Why retired investors need mutual funds

Let me tell you about a 60-year old gentleman, whom I recently met.  He had just stepped into retirement, had a retirement fund of 1 crore and, to start with, needed an income of 65,000 p.m. I take this example because I think this is reasonably representative of the retired people I have met.  Most retirees that I have met (who have retired around the age of 60), have had retirement funds that were between 100 and 200 times their desired monthly income at the start of retirement- this individual had a retirement fund that was about 154 times that.  Additionally, like most retirees that I have met, he was keen to invest his money in an option that carried an assurance of a fixed return, preferably from the Government, or a Government-owned entity. 

After a bit of looking around, he had short-listed monthly-interest paying deposits across three banks, which were offering a rate of 9% p.a.. If he invested his entire fund, he would get 75,000 p.m. from these deposits.  Leaving aside taxes, it was his opinion that the bank deposit would be more than adequate for his needs.  So certain was he of his choice that his only question to me was regarding the tenure of the deposit, “Should I go for a 5 year deposit, or should I go for a 10 year deposit?”

As I saw it, he was, most likely, in for an unpleasant surprise. 

The biggest challenge for any retired investor is to deal with inflation (or price rise). While inflation impacts us throughout our lives, its impact is arguably most severe during the years of retirement.  In the above example, if we were to assume an annual inflation rate of 6% (which is a reasonable assumption), that would mean that to maintain the same quality of life a year later, he would need a monthly income of 68,900.  Two years later, the monthly income would have to go up to 73,034.  Five years later, it would have to go up to 86,985.  Ten years later, it would have to go up to 116,405.  

While the deposits are not designed to match such increases, in the first couple of years, these would generate a surplus (over the required monthly income), which could be reinvested and used in later years.  However, this wouldn’t last too long.   If the surplus were to be reinvested at the same rate of 9% p.a., then somewhere in the seventh year of retirement, it would run out.  The only way to survive from the income from the deposits would be to cut his monthly expenses by a third.

But let’s go back to the start.  In this example, to adequately counter the impact of inflation, the deposits should have generated a monthly income of just over 110,000 p.m. (this calculation assumes the person lives till the age of 90).  To get that kind of income each month, this person would have had to invest about 1.47 crore (@ 9% p.a.).  In other words, on this count alone, he should have had a retirement fund that was about 226 times the monthly income needed at the start of retirement.

Even so, this would still leave the issues of taxes to contend with.  Secondly, there would still be the very realistic possibility of inflation being higher than 6% p.a. (a number of people may regard my assumption on the rate of inflation as being unrealistically low).  If we were to consider taxes and a higher rate of inflation, then one would need a much bigger retirement fund. 

In my estimate, anyone retiring at the age of 60, and relying on bank deposits for monthly income, should have a retirement fund that is at least 300 times the monthly income needed at the start of retirement.  My experience also suggests, as I mentioned earlier, that most Indians entering retirement do not have a fund of that size.  Therein lies the case for mutual funds.

Having a slice of equity funds in one’s portfolio is a great way to counter the impact of inflation.  Having debt funds instead of fixed deposits (or other debt instruments) carries two advantages: a. it allows for efficient withdrawals i.e. you can withdraw the exact amount that you need, exactly when you need it and b. it offers greater tax efficiency i.e. you can defer the incidence of taxes and even bring down the amount of taxes needed to be paid.  Thus, using debt and equity funds together, it is very possible to enjoy the quality of life one aspires for, with a smaller retirement fund compared to what would be needed if one invested only in options with assured returns.

Do you really need to invest in mutual funds?

If you fall into one of these three categories of investors, there is a cogent case for you to consider investing in mutual funds.

• You are presently working but will retire at some time in the future.
• You are retired and dependent on the income from your investments.
• You pay high taxes.

Let me elaborate on each of these scenarios.

Presently working, planning to retire:

Barring a miniscule minority, most of us who work, are dependent on the income from our profession. When we retire from our profession, we will be fully dependent on the income that we can passively generate from our investments. Whether we realize it or not, a key purpose of our working life is to acquire adequate wealth to passively generate the income we desire, post-retirement.

Let’s assume for a moment that one were to retire at the age of 60. If medical science continues to progress the way it has, there is a high chance of living up to the age of 90 or beyond. That means that the wealth that one has at the start of one’s retirement needs to see one through a period of 30 years.

The evidence suggests that for a lot of Indians working today, getting to that level of wealth will need them to earn a return on their current investments that is higher than what bank deposits offer. That limits the choice of investment options to stocks and real estate. Without getting into a debate at this point over which is a better choice, let me suggest that directly investing into both these options requires the kind of expertise which is beyond the capability of most investors. That’s where mutual funds come in. Currently there may be no real estate funds in India but there are a wide variety of equity funds available. Yes, building and nurturing a portfolio of equity funds, too, calls call for some degree of expertise but that is far less than what is called for building and nurturing a portfolio of stocks. Furthermore, there are many more financial advisors who possess and offer the expertise for the former, as compared to those who possess and offer the expertise for the latter.

Retired:

As mentioned earlier, individuals in this stage don’t have the luxury of being able to take much risk on their investments. Coupled with the need for assurance of return, such investors tend to choose debt instruments. These instruments carry one significant limitation: you are stuck with receiving a fixed amount for the entire tenure of the investment.

Why is that a drawback? Our expenses do not remain fixed: these tend to go up with inflation. Retired individuals, thus, need an investment option which can either generate the income they need (after adjusting for inflation), or give them the flexibility to draw upon their investment principal, as and when necessary. Open-end debt funds score on the second count. Combine these with a slice of equity funds, and you have a portfolio that could score on both counts.

The need for tax efficiency

To the extent that our money needs to be in debt instruments, we have the choice to opt for debt instruments like bank deposits, Post Office schemes, bonds, and the PPF, or go for debt funds. For individuals paying higher taxes, PPF and debt funds represent more tax efficient choices. The PPF is unique in that it offers both a tax rebate at the time of investment, and its income is completely tax free. It has two major drawbacks, though. There are restrictions on the amount you can invest, and it is not very liquid.

In this backdrop, open-end debt funds present an interesting alternative. These are highly liquid, and have no restrictions on what you can invest. Unlike other debt instruments, there is no assurance of ‘fixed income.’ There are debt funds, though, which have a high degree of predictability as to the return these will generate.

On tax efficiency, open-end debt funds score lower than the PPF. But relative to any other debt instrument these offer far greater tax efficiency. The tax efficiency comes in two forms: the rate of tax, and the ability to defer paying taxes until we withdraw.

I hope to further expand upon some of these issues in the weeks ahead. Nonetheless, feel free to email me if you have any questions or feedback on this post.