In one of his budget speeches, the Finance Minister, Arun Jaitley said that an important objective of his Budget was to step in the direction of making India a “pensioned society from a pension less society”. Many people still think that, providing pension to people is the responsibility of the employer or the Government; this kind of thinking is a legacy of the centrally planned economy that we had for more than four decades after Independence. Centrally planned economy in our country gave people a sense of entitlement, but created very little, for large sections of the population, in terms of real prosperity.
Some people have told me that, senior citizens in the United States get pension. What they ignore is the fact that, the pensions received by retirees in the US come from the Individual Retirement Accounts (IRAs) where people put a portion of their savings in stocks, bonds and mutual funds throughout their working lives. Even the Social Security Pension, a Government programme in the US, comes from the social security payments thatemployersdeduct from the employees’ salaries when they are working.
Anyway, coming back to India, in the absence of pension, our society traditionally relied on the joint family structure, where family members take care of each other in different stages of life. But with changing socio-economic conditions in our country, e.g. job mobility, nuclear families, changing lifestyles, rising cost of living (including healthcare) etc, retirement planning is now more important than ever before. In this blog, we will discuss 6 common retirement planning mistakes that individuals must avoid, in order to achieve financial independence and be free from financial stress during their retirement years.
Most individuals do not think about retirement planning early in their careers. It is human tendency not to worry about a problem that will not affect us in many years, but just because we are not worried about a problem, it does not mean that the problem does not exist. Once retirement looms large, you will start to worry about it, but it may be too late. Starting to save and invest for your retirement from an early age has great benefits. The earlier you start the better are the chances for creating wealth as your investments get more time to compound.Many investors are not aware of the power of compounding. If an investor wants to set a goal of creating a retirement corpus of say, Rs 1 Crore, he or she can achieve it with much smaller savings simply by starting earlier, as shown in the chart below.
We can see from the chart above that starting early has major benefits. Starting too late, on the other hand, will put your retirement planning at serious risk.
A common mistake is to ignore or even underestimate the impact of inflation on expenses. Inflation cannot be wished away and it reduces the value of savings. The chart below shows the annual (December to December) CPI inflation rates in India from 1986 to 2016.
The chart above shows that except for a 5 – 6 years period from2000 to 2006 and very recently (post 2015), the annual inflation rate in India has been mostly above 6%. The geometric mean annual inflation rate over the last 3 decades has been 7.3%. This means than an expense of Rs1,000 in 1986 would be nearly Rs8,300 today. Now, if we extrapolate 20 years forward, an expense of Rs8,000 today, even at an inflation rate of 5% (assuming the long term inflation is contained within 5%, as the Reserve Bank of India expects to), would be nearly Rs22,000. In other words, if you are 30 years old and your monthly expense is Rs 20,000, you should expect your monthly expense at the same lifestyle to be nearlyRs 90,000 by the time you retire. Mind you that, your lifestyle expenses are certainly going to increase as your income increases. When you set a retirement goal for yourself, you should always factor in the effect of inflation and lifestyle changes, and plan accordingly.
Healthcare costs in India are increasing at a distressing rate. Based on some estimates, the annual healthcare inflation is in the range of 15 – 25%. A hospitalization for a serious illness can cost Rs 5 lakhs or above. While health insurance or Mediclaim is essential for all, it is even more relevant for senior citizens, because health risks increase substantially with advancing age. In the absence of Mediclaim, a serious illness in your family can cause financial distress at a time when you least expect it.
Even if you are covered under the group health insurance plan of your employers, you are likely to lose the health cover once you retire. Loss of health cover can put you and your dependents at serious health related financial risks. IRDA's portability guidelines cover policy transfers from group to retail, allowing retiring employees to switch to the retail policy of the insurer offering the group insurance plan to their former employer. However, the premiums and the policy terms may change once you switch to the retail plan. Alternatively, senior citizens can buy separate health insurance or Mediclaim depending on their healthcare requirements. Whether you continue with your pre-retirement health insurance plan or buy a new plan, it is imperative for senior citizens to ensure that, they have comprehensive health insurance cover to meet any medical emergency.
