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Retirement Planning
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Retirement Planning is the process of ensuring adequate income is available to meet the expenses at retirement stage.
Most Retirement plans are drawn so that employer pension is made available or income is draw from the retirement corpus.
The best way of creating retirement corpus is to build during the active working life stage of the individual.
Contents
- 1 Why is Retirement Planning important and ignored early?
- 2 Retirement Planning
- 3 Stages of Retirement Planning
- 4 Building Retirement Corpus
- 5 Review and Monitoring
- 6 Retirement Products
- 7 Drawing on the Corpus
- 8 Questions
- 9 Related Lessons
Why is Retirement Planning important and ignored early?
Retirement is a very important financial goal that people often neglect.
As they normally have pressing short and medium term goals they often tend to forget to save for retirement.
We have to remember that we won’t be working the same after a certain age and depending on others after we stop working is not a good option.
Hence retirement planning is a must and the sooner we start, the better it will be.
Retirement Planning
Retirement Planning is the process of ..
1. Making an estimate of the expenses during retirement stage
2. Identifying income required to meet the expenses
3. Calculating corpus that is needed to generate the income
4. Identifying products that will generate income
5. Identifying products that will build the corpus
Stages of Retirement Planning
Two stages
1. Accumulation Phase
2. Distribution Phase
Compounding accelerates the growth of corpus.
If started early, the amount to be contributed will be less.
In the initial earning years, immediate financial needs gets most of the attention over retirement goal.
Accumulation Phase
Should be growth-oriented instruments.
Since long horizon is taken, short-term volatility is to be accepted.
Greater ability to take risk
Portfolio oriented towards high return instruments.
Accumulation stage = All those years that we keep working and saving a part of the salaries towards retirement
So that smaller contributions made can also contribute to the biggest wealth.
Distribution Phase
Period when corpus built during Accumulation phase is used to generate income.
Investments in this phase are Income-oriented instruments.
Income-oriented instruments have low risk and less probability of capital erosion.
Post-retirement period.
Building Retirement Corpus
Involes two steps:
1. Estimating income requirement
2. Estimating corpus to be built that will fetch the income
Estimating income requirement
Two popular methods
1. Income Replacement Method
2. Expense Protection Method
Income Replacement Method
We will have to calculate Income replacement ratio.
Income replacement ratio = Income After Retirement / Gross Income Before Retirement
In most cases, as much as 70 to 90% of the income before retirement is required to maintain the same lifestyle of the individual after retirement.
If, however, if the savings are high, it might not be the case.
Example:
Current Annual Income (Rs.) 1000000
Age 30
Retirement age 55
Years to Retirement 55-30 = 25 years
Annual Rate of Growth in Income 10%
Income at the time of Retirement 1000000*(1+10%)^25 = 10834706
Income Replacement Ratio = 75%
Annual Income required in Retirement 10834706*75% = 8126029
Expense Protection Method
Focus is on identifying and estimating the expenses likely to be incurred in the retirement years and providing for it.
Consider this example
Current monthly expense (Rs.) = 50000
Proportion of household expenses = 60%
Current household expenses (Rs.) 60% of Rs.50000 = 30000
Additional discretionary expense in retirement (Rs.) = 10000
Total retirement expenses at current prices (Rs.) = 40000
Time to retirement (years) Retirement age(55) – Current age(30) = 25
Expected rate of inflation 6%
Expense at the time of retirement (Rs.) 40000 x (1+6%)^25 = 171675
Determining the Retirement Corpus
Four variables involved:
1. The periodic income required
2. The expected rate of inflation
3. The rate of return expected to be generated by the corpus
4. The period of retirement, i.e. the period for which income has to be provided by the corpus.
Inflation is a general rise in prices of goods and services over a period of time.
Never underestimate it.
Take an average of 6% in making computations.
Travel and health care expenses rise beyond the normal inflation levels.
