I recently received an email from a reader asking my suggestions on retirement planning for his parents. The timing of his question is good as I have been working on this topic for the last few weeks for my family.
I will try to detail out my thoughts on the above topic . This is however my own idiosyncratic way of doing it. It may make sense for some of you to approach a licensed financial advisor (if they exist in India!) for advice.
Before I discuss about the above topic, let us look at the above issue by inverting the problem. We need to identify what we should absolutely not do when planning for retirement - especially for our parents
- Chasing returns: Repeat after me - I will not put my parent’s or family’s funds at risk in pursuit of returns. Please read this a few times and memorize the statement. I cannot stress this enough. It would be completely stupid and irresponsible to chase an investment idea for extra returns with your parent’s money when they are depending on this capital to support themselves for the rest of their lives
- Due diligence - Do not put your family’s money in any instrument without complete due diligence. This includes the obnoxious ULIP schemes sold by most banks and guaranteed return policy sold by friendly insurance agents to unsuspecting seniors. The agents in question are not targeting your parents out of malice. Most of them have good intentions, it’s just that they do not fully understand the product they are selling. So please avoid all such agents unless you are sure you are buying something worth it.
- Be realistic - Do not assume returns in excess of 10-12% for a conservative, low risk portfolio. Even if you have made 30% returns in the past and consider yourself a finance whiz kid, please hold your horses and spare your folks of your brilliance. If this performance turns out to be a fluke or you hit a bad patch, they will suffer and you will carry the guilt (which is a horrible feeling)
- Face the facts - If your parents have unfortunately not been able to save enough for their retirement, do not target higher returns to cover for it. It could mean tough decisions for you and your parents in terms of lower standard of living (though assured) or help from you to maintain their current living standards.
- Paper work and admin - Do not develop an intricate investment portfolio where your parents have to spend half their time filing documents, visiting banks and other such administrative tasks. I have done this in the past and made it difficult for my family.
- Teach - Do not keep them in the dark about where their money is being invested. Teach or atleast educate your parents about the investment options you are selecting for them. Do not make it mumbo jumbo for them - When the market hits the top and retracts 5%, I will sell 6% and move to cash! Keep it simple and understandable. It will also ensure that you will pick some sensible options for them.
I do not plan to layout a template which can be followed step by step to plan for retirement. It would be difficult to do that as individual circumstances vary and so would the solution. My attempt is to layout my thought process on various factors for retirement planning which can be used to think through and execute a plan.
Risk and return
The starting of risk and return should be risk and not returns. One should not start with a return target of x% and then work out the investment plan. On the contrary, it is important to look at your risk tolerance and how much time you would have to cover losses, if any.
Risk tolerance in turn is a difficult and subjective topic. What is risky for me, may be low risk for you. As a result, risk should be analysed from a personal perspective. I personally do not follow the typical risk measures of beta and other such academic concepts.
I look at risk as doing something without the knowledge and experience to do it, especially where I do not have a clear view on how much I can lose in the worst case scenario. Lets explore that point further - Lets say I wish to invest for my family in such a way that they are able to get a return of 10-12% over 3-5 year period. It is easy to get around 8% through FDs and other such fixed income instruments. In order to get the extra 2-3% per annum, I need to look at equity to improve the returns.
My own personal experience and the last 10-25 yr data shows that the BSE index has returned between 12-15% per annum over the long term. However at the same time, this average return has been marked by 30% drops and 40% increases too. So in this case I can look at index funds as a possible option as I have a rough idea of the risk and return profile.
Now suppose someone suggests that I should invest in gold or real estate as these are good hedges against inflation. I would hesitate for multiple reasons
- I have never invested personally in these asset classes for investment purpose.
- There is lack of enough long term information and transparency in case of real estate (or atleast I do not have access to it)
- Gold has not provided good long term returns over the last 20 yrs. Now the next 10 yrs could be different and there seem to be a lot pundits saying so, but I don’t have the data to validate it and hence would stay away from it.
In a nutshell, risk for me is a lack of understanding the investment option in terms of the long term return and the maximum possible loss under various scenarios.
Expected returns
The next aspect of investment planning is returns. Returns are closely tied with the level of knowledge and sophistication one can bring to the process of investing. Lets look at some scenarios
The know nothing investor - you have no idea of equities and have never invested in the stock market. Your idea of a bull market is the bull or cow you may have seen in a local indian market :). A person who has no idea of even the basics of investing should look at investing in bank FDs and look at 7-8% returns. Such an individual when planning for retirement for self or for parents should not go beyond these FDs. There is however a risk for such an investor too. The risk is inflation. As the investor is barely earning 1-2 % above inflation (or even less), there is serious risk that the investor would not be able to support himself with the excess 1-2% returns over inflation. If the investor draws any more than 3% of the capital per annum for expenses, he or she will run out of money in due course of time
The beginner - you have some idea of equities. You have invested a little bit in mutual funds. You typically watch CNBC and think the anchors are dispensing good advise. Your idea of the stock market is that this place is like a casino where you can make it big or lose money big time. A person at this stage is at the highest risk of losing his or her capital. Half knowledge is always dangerous. A person at this stage needs to decide whether he is ready to invest the time to learn more about investing. If this person is not ready to invest the time and energy to do so, then the best option for such a person is to invest a small portion of his capital every month in a good index fund (via a systematic investment plan) and the rest in bank FDs. If the person is able to keep a 40-60 asset allocation (40% in equities), he or she can expect 10-11% returns over the long term.
The key issue for such an investor is that he or she needs to start saving and investing early in life and reduce the equity allocation to a max of 20% after retirement. I would not recommend an equity exposure (via index funds) of more than 20% of capital for anyone in this group who has crossed retirement.
The sophisticated investor - This kind of investor has been investing for the last 6-7 years. He or she has seen 1-2 bear market and has not been scared by it. He understands the risk involved in investing and has a fair amount of risk management skills. If you parents fall in this bucket, I doubt they would need your help.
If you are planning your own retirement and have 15-20 years to go, then you are in a good position. A 60-70% allocation in equities can be maintained. A 30-40% investment in stocks with the rest in good mutuals or index funds can be built via a systematic investment plan (investing a fixed amount of money each month).
This kind of investor needs to keep the long term in mind and should avoid a short term approach of performance chasing. The risk of losing capital for an extra 2-3% is fairly high and should be avoided. An investor in this group can expect around 13-15% return in the long run and if he or she starts an investment program early, should be able to retire very comfortably
The expert or the guru - This kind of investor has been investing for more than a decade. He or she has beaten the pants out of the market (in excess of 20%). If your parents are in this group, congratulations !!. They will take care of your retirement 
If you fall in this group, I am not sure why you are reading this post. A person in this group has no reason to think or worry about his or her retirement. Any one who can compound money in excess of 20% can retire a very rich man ( for ex: such a person can convert 100000 to 40 lacs in 20 years). A person in this category can manage money for others and become seriously rich before his or her retirement.
Various instruments
In the above discussion I have discussed about fixed income instruments and equities. You would have noticed a lack of discussion about other assets such as real estate, gold, commodities, options etc. Let me share some thoughts on the various asset classes below
fixed income: One can expect returns in the range of 6-8% and low risk. Typical options are bank FDs, Post office deposits and debt mutual funds. All these options are low to very moderate risk and good for the first two group of investors (the know nothing and the beginner)
Equities: One can expect returns in the range of 12-14 %. Typical options are index funds and mutual funds. This option has moderate to high risk and should be handled with care. A beginner should look at only index funds or some good mutual funds. A sophisticated investor can look at stocks as long as he or she knows what they are doing. A lot of investors and financial planners would like to assume that equities can returns in excess of 20%. However the indian markets over the last 15-20 yrs (a typical retirement planning horizon) have returned around 13-14% and I would not like to assume anything more than that when planning for retirement.
