BY RANJAN VARMA HTTP://RANJANVARMA.COM Financial Planning for Retirement
Why the necessity ?
Management of retirement funds is one of the most difficult/complex jobs today
Correct estimation of longevity required
Correct estimation of inflation required
Correct estimation of future expenses
Provision for mediclaim/life insurance
correct estimation of future taxes
Spending too much on retirement
Correct retirement plan & strategy
Estimating longevity is an essential part of planning for retirement. An underestimation will cause people to save too little, retire too early and spend too much.
If you don’t have a realistic estimate of personal longevity, how can you know whether you have the right retirement plan ?
Contrary to your working years, when you work for money to sustain your lifestyle, during retirement, money must work for you.
For retirees, the principal, needs to be an income producing cash cow.
Some people think that they need to ride the fastest horse in the race in order to win, and often they wind up losing at a time when they can least afford it.
The best strategy is to maximize your greatest possibility of winning, right from the start. That approach is not the same as trying to win the most. Poor investors seek the highest possible returns, while the great investors seek the highest probability of good returns.
If you want to leave a portion to your children or to charity, and be sure you do not outlive your income, then you need to have a reasonable money-management strategy in place.
Our goals should be shaped not only by our wants (which must take second place to our needs), but also by an honest assessment of the marketplace.
For most retirees, at least 40 % in equities for growth is essential, some say even more is needed. Buying equities does not mean speculative trading in stocks. That is gambling and not ownership.
The stock ownership portion should be placed into a well-balanced , professionally managed portfolio.
Male Life Expectancy 50 percent
IAM LIC will live past
55 24.8 yrs 25.2 79.8 yrs
60 20.6 yrs 21.2 80.6 yrs
55 30.2 yrs - 85.2 yrs
60 25.7 yrs - 85.7 yrs
Source:1983 Individual Annuitant Mortality Table; Mortality Rates of Annuitants in LIC A (96 – 98) Ultimate
Decade Avg. Decadal Growth
1950s 2.1 %
1960s 6.0 %
1970s 7.5 %
1980s 9.1 %
1990s 9.5 %
2000s 4.0 %
2005 5.5 %
2006 7.0 %
2007 6.5 %
Rate of Interest
Year Bank Rate(%)
Growth in CPI
Year CAGR (%) Overall
2/86 – 2/91 7.55 7.55
2/91 – 2/96 10.09 8.70
2/96 – 2/01 7.03 8.18
2/01 – 2/06 4.20 7.21
2/06 – 2/07 6.78
2/07 – 2/08 5.52 7.12
Future Expenses ?
Let us assume that total monthly expenses today are : 15,000, i.e. 1,80,000 p.a.
Further, let us assume that the annual rate of inflation is 7 %.
Then, after 25 years, the annual expenses are likely to be 9.8 lacs, i.e 81,000 p.m.
The total expenses of 25 years will be an astonishing 1.24 Crores.
The problem is , how to provide for this, now.
List of Probable Expenses
TOTAL MONTHLY EXPENSES
TOTAL ANNUAL EXPENSES
Why this list ?
If you don’t know how much you need to live on, the money you make is never enough.
If you think good health is everything, then health insurance is next to every thing.
The day when you need insurance is the day it is too late to buy it.
Most retirees must have both a spending discipline and an investment discipline.
Retirees generally need between 70 – 80 % of their last drawn “net salary” as monthly expenses.
Wealth is not defined by the number of things you have but by the largest number of things you can do without.
Company Premium/ 3 lacs
Name Age 60 yrs
Chola Genl. Ins 8045/-
Royal Sundaram No Cover
New India Assurance 7862/-
How much to spend ?
This is a tricky question because we must know the following :
What is the rate of inflation (w) ?
what is the rate of return on the principal (x) ?
What is the rate of taxes to be paid (y) ?
What is the amount (%) that can be safely withdrawn so that the principal never goes down (z) ?
Hence, under any circumstances,
z < (x – y – w)
For example, let
Rate of inflation = 7.0 %
Rate of Taxes = 0
Rate of withdrawal = 5.0 %
Then, rate of return, has to be equal to or more than,
7.0 + 0 + 5.0 = 12.0 %
This means that you have to find an avenue that gives you a minimum return of 12.0 %.
Pension = 10000 x 12 = 1,20,000
Interest on 20lacs FD
( @ 9.50 % for Sr.Cz) = 1,90,000
Less - Income Tax = 8,755
Reserve for inflation @7.0% = 1,40,000
Total = 1,61,245
Average/month = 13,437
This is the amount within which you have to manage all your expenses.
