year will make the corpus last for 34 years instead of her/his intentional period of 25 years. This means at the end of 25 years assuming inflation adjusted return of 2 per cent on the retirement corpus, s/he still has Rs 33,28,824 in her/his corpus, which can be handed over to legal heirs in case of some unfortunate eventuality.
The table below gives various scenarios for which the corpus of Rs 1 crore can last for various different periods based on the spending pattern of the investor and the expected return on corpus.
The table above a sensitivity analysis on the varying return on corpus at different level of withdrawals with an initial corpus of Rs 1 crore, there are other parameters which can also vary and thus drafting a strategy in consultation with an expert is warranted.
There can be two strategies for withdrawal of corpus:
1. Steady income till life expectancy, with no estate left: Annuity
2. Steady income till life expectancy, with corpus left as estate: Perpetuity
A higher sum of money needs to be invested per period to create perpetuity as compared to creating an annuity, and the exact amount can be calculated as per the specific details of the investor in consultation with a financial planner. In the table above rows 3 and 4 of the second column are the cases of perpetuity where the amount withdrawn each year is either equal to or less than return generated.
With improved healthcare facilities and above average hygiene factors, the life expectancy and the average age -- both are on the rise -- it is important for one to secure the well being of self and the dependents during the non earning period of the life. By 2050, we shall have nearly 9 per cent of the estimated population of 160 crore: that is, around 15 crore individuals in the age bracket of above 60. Thus if the individual planning for retirement is encouraged, this would mean reduced burden on state to provide for elderly.
Not being able to plan properly can lead to two scenarios
1. Shortfall in the expenses at an advance age
2. Major portion of corpus lying idle and outliving the investor
Second case may still be bearable but the first is a situation which should be avoided at any cost. The work towards the same should begin far earlier in the initial stages of one's career or even if postponed then mid career is the latest stage when it is feasible to plan for retirement. However it is crucial to note here that retirement plan is a part of financial plan only and withdrawal management should be planned at the time of financial plan construction. This will ensure that the corpus accumulated at the time of retirement is available throughout the retirement period and the individual is not in shortage of funds and is not dependent on anybody as well.