Introduction: Why retirement planning is important? It ensures availability of fund when its time to retire from job.
In India, majority retired people are dependent on pension or on the accumulated money parked in provident fund.
But often, this is not enough to lead a decent retired life.
Hence it is essential to do immaculate retirement planning when the person is still earning (is in job).
Here the person must divert sufficient money to a good retirement linked investment plan.
When we say retirement planning, it means several things.
First essential step is, estimating how much fund (retirement corpus) will be necessary to lead a decent retired life.
Once this is established, the second step is to find a method to generate sufficient income to meet this requirement.
The third and final step is about investing wisely the retirement corpus.
In order to successfully execute these steps, it is essential to first judge one’s present financial position.
If ones current financial position is strong, smaller savings will be necessary to build the required retirement corpus.
If ones financial position is weak, larger savings will be necessary to build the required retirement corpus.
Once the savings target is set, it is also necessary to know where to invest this money.
In order to build a sufficiently large retirement corpus, only savings will not help.
The saved money must also be invested wisely.
There are several retirement linked investment vehicles which can be used to build one’s retirement corpus.
Retirement planning also deals with suggesting which investment vehicle must be considered to build the retirement corpus.
The last but not the least, retirement planning also deals with suggestions on how to invest one’s already accumulated retirement corpus.
#1. Accumulation and Distribution Stage
To understand retirement planning completely, one must know these two terms.
In accumulation stage, people save and invest money to build their retirement corpus.
In distribution stage, people withdraw money from their retirement corpus.
It is point worth mentioning that the longer will be the accumulation stage, easier it will be to build a sufficiently big retirement corpus.
Hence experts often recommend to start retirement linked investing as early as possible.
The required retirement corpus for any family is often a big amount.
Hence starting early gives a nice head start.
It means that even a smaller sums of saving each month will eventually build a large retirement corpus.
In the above graphical representation, orange portion is the principal contribution towards the retirement corpus.
In this case I have assumed it to be Rs.5,000 per month.
The green portion is the compounded earning generated by the invested principal over the course of time.
In this example, I have assumed Rs.5,000 invested for 35 years generating 8% returns per annum.
You will note that in the initial years (till 20 years), the principal portion dominates the accumulated retirement corpus.
But after the 20th years, compounded earnings start to increase at a dramatic pace.
In the last 5 to 6 years, the compounded earning has become so dominant that the principal amount is looking like a midget in presence.
This is what is called as power of compounding.
The invested money grows more rapidly in the later years.
Hence the longer the money stays invested, bigger is the benefit.
#2. Starting early is beneficial
Suppose there are two friends Jack and Harry.
Their age is 25 years of age.
Both these friends decided that they would like to retire at the age of 60 years.
Both of them have a set a goal to accumulate Rs. 3 crore by the time they are 60 years of age (after 35 years).
Jack starts a SIP in mutual funds immediately after making this decision.
But Harry delayed the action by 4 years.
Harry started an SIP in mutual fund for retirement only when he was 29 years of age.
Do you know what will be contribution of Jack and Harry to accumulate Rs. Crore by the time they are 60 years of age?
|Starting Age||25 Years||29 Years|
|Retirement Age||60 years||60 years|
|Investment Horizon||35 years||31 years|
|Retirement Corpus||Rs.3 Crore||Rs. 3 Crore|
Just because Harry started late by just 4 years, his monthly contribution increased from a potential Rs.5,000 to Rs.7,960 per month.
This is almost an increase by Rs.3,000 per month.
For an average middle class Indian, taking a hit of Rs.3,000 per month is not easy.
Let’s take another example.
Both Jack and Harry decided to invest Rs.5,000 per month as part of their retirement planning.
They were investing through SIP route in mutual funds yielding returns @ 12% per annum.
Jack started invested when we he was 25 years of age. While Harry started investing when he was 29 years of age.
