In last week's post, I delved into the framework for the accumulation phase of our retirement goal. It was shown that assuming zero real returns over the long term with a life expectancy of 90 :
Required retirement corpus = Current Annual Expenses * (90-age at retirement)
For more on the calculations underlying this formula, have a look at last week's post here : Retirement Investing - I : The Accumulation Phase
Managing a corpus post retirement is much more challenging than accumulating it. With most other goals, the corpus we build for it would get spent either :
A. Immediately when the goal falls due (for instance purchasing a vehicle/home, vacations, school fees and so on) or,
B. Over the course of 3-5 years (for instance cost of children’s higher education)
Retirement is the only goal where the corpus we build needs to last us for multiple decades past the point of retirement. Therefore the way we manage our corpus post retirement must be completely different. It mandates the need for a clear framework to manage the asset allocation of the corpus and subsequent annual withdrawals. The ideal asset allocation for a corpus post retirement would depend on the age of the individual at the point of retirement.
For someone who retires early at say age 45, the simplest solution would be to run an asset allocation of 50% equity, 50% debt. Index funds can be used for the equity portion. It is important to keep credit risk and interest rate risk in the debt portion of the portfolio low. Liquid and money market funds therefore become ideal candidates for the debt portion of the corpus. The 50-50 allocation can be maintained with regular rebalancing until the age of 60 or 65. At this age the individual may reduce the equity allocation to say 30-35%. Further on at age 75-80, the option of further reducing the equity allocation to 10-15% may be considered. Those who retire at age 55-60 may start with an equity allocation of 30-35%. It may be further reduced to 10-15% at age 75-80 depending on the needs and preferences of the individual.
The next question would be that of structuring the retirement corpus. There are three broad approaches to structuring a retirement corpus. The first among them is the Retirement Bucket Strategy. It segregates a retirement corpus into various buckets. Each bucket would contain money for different phases of post retirement life. The money required for the initial years post retirement can be put into debt. The money required for later years can be in a mix of debt and equity. The money required for the last few retirement years can be put entirely into equity. An illustrative example assuming a post retirement period of 45 years is laid out in the graphic that follows.
This would help the corpus grow and last longer post retirement. Money in various buckets would need to actively managed based on the needs of the retiree.
The second approach would be the Annuity Laddering Strategy. The strategy involves buying an annuity at various points in retirement. The annuity rates would increase with the age at which the annuity is purchased. The income floor would therefore become higher as the individual progresses through retirement. It would therefore allow the creation of multiple pension streams that increase progressively through retirement. This would provide for our spending needs on an inflation-adjusted basis post retirement. But the size of the corpus required to adopt this strategy would be significantly higher. The multiple pension income streams may also increase the individual's overall tax liability.
The third approach involves a combination of the the first two approaches. A portion of the retirement corpus can be used to purchase an annuity at the start of the retirement period. It can be purchased for an amount equal to annual expenses in the first year of retirement. The rest of the corpus can be put into buckets. Withdrawals from the buckets can be made to meet inflation in expenses over the
forthcoming years. Retirees can adopt any one of these three approaches as per their preferences and needs.
With the asset allocation and structure of the portfolio in place, we would next need to think about managing withdrawals from our corpus. Managing withdrawals comes down to answering two questions :
How much to withdraw each year?
From where to withdraw?
To answer the first question, we usually tend to look at thumb rules like the 4% rule.
But this rule is no longer relevant for a number of reasons. This rate has been prescribed based on research conducted in America in the 1990s. The research was based on a 50:50 asset allocation between equity and debt. It assumes a retirement age of 60. Life expectancy post retirement is assumed to be 30 years.
But, India’s average retirement age is coming increasingly closer to 55. Therefore, a corpus lasting 30 years post-retirement may not always be adequate to retire completely. Asset allocations of retiree portfolios may vary from the 50:50 allocation between equity and debt assumed by the research study. Also, inflation in America has historically been a lot lower than in India.
Also, adhering to such rates implies that we withdraw a fixed percentage of our portfolios, after adjusting for inflation in during each year of retirement. But in reality, our spending needs may change from year to year. In fact, our spending in retirement may follow a phased pattern. During the first phase of our retirement (say until age 65), we may spend more from our corpus. This can usually be put down to discretionary expenses such as travel.
During the middle phase of retirement (say between age 65 and 75) we may slow down physically. Therefore we may tend to spend relatively less from our corpus during this phase. During the late phase of retirement (say age 75 onwards), long term cognitive and lifestyle issues are likely to kick in. This would lead to an increase in spending owing to healthcare expenses. We are therefore likely to withdraw more from our corpus during this phase. This means that our spending patterns throughout retirement are likely to resemble a smile shaped curve. This is borne out by the concept of the Retirement Spending Smile as shown in the graphic that follows.
All of this points towards the fact that the concept of a safe withdrawal rate is arbitrary. A possible way around the use of withdrawal rates may be to define an upper limit to portfolio withdrawals for each year in retirement. This can be done as shown in the illustrative example below.
Available retirement corpus = Rs 7,00,00,000
Current age = 55
Life expectancy = 90
Years in retirement = 90 – 55 = 35
Withdrawal limit for the current year = 7,00,00,000/35 = Rs 20,00,000
This shows that portfolio withdrawals for the year should be capped within Rs 20,00,000. It does not mean that the individual cannot exceed the spending limit during a particular year. It only means that if ever the limit is exceeded, the individual may have to curtail spending for some years in the future. This calculation can be repeated year after year. It would define each year’s upper spending limit and maximum withdrawal amount.
This answers the question as to how much we need to withdraw each year post retirement. We next need to think about sourcing and structuring withdrawals. It must first be understood that withdrawals post retirement be made from investments which generate volatile returns. This is because we cannot risk a significant drop in the value of our investments right when we need to make a withdrawal. This rules out the option of tapping into the equity portion of our retirement corpus for withdrawals. A widely propogated option for post retirement withdrawals is that of a Systematic Withdrawal Plan (SWP) from hybrid funds.
Hybrid funds seemingly represent a better option for withdrawals than pure equity products. This is because hybrid funds offer exposure to both equity and debt. But there are two major issues here. First, the equity exposure in the hybrid fund means that returns from hybrid funds would also be volatile. Second, the investor's biggest advantage in case of a Systematic Investment Plan (SIP), becomes their biggest disadvantage in case of an SWP.
An investor doing an SIP would stand to benefit from market volatility. This is because the investor would buy more units when the markets are low, and fewer units when markets are high. But an investor doing an SWP would do the exact opposite. They would redeem more units when the markets are low and less units when the markets are high. SWPs are therefore not a viable strategy for withdrawals post retirement. Withdrawals must only be made from non volatile and highly liquid products in the corpus. Savings deposits, liquid funds and money market funds therefore become ideal avenues from which to make most of our withdrawals post retirement.
I hope it is now clear that both the accumulation and withdrawal phases of the retirement planning goal have bespoke strategies and frameworks that we can follow. But regardless of the strategies we follow, it is our discipline and consistency of effort that is the ultimate difference maker. As long as we combine our strategies with these two aspects, we are assured of a reasonable chance of being able to manage our retirement effectively.