Retirement Planning- Consider Fixed Deposits, Life Insurance, Provident Fund, Mutual Fund, Stocks For Investments

What is a perfect retirement plan?

Ankur and Vanita are software professionals in their mid-thirties. They have a 4-year-old son and a 2-year-old daughter. Now that they have settled into their jobs and lives nicely, they think this is the right time to begin saving for the retirement.

Case facts

• Together, Ankur and Vanita earn a salary of Rs 15 lakh p.a., of which Rs 6 lakh is basic.
• They both are 36 years old and plan to retire at the age of 60. They hope to live till 80.
• Their Provident Fund savings is Rs 1.5 lakh.

So how should they start off with their retirement planning? The following steps may help:

Will PF investments meet retirement goal?

Let us now consider the steps suggested for the couple's retirement planning one by one.

Step 1: Estimate post-retirement expenses

We will first evaluate the major expenses that the couple will bear after retirement.

• We will use current prices to calculate the couple's post-retirement expenses.
• Post-retirement expenses do not include expenses of their son, for the parents expect him to support himself when they retire (at 60 years).

Step 2: Calculate retirement goal met by PF

Ankur (as also Vanita) invests 12 per cent of his basic pay in Provident Fund. This is matched by an equal contribution from his employer. The couple presently has Rs 1.5 lakh in the PF account.

Let us assume the following:

• Long-term inflation rate to be around 5 per cent during the couple's lifetime
• Post-retirement returns at 7 per cent, compounded annually
• An annual increase of 8 per cent in the couple's salary
• Provident Fund investments to generate an average return of 7 per cent annually in the long run

Let us understand how we arrived at the following figures

1. At current prices, the couple's retirement corpus is Rs 1.14 crore. If we assume the inflation rate at 5 per cent, then the required retirement corpus will become Rs 3.67 crore.
2. Monthly expenses of Rs 40,000 at current prices will become Rs 1.29 lakh at inflation-adjusted prices. To get this amount, the couple will need a retirement corpus of Rs 2.43 crore at an assumed investment rate of 7 per cent.
3. At the current monthly basic salary of Rs 50,000, the annual PF contribution will be Rs 1.38 lakh. Since the salary will be growing at 8 per cent per year and the couple has an additional savings of Rs 1.5 lakh in PF, the total amount will grow to Rs 1.82 crore at an assumed rate of 7 per cent in a span of 24 years (years to retire).

It is clear that PF alone cannot meet Ankur's retirement needs, thus, he has to make additional investments such that the total worth of these investments will be Rs 4.29 crore at retirement.

What other investment options Ankur should consider?

Step 3: Design retirement plan to meet unmet retirement goal

Besides PF, Ankur needs other investment tools to achieve his retirement goal. A judicious mix of debt and equity should work for him. While Ankur is young, he can take a greater risk and invest in equities. But as he grows older and becomes risk averse, he should allocate a greater portion of his investments to debt. In our article on investment options for retirement, we have discussed the rates of return investment options have historically obtained. Let us now devise an investment plan for Ankur with four main investment options: Fixed Deposits, Life Insurance, Mutual Funds and Stocks.

Ankur's approximate annual contribution to investment options and resultant debt-equity ratios shall be:

For more details on how Ankur made investments over a period of 24 years to generate this corpus,

(It should be kept in mind that Ankur can always save more and hence have a larger retirement corpus as he is still young and has comparatively less responsibilities. This retirement plan has been made to achieve the minimum retirement goal only.)

Plan Features

• Ankur should invest in stocks early in life. Though stocks generate the highest return, they also carry the highest risk. At a young age, Ankur will have a greater risk appetite and hence he should continue investing in stocks, gradually decreasing the amount, till he turns 45. After that, he should explore alternative investment options like FD and Mutual Funds.
• Contingency Fund requirement of Rs 10 lakh should be met by periodic investments in FD. This provides a safe investment opportunity which can be encashed in case of emergency.
• Since Ankur has two dependants, it is wise to insure himself and his wife in a manner that the dependants can be taken care of in case of any eventuality. Though the exact amount of insurance required can be calculated by using a Human Life Value method, Rs 25 lakh appears to be a reasonable amount.
• As Ankur ages, he should invest in Hybrid Mutual Funds. Even though returns depend on the stock market and interest rates, this is a relatively secure investment and will help Ankur reduce the debt-equity ratio to a healthy 54:46 by the time he retires.

What factors can affect the plan?

Step 4: Analyse the risks involved

While estimating the retirement goal, we have made the following assumptions:

• Long-term inflation rate around 5 per cent during the couple's lifetime
• Post-retirement returns at 7 per cent, compounded annually
• Salary to increase at 8 per cent per annum
• Provident fund to generate an average return of 7 per cent per annum in the long run

As the return on PF reduces, the retirement goal met by PF also reduces. Thus, Ankur will have to invest more in alternative instruments to retire comfortably.

1. Rate of return on Provident Fund
   In an era of falling interest rates, it is possible that the return on Provident Fund will further decline. Even though we have conservatively assumed an average rate of return at 7 per cent, the return on PF might go down further.
2. Inflation rate
   Another major factor that will affect Ankur's investment plan is the inflation rate in the economy.

    

   

   As the inflation rate increases, the future value of his expenses will also increase. This will translate into a larger retirement corpus. If at the same time, the return on PF does not increase, Ankur's PF will meet a smaller portion of his retirement needs. This means, he will have to save more in other instruments, particularly in those offering a greater return.

Summing it up

• Early on in life, Ankur and Vanita should invest primarily in stocks for higher returns, depending upon their risk appetite. But as they age, they should shift their investments to safer and stable debt-related instruments.
• The couple should achieve an ideal debt-equity ratio of their investments, based on their requirements, risk appetite, comfort levels, and general market conditions.
• To create an adequate Contingency (Emergency) Fund, they need to invest a sizeable amount in safe and relatively liquid instruments like FD.
• They would also need adequate life insurance cover to provide for dependants, in case of any eventuality.
• An increasing inflation rate might render traditional investment opportunities futile. So to neutralise the effect of escalating inflation, the couple must either invest larger amounts or select those instruments that generate greater returns.