Retirement Planning – Road to Financial Freedom
You have a good job with a fat salary, leading a cushy lifestyle now. But eventually all of us will retire, and those paychecks will stop. Most of us don’t have an assured pension. Are you ready to face such a situation? Have you saved enough to maintain the same lifestyle even after retirement? Do you know expenses could double or triple then because of inflation? If your answers are no, then it is time to pause and ponder about retirement planning.
Retirement planning is all about preparing for your future, today. Helps you continue your lifestyle and meet all your financial needs especially after retirement.
Inflation is the biggest threat to retirement planning. As the cost of living goes up. It erodes the value of your savings. One year to next, this may not be noticeable, but over a long time, its effect is debilitating to the financial health. A family with a monthly expense of ₹50,000 can expect their expenses to go up ₹2 Lakh in 25 years if inflation is at 6%. This must be considered while planning. There should be enough corpus accumulated to generate income to cover expenses and thus maintain the same living standard.
Another major factor which affects retirement is the cost of healthcare. As we grow old, expenses towards healthcare will rise. Insurance coverage may be inadequate or may not be available. In such a case, the only option is to retain a sufficient buffer, a lump sum emergency fund, for unexpected medical expenses.
These two – living expenses and medical expenses, are the two major components to be considered while planning. Timing and duration of retirement also will have a major impact on the amount needed to save. Based on current life expectancy, a period of 30 years in retirement is not uncommon. Note that retirement duration is decided by the youngest among couple and not the oldest.
A number – how much to be accumulated, can be reached based on these factors. Assumptions to be made on expense, inflation rate, retirement duration etc. Typically for a couple retiring in twenty years, with conservative spending habits, this number can be between ₹4 to ₹6 Crore! A financial planner may be able to fine tune this estimate.
How to accumulate?
Now we have a number, focus can be on accumulating this corpus. Just like any financial planning, the earlier you start, the better. ₹1 saved at age 24 could become ₹64 at age 60, whereas the same ₹1 rupee saved at age 42 could only grow to ₹8. Power of compounding will do magic to help you reach your retirement target, sooner you start saving for it. So, start early and square away some portion of your earnings towards retirement kitty. 15% of your income is a good starting point. Chances are that you are already doing it. Regulations insist on mandatory contributions towards your retirement through instruments like Employee Provident Fund (EPF), National Pension Scheme (NPS), SuperAnnuation (SA).
EPF, NPS: Hidden Gems of Retirement Planning
Employee Provident Fund (EPF), with its many variations are mandatory contributions employee and employer must make towards retirement of the employee. Contributions are often a percentage of salary and invested in safe and long-term instruments. They can accumulate a tidy sum over a long working period. EPF investment choices are limited but give more flexibility during withdrawal.
The National Pension Scheme (NPS) is also a similarly designed instrument to help accumulate corpus for retirement. Unlike EPF, NPS provides more flexibility and choices for investment (equity and bonds), whereas withdrawal norms are somewhat restrictive.
Similarity SuperAnnuation (SA) is another good, regulated retirement saving instrument. Then there is the Employee Pension Scheme (EPS), managed by EPF Organization, which provides a small pension in retirement. Please check with your employer and ensure you are enrolled. All these instruments are meant for retirement savings. Government provided tax benefits to all of them to encourage savings for retirement. They help build a substantial portion of the corpus needed for retirement. So, make sure you utilize these instruments to the maximum extent possible.
They may not be enough: However, they alone won’t do the job. Limits on contributions and lack of investment choices in these instruments can limit the amount you can save using them. Additional investment to supplement these is needed. Given retirement investment is done long term, a large portion of investment can be in equity. This will ensure your savings grow at inflation beating pace, which will help you to continue the same lifestyle even in retirement. Direct equity investment or mutual funds can be considered. Passive investments through ETF are also popular vehicles. Remaining portion can be allotted in other assets like bonds, real assets, gold etc.
Proportion of investment in each of the assets will depend on your asset allocation plan, decided by your specific situations. A financial planner can help arrive at a suitable plan for you. One of the mistakes people routinely make is omit equity entirely, out of fear of losing money. They load up on assets like real estate. Problem is that real estate may not grow higher than inflation and will not provide enough income or liquidity needed for retirement expenses. Historically, equity investment was able to beat inflation consistently. If you don’t have enough exposure to equity, you might just run out of money in retirement, a scary situation. In short, bigger risk is avoiding equity, not investing in it.
During retirement – Withdrawal
Once you retire, the investment should be in such a way, it generates sufficient income for your needs. It can be Interest from bonds and Bank FDs, dividend from equity investment, pension from annuity, rent from real estate holdings etc. if such income is not sufficient, a certain portion can be withdrawn to meet the gap.
Biggest threat during retirement is running out of money. If retiree overextend and withdraw more from his/her retirement kitty, she/he can outlive their savings and become poor. This is called longevity risk. So, it’s critically important to plan and adjust their withdrawals in such a way, it will last their entire retirement.
Annuity addresses the problem of outliving one’s savings, head on. It provides agreed upon money on a periodic basis until death. You can buy annuity from insurance companies by paying a lump sum amount or by paying premium over a period. Insurance company in return pay a pension as long as you live. Longevity risk is then taken by the insurance company instead of the retiree. This is a good solution except that Annuities generally are very expensive. On top of it, many annuity payments won’t adjust for inflation. Hence annuity payments may not be enough to cover your expenses during retirement. These issues make Annuities an imperfect and at best a partial solution.
The 4% rule is a well-known empirical rule for withdrawal, which states that you can comfortably withdraw 4% of your savings in your first year of retirement and adjust that amount for inflation for every subsequent year without risking running out of money for at least 30 years. This has been found true for various cases of starting period and duration. Only expectation is that the retirement corpus will continue to be invested at 60% stock and 40% bonds combination. This rule also provides an estimate of how much you need to accumulate for a given spending.
What if you don’t have enough saved for retirement? This is not a good situation. Options available are limited and undesirable. Delaying retirement or working part time may be one way out. This will help avoid dipping into little savings you have and giving it more time to grow. Nowadays many part time gigs are available, which are suited for retirees. Another option is reverse mortgage, where banks could provide periodic payment to home owning retirees, by taking their home as collateral. You will be able to live in the same home until your death, but ownership will shift to the bank over the course of time. This is an extreme scenario but still worth considering if no other options are feasible.
Retirement is the only stage of life, where no one will lend you money to cover your expenses. Thus, planning, saving, and investing for retirement must be a non-negotiable part of everyone’s financial planning. The future may be uncertain, but it can help to be prepared. Diversify your retirement corpus by investing in equity, fixed-income securities, and other government-backed securities. Fully utilize tax advantaged instruments like EPF & NPS. Start as soon as you can so that your golden years are tension free.