Retirement planning is one of the most crucial aspects of financial planning. There exist a vast amount of literature discussing and explaining various strategies of retirement planning. So rather than discussing multiple strategies, I will simply discuss my approach towards retirement planning.
First, let us address the question what is retirement planning? In the simplest terms, retirement planning includes three steps, first is calculating your total post-retirement expenses. Next based on your post-retirement investment plan you can calculate the corpus you need at the time of retirement to fulfill your post-retirement expenses. Once you have determined your retirement corpus you can make an investment plan to achieve this corpus.
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I have provided an excel file that you can download. The excel sheet uses the same calculations and strategy discussed in this article.
By explaining each aspect of the definition we can actually understand what retirement planning is. So let us take it one step at a time.
Determining Post Retirement Expenses
This is the first and paramount step for retirement planning. But unfortunately, most articles and calculators available online are not doing this properly. Post-retirement expenses mean the total expenses you will incur from the day you retire until you live. To calculate this you need five things.
- Current Age
- Expected Age of Retirement
- Age up to which you want your retirement corpus to last
- Expected Inflaton rate
- Annual expenses in present value for maintaining your desired lifestyle
The ‘current age’ and ‘expected age’ of retirement are pretty much self-explanatory. By ‘age up to which you want your retirement corpus to last, I mean age up to which you expect to live. The expected inflation rate should not be kept low, a rate 2 -3% higher than one declared by RBI should be considered. Annual expenses in present value can be calculated by determining expenses if you were to retire today. You should remove expenses that will not be there after retirement, like school fees for kids and most EMIs.
Now let us move on to the actual calculation, and this is where most calculators in the name of simplifying make a big mistake. We know the annual expense in present value, if we use compound interest formula and inflation rate we can calculate our annual expenses in the future. What many people and online calculators do wrong is they calculate the expenses for the first year of retirement and take this as the same for all post-retirement years. But in reality, inflation does not disappear after retirement so the value of your annual expenses increases each year, so you have to calculate the annual expense for each post-retirement year using the compound interest formula and add them all to determine total post-retirement expenses.
We can use the following formula to calculate the post-retirement annual expense for each year, represented by EA.
EA=e(1+i/100)n
Where, e = annual expense in current value
i = rate of inflation
For first-year after retirement, the value of ‘n’ can be calculated by subtracting the current age from retirement age. For the second year the value of ‘n’ can be calculated by subtracting the current age from retirement age, plus ‘1’. For third-year instead of ‘1’ you add ‘2’, so on and so forth until you have calculated for all post-retirement years. This way you calculate your post-retirement annual expenses as well as total expenses by adding all the annual expenses.
For example, take a person of 30 years of age, who wants to retire at 60 and expect to live up to 85 years. Also, let us assume his monthly expenses are Rs 40,000 in present value and the rate of inflation is 7%. For first-year after retirement ‘n’ will be 60-30=30, for second post-retirement year ‘n’ will be 60-30+1=31, for third 60-3-+2=32, and so on. His annual expenses for all post-retirement years are shown in the image below. The total comes out to be Rs 25,09,35,747 yes that is more than 25 crore.
Post Retirement Earnings
For many people, retirement does not mean an end of all earnings. Pension, business earnings, etc can provide regular earnings to an individual even after retirement. These earnings will cover a part of the post-retirement expenses. Now it can be a bit difficult to calculate the exact amount of post-retirement earning, so make sure you have an estimated figure which is not exaggerated. I would suggest you calculate the possible earnings for each post-retirement year, add the earning of all years and you have total post-retirement earnings.
Substracting the total earnings from total expenses will give you the total amount required for post-retirement years.
In the example, we have taken earlier let us assume that that the person can earn an income equal to Rs 10,000 per month in today’s value. If we consider a 7% inflation rate and use the same calculation we used for expenses we can calculate the annual earning for all post-retirement years. The annual expenses, earnings, and the amount required are shown in the image alongside. Total earnings come out to be Rs 6,27,33,936, and already your amount required for post-retirement years comes down to around Rs 19 crore.
