The Why And How Of Portfolio Construction In Retirement

When it comes to constructing retirement portfolios, the focus mostly remains on portfolio construction during the accumulation phase. But the way a portfolio is constructed post retirement is just as crucial to the effectiveness of a retirement plan. There are various methods available for portfolio construction post retirement. And in today's post I am going to talk about each of these strategies in detail. I will show why each strategy is effective. I will also show how each of them can be employed.

Retirement Bucket Strategy

The Retirement Bucket Strategy is an ideal strategy for managing a corpus post retirement. 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.

Those employing the bucket strategy can have 15 years’ worth of inflation adjusted expenses in a very low risk income bucket. It can contain products such as annuities, FD or bond ladders, money market mutual funds, dividends from listed stocks, etc. Upto 30% of the available retirement corpus may be parked in equity. This would significantly reduce sequence of returns risk post retirement. I have spoken about sequence of returns risk in detail in an earlier article Sequence Risk And Our Long Term Goals. An illustrative representation of the bucket strategy for a 45 year retirement period is given in the graphic that follows.

This would help the corpus grow and last longer post retirement. Adopting the retirement bucket strategy requires managing the money in various buckets post retirement. Money has to be shifted between various buckets based on market conditions and the individual’s needs.

Annuity Laddering Strategy

Those who wish to avoid active management of the corpus post retirement may opt for an annuity laddering strategy. The strategy involves buying an annuity at various points in retirement. This creates a minimum level of income for the individual throughout retirement. The interest rates offered by most annuities would increase with the age at which the annuity is purchased. The minimum income recieved would therefore increase as the individual progresses through retirement. Take a look at these indicative interest rates for an annuity purchased at various ages starting from 55 are in the graphic below. It is assumed that the individual purchases an immediate annuity for life when they retire.

Assuming a retirement age of 55 with a 35 year post retirement period, annuities can be purchased say once every five years. It would allow the creation of multiple pension streams that increase progressively through retirement.

Those opting for the annuity laddering strategy can purchase a fresh annuity for every decade in retirement. Each annuity can be purchased for an amount equal to the average inflation adjusted annual expenses for each 10 year period. This would reduce sequence risk while allowing the retiree to benefit from increasing annuity interest rates in each passing decade. It would reduce dependence on appreciation and income from market linked assets.

But there are a couple of significant drawbacks inherent to the annuity laddering strategy. The initial retirement corpus required would be much higher than the bucket strategy. Also, annuity income received is taxable at slab rates applicable to the individual. So this strategy may not be viable for most individuals.

Income Flooring Strategy

The bucket strategy and the annuity laddering strategy can be combined using the income flooring strategy. Here, 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 a post tax amount equal to annual expenses in the first year of retirement. It would guarantee that much income for life. 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.

Say for example that an individual has a corpus of Rs 5 crore available at retirement. The age at retirement is assumed to be 55. Life expectancy is assumed to be 90 years. The post tax interest rate from the annuity is assumed to be 6%. The purchase price of the annuity in such a case may be given by the formula :

Purchase price of the annuity = Annual Expenses/Post Tax Annuity Interest Rate

In this case the purchase price of the annuity is Rs 200 lakh or Rs 2 crore (Rs 12 lakh/6%). This means that of the Rs 5 crore available, Rs 2 crore would be parked in an immediate annuity for life. The remaining Rs 3 crore would be parked in a bucket portfolio of market linked assets. An illustrative pattern for annual expenses and portfolio withdrawals during the first 5 years post retirement is laid out in the graphic below.

Remember that the market linked corpus has to last for 35 years post retirement when the individual retires at 55. This means that the maximum amount that can be withdrawn from the portfolio each year at age 55 is Rs 8.57 lakh (300 lakh/35). This figure can be recalculated once a year. Notice that the annual amount being withdrawn from the portfolio is below Rs 8.57 lakh in each of the 5 years. This means the annual withdrawal limit would keep increasing each year. This greatly increases the chances of the market linked portfolio lasting through the entire post retirement period. This is the biggest advantage of the income flooring strategy.

What All Of This Means

Each of these strategies come with their own strengths and weaknesses. None of them can be considered to clearly be superior than the others. The choice of strategy would depend upon the needs and preferences of each individual retiree. But once a particular strategy is chosen it must be persisted with throughout the post retirement period. A lot of thought and careful consideration must therefore go into the choice of strategy.