Formula
Inflation Adjusted Return = [ (1 + Return) / (1 + Inflation Rate) ] - 1
If the inflation is 6% and we generate a 10% return, then the actual return is only 4% (we really need to remember this).
And we call it - Inflated Adjusted Return
The rate of inflation and the expected rate of return on investments act in opposite directions on the amount of retirement corpus required. As the inflation pushes up the expenses, the rate of return will reduce.
Preparation
So, as of now, we know these things
- we all will retire one day - we cant work after that like we do now - we know the 2 stages of retirement - we need to invest for retirement - we know how to calculate how much we need after retirement
Impact of inflation on retirement
At the time of calculating the income required, the value of the current expenses has to be adjusted for inflation to arrive at the cost of the expense at the time of retirement.
For instance, if consumer goods prices rise 6% a year over the next 30 years, items that cost Rs. 100 today would cost Rs. 179 in 10 years, Rs. 321 in 20 years and Rs. 574 in 30 years.
So, over the retirement years, the income required to meet the same level of expenses would not be constant but would go up due to inflation.
If you're planning to live on Rs. 60,000 a month during retirement, a 6% inflation rate means that in 10 years you would actually need Rs. 1,07,451 a month, and in 20 years you'd need Rs. 1,92,428 a month to cover the same expenses.
Calculation of Retirement Corpus
Take the example of Rani
She needs monthly income of Rs 35000 as per todays rates
Her retirement is 25 years away. i.e her 60 years
She is estimated to live till 80 years.
Assume the yield on investments is 8 percent and rate of inflation is 6 percent.
Two steps:
1. Calculation of income at retirement
2. Calculation of retirement corpus
Calculation of income at retirement
Income required at current value (Rs.) 35000
Time to retirement (Years) 25
Expected inflation 6%
Income required at retirement (Rs) 35000 x (1+6%)^25 = 150215
Calculation of retirement corpus
Income required at retirement (Rs.) 150215
Retirement Period (80-60) = 20
Rate of return on corpus 8%
Inflation rate 6%
Inflation adjusted rate of return ((1+8%)/(1+6%))-1 = 1.89%
The retirement corpus can be calculated using the PV formula in excel.
The inputs required are
Rate (inflation adjusted rate of return) : 1.89%/12
Nper (retirement period in months) : 240
PMT (inflation adjusted monthly income at retirement) : Rs. 1,50,215
Type (0 for payment at end of year and 1 for beginning) : 1
The corpus required to generate a monthly income of Rs. 1,50,215 for 20 years is Rs. 3,00,48,832
Planning to build the corpus
In the previous example, what is the monthly saving that Rani must make to create the retirement corpus if she expects a return of 12% per annum on her investments?
The amount of monthly savings required can be calculated using the PMT function is excel.
The inputs required are:
Rate (return on investment expected) : 12%/12
Nper (period in months available to create the corpus : 300 months (25 x 12) which is the period between now and retirement date)
Future Value (retirement corpus required) : Rs. 30,048,832
Type (0 for investment at end of year and 1 for beginning) : 1
The monthly savings required is Rs. 15,835. If this sum is invested at an annual rate of 12% for 25 years, then the savings will compound to a value of Rs. 30,048,832, which is the retirement corpus required.
Review and Monitoring
Retirement planning is an on-going process.
The performance of the investments that have been made also needs to be monitored to ensure that the retirement savings are growing as expected.
A review will also identify underfunding of the corpus.
If identified early enough investors can take steps to correct it.
Increasing allocation to the goal, if finances allow, is the way to make sure that an adequate corpus is built.
Alternatives available are:
1. Postponing the retirement by some years
2. Augmenting retirement income by post-retirement employment
i.e Even the mind gets retired along with the body, when we don’t make ourselves useful to others. i.e Working after retirement. Part time job or teaching / councelling.
Retirement Products
Two types of products:
1. Defined Benefit (DB) plans
2. Defined Contribution (DC) plans
Defined Benefit (DB) plans
Most conventional plans follow this.
