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Managing money after retirement

During the decades of retired life, inflation destroys the value of your savings relentlessly. And there's only one way to fight old age poverty

Managing money after retirement

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'Retirement' is an event that takes place on one appointed day, but retired life is something that lasts for two to three decades. Confusing the two could lead to your senior years being seriously uncomfortable.

A few weeks ago, I wrote about how the conventional wisdom on retirement savings is condemning Indian savers to old age poverty. During the decades of retired life, inflation destroys the value of your savings relentlessly. Many, many people find that their savings are just not enough. Eventually, at some point, they realise that they are running out of money. Nothing is worse than a long period of old age where an old couple gradually loses prosperity and then eventually enters poverty. And yet, all around us, all of us can see any number of senior citizens to whom this is happening.

So how can you prevent this from happening to you? The first half, which I have written about in detail earlier, is about saving enough during one's working life and investing that money in equity-backed mutual funds. That sets the stage for a financially comfortable old age. The second part, which is the outcome, is deriving income from these savings once retired life begins.

If you have appreciated what I've been saying about inflation, then this much should be self-evident: you must spend, at most, only that part of your investment returns that exceed the inflation rate. This is another way of saying that you must preserve the value of your principal. However, you must preserve the real, inflation-adjusted value of your money, and not just the nominal face value.

Please read the preceding paragraph again, slowly and carefully. It's possibly the single most important input in having a financially comfortable old age. Now the question arises, how do you actually do this?

Let's take a simplified example. Suppose you retire today with say Rs 1 crore as your retirement savings. You place it in a bank fixed deposit. A year later, it is worth Rs 1.07 crore. So you have earned Rs 7 lakh, which you can spend, right? Not really. Assuming a realistic inflation rate of 5 percent, if you want to preserve the real value of your principal, you must leave Rs 1.05 crore in the bank. That leaves Rs 2 lakh that you can withdraw to spend over an year, which is Rs 16,666 a month. Is that enough? For a middle class person, surely not. It could be a little worse with some banks, and it could be a little better for something like the Post Office Monthly Income Scheme, but basically, for any kind a fixed income type of investment, this is roughly the calculation.

A very important thing to understand is that for fixed deposits (and similar investments) this calculation does not change even when interest rates rise because inflation and interest track each other quite closely. The real (inflation-adjusted) interest rate is not going to be more than about 1.5 to 2 per cent at best. So, if you need Rs 50,000 a month, you need about Rs 3 crore. Of course, at that level of income, income tax also has to paid; so, about Rs 30,000 a year will go out. This is the best case scenario. In practice, it's often worse, as there have been long periods of time in the past when the interest rate has been below the real inflation rate. Moreover, income tax on deposits has to be paid whether you realise the returns or not and that cuts further into returns. There can be a situation (often is, in fact) when the interest rate barely exceeds the inflation rate and the income tax on the interest is effectively reducing the real value of the money.

The situation is very different in equity-backed mutual funds. Unlike deposits, they are high-earning but volatile. In any given year, the returns could be high or low, but over five to seven years or more, they comfortably exceed inflation by six to seven per cent or even more. For example, over the last five years, a majority of equity funds have returns exceeding 17 per cent p.a, with about a fourth of them crossing 20 per cent. The returns may have fluctuated in individual years, and that's something that the saver has to put up with for getting rid of fear of old age poverty.

In such funds, one can happily withdraw four per cent a year and still have a big safety margin. On top of that, there is no income tax and the capital gains tax is 10% on actual withdrawals. Effectively, for a given monthly expenditure through equity funds, you need just half the investment that you would in deposits. So, for a monthly income of Rs 50,000 a month, Rs 1.5 crore will suffice instead of Rs 3 crore.

Even now, only a small (but growing) number of people have begun to understand and appreciate this idea and have started implementing it. These tend to be those who have used equity funds as their savings vehicle anyway and are used to the idea of ignoring short-term volatility in the interest of long-term gains. Unfortunately, most retired people are still looking for the non-existent safety that fixed deposits provide and end up facing hardships as they grow older.