Somnath is 30 and salaried and hopes to retire by 55. In this case study, we shall find out how he can plan for financial freedom in retirement. That is, we shall find out how Somnath can derive an inflation-protected income and be financially free after retirement.
What is inflation-protected income? A retirement income that increases each year as per the needs of the family. It takes into account inflation in expenses as well as due to lifestyle modifications. Young earners today should not be thinking and be talking about constant income or pension in retirement. They should consider how to consistently beat inflation with an inflation-protected income (also known as inflation-indexed income). Read more: Generating an inflation-protected income with a lump sum.
What is financial freedom? The ability to generate inflation-protected income for a given number of years, preferably until the death of the youngest dependent.
We shall use the freefincal robo advisory tool to create a retirement income plan for Somnath who is married to a homemaker aged 25.
Recommendation: After a few years, we recommend Somnath reduce the retirement age to 50 as many salaried employees may not have the health to continue further. See: How to prepare for the “new normal” in retirement planning.
We shall plan for retirement income from the time Somnath reaches 55 to the time his wife (younger spouse in general) reaches 90. Therefore, Somnath has 30 years to invest (the most precious asset) and needs to plan for inflation-protected retirement income for 35 years.
We shall consider 6% inflation before and after retirement. It is better to find out how much your expenses are increasing year on year and use that rate. You can use out Personal Inflation Calculator.
Somnath has monthly expenses of Rs. 40,000 per month and another Rs. 40,000 annual expense. All these expenses will persist until retirement. His average monthly expenses at the time of retirement will be about Rs. 3 lakhs.
The total corpus required (excluding existing investments) is about Rs. 14 Crores! The monthly investment to be made (including mandatory EPF or NPS deductions) is Rs. 1.35 Lakhs.
If Somnath can increase the investments at the rate of 10% a year, the initial investment will come down to Rs. 51,000! That is quite a drop!
To ensure the actual retirement corpus at any point in time is close to the expected corpus, the robo tool recommends a variable asset allocation as the one shown below.
Starting with 60% equity exposure, Somnath can gradually taper down to about 36% at retirement and maintain that.
As the portfolio’s equity exposure decreases, so too do the expected net return from the portfolio. This is factored in from day one in the above calculation.
This is only one part of the retirement calculation. The second part is to determine how the corpus will be divided into buckets. A retirement bucket strategy refers to the way in which a retiree invests her corpus in different investments and tries to generate inflation-protected income.
The robo tool divides the retirement corpus into five buckets. That is, the retirement corpus will be divided into five parts. This is only one of many ways to construct a bucket strategy. This assumes 40 years in retirement.
- An emergency bucket to handle unexpected expenses. Example: 5%
- Note: the overall equity allocation from the entire corpus is only 36% after retirement.
- Income bucket that provides guaranteed income for the first 15 years in retirement. During this time, investments are made in the following three buckets.
- Corpus from a low-Risk bucket that provides income from year 16 to year 25 in retirement. To provide this income, the low-risk bucket will have an asset allocation of 50% equity 50% debt during the investment period (years 1 to 15 of retirement). This corpus has a weight of about 20-25%.
- Corpus from a medium risk bucket will provide income from year 26 to 33 in retirement. To provide this income, this bucket shall have an asset allocation of 70% equity and 30% debt during the investment period (year 1 to year 26). This corpus has a weight of about 15-17%.
- Corpus from a high-risk bucket will provide income from years 34 to 40 in retirement. To provide this income, this bucket shall have an asset allocation of 100% equity during the investment period (year 1 to year 35). This corpus has a weight of about 10-15%.
- During this investment period, the buckets will be actively managed to reduce risk: rebalancing and profit booking from one bucket to another. To understand how this works, try this: The Retirement Bucket Strategy Simulator.
- After 15 years, the low-risk bucket will be turned into 100% debt and provide income for about 11 years. After that, the other buckets will also be progressively used. One can always customize this usage after retirement.
- Please note that bucket allocations will change as per the user inputs, and auto-determined by the robo tool.
Will Somnath achieve financial freedom? Somnath and his wife have time on their side. With disciplined investing and disciplined risk management, they will be able to retire comfortably and fight inflation.
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About The Author
Dr M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over nine years of experience publishing news analysis, research and financial product development. Connect with him via Twitter or Linkedin or YouTube. Pattabiraman has co-authored three print books: (1) You can be rich too with goal-based investing (CNBC TV18) for DIY investors. (2) Gamechanger for young earners. (3) Chinchu Gets a Superpower! for kids. He has also written seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice.
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