What corpus both of them will have when they reach 60 years of age?
|Starting Age||25 Years||29 Years|
|Retirement Age||60 years||60 years|
|Investment Horizon||35 years||31 years|
|Monthly Contribution||Rs.5,000||Rs. 5,000|
|Retirement Corpus||Rs.3 Crore||Rs. 1.89 Crore|
You can see that, just because Harry started investing 4 years later, his retirement corpus is reduced by 37% compared to Jack.
#3. Initial years are tough…
Senior Man Doing Taxes
This is very natural. When one starts to include a new activity in one’s life, the starting is always tough.
The reason being, current priorities.
If suppose, one’s current priorities are like:
- Child education,
- Parent care,
- Home purchase,
- Gadget purchase etc,
In this case, including retirement linked investments may get compromised.
Those financial goals which are closer in future automatically takes priority.
Retirement corpus is one goal which is farthest away from today.
Hence people often take it casually.
It is true that all financial goals are important.
Immediate ones, and distant ones like retirement, both needs fair treatment.
But how to plan for retirement linked savings when immediate ones look far more important?
The idea is simple. Start low. Start diverting a small sum of money each month into retirement linked plans.
If allocating funds is a problem, it is ok to start even with a smaller denominations like Rs.500 per month.
But the trick is to increase it gradually every year.
This is a point worth noting that, accumulation stage in retirement linked savings is very long.
Generally this investment horizon is close to >25years.
It means that one can take more risks while practising investments for this goal.
As investment horizon is long, short term volatility of riskier investments gets negated.
Post accumulation stage, when the person reach the distribution stage, the risk taking capability of the individual is greatly decreased.
Here, even though the investment horizon may be longer, but still taking high risk is not advisable.
This is the reason why experts’ advice retired people to invest their retirement corpus in income-linked plans.
These plans are less risky and they generate regular income for retired people.
#4. How to calculate ones required retirement corpus?
How big should be ones retirement corpus? The corpus should be big enough so that it generates enough income to support retired life.
There are two essential questions that need answering at this step:
- a) Income required after retirement, b) Size of retirement corpus necessary to generate required income
#4.1 Income required for retirement
In order to estimate the income required after retirement, the first step is to quantity the present income needs.
In order to do this, one must first list down all current expense that one incurs daily/monthly/annually.
Once this is done, extrapolate all these expenses to the time when you are 60 years of age.
Here you will notice that all expenses which you are incurring now will not be same after retirement.
Cost of some expense line items will reduce. Cost of few line items will increase.
Once this extrapolation and adjustments are done, the net expense will be total expense requirement after retirement.
Just for example few expense line items that change when a person retires are as below:
- Income tax liability will reduce after retirement
- Retirement linked savings like PF, PPF will stop
- Other financial goals like child education, child care etc will stop
- Expenses like dining out, entertainment etc will reduce
- Expense related to vacation may increase
- Medical expense will increase
- Petrol/Diesel expenses for local commutation will reduce
As a rule of thumb, once safely assume that their monthly expense after retirement will close to 75% of their present expense.
This percentage is called a replacement ratio.
People who save more will have this value even lower.
For a heavy savers, this value can go down to as low as 50%.
People who are in their 50’s age, generally save majority portion of their paycheck.
Hence it is highly recommended that when people cross 50 years of age, they must review their expense budget.
After review, trying to forecast retirement expenses/income requirement will be beneficial.
I have personally taken premature retirement.
I was also one of those people who used to save majority portion of the income (though I am not in 50’s J).
So I am speaking something from my practical experience.
After my retirement, I was able to reduce my expenses by almost 59%.
Though it is a very tough target but it is possible.
I will present to you a formula that one can use to estimate ones retirement income requirement.
Let’s take an example:
Suppose Jack and Harry want to estimate their retirement income.
Their current income is Rs.800,000 per annum. Jack is 25 years of age.
Harry is 29 years of age. Expected average income growth for next 30-30 years is 6% per annum.
