Retirement planning is one of the most essential financial goals an individual saves towards. It is primarily concerned with ensuring there is an adequate income flow to meet the expenses in the retirement stage of the person’s lifecycle. However, to get there, one must invest a portion of his current income to create a sufficient retirement corpus. And once the corpus is accumulated at the time of retirement – one must be able to draw a regular income from it to help them live a comfortable life without compromising on the quality
As we can see, there are primarily two stages: a) the Accumulation Phase: The phase in your life where you invest in building that nest, and 2) the Distribution Phase: Your retirement phase where you will need to draw on the corpus so created.
Let’s see each of the phases in a bit more detail:
Retirement Planning – Accumulation Phase:
Ideally, one should start investing as soon as they are comfortable doing so. Even in the earlier stages of your life when your income is not very high, you should get into the habit of keeping aside a particular portion of your income for retirement. One of the biggest benefits of starting early is that you can let the magic of compounding work.
Let’s take the case of Ram who started investing when he was 25 years old and Shyam who started investing when he was 35. If each of them wants to accumulate Rs 1 crore by the time they are 60 years, Ram would need to contribute only 1,555 per month whereas Shyam would need to save 5,322 per month. We have assumed a 12 percent rate of return on their investments.
|Age||Period of contribution||Contribution required per month||Total Contribution|
|Ram||25||35 years||1,555||6.5 lakhs|
|Shyam||35||25 years||5,322||15.9 lakhs|
As we can see, starting early can have a significant benefit on the contribution one needs to make every month. Here are a few points to make a note of when thinking of this phase:
- Higher Equity exposure: Investments in the accumulation phase should primarily be made in equities or equity-related instruments since the long-term time horizon allows you to eventually smooth out the volatility of the markets and generate higher returns.
- Higher risk-taking ability: This is also because there is a greater willingness and ability to take risks in the early parts of your career.
Retirement Planning – Distribution Phase:
Once you have accumulated a significant retirement corpus during your accumulation phase, your goal now should shift from growth to preservation. In the distribution phase, you are now concerned about withdrawing a regular income from that corpus to help you meet your day-to-day expenses.
Two things to note here:
- Lower Equity exposure: Investments in the distribution phase should primarily be made in debt or debt-related instruments since your goal now is to preserve your capital and generate regular income from it
- Lower risk-taking ability: This is because you can no longer afford an erosion of your accumulated capital and thus are primarily seeking safety.
Great, now that we have an idea about that – how do we answer the two most important questions:
- How do we estimate our retirement corpus? In other words, how much should I have accumulated by the time I retire?
- How much do I need to invest every month to reach that corpus?
Let’s answer each of those questions in a bit more detail:
- Determining the Retirement Corpus
Determining your retirement corpus requires you to go through a step-by-step process:
- Estimate your monthly expenses in retirement: For e.g. If Ram has a current monthly expense of Rs. 35,000 and has 35 years left till retirement – then he will require Rs. 2,84,324 per month by the time he is 60. This assumes an inflation rate of 6%.
Calculation – 35,000* (1+ 6%/12)^ 420 months.
- Calculation of retirement corpus
|Income required at retirement||Rs. 2,84,324|
|Retirement Period||20 years||(80 years – 60 years)|
|Rate of return on corpus||8 percent|
|Inflation Rate||6 percent|
|Inflation-adjusted rate of return||1.89 percent||((1+ 8 percent) / (1 + 6 percent)) – 1|
The retirement corpus to be accumulated by the time Ram is 60 is Rs. 5.68 crores. This can be calculated using the PV formula in excel.
In other words, Ram will need to invest Rs. 5.68 crores once he turns 60 at a rate of return of 8 percent to generate a monthly income of Rs. 2,84,324 to fund his monthly retirement expenses. Now you may ask that there will be inflation during his retirement years – but this has been accounted for since the calculation took into account the inflation-adjusted rate of return on the investment.
Once you have an idea of much money you will need at the time of retirement – we need to now see how we get there. Or how much should we invest per month to reach the goal of Rs. 5.68 crores in 35 years?
- Investing to accumulate the retirement corpus
Continuing from our previous example, we need to now determine how much will Ram need to save and invest monthly to accumulate a sum by the time he is 60. Let’s see the calculations:
|Number of periods||420 months (35 years)|
|The assumed rate of return||12 percent|
|Future Value (retirement corpus required)||Rs. 5.68 crores|
Once we have these parameters, we can calculate the amount using the PMT function in Excel. Inputting the values, Ram will need to invest Rs. 8,756 per month to generate a corpus of Rs. 5.68 crores by the time he is 60 years old.
As you can observe, the monthly investment amount is dependent on the 1) time horizon 2) assumed rate of return and 3) the total corpus required at the time of retirement. If the time horizon increases and others remain the same then Ram will need to invest lesser amounts of money every month. But if the assumed rate of return decreases, let’s say, by investing in lower yield instruments like debt – then, assuming the time horizon and corpus remains the same, Ram will be required to invest a higher amount every month.
Retirement may seem daunting and scary, but as we can see above that if we start early – then we can make the process simple and easy. It is just about being methodical in your approach and investing in a disciplined manner over your lifetime.