How to keep the money flowing

If you are approaching retirement or have just retired, you need to take important investment decisions. How should you fund your post-retirement living expenses?

In this article, we discuss why stable income products such as bank fixed deposits and life-time annuity can be used to fund your living expenses. We also show how you should decide between fixed deposits and annuity.

Your active income stops at retirement. You, therefore, have to depend on investment or passive income to sustain your post-retirement lifestyle.

Now, a typical portfolio contains stocks and bonds to meet all retirement expenses — living, leisure, and healthcare costs such as major surgery.

To meet your living expenses, you have to receive monthly income from bonds and bridge the cash flow gap (difference between desired cash flow and interest income) by selling stocks.

But the cash flow you generate from selling stocks will depend on the market condition. What if the stock market declines in any year? You have to sell more shares to generate the required cash.

In any case, selling stocks would deplete your portfolio. You, therefore, have to balance your cash flow gap with longevity risk — the risk that depleting your portfolio could lead to a situation where you outlive your investments.

You, therefore, have to fix a sustainable withdrawal rate (SWR) — the rate at which you can withdraw cash from your portfolