Mutual Funds Investing For The Newly Retired

Recent studies have confirmed what we already knew all along - that most Indians are putting off Retirement Planning to a point where creating a sizeable enough corpus will prove extremely challenging. It would seem that although there is a fair degree of awareness present about the importance of Retirement Planning, other goals (such as Child Education Planning or a Home Purchase) are ending up taking precedence, and most Indians wait till their early 40's before starting to think seriously enough about their Retirement.

Most new retirees in India will likely not consider their primary home to be part of their retirement portfolio, as products like reverse mortgages haven't actually managed take off - and liquidation is usually the last thing on a retirees mind; most will plan to bequeath their home to their next of kin at some stage.

Your post Retirement years are a tricky time. Invest all your money in low return assets such as bonds, annuities and deposits, and you run the risk of outliving your liquid savings. Overexpose yourself to risky assets, and you run the greater risk of a market downturn eroding your liquid savings to a point which may be considered critical. As much as we would like to have our cake and eat it too, it would be prudent to consider that every additional unit or target return will, in fact, be accompanied by increased risk.

In a situation such as this, Mutual Funds provide a great solution. By combining various kinds of Mutual Funds, a newly retired person can create an optimal mix of returns, risk, liquidity and the generation of periodic cash flows. As a thumb rule, one must not chase aggressive returns from their retirement corpus. A post-tax return of 9-10 per cent should most likely be the target. If you're aiming to achieve anything higher, you'll in all likelihood be taking on a quantum of risk which is inappropriate for you at this stage of your life.

Start with a Reality Check
Numbers don't lie, and that's where you probably need to start. Begin with a basic assessment of your future cash flows (such as annuities) and lump sums which you have received or will receive shortly. The idea is simple - to start with a basic return assumption of 10 per cent per annum (on the reducing balance of these amounts), and arrive at a "monthly expenditure" figure which is reasonable from now until say the age of 85. Do not attempt to work it the other way round, which is to start with what you'd like your monthly income to be, and then arrive at a target return figure!

A qualified Financial Planner may be the best person to help you with these numbers. For instance, if you've retired with Rs. 1 Crore today and expect to generate a return of 10 per cent per annum on it, you can spend the inflation adjusted equivalent of approximately Rs. 45,000 per month throughout the course of your retirement years, ending up with a zero balance portfolio at Age 85.

Aditi Kothari Desai, EVP and Head - Sales & Marketing, DSP BlackRock Investment Managers, advises newly retired individuals to aim for a balanced approach. "An individual who has recently retired would seek income from his savings. However, he would also need to consider factors like inflation and increasing life-spans, which would require not only capital preservation but also capital appreciation", she says.

Define your Asset Allocation and stick to it resolutely
It's a well-known fact that when it comes to long term investment returns, investment policy (asset allocation) trumps investment strategy (market timing and selection of securities). In fact, some studies have shown that over 90 per cent of portfolio returns can be accounted for by the asset allocation policy one follows.

The corollary is fairly simple - if one aims to achieve a 10 per cent post tax return from their retirement corpus, the correct way to begin is by arriving at the correct split among various types of mutual funds. For instance, you may decide (after evaluation your current situation) that an 80:20 Debt: Equity mix is the right one for you.

The next level of analysis should yield what we can call the tactical asset allocation between various types of debt and equity funds (within this 80:20 framework). For instance, somebody who retired today may invest into a mix of mid cap equity funds, large cap equity funds, dynamic bond funds, FMP's, short term debt funds, arbitrage funds and dual advantage funds. A qualified Financial Advisor can help you arrive at your optimal mix, based on your unique situation and cash flow requirements.

According to Aditi, there's no magic formula to arrive at your ideal post retirement asset allocation, but rather, one need to follow a holistic approach. "In addition to age, the other factors to consider while considering an asset allocation for this person would be - other sources of income, lifestyle, financial goals and liabilities", she says.

The key would be to periodically rebalance your portfolio back to the pre-decided asset allocation in a disciplined manner, at fixed intervals (say on your portfolio anniversary). Although you may have started off with 80:20 debt : equity, the markets may have distorted your asset allocation to say, 85:15 within a year. In that case, you'd want to divest from debt and invest more money in equities, in order to bring your asset allocation back to 80:20.

Don't rush into MIP's
It's an incorrect notion that MIP's (Monthly Income Plans) provide guaranteed monthly incomes. An MIP, in fact, is nothing but a debt oriented hybrid fund with a ballpark 80:20 asset allocation. Although MIP's make an attempt to declare monthly dividends, these cash flows are in fact not guaranteed. In addition, they are subject to a dividend distribution tax of 28.33 per cent, which make the returns highly tax inefficient. The effective tax rate for a retail investor actually works out to approximately 22.07 per cent, meaning that out of Rs. 100 dividend declared, only around Rs. 78 will flow to the investor.

Past trends indicate that MIP's may provide pre-tax dividends to the tune of approximately 5-6 per cent per annum, with the remaining returns (if any) going towards capital gains. What this means is that on a Rs 10 lakh investment, you can expect a post-DDT income of approximately Rs. 3000 to 3500 per month (non-guaranteed)

Aditi explains how MIP's are structured. "MIPs are schemes of mutual funds that have a larger allocation to fixed income securities like government bonds and /or corporate debt, hence possibly their price fluctuation or volatility can be more stable than an equity product even though they may have some exposure to equity. MIPs therefore endeavor to offer regular dividends when they have surplus reserves. However, because of the higher fixed income proportion they are taxed like fixed income funds and you need to stay invested for at least three years to avail of any tax benefits.", she explains.

Understand the various types of Debt Funds
Since debt funds will form the bulk of your post retirement portfolio, you must make an attempt to understand their various avatars.

Debt funds have the potential to deliver long term returns ranging from 6 per cent to 11 per cent (not guaranteed), across the risk spectrum. The two dominant kinds of risks that debt funds have are default risk (that the bond issuers will not pay up) and interest rate risk (that RBI's policy changes will send bond prices soaring or cause them to fall). "Buy and hold" types of debt funds have a higher element of default risk, whereas actively managed debt funds have a higher element of interest rate risk. It would be wise for a retired person to invest across various kinds of debt funds, in order to create an adequate balance of liquidity, risk, income, and capital growth.

Given the current debt market scenario, what kind of debt funds should a newly retired person opt for? "To remain on the conservative side, we would recommend investing in short and ultra-short term debt funds, and capital protected Dual Advantage Funds", advises Aditi for moment.

What about Traditional Instruments?
Traditional instruments such as SCSS (Senior Citizens Savings Scheme) and POMIS (Post Office Monthly Income Scheme) offer returns ranging from 7.8% to 8.6% per annum, taxable. In addition, there are caps on the maximum allowable investments. Banks have special rates for senior citizens (25-50 bps higher than usual), but the rates are fairly low. Annuities provide long term returns not exceeding 6-7% per annum. In such circumstances, it becomes necessary for a retired person to look beyond the traditional and consider Mutual Funds, as even a 2-3% difference in portfolio returns over the long term can make a big difference to the number of years the corpus stands to last.

In conclusion, Aditi offers sensible advice related to traditional instruments. She says, "Traditional investments with guaranteed returns may provide income, but with changing lifestyles, increasing life-spans and most of all inflation, it becomes imperative that one's wealth and income keep pace with the mounting expenses. Therefore, it is essential that a retired person should have a mix of asset classes and investments in their portfolio. Diversification in the portfolio helps provide regular income, stability in returns and capital appreciation. It is imperative that the rate of return you get over a longer period of time beats inflation over that time period, otherwise it would seem that you are actually losing money. Mutual funds can provide tax benefits and liquidity that other traditional instruments may not necessarily provide."