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The retirement trap

Conventional wisdom about saving and investing for retirement is very far from being wise

The retirement trap

In the words of a Wall Streeter as quoted by Warren Buffett, "Those who're looking for risk-free returns are more likely to find returns-free risk." While the original statement was intended for US bond investors, it's just as true in the context of my topic today, which is retirement.

It is a deep belief amongst Indian savers, investors and investment advisors that retirement savings should be invested with the lowest risk possible. In the abstract, this is an excellent urge to have, and one could hardly disagree with it. However, in practice, the impact of this obsession with zero-risk is terrible. The reason for that is that everyone ignores the risk posed by the biggest threat to your financial well-being, which is inflation. Sorry to put it so bluntly, but if you ignore the effects of inflation in your retirement savings, then you are heading for old-age poverty.

Conventional Indian thinking about retirement investing teaches that one must not tolerate even the minutest drop in the nominal value of one's investment, all the while ignoring that inflation is constantly reducing its real value by anything ranging from 5-12 per cent a year. There are a lucky few who have some sort of an inherently inflation-linked source of income--like property which fetches good rent. Everyone else must fight a lifelong battle against this relentless financial enemy.

The risk that critics talk about are based on the casual impression of volatility. Equities may be volatile, but for investments over a few years, the volatility gets more than compensated by returns. For a long-range investment, short-term volatility is no concern. Take the example of the decade gone by. A typical fixed income option would have yielded a return of a little more than 8 per cent. An investment of Rs 10,000 a month would have grown to about Rs 18-19 lakh. Over the same period, an average (far from the best) equity fund would have grown to Rs 25 lakh, a return of about 14 per cent. Extend this kind of a differential over three decades and the equity option would generate about 2.5 to 3 times what the fixed income option would generate.

This kind of a difference between returns would separate a saver starting retired life in prosperity from a saver who is always struggling to make ends meet. The thing to realise is that saving for retirement is a long-term goal. There is no earthly reason to think of it differently from any other investment in the same time range.

Actually, the time horizon of retirement savings is even longer than we generally suppose. People take the date of retirement as the target date of the investment. However, retirement may be an event in your life, but from an savings and investment perspective, it is not an event but the beginning of a long stretch of retired life. At the age of 55, you may think that retirement is just a decade away, so your retirement kitty should be in 'non-risky' investments, but actually that doesn't make any sense. You will be using the earnings from these investments when you are 65, 75, 85 or 95 years old. Retirement can be a very long time. The years from 60 to the end of a full life can be as long as 30 or 35 years. That's as much as your working life. In those 30 or 35 years, prices would again multiply five to seven times, maybe more. Worse, you're likely to face unpredictable and growing medical bills, which is a major component of real inflation that people face in their lives. Planning for retirement as a single event that occurs at a point of time is a very common error. This error is even baked into the rules and regulations that govern the National Pension System, but I'll discuss the NPS fully in a future column.

Clearly, the conventional ideas of risk and retirement are perfectly described by the term 'return-free risk' that I began with. Savers who want to successfully provide for their old age must think through these issues clearly and abandon the trap that conventional thinking leads them into.