They have safely assumed their income replacement ratio as 65%. What will be their required income after retirement?
|Starting Age||25 Years||29 Years|
|Retirement Age||60 years||60 years|
|Investment Horizon||35 years||31 years|
|Current Income (Ic)||Rs.8 Lakhs||Rs.8 Lakhs|
|Income just before retirement (Ir)||Rs.61.48 Lakhs||Rs.48.7 Lakhs|
|Income Replacement Ratio||65%||65%|
|Required Income After Retirement (IR)||Rs.40 Lakhs||Rs.31.6 Lakhs|
#4.2 Size of Retirement Corpus
This is a very important step in retirement planning.
Once we know what income will be necessary after retirement, next step is to calculate the retirement corpus.
This corpus will eventually generate this income (remember money makes money).
Before we move further into the calculations, one must first know the concept of inflation.
What is inflation?
Positive inflation makes everything expensive with passage of time.
If rate of inflation is higher, things become expensive faster.
If rate of inflation is low, things become expensive slowly.
Some European countries are also experiencing negative inflation.
This is called as deflation. But in our study we are considering only positive inflation.
So, how this knowledge of inflation helps us to plan our retirement?
Till last steps we have calculated and arrived at how much income is necessary after retirement.
But this calculated income will not remain same for all future years.
What is calculated will be applicable only for 61st years of age.
But after 61st years, the income requirement will increase due to inflation.
This is the reason why, calculated income requirement (IR) must be adjusted for inflation.
If this is not done, there is huge chance that the retirement corpus remains insufficient.
This inflation adjusted income (IR) has direct impact on the retirement corpus.
Lets understand this with an example.
In our previous example (see table), Harry needs an income of Rs.31.6 lakhs Rupees in the first year after retirement (31 years from now).
It means a monthly income of Rs.2.63 lakhs.
If we adjust this amount with 6% inflation rate, 5 years after retirement this same amount will grow to become Rs.3.52 lakhs.
People often ignore the impact of inflation on their retirement corpus.
But its a huge mistake. We have only considered 6% inflation.
In reality, the cost of food products, medical expense, and many other expenses increases at a much faster rate.
Hence ignoring inflation is only like living in a fool’s paradise.
#4.2.2 Investment Return
While planning for retirement, there are two investment returns that must be kept in mind.
- First is the investment required in accumulation stage.
- Second is the investment return required in the distribution stage.
In order to correctly estimate the size of retirement corpus, figuring out a realistic investment return is necessary.
Ideally, higher will be the investment return in the accumulation stage, the faster will be the growth of retirement corpus.
Similarly, higher will be the investment return in the distribution stage, the higher will be the generated income.
For sure, higher returns always come with their own share of risks.
But in accumulation state, where the risk taking capability is higher, one can opt for higher-return-generating investment options.
In distribution stage, riskier returns shall be avoided.
#4.2.3 Inflation and Investment Return
Here we will see the combined effect of inflation and investment returns on retirement corpus.
Inflation has a negative effect on retirement corpus.
As inflation makes things more expensive, hence bigger retirement corpus is required to generate matching income.
Investment return has a positive effect on retirement corpus.
Investment returns helps to build retirement corpus faster and it also helps in generating higher income.
Hence, the real investment return will be net of ‘return on investment (ROI)’ and ‘inflation rate (IN)’.
This is is called inflation adjusted rate of return.
#4.2.4 Calculation of Inflation adjusted rate of return
Generally, in order to calculate the inflation adjusted rate of returns we subtract Inflation rate (IN) from ROI. But this is not the right method.
In order to calculate inflation adjusted rate of returns, there is formula.
Lets see how this formula is different than our normal understanding.
Suppose, investing in a balanced mutual fund gives a return of 12% per annum. Prevailing inflation rate if 6% per annum.
What will be the inflation adjusted return?
|General Understanding||Above Formula|
|Inflation Adjusted Return||6%||5.66%|
#4.2.5 How to calculate retirement corpus
Now we know how to calculate the real return (inflation adjusted return). So now we are ready to compute the retirement corpus.
