Your post-retirement finances

A note on how to avoid the mistakes in managing our post-retirement finances

Your post-retirement finances

Last week, I discussed how the conventional wisdom on retirement savings is condemning Indian savers to old age poverty. Retirement is not an event but a long phase in your life that can last up to 30 or 35 years. During those decades, inflation cuts down the value of your savings ruthlessly. If your savings do not earn enough, then you are going to run out of them within your lifetime. Nothing can be worse than a long period of old age where you are gradually losing prosperity and then eventually entering poverty. And yet, all around you, you can see any number of senior citizens to whom this is happening.

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So how can you prevent this from happening to you? The first part, which I wrote about in detail last week, is to save enough during your working years and then invest the savings in equity-backed mutual funds. The second part, which I'll discuss today, is how to derive income from these savings after you have retired.

If you have understood what I've been saying about inflation, then the basic requirement is self-evident: you should spend 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, the single most important thing to understand in this whole business is that you must reserve the real, inflation-adjusted value of your principal, and not just the nominal face value. So how do you 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 so fast. Assuming a realistic inflation rate of 5 per cent, 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, this is it for any supposedly fixed income asset class.

The interesting thing is that this calculation does not change even when interest rates rise because inflation and interest track each other quite closely. It's actually a publicly declared goal of the RBI (from Rajan's time) to keep the real (meaning inflation-adjusted) interest rate between 1.5 and 2 per cent. However, the actual rate tends to be lower, especially when compared not to the official inflation rate but the real inflation that you face. This means that if you need Rs 50,000 a month, you need Rs 3 crore. Of course, at that level, income tax also kicks in and about Rs 30,000 a year will have to be paid. It's actually worse, there have been long periods of time when the fixed income interest rate has been below the inflation rate. Moreover, the tax has to be paid whether you realise the returns or not. 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 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 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 of 12 per cent p.a. or more, some as high as 20 per cent. The returns may have fluctuated in individual years, and that's something that the saver has to put up with, but the threat of old age poverty does not exist.

In such funds, one can comfortably withdraw four per cent a year and still have a comfortable safety margin. On top of that, there is no income tax. As long as the period of investment is greater than one year, returns from equity funds are completely tax free. This means that to have a given monthly expenditure through equity funds, you need just half the investment than you would need in deposits. So, for a monthly income of Rs 50,000 a month, Rs 1.5 crore will suffice instead of Rs 3 crore. And no matter how high your savings and expenditure, it's all tax-free.

I find that a small but growing number of people have begun to understand and appreciate this idea and have started doing 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. However, the vast majority of Indian retirees are still wedded to the mythical safety that deposits provide and end up facing tragic problems as they grow older. There's no need for you to be one of them.

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