Passive Investment For Retirement Planning
Post-retirement it becomes more important to protect your capital and income generation takes precedence to the growth of your capital. This demands a change in approach to investment with a fresh outlook
Different stages of life require different forms of investment planning. The way you invest when you are young cannot be replicated when you are retired. For instance, when you are young you can take risks and invest in riskier assets with better return potential, albeit in the longer run. Nevertheless, once you have retired you require a different approach to investing given the fact that your priorities change. During your accumulation phase or before retirement you invest to amass wealth for retirement. Your priority is to accumulate more and more and invest in securities that have better return potential. However, post-retirement it becomes more important to protect your capital and income generation takes precedence to the growth of your capital.
Retirement Portfolio
This also demands a change in approach to investment with a fresh outlook. Building a stable income source without taking much risk becomes important for retirement planning. One of the most conventional ways of building such a stable portfolio is to divide your retirement corpus into two broader asset classes – equity and debt – in equal proportion. After this you decide on the sub-asset class, as for example, large-cap, mid-cap fund or liquid or money market fund, which will depend upon your risk profile. Once you have decided and invested, you can start a systematic withdrawal plan from this corpus. The amount that has worked for many is to use 4 per cent of your year-end corpus. Studies elsewhere have shown that this will help your fund to run for 30 years.
We will explain the concept with an example. Assume that you have accumulated Rs 7.63 crore for your retirement. At 60 years of age, you may need Rs 3.8 lakhs per month which turns out to be Rs 45.6 lakhs per annum. This amount that you need to withdraw every year would be growing by 7 per cent every year in line with inflation. So, post accounting for an outflow of Rs 45.6 lakhs for your requirement, you are left with Rs 7.17 crore to invest, which is assumed to be invested 50 per cent in equity and 50 per cent in debt. It is also assumed that the equity part of the portfolio would grow at a rate of 12 per cent, whereas debt would grow at a rate of 8 per cent. With these assumptions, your fund is sufficient enough to fulfil your needs till you reach the age of 81.
Author Mark Twain once observed, “All generalisations are false, including this one!” The value of our investments and the amount we spend every year is quite dynamic, often due to forces outside our control. The above example is only for the purpose of illustration. You can further optimize the amount you can withdraw during retirement, which will help your fund to last even longer. We will not go into those strategies; instead we will focus on the type of instruments you can chose, which will have the same impact to make your fund last longer. One of the best ways is to invest in passively managed funds such as exchange traded funds (ETFs) and index funds.
Passively Managed Funds for Retirees
There are two factors that one must consider when it comes to passively managed funds. These are as follows:1)
Cost Advantage : While building a retirement corpus that you will use during your retirement, you can always have actively managed funds till the time they carry a lower expense ratio since a higher expense ratio eats your returns directly. Saving on expense ratio will help you to earn more. Actively managed funds in general have higher expense ratio than passively managed funds. The following graph shows you the average expense ratio of the equity-dedicated mutual funds at the end of February 2021.
Passive Funds
✓Index Funds: An index fund buys up all the index stocks in the same proportion as the index. The fund manager manages the tracking error and ensures that the fund performance is as closely aligned to the index as possible. The most prevalent index funds are based on Nifty 50 and Sensex.
✓ETFs: Exchange traded funds are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognised stock exchange. When you buy or sell an ETF it only leads to transfer of ownership without any shift in the AUM of the ETF. ETF units can be bought and sold through your existing equity trading account and can be held in your regular demat account.
We clearly see that index funds have lower expense ratio compared to actively managed funds. The difference is starker in case of a direct plan. Every year the expense ratio can reduce your returns by 0.76 per cent, which means more than 10 per cent in 10 years. It can be a huge amount considering your retirement corpus. For every Rs 1 crore of your corpus you will pay Rs 76,000 extra as fees per annum. The difference between the regular plan of an actively managed fund and a direct plan of an index fund is huge. It is 1.6 per cent.
There is always uncertainty regarding whether actively managed funds will outperform their benchmarks or not. However, the saving in cost is certain. The expense ratio of index funds is likely to remain stable as it involves lower churning of the portfolio and lower management charges compared to actively managed funds. When you are retired and do not have any other source of income every rupee saved is a rupee earned. Besides, you do not have the stomach to face such uncertainty.
2) Easy Maintenance : Besides cost savings, index funds or ETFs are easy to manage. They need a limited oversight. This becomes important as there are many other important things for the retirees to do in their second innings rather than tracking news flow on individual funds and their holdings. By their structure, index funds don’t make active bets or invest outside the index. Therefore, if an investor is employing total market index products such as index funds imitating the Sensex or Nifty, he won’t find portfolios listing towards a single sector or tilted towards a particular style such as ‘growth’ or ‘value’. Hence, just overseeing the overarching asset class exposure will be enough and does not require micromanaging the portfolio. Index funds are pure play of a particular asset class and hence become handy even while undertaking asset allocation and re-balancing.
Constructing a Retirement Portfolio
The Indian market, although it has a lower option than many developed markets when it comes to passively managed funds, offers enough options for a retiree to build a sustainable portfolio. Earlier, there was paucity of option when it came to passively managed debt funds. However, we are now witnessing fund houses filling this gap. Your retirement corpus should fall into three buckets. The first bucket is where you will put the amount needed in the next three years andcan choose arbitrage, ultra-short duration fund or low-duration funds.
The second part, which you require after 4-5 years, can be invested in passively managed target maturity index funds. These funds will give you predictable returns like fixed deposits but are more tax-efficient. The third bucket will contain your equity investment. Depending on the individual condition, 60-70 per cent of your corpus should go to fixed income or debt funds and the remaining into frontline equity index funds. As you grow old you should further reduce exposure to equity.
"You get what you don’t pay for, and not paying for investments is especially important when returns aren’t especially high, to begin with "
Jack Bogle