Lets try to do this using a real life example.
Suppose Jack wants to retire today.
If he does this, He has estimated that he will require and minimum Rs.60,000 to survive decently.
He has 25 more years to retire from today. Moreover, he also expects to survive till 85 years of age.
After retirement, Jack has decided that he will keep all his money in mutual fund MIP which will give him annual income @ 12% per annum.
What should be the size of Jack’s retirement corpus?
Step-1 : Let’s calculate the income required at the time of retirement
|Inflation (R)||6% p.a.|
|Investment Horizon (Y)||25 years|
|Income required if Jack retires today (Ic)||Rs.60,000|
|Income just before retirement (Ir)||Rs.2,57,512||60,000 x (1+6%)^25|
Step-2: Size of retirement corpus
In order to calculate the size of retirement corpus, we will not use any formula.
Instead we will use Microsoft Excel to calculate the corpus.
The formula that must be used is called “Present Value (PV)” function. The formula is like this:
Before using the above MS Excel function, lets calculate the Inflation adjusted rate of return
|Expected return (ROI)||12% p.a.|
|Inflation rate (IN)||6% p.a.|
|Inflation adjusted return||5.66%||(1+0.12) / (1+0.06) -1|
So, by using this formula in excel, the retirement corpus that jack must have before retirement is Rs.2.45 Crores.
#4.3 How to build the Retirement Corpus?
Now we know that how one must calculate their requirement of retirement corpus.
In this calculation one estimates what retirement income is necessary to lead a decent retired life.
Moreover, one also calculates what should be the size of retirement corpus which will eventually generate the retirement income necessary.
In our previous example we have seen that Jack needs Rs.2.45 Crore as his retirement corpus.
So now what is the next step? What is the next question that must be answered?
The next important question is, how to build this retirement corpus. F
or Jack he has 25 years in hand to build this retirement corpus.
What should be the monthly saving and investment that Jack must do to achieve this target?
In order to answer this question, we will not use any formula again.
Instead we will use Microsoft Excel to estimate the monthly savings requirement.
The formula that must be used is called “PMT” function.
The formula is like this:
This formula one can use to know what monthly savings and investment is necessary to build one’s retirement corpus.
Lets use this MS Excel formula for Jack.
|Size of Retirement Corpus (fv)||Rs.2.45 Crore|
|Years in hand before retirement||25 years||Nper = 25 x 12|
|Return on investment||12%||Jack has decided to invest systematically through SIP in a balanced mutual fund|
So lets see how this formula shapes up for Jack:
So, by using this formula in excel, monthly savings and investment that jack must do to build and retirement corpus of Rs.2.45 Crores is Rs.12,911 per month
#5. Where to invest money in accumulation stage?
In the accumulation phase, the target of the planner should be on corpus building.
The faster and easier the corpus is build the better.
In my opinion, here the person should concentrate on growth investing.
Generally people try to play safe here too.
But considering that one has such huge time horizon available for investing, going all guns blazing should not be a big worry.
People who are farthest away from retirement (like people in their 20’s and early 30’s) should definitely consider growth investing over any other options.
Here I will try to list down all “traditional” investment options which a person can use to invest their money in accumulation stage of retirement planning:
#5.1 Employee Provident Fund Scheme (EPF)
This is a mandatory, retirement linked, savings scheme that all employers must provide for its employees.
As per this scheme, the employee mandatorily must contribute 12% of his basic salary and allowances to the EPF scheme.
Employee’s can also contribute voluntarily more than 12%.
Employer’s contribution is fixed at 12%.
Each passing month both employee and the employers must contribute 12% + 12% to the EPF scheme.
EPF scheme provides close to 8.6% interest rate on the deposits made by the employers and the employees.
These days one can also check their EPF balance by sending SMS from the registered mobile number.
#5.2 Employee Pension Scheme (EPS)
Employee pension scheme actually comes in the package with the above EPF scheme.