Real estate: This asset class has become a hot favorite in the last few years. However the long term history of real estate across the world and across time horizons is that the returns from this asset class are 1-2% lower than equity. If you are beginner or a know nothing investor, I would really not look at putting money in real estate (other than for primary residence). This is an illiquid asset class with lack of transparency in india. If you are a sophisticated investor, then it may be possible to get a fair return, but then one has to be ready to spend the required time managing it too. I have written about real estate here in the past
Gold, commodities, and options: I have clubbed all these options on purpose. If you are a know nothing or beginner, I would stay away from these assets as far as possible. In these categories I will buy gold when I am buying jewelry for my wife and commodities when I need sugar or wheat for my kitchen J. The only group which should invest in these assets should be the experts. I would even say that sophisticated investors should not look at these assets for long term investing. If you need an ego boost, invest a little bit for fun, but If you are not an expert, you can get you’re a** kicked big time in the market.
Asset allocation and rebalancing
I have written about how asset allocation drives you portfolio returns. All of us think we can tolerate risk and can afford to have a high equity component. My suggestion is to keep it lower than the level you think you can maintain without losing sleep.
Let’s say you are looking at 11-13% returns and are planning to keep around 50-55% of your portfolio in equity. I would suggest that one should start with a 30-35% allocation and go through a bear market and see how one is able to survive it. If you are able to avoid the gloom and doom and still able to invest during the bear, then go ahead and start raising the allocation. It is easy to maintain a high equity allocation during a bull market. We are all geniuses during bull runs. The test of patience and risk tolerance is during a bear market.
Finally if one is not actively managing his or her investment, then it makes sense to start reducing the equity holdings during a bull run to bring it to the target allocation. For example, if you target is 40% and the equity components goes up during the bull market to 60% of your portfolio, then it makes sense to start liquidating some equities to bring it to around 40%. In contrast, if your allocation drops to 30% during the bear market, then one should start buying equity to bring it up to the target level.
The above suggestion is easy to understand and very difficult to execute. I have personally gone through this last year. It felt like quick sand. I was constantly adding money from March 2008 to my equity portfolio and the market kept dropping at the same time. So at the end of the year, the absolute value of the equity portfolio stood at the same level as the start of the year, inspite of pouring money into it. It is not easy to constantly lose money in face of a bear market.
One can further split the allocation between different instruments in each of the categories. One can split the debt component into Bank FDs, Debt funds, Post office deposits etc. In a similar manner the equity component can be split between mutual funds and shares. The actual numbers need not be precise and you do not have to get very scientific on it. As long as you are close to your target levels, it should work out fine.
Administrative effort
This is an ignored, but important component of portfolio planning. It does not make sense to invest in an option where there is a lot of documentation and other risks and costs involved. In the past, shares could be bought and sold only in the physical format and there was always a risk of bogus shares and the headache of paperwork.
In a similar manner mutual fund investing also involved a decent amount of paperwork. Luckily most investment options (except Post office schemes and Bank FDs like that of SBI) are now convenient and easy to manage. However one should keep in mind the paperwork involved in the specific investment option. My own preference is to look for option which requires minimal paperwork, allows online mode of investing - preferably automated, and does not require me to track payments and receipts on an ongoing basis. I also prefer investment options which would allow me to pull an electronic statement at the end of the year for tax purposes.
Most of the investment options and firm providing them are focused on making it smoother and easier for the investor. However we still have some options such as the post office and public sector banks who believe in torturing you, even when they take your money.
The entire topic of retirement planning which is a subset of personal finance is a vast topic. One could write a book on it and could easily update it on an annual basis. I have tried to scratch the surface here and just provide some initial thoughts or factors to look at when developing your portfolio for your or your parent’s retirement.
If you have to take one point from my post, it should be this - Invest with full knowledge and understanding of the investment option and always focus on the risk or downside.
This article was written by Rohit Chauhan
. He also writes at his own blog
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