The No.1 retirement mistake you can make

By Uma ShashikantShould I have equity in my retirement portfolio? A just-retired friend wanted to know. After dismissing equity investing as gambling, he finally became convinced by the many SIP stories he heard. It was in his 50s that he started investing small amounts. Now without a pension and only his savings to rely upon, he is worried.He wants to earn an interest on the retirement corpus, while not touching it, or risking it at all. But these ideas are so yesterday.There was a time when the government was the primary borrower and paid a benevolent interest and guaranteed the safety of money invested. Retired people simply queued up at the post office. Today, we live in times when we worry if a government-owned bank will go belly up. We remain risk-averse, but around us risk is omnipresent. Bad borrowers, cheats and colluding corrupt lenders have made the lending markets too risky for the retired investor.We can throw a tantrum and demand the government assure the retired investor a sensible investment avenue. Fair point. However, that reform is miles away, because our policy makers still don’t get that the only way to manage risk is diversification, or that without accountable fiduciaries we cannot manage other people’s money. Thus, the largest insurance provider bails out failing companies, and the largest pension scheme runs in circles to put a robust investment process in place. We digress and rant.The positive side to the story holds three strands: One, compared to the past, retirees are wealthy. They mostly live in a house they own, have accumulated some assets and managed to save out of their incomes. Recall the times when the PF was meant for taking a loan; the first house was bought close to retirement; and incomes barely covered expenses. We are better off .Second, inflation, the biggest threat to retirees, has been tamed to a single digit. Like most macro variables, it is tough to predict. However, we can reasonably expect it to be a small single digit number. Do not remind us of the 18% of the 1980s.Third, the next generation is better off. For many, including my friend, there is no need to leave an inheritance, as the children are earning well. They can support the parent if the need arises. Being able to spend the corpus on oneself is a perk the current generation of retirees can well afford.What does all this mean to my friend? He should look beyond the traditional and take some risks, given that he has the ability or the need to do so, given all the above.What does equity do to a retirement portfolio? It offers long-term growth. Growth in portfolio value is an effective tool against inflation. It cushions risks to income when the investor becomes old. Since only a portion is being used during his lifetime, the rest of the money can grow. The portion that he will leave behind for his children can be in equity, since they are young and have a longer investing horizon.A portfolio that has one portion in equity, and one portion in fixed income instruments will serve his purpose well. Fixed income will serve routine needs; the equity will offer potential for growth. How much should be in equity?My friend tells me that 6% annual return is enough for the retired couple’s yearly expenses. Should he draw it annually, and keep all the money in equity?That would be a mismatch. The need of the investor is steady income; but the portfolio is in risky growth assets. The investment won’t generate income; a portion of it must be liquidated to meet the needs of the investor. The investor is drawing only a small amount, would it matter? Assume that the equity market corrects severely. The investor’s money shrinks and he runs the risk of outliving his falling corpus. Most don’t invest in equity for this fear.If my friend needs 6% of his corpus as income, and if the interest offered is about 6%, should we choose a 100% allocation to income assets? We will starve the corpus of growth to fight inflation, and leave a superfluous 100% to heirs. How do we decide between the extremes?We begin by exhausting all avenues of income, before depending on the retirement corpus to generate it: Rent, second career, dividends, and whatever else we can get. The comfortable retirement stories we see around us are mostly funded by pensions that do not stress the retirement corpus.Then we arrive at a small portion of the corpus that we will be willing to draw for our expenses. Assume we draw 2% of the principal for annual use. What does this do? This reduces the burden on the portfolio to generate income and frees up space for equity investing. How?Assume we have RS 100, and we need Rs 6 every year. Since Rs 2 is coming from drawdown, the income that the portfolio must generate is only Rs 4. At an assumed market interest rate of 6%, this Rs 4 can be generated by 67% of the corpus. The allocation is 67% debt and 33% equity— this is indicative of the principle and not cast in stone.The equity portion is preferably in a large cap mutual fund. Or the investment is in a balanced fund that invests primarily in debt, and the withdrawals are set up as systematic transactions. These are operational and implementation details. One can tailor whatever one is comfortable with.For my friend to invest in equity, the following are needed: One, he should see equity as enabling long term growth in his corpus. That is far better than letting it lie without any change in value. Two, he should be willing to drawdown a small portion of his corpus for his use. Keeping it small reduces the risks and enables the rest of the money to grow. Third, his ability to invest in equity grows if he has other sources of income that do not depend on his retirement corpus. Asset allocation and diversification hold more answers than we care to consider.(The writer is Chairperson, Centre for Investment Education and Learning)

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