We know that 12% is contributed to the EPF by the employer.
Out of this 12%, 8.33% is diverted to the EPS scheme.
Moreover, the central government of India also contributes to EPS.
In addition to the employer’s contribution of 8.33% to EPS, GOI (Central) also contributes 1.16% of employee’s basic salary towards EPS.
An employers should mandatorily pay a gratuity to the employee.
If the employee has completed the services in company for a continuous period of 5 years, he becomes eligible for the gratuity.
The employee can claim gratuity only when his employment is terminated due to resignation etc.
Insurance companies like:
- AEGON LIFE,
- SHRIRAM LIFE etc
…provide group gratuity scheme.
#5.4 Voluntary Provident Fund (VPF)
When we have options like EPF, why VPF is required?
It is true that EPF is a great retirement linked investment option.
But the problem with EPF is that, it is available for only salaried employees.
So what options are available for self-employed people which can compare with EPF?
Voluntary Provident Fund (VPF) is the answer.
VPF can also be used by salaried employees to contribute additionally to their retirement fund over and above their EPF.
Salaried employees often use VPF to increase their retirement linked savings if they think that EPF fund is not sufficient.
Employees can also ask their employer to deduct VPF from their salary each month.
#5.5 National Pension Scheme (NPS)
NPS is also a retirement linked investment scheme that all individuals above 18 years of age can utility to build their retirement corpus.
NPS is comparatively a new retirement plan made available by government of India in year 2009.
I personally consider it as very effective tool to building a heavy retirement corpus.
NPS is suitable for anyone. Why?
Because the minimum contribution in NSP is as low as Rs.500 per month (Rs.6000 per year).
There is no maximum limit. It means people of almost all income class can opt for NPS.
Another advantage of NPS is the way they invest their accumulated money.
The distribution of funds by NPS is fantastic.
It exactly match the priority of an average Indian to build a sufficiently big retirement corpus.
NPS distributes their funds into three asset class.
- E : 1st Asset Class (High risk, high return options like equity)
- C: 2nd Asset Class (Medium risk, medium return options like fixed income plans)
- G: 3rd Asset Class (low risk, low return options like low risk debt linked plans)
How funds are distributed between E,C & G? The proportion is decided based on the investor’s age.
Younger people will have portfolio heavier in E. Old people will have portfolio heavier in G.
Lets see how portfolio contribution change with age of people:
How much returns can be expected from NPS?
#5.6 Public Provident Fund (PPF)
Like EPF and VPF, Public Provident Fund (PPF) scheme is another retirement plan offered by government of India.
Like VPF, here as well, one can contribute as low as Rs.500 per month.
But in VSF, there is a upper limit to contribution.
The upper limit is Rs,1,50,000 per annum (Rs.12,500 per month).
PPF also has a lock-in period of 15 years.
But partial withdrawals are allowed from seventh year onwards.
Premature closure of PPF account is not not allowed.
Means the contributed fund must remain locked for 15 years (except for partial withdrawals allowed as per rules).
After completion of 15 years, one can withdraw the whole amount or can extend the with 5 years block periods.
At present the interest offered by PPF is close to 8.7% per annum.
#5.7 Pension Plans offered by mutual funds
These days mutual fund companies offer pension plans for people who are interested to plan their retirement corpus.
But we have already a great option like NPS, so why one should consider pension plan offered by mutual fund companies?
In case of NPS, people are obliged to buy an annuity at the time of maturity. This annuity in turn generates regular income post retirement.
But in case of pension plan of mutual funds, buying annuity is not compulsory.
One can also decide to opt for a systematic withdrawal plan post retirement.
The money that is systematically withdrawn becomes the person income, and balance corpus remain invested to generate more returns.
Moreover, pension plans offered mutual funds are capable of giving higher returns in long term.
A typical pension fund can give a return of close to 9.6%.
The reason why they can give such high returns as they invest in equity linked options as well.
In long term, exposure to equity options improves the overall returns.