Post Retirement Withdrawal and Investment Planning
Now you have an amount that is equal to the money you require to fulfill your post-retirement expenses. If you are in a position to accumulate the entire amount you don’t have many worries, but if you are like most of us this amount might be too much for you to accumulate.
So what to do in such a scenario? At the time of retirement you will have a large corpus, but what you will immediately need is just one year of expenses. You can invest the remaining amount, and you can withdraw your annual expenses at the start of each year and let the rest of the corpus grow. Now while planning, do not assume high returns from post-retirement investment. Start with a low rate of returns and check if you can save the required corpus. if you can’t there is no option other than to assume a higher return post-retirement. The reason I am suggesting this is because at 60 65 years of age you won’t be able to take as much risk as you can today.
So for the first year, you withdraw the amount you require for the entire year’s expenses from the total corpus and invest the remaining amount. at beginning of the second year you do the same, and so on and so forth.
You keep doing this for each year if your amount is enough for all your post-retirement years it is well and good. Otherwise, you either increase the corpus or increase the rate of return from post-retirement investments. Or you do both to achieve a balance. To keep it simple take corpus as the total amount you require for retirement, then slowly decrease it and figure how much actual corpus you need with low risk.
Again in our example, if we assume that we can generate a return of 8% that is 1% extra than inflation (remember we are talking about a 60-year-old retired person, do not assume high returns), and we assume we start with Rs 6,40,00,000 corpus at retirement. In the end, we are left with Rs 28.5 lakh. So for an 18 crore requirement, we can do with around 6.5 crore corpus with inflation + 1% rate of return.
Where to Actually Invest After Retirement?
Why did I suggest determining the minimum rate of return you need from your investment after retirement first? So that you can plan your post-retirement investment plan with the least amount of risk.
Depending upon the rate of return you should keep the equity as low as possible, or other volatile assets. The lower the required rate of return, the lower will be the need for high-risk assets. It is of utmost importance that you keep your risk as low as possible in post-retirement years.
Now you have a target rate of return, and the amount you can invest, you can create a simple portfolio to achieve this rate of return. To create this post-retirement portfolio, the bucket strategy is a very good option, in my view. Let us take a look at bucket strategy in brief.
Bucket Strategy
You design 3 to 5 buckets consisting of one or more investment instruments with different risks and returns. In the image we have shown a 4 bucket portfolio, all 4 buckets have different risks and provide different returns. You should invest the largest amount in the bucket with the lowest risk and the least amount in the bucket with the highest risk. In our example, Bucket 1 has the lowest risk thus has the highest amount (30%). You withdraw your annual expenses from the bucket with the lowest risk, while allowing other buckets to grow. In our example, we will withdraw our annual expenses from Bucket 1.
When the bucket you are withdrawing your annual expenses runs out of money you or is low on funds, you withdraw some money from other buckets and put it in this bucket. In this way you have the money, you need for the next few years in safe investment, while the risky investments have more time to grow. One more benefit is that if one bucket is performing poorly, you can manage that without affecting your entire retirement investments.
Planning and Investing for the Corpus
Now after so much effort, calculations, and time you have a target amount that you need for your retirement, without taking unnecessary risk after retirement. Now the question is how to achieve this target corpus. Achieving this retirement corpus on time should be a very high priority. Thus you should not take too much risk while planning for this goal, even if you have a long period of investment. A few cautions that I take and advise you to do the same.
- Do not take too much equity exposure, personally i have only invested 60% in equity for retirement corpus.
- Reduce equity exposure as you reach close to your goal, so as to avoid any market fall close to your goal.
- Rebalance annually and also when your asset allocation has deviated too much.
- Keep portfolio simple and manageable and avoid fancy complicated products.
You can read How to Plan for a Financial Goal? This is an article about how to plan for a financial goal, and use it to make an investment plan for achieving your retirement corpus.
You can use the following excel sheet for all the calculations.