The Other Option
Pension 10000 x 12 = 1,20,000
Withdrawal of 5 % Principal
20 lacs (Equity/Mutual Fds) = 1,00,000
Income Tax (After Sec 80D) = NIL
Balance Fund Available = 2,20,000
Average/month = 18,333
In this way you can increase your monthly
Income by Rs.4896/-per month.
A Return of 12 % Possible ?
Annual returns will most likely be, on an average, what the returns have been for the last 50 years – about 13 % for the S & P 500 – even then we cannot count on the ambiguity of returns when managing retirement money.
Some think, a better bet may be the combination of large stocks and bonds, but that combination also did about 13 %.
Regulating how much you draw can be accomplished by setting some minimum withdrawal rate to meet your needs. You can withdraw further amounts every couple of years, after seeing what the market delivers. Such an approach will make your retirement account a good servant and not your poor master .
Using actual historical data from 1926 to 1992 it was found that an appropriate asset allocation for a retiree’s portfolio must include no less than 50 %(and up to 75 %) in stocks.
A Harvard University study concludes that if one took a payout of 5 % of the account each year, there would be a 95 % chance of having the principal grow to outpace inflation.
Trinity University conducted a study examining and comparing the outcomes of different withdrawal rates from hypothetical portfolios made up of stocks and bonds, in which the percent invested in stocks and bonds changed, but the percentages added together always equaled 100 %.
The study found that at a 6 % withdrawal rate an investment mix of stocks and bonds outperformed both an all-stock and an all-bond portfolio.
And at a 7 % withdrawal rate , a 50/50 mix of stocks and bonds outlasted portfolios with higher stock allocations for 20 and 30 year payout periods.
Creating a Financial Planning Review
The first step, before making investments, would be to enter into a process that includes a comprehensive financial plan or review :
Organize a personal balance sheet that shows what you have done to this point
List your investments that support (or do not support ) your investment goals
Examine your tax liabilities and suggest ways of controlling or reducing them
Review your cash flow (sources of income and cash needs) and how they change
Make calculations regarding the surviving spouse’s income goals
Review your risk exposure, especially your medical and long term care coverage
Target Asset Mix Asset Class Minimum Weight Target Weight Maximum Weight Equities 45 % 50 % 65 % Fixed Income 30 % 45 % 60 % Cash and Equivalents 0 % 5 % 15 %
One’s goal to maintain the following overall portfolio balance may be :
35 % large cap funds included in the
S & P CNX Nifty/BSE Sensex
10 % mid - cap funds measured by the
CNX Nifty/BSE mid – cap index
5 % small – cap funds through the top mutual fund houses
25 % in purely debt mutual funds
10 % in real estate mutual fund
10 % in gold ETF
5 % money market mutual funds
HOW TO CUT YOUR RISKS
There are a few steps which must be scrupulously followed to cut down risks while investing in the capital market –
1.Invest through the mutual fund route
2.Opt for the long term
3.Diversify through different asset classes
4.Use the Systematic Investment Plan
Under Section 2(42A), a unit of a mutual fund is treated as short – term capital asset if the same is held for less than 12 months.
The units held for more than twelve months are treated as long term capital gains.
Thus, long – term capital gains on equity oriented funds [>65 % in equity (AY 06/07)] is exempt from tax from AY 05-06.
Short – term capital gains on equity – oriented funds is taxed @ 10 % + cess
Long – term capital gains on debt – oriented funds are taxed @ 10 % flat or 20 % with indexation benefit, whichever is less.
Short – term capital gains on debt – oriented funds are taxed at the tax bracket applicable.
Dividends declared by debt or equity oriented mutual funds are tax free in the hands of the investor, as dividend distribution tax of 12.5 % including surcharge is paid by the mutual fund.
Interest income on fixed deposits and bonds is taxable under the head “income from other sources”. The entire income received is taxable from FY 05-06.
Break up of Portfolio
Type of Fund No.
1)Diversified 3-4 large caps
Equity Fund 5 - 7 2-3 mid caps
2) Tax Saving
Fund 1- 2 1 large cap
1 mid cap
3) Debt Fund 2
NFO’S OR OLD FUNDS ?
New Fund Offers are invariably at Rs.10/- whereas old funds are invariably priced many times higher. So the dilemma is whether to buy the NFO or the old fund?
If the fund manager and house are same, it makes absolutely no difference!!
If the fund manager or house are different, then always go for the old fund, as there is a track record to guide you.