Typical portfolio composition of a pension fund is as below:
#5.8 Balanced portfolio funds offered by mutual fund companies
I personally recommend my readers to go full throttle when it comes to building a retirement corpus.
Traditionally people opt for safer options like PEF, VPF, NPS etc.
But when time horizon in hand is so huge, why to play safe?
But this is also a fact that one cannot afford to play reckless when it comes to retirement planning.
There must be a clever balance between aggression and playing safe.
This is one reason mutual fund companies offer debt linked mutual funds which also invest in equity.
Such funds are normally called as balanced funds.
In India we have several balanced funds which offer fantastic long term returns.
These balanced funds can offer close to 10%-12% returns in long term.
#6. Where to invest money in distribution stage?
In the distribution stage, the funds in retirement corpus must be done conservatively.
This is necessary because in this stage the family is dependent on income generated by the accumulated retirement corpus.
Over and above this, the priority is also to keep the corpus amount intact as much as possible.
Distribution stage can further be subdivided into two sub-stages:
- Stage 1 – First 10 years of retirement (where person is expected to be active)
- Stage 2 – After 10th year of retirement (where person becomes less active)
In stage1 person can maintain some exposure to equity.
But in stage2, equity exposure should not be allowed.
Though the equity exposure is allowed post retirement (60 years) but care must be taken that this exposure does not cross 8-10% mark.
Investment diversification must also be maintained in the distribution stage.
The retirement corpus must be spread evenly in multiple income generating source.
Ideally, income should flow in from multiple sources instead of one or two options.
Here we will see a list of most highly recommended investment options post retirement.
A retired person can buy an annuity.
This is perhaps the safest and most used option by retired people in India.
Annuity generates regular income for its investors.
The investor can select the options of annuity payment to made either:
- half-yearly or
On an average a typical annuity scheme can offer interest rate at rate of 6.5% to 7.5% per annum. I know, this interest rate will raise few eyebrows, because it is low.
This is one reason why not may financial planner recommend allocation to large portion of one’s retirement corpus in annuity.
Though annuity is very safe but they yield very low return.
Moreover, the fund put in annuity becomes complete inaccessible to the investor.
Though it will generate income throughout the lifetime of the retired person, but the principal amount invested in annuity becomes locked forever.
#6.2 Senior Citizen’s Savings Scheme (SCSS)
People of only 60+ years of age can invest in SCSS.
One can open a SCSS account with a Indian Post Office.
The money invested in SCSS has a lock-in period of 5 years.
After the first maturity, the SCSS A/c can be extended once for another 3 years.
The maximum amount one can invest in SCSS is Rs.15 Lakhs per account.
There are no restrictions as such on the number of accounts a retired person can open as SCSS.
But sum total of all those accounts cannot be more than Rs.15 lakhs.
Presently SCSS offers a reasonable interest rate of 9.3% per annum.
The interest accrued is paid quarterly.
One can also close the SCSS account prematurely.
But premature closure will attract a penalty of 1%-1.5%.
#6.3 Post Office Monthly Income Scheme (POMIS)
This is a savings scheme offered by Indian Post Offices across the nation.
The main purpose of POMIS is to provide stable income to its investors.
The lock-in period of POMIS is 5 years. One invest a minimum amount of Rs.1500 in POMIS.
The maximum limited that can be invested in POMIS is Rs.4.5 lakhs.
In case of joint account the maximum limit is increased to Rs.9 lakhs.
Like SCSS, one open multiple POMIS accounts.
But the sum total all such accounts cannot go beyond the prescribed maximum limits.
Presently POMIS offers a reasonable interest rate of 8.4% per annum. The interest accured is paid monthly.
One can also close the POMIS account prematurely.
But premature closure will attract a penalty of 1% to 3%.
Premature closure is allowed only after the 1st year.
#3.4 Other investment options post retirement
- Monthly income plan of Mutual Funds
- Bank Deposits
Real estate investment