The investors who are about to retire hold a corpus built through several years of work.They are past their peak income and primarily depend on this corpus for their post-retirement income. Many of them recognise their primary strategic need as a steady flow of income and, therefore, choose fixed income assets.Bank deposits, government saving schemes and bonds are the popular choices. They believe their decision is strategic and correct because they have chosen on the basis of what they need--interest income, protection of capital and low risk.However, they may have missed a critical point.
The single most important objective after retirement is to earn an income that fights inflation.The fixed interest income from these traditional investments might look good in nominal rupee terms, but inflation is a number that compounds year after year. So, `9 lakh of interest income from a corpus of `1 crore might look more than adequate today , but if inflation were 7-8%, the expenses will double every 10 years. The corpus should double to keep the investor afloat, but since capital protection was sought to earn the interest income, the corpus will remain unchanged. If the investor lives for 25-30 years after retirement, penury will hit at an age when increasing the corpus in any manner would be impossible to achieve.
Investment decisions for the retired investor should take on board this core objective: the corpus should continue to grow and compound in value so that it fights inflation, while the investor draws income from it as required. On the face of it, this is a complex problem to solve. There are two broad types of assets-those that offer growth in value, but earn a limited income; and those that offer a regular income, but do not grow in value. Growth assets are typically risky since their value fluctuates in the short term, but they appreciate in value in the long term. Real estate, equity and gold are examples of growth assets. The rental yield and dividend yield is tiny , and gold offers no income.However, these assets hold the potential to appreciate in value.Deposits, bonds and saving schemes are income assets. They provide a regular income, but do not appreciate in value. If the retired investor chooses growth assets, he would be able to fight inflation as his corpus would appreciate, but there would be no income to draw. If he picks income assets, there would be income without the ability to fight inflation.
Assume that `1 crore is invested at a fixed interest rate of 8% and the investor hopes to draw `6 lakh a year as expense. If you consider an inflation rate of 7%, the interest income will fall short of the expense in a short span of five years since inflation would have taken the `6 lakh at the start well past the `8 lakh of annual interest income. The reinvestment of the initial years' surplus will enable the investor to stay afloat for another two years. There will be a serious shortfall if one considers 25-30 years as the postretirement period. How does the retired investor attain the core objective of inflation-adjusted income over the years?
He should consider the compromises. What can he give up to achieve his strategic objective?
The investor should see his expenses as withdrawal from a corpus that is allowed to grow, rather than ask for a regular income and preservation of the principal. The principal amount that is compounding in value over time, while rising and falling in value and eventually being drawn down, might be the compromise in exchange for an inflation-adjusted cash flow. An asset allocation, where a portion is in growth assets and another portion is in income assets, might be the solution. The crux of this strategy is the compounding of the invested amount to fight inflation, and the utilisation of the corpus over time to meet income needs.This strategic approach means the investor is not focused on the income his assets generate; instead, he is concentrating on how it is growing year after year.
It is not tough to make the investment choices in this context. An 8% special deposit, which accumulates at a compounded rate and allows the sweeping out of withdrawals, might serve this need. Or a PPF account, which is opened before retirement and holds the corpus that is available for withdrawal, serves this need. The lower the gap between the rate of growth of the investment and the rate of inflation, the faster the depletion of the corpus. At 8% compounded return and 7% inflation, a `1 crore corpus will be depleted in 18 years. At 12%, it will last 30 years and leave `1.34 crore.
How could one earn a 12% annual growth? Isn't equity risky?
Asset allocation holds the answer. A strategic portfolio will be defined as one that runs at an average rate of 12% with a maximum downside of 10% over 2530 years. A portfolio that had 25% in the Nifty , 60% in the PPF , and 15% in gold would have grown at 12% over the past 10 tumultuous years of equity markets. The maximum erosion in the corpus would have been 3% in 2008. The only task for the investor would be to focus on these proportions and restore them once a year without caring for the markets and views. Such is the power of diversification.
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