Retirement provision | Equity and Retirement Provision: Why You Shouldn’t Just Invest in Traditional Instruments
From Uma Shashikant
Should I have equity in my retirement portfolio? A friend who had just retired wanted to know. After dismissing stock investing as a gamble, he eventually became convinced by the many systematic investment plan (SIP) stories he heard. He started investing small amounts in his 50s. Now without a pension and only with his savings he is worried.
He wants to earn an interest in the retirement corpus without touching it or risking it at all. But these ideas are so yesterday.
There was a time when the government was the main borrower, paying benevolent interest and guaranteeing the safety of the money invested. Pensioners just stood in line at the post office. Today we live in times when we worry about a state-owned bank going to its knees. We remain risk averse, but risk is omnipresent around us. Bad borrowers, scammers, and collusion over corrupt lenders have made the credit markets too risky for the retired investor.
We can cause a tantrum and ask the government to provide the retired investor with a reasonable investment route. Good argument. That reform is miles away, however, as our policy makers still fail to understand that the only way we can manage risk is through diversification, or that without accountable trustees, we cannot manage other people’s money. This is how the biggest insurer saves failing companies, and the biggest pension system goes in circles to put in place a robust investment process. We digress and scold.
The positive side of the story has three aspects: First, retirees are wealthy compared to the past. They mostly live in a house that they own, have accumulated some assets, and managed to save on their income. Do you remember the days when the PF was designed to take out a loan; The first house was bought shortly before retirement. and incomes barely covered expenses. We are better off.
Second, inflation, the biggest threat to retirees, has been tamed to single digits. Like most macro variables, it is difficult to predict. However, we can assume that it is a small single digit number. Don’t remind us of the 18% of the 1980s.
Third, the next generation is better off. For many, including my friend, there is no need to leave a legacy as the children make good money. You can support the parents if necessary. The ability to spend the corpus for yourself is a benefit that the current generation of retirees can afford.
What does it all mean for my friend? He should look beyond the traditional and take some risks, provided he has the ability or the need to do so, given all of the above.
What does equity do to a retirement provision portfolio? It offers long-term growth. Portfolio value growth is a powerful tool against inflation. It cushions income risks as the investor ages. Since only a part is used during lifetime, the rest of the money can grow. The part he leaves for his children may be in equity since they are young and have a longer investment horizon.
A portfolio with a portion of equity and a portion of fixed income instruments will serve its purpose well. Fixed Income meets routine needs; Equity offers growth potential. How much should be in equity?
My friend tells me that a 6% annual return is enough for the retired couple’s annual expenses. Should he pull it annually and keep all the money in equity?
That would be a disproportion. The investor’s need is a stable income; However, the portfolio is in high risk growth goods. The investment will not generate any income; Part of it needs to be liquidated to meet the investor’s needs. The investor only draws a small amount, would that be important? Suppose the stock market corrects sharply. The investor’s money is shrinking and he is in danger of surviving his falling corpus. Because of this fear, most do not invest in equity.
If my friend needs 6% of his corpus as income and the interest offered is around 6%, should we choose a 100% breakdown of income wealth? We will starve the growth corpus to fight inflation and leave the superfluous 100% to the heirs. How do we choose between the extremes?
We start by exploring all income opportunities before we rely on the annuity corpus to generate it: rent, second career, dividends, and whatever else we can get. The comfortable retirement stories we see around us are largely funded by pensions that don’t weigh on the retirement corpus.
Then we come to a small part of the corpus that we are ready to draw for our expenses. Let’s say we draw 2% of the capital for annual use. What does it make? This reduces the burden on the portfolio to generate income and creates space for equity investments. How?
Let’s say we have Rs 100 and we need Rs 6. Since Rs 2 comes from the drawdown, the income the portfolio needs to generate is only Rs 4. Assuming a market rate of 6%, these Rs 4 can be 67% of the body can be generated. The allocation is 67% debt and 33% equity – this is an indication of the principle and not set in stone.
The equity component is preferably in a large-cap mutual fund. Or the investment is made in a balanced fund that invests primarily in debt and the withdrawals are set up as systematic transactions. These are operational and implementation details. You can cut anything you are comfortable with.
In order for my friend to invest in equity, it takes the following: First, equity should enable long-term growth of his corpus. That is far better than leaving it without a change in value. Second, it should be ready to retrieve a small portion of its body for its use. Keeping it small will reduce the risks and let the rest of the money grow. Third, his ability to invest in equity grows when he has other sources of income outside of his retirement corpus. Asset allocation and diversification offer more answers than we consider.
(The author is the chairman of the Center for Investment Education and Learning.)