We should understand that, debt in any form has a cost associated with it. Home loans, vehicle loans, credit card loans etc, have interest cost which comes out of our savings. For unsecured debt, like credit card loans the interest cost can be quite high. Many investors over extend themselves buying a house and the home loan EMIs constitute a large chunk of their incomes. Interest costs comprise the major part of the home loan EMIs in the early and mid part of the home loan term. The higher the interest and the longer we pay it, the more we put our long term financial goals at risk. We should strive to be debt free early in life, so that we can free up our savings to work towards our retirement planning.
Most Indian retail investors like risk free or low risk assetsas long term investment options. Accordingly they often opt for risk free or low risk investment options like small savings schemes, bank fixed deposits and life insurance savings plans with guaranteed additions for long term investments. Investing in low risk investment options can result in falling short of your retirement plan or other long term financial goals. Risk free or low risk investment options often fail to beat inflation (especially relating to the urban consumption basket) on a post tax basis or at best barely manage to keep up with inflation. Equity as an asset class has historically been able to beat inflation in the long term and create wealth for the investor. The chart below shows the Sensex returns and the annual inflation rates over the last 25 years from 1992 to 2016.
Source: www.inflation.eu and Bombay Stock Exchange
We can see from the chart above, that while Sensex returns have been volatile, it has managed to beat inflation most of the times. Investors should understand that volatility is a short term phenomenon and does not impact the long term objectives. For long term investors, not meeting the financial goal is the real risk.The compounded annual growth rate of the Sensex from 1992 to the 2016 is around 10%, while the geometric mean average inflation rate during this period was around 7%. This shows that, volatility notwithstanding, equity has created real wealth for investors over the last 25 years. It is essential that equities form a significant portion of your investment portfolio to help you meet your retirement goals.
While the conventional financial wisdom dictated that we avoid risks after retirement and allocate our accumulated corpus to safe investments like fixed income, longer life span and high inflation necessitates a rethink of the conventional wisdom. Retired lives can now last 25 to 30 years or even more. Yields of low risk assets may not be sufficient to meet your post retirement expense needs and prolonged drawdown from your asset base can result in you running out of your funds and losing your financial independence. Let us try to understand with the help of anexample.
Suppose you have accumulated a retirement corpus of Rs 1 Crore. Let us assume your monthly expense is Rs 50,000; your annual expense is 6% of your retirement nest egg. Let us assume, after retirement you deploy your corpus in risk free assets like fixed deposits giving you interest rate of 7%. Some of readers may think this is a comfortable situation.
But in reality, it is not because of inflation and taxes. Your annual pre-tax income, assuming 7%interest rate, is around Rs 7 lakhs. You will fall in the 20% tax bracket. Let us assume the inflation rate is 5%. Your retirement corpus will get depleted before you reach the age of 80. For the last 10 years or so of your retired life, in this example, you may lose your financial independence, even though you were financially comfortable to start with. If your spouse is a few years younger than you, she may have to be financially dependent on your children for even longer. The chart below shows the diminishing retirement corpus in the above example.
The post tax yield of risk free investments is not sufficient to keep up with inflation in the long term. Let us now revisit the Sensex versus inflation chart. We have seen that, equity over a long period has beaten inflation. Equity is also the most tax friendly asset class; long term capital gains from equity assets are tax free. A prudent allocation of debt and equity during retirement will help you meet your income needs and also protect you from inflation in the long term. With good equity returns, you can leave behind an inheritance for your loved ones, after enjoying a successful retired life.
In this article, we have discussed some common retirement planning mistakes that we should avoid. Retirement planning is a very important financial planningaspect and if required, you should take the help of a financial planner for retirement and other long term financial goals. We should take retirement planning seriously from an early stage of our careers, so that we can have a happy and fulfilling retirement.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development
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