In a defined benefit plan, the pension amount or value of retirement benefit is known beforehand.
i.e The formula based on which the pension amount would be calculated is known.
A contribution is made by the employee, employer or both towards the benefits, which is invested to generate returns.
The investor is assured of the pension amount as defined, irrespective of the returns that is generated by the pension fund.
Disadvantage: May become ‘under-funded’ or unable to make the defined payments
Defined Contribution (DC) plans
Most modern plans follow this.
In a defined contribution plan, the pension amount is not known beforehand.
In a DC plan, a defined amount is contributed by employee, employer or both, towards a pension fund over a period of time.
The final corpus of the pension fund determines the retirement benefit, which can be taken in a lump sum or as an annuity bought from the funds received, or a combination of the two.
Advantage: Since the pension depends upon the returns made on the investment, the contributing individual usually gets some say in the way the amount is invested.
Retirement Products in the Accumulation Stage
1. National Pension Scheme or NPS
2. PPF
4. Retirement products from insurance companies
Mandatory Retirement Benefit Schemes
1. Employees Provident Fund (EPF)
2. Employee Pension Scheme
3. Employee Deposit-Linked Insurance Scheme
4. Gratuity
5. Superannuation Benefit
6. National Pension System (NPS)
Voluntary Retirement Schemes
1. Voluntary Provident Fund (VPF)
2. National Pension System (NPS)
3. Public Provident Fund (PPF)
4. Pension Plans from Insurance Companies
5. Pension Schemes from Mutual Funds such as UTI Retirement Benefit Pension Fund (RBPF) & Templeton India Pension Plan (TIPP)
Drawing on the Corpus
1. Annuity
2. Senior Citizens’ Saving Scheme (SCSS)
3. Post Office Monthly Income Scheme (POMIS)
4. Monthly income plans (MIPs)
5. Other Schemes of Mutual Funds
6. Bank Deposits & Other Deposits
7. Debentures and Bonds
8. Income from Real Estate
Income from Real Estate
Real estate investments can provide appreciation as well as income. In the distribution stage of retirement, its ability to generate good rental yields is what is important.
The self-occupied home can also become a source of income to fund a comfortable retirement. The reverse mortgage scheme is offered by housing finance companies and banks.
Indian citizens of 60 years or more can benefit from reverse mortgage on the primary residence owned and occupied by them.
The amount of loan available under reverse mortgage loan depends on the age of the borrower, appraised value of the house and the prevalent interest rates of the lending institution.
The Reverse Mortgage Loan Enabled Annuity (RMLEA) ensures a life time payout to the senior citizens through an annuity bought from an insurance company using the reverse mortgage loan amount disbursed by the primary lending institutions. ==Online calculators
https://www.vertex42.com/Calculators/inflation-calculator.html
https://www.icicibank.com/privilege-banking/personal/buyinganasset.html
Questions
1. What is the name of the Immediate Annuity Scheme from LIC called?
Answer: Jeevan Akshay
2. What type of plan is NPS? DB or DC?
Answer: DC
3. In retirement terminology, what is VPF ?
Answer: Voluntary Provident Fund
4. Inflation ________ the retirement corpus required? Increases or Decreases
Answer: Increases
5. What are the options available if the retirement corpus is not sufficient?
Answer:
1. Postpone retirement
2. Augmenting retirement income by post-retirement employment
6. What is the formula in Excel that can be used for retirement calculation?
Answer: PV
7. Traditional retirement peroducts follow which approach? DB or DC?
Answer: DB
8. What is the minimum age for opting reverse mortgage in India?
Answer: 60 years
9. What type of scheme is Senior Citizen Schemes?
Accumulation Phase or Distribution Phase?
Answer: Distribution
10. Which MS Excel formula can be used to compute amount of monthly savings required?
PMT
Related Lessons
- Pre and Post Retirement Financial Planning
- National Pension Scheme (NPS)
- Retirement Planning with Mutual Funds
- Investment Adviser and Regulatory Environment
- Asset Allocation and Investment Strategy
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