Have you ever thought about Retirement?

When celebrities like famous actors or top athletes are asked about retirement, a lot of them tend to answer that they would continue to act/ play as long as they enjoy doing so. If you are one of them, probably you can afford not to read this any further. However if you are not, please continue reading because you like most others will need a retirement plan.

You may think that this is going in a negative direction – we are discussing ‘retirement’ instead of ‘career growth’. In all probabilities, you may also think that ‘retirement’ is too far away to be thought of right now. But believe me when I say that retirement is a critical phase in everyone’s life, not only from a personal perspective but more so from a financial perspective.

Now, retirement is that phase of life when a person decides not to participate in any full-time economic activity. As a result, there is no steady stream of cash inflows. In such a scenario, how is a person expected to continue having the same living standards or paying the bills for basic necessities? How can a person spend the retired life travelling around the world like he always dreamed of but was never able to actually fulfill due to work or other responsibilities? Essentially, how can a retired person be financially independent?

A plan is usually necessary for undertaking any major activity or mitigating any contingency in our lives. Therefore, the answer to the above questions is to formulate a retirement plan at the earliest, if you haven’t done that already. While retirement planning must be a part of overall financial planning, it tends to be one of the most neglected financial goals. The key to any planning is the ability to articulate the goals and timelines and then work backwards, to the present and to properly identify dependencies and milestones. When the retirement planning is conducted, the time horizons are expected to be long and uncertain, ranging from a few years to even 50 years in some cases. In such cases, it becomes imperative to divide the goals into milestones and timelines into phases of smaller intervals (say 5 years) and re-evaluate the plan for those intervals.

In the context of retirement planning, the goal is to build a corpus of assets by the time of retirement, which will generate sufficient cash inflows to meet all the expenses during the retired phase of life. Let’s take up an example for better understanding – the hypothetical case of a certain Mr. A. Kumar. To be able to estimate his retirement corpus requirement, following information are required:

• Current annual expenses (assuming that he would like to continue maintaining the same lifestyle post-retirement), say ₹ 300,000
• Post-retirement life-span, say 20 years
• Number of years to retirement from now, say 20 years
• Average inflation over the life span, say 7%
• An additional multiplying factor for expenses which may be needed for healthcare or travel, say 20%
• Annualized returns on the retirement fund, say 10%
• Current size of savings in retirement fund, say zero
• All the withdrawals from and contributions to the retirement fund are assumed to be at the beginning of the year (for the sake of simplicity)

Based on the above assumptions, the required annual contribution towards the retirement fund, assumed to be increasing annually at the same rate as inflation, is calculated as explained below.

• Equivalent annual expenses at the time of retirement considering the impact of inflation = ₹300,000 * (1+7%)^20 = ₹ 1,160,905
• Using the multiplier of 20% for healthcare/ travel costs, annual expenses at the age of retirement = ₹ 1,160,905* 1.2 = ₹ 1,393,086
• Using this as the base and sustained impact of inflation, the annual expenses for post-retirement years can be calculated as shown below (see the column for Expenses):

Table 1: Projection of expenses

• To be able to meet these expenses, the corpus amount which is required to be built by the time of retirement (assuming that this is the only asset that Mr. A. Kumar would have to meet his post retirement expenses, and the given annualized rate of return of 10% on the invested funds), has been calculated using the principles of compounding (shown in the second column of the table above). So for Mr. A. Kumar, the retirement corpus that needs to be built is ₹ 21,698,513.
• The retirement corpus of ₹ 21,698,513 can be built by Mr. A. Kumar over a period of 20 years before retirement, with contribution of  ₹ 220,577 in first year, contribution increasing annually at 7% (assumed rate of inflation) and an annualized return of 10% on the amount invested in the retirement fund, as shown in the table below:

Table 2: Projection of retirement fund corpus

When a similar analysis is conducted by varying 2 key parameters i.e. years to retirement and the annualized returns on the retirement funds, keeping all the other parameters same as above, following results are obtained.

Note: It is assumed that retirement funds would continue to generate the given returns throughout the pre-retirement and the post-retirement phase. As a result, in case of higher returns, smaller corpus would be required to be built, to successfully meet the expenses during the post-retirement phase of life. Corpus that needs to be built is a function of: a) Inflation b) Expenses c) Returns on the retirement funds

Table 4: Starting annual contributions required to build the required retirement corpus – contributions increasing annually at the rate of inflation (7%)

(To be read with reference to corresponding values from Table 3)

Key observations from the tables above:

• More the years to retirement, higher would be the retirement corpus required, considering the effect of inflation for more number of years (Table 3)
• The earlier you start building your retirement corpus (i.e. more years to retirement), lesser  is the required annual contribution (read through any of the columns from top to bottom in Table 4)
• Higher the expected return on investment, lower the required contribution to the retirement fund (read through any of the rows from left to right in Table 4)
• The effect of compounding over long durations is expected to be highly significant. Even a decrease of return on investment by 2% (say from 12% to 10%) leads to an increase of almost 52% (₹ 163,616 vs ₹ 107,689), in the required annual contribution (for ‘25 years to retirement’)
• It is critical that your investment fund generates higher returns than inflation, without which it will be impossible to maintain the same lifestyle (given the decrease in real value of money due to inflation)

There are some other important points with respect to retirement planning, as follows:

• The post-retirement life expectancy is extremely critical because:

1.  On one hand, if Mr. A. Kumar happens to live longer than 20 years post retirement, he will possibly have no funds left if he continues to maintain the same lifestyle. In such a case, Mr. Kumar will have to proactively change his lifestyle, location, travel plans, etc. to cut-down on expenses so that his retirement fund lasts longer.

2.  On the other hand, if Mr. Kumar is unable to survive for 20 years post retirement, he will have some unused funds in the corpus at the time of his death.

• Since life expectancy is uncertain, additional margin of safety may also be applied for the calculation of target retirement corpus to avoid exhaustion of funds. Obviously, this margin of safety would come at the cost of current lifestyle
• It is critical to distribute and manage the risks pertaining to building the retirement fund because it can have significant impact on the post-retirement lifestyle that one can afford
• When the time to retire is longer (say more than 20-25 years), it may be advisable to invest in risky assets such as equity which have high potential returns because:

1.  There is no need to worry about short term volatility because in the long term returns are generally expected to be high

2.  Even if there are sustained losses over a period of time, there will still be time to increase the contributions to the retirement fund to meet the goals

• It is advisable to allocate more of the retirement corpus to less risky assets as the retirement approaches (less than 10 years), to avoid uncertainty and unfavorable shocks

Retirement planning is complex, needs diligent efforts and a high level of personalization based on various factors.

Quick Summary:

With increasing life expectancy and cost of living, retirement planning is important, especially in the economies where social security schemes are not present or dependable. There are a few parameters which if assessed objectively and accurately, can lead to the development of a highly precise and dependable retirement plan. Still, it is worthwhile to revisit the overall retirement plan including annual contributions and the asset allocation within the retirement fund periodically, at least once every five years.

Happy Retirement Planning!