Retirement Investing - I : The Accumulation Phase

An overriding notion when it comes to investing for retirement is that the major reason why most people do not end up creating a corpus for retirement that is large enough to allow them to retire at the time of their choice is because they may not have begun planning for their retirement early enough. This is not entirely true. The approach that we follow towards investing for retirement matters a lot more to our chances of success than how early we begin investing for retirement. And most of us lack a clear approach when investing for retirement. This is true for both the accumulation phase (where we build a corpus), and the withdrawal phase (where we use the corpus post retirement). So over this post and the next, I will share a clear framework for each phase of retirement. This post would focus on the accumulation phase. Next week's post would cover the withdrawal phase. Through these posts, I also hope to show why investing for retirement is a more complicated challenge than we usually appreciate.

During the accumulation phase, putting a few thousand rupees into our retirement portfolios every month is simply not enough. To plan for retirement effectively, we must begin operating under the assumption of zero real returns. In other words, we must assume that our post tax portfolio return would be equal to the rate of inflation we experience over our lifetime. This may seem like an overly conservative assumption, but it is not. (I will explain the logic behind the zero real return assumption at length in a future post). Going by the zero real return assumption would mean that the retirement corpus we require would be : Current annual expenses * Years post retirement. An example is given below.

We next need to realistically estimate how much we need to invest for retirement each month. The ideal starting point would be to look at our monthly expenses. Lets call this amount E (representing expenses). Now take the case of a 30 year old who has a life expectancy 90, and wants to retire at 60. Such an individual must invest an amount equal to their monthly expenses each month for retirement. Therefore monthly investments for retirement should be equal to E. So if for instance the individual spends Rs 50,000 a month, they must invest another Rs 50,000 for retirement each month.

For those who begin investing after 30 or wish to retire before 60 the requirements change. Consider first someone who begins investing for retirement at age 35. The required monthly investments for retirement are illustrated in the graphic below.

Similarly consider someone who wants to retire before 60. The illustrative calculations are given below.

In subsequent years actual figures for monthly expenses need to be reviewed once a year. This means inflation would be factored into the expense figures. This removes the need to assume an inflation rate. The actual market value of the retirement portfolio is converted into a multiple of the individual's current annual expenses. This removes the need to assume a rate of return from the portfolio. Take a look at the illustrative figures given below for a better understanding. Here the 30 year old individual is 31 years old with a retirement age of 60. His life expectancy is 90 years. His monthly expenses at age 31 are Rs 55,000.

Let us now look the ideal asset allocation and assumptions around which to make our investments for retirement. For someone who begins planning for retirement at a reasonably early age (say mid 20s to early 30s), the ideal asset allocation strategy for a retirement portfolio would be 60% equity and 40% debt. The product choices within each asset class do not matter as long as the overall asset allocation is maintained and coupled with regular portfolio rebalancing. But for the sake of convenience we may provide for the equity portion of our portfolios with a single large cap index fund that has adequate liquidity and is offered by a reputed mutual fund house. The debt portion may be provided for through a combination of liquid funds and defined retirement contribution schemes offered by our employers (such as EPF or NPS), if any. Public Provident Fund (PPF) can also be an option.

As far as setting return expectations is concerned, a reasonable assumption would be to expect a long term return of headline inflation +3-4% post tax on the equity portion of our portfolios. Headline inflation in India averages around 6%. This means we may realistically expect a long term post tax return of 9-10% from equity. We may realistically expect a long term post tax return of 7% on the debt portion of our portfolios. This would give us a long term portfolio return of 8.2% with an asset allocation of 60% equity and 40% debt. That is, (60% * 9%) + (40% * 7%) = 5.4% + 2.8% = 8.2%.

Tax planning and optimisation is undoubtedly another important aspect of investing for retirement. But an essential drawback in the way that most of us plan our taxes is the fact that we place on minimising our tax payouts. We must understand that tax optimisation does not only mean tax reduction. It only means ensuring that we don't pay more taxes than we actually need to. This means that we don't need to benefit from every possible tax break or hold every possible tax saving investment product in our portfolios. It is more than sufficient to pick a couple of tax saving investments and focus on investing in them consistently. Tax benefits should only be viewed as an additional bonus and not the central crux based on which to make our investment decisions. Having to pay a nominal amount as taxes every year should not make us deviate from the much larger and more important goal of creating enough wealth for ourselves.

Also, we may not be able to invest enough for retirement every year on a consistent basis. This is especially true in the early years when our incomes are relatively modest. But this should not dissuade us from making an honest and consistent effort to invest for retirement. We need to get over the tendency where we view achieving anything less than our intended targets when investing for retirement as a failure. As long as we make a start and are disciplined in our efforts we can rest assured of being on the right track. And following a process driven approach when investing for retirement would give us a perfectly fair chance of success. And this is realistically the best we can hope for when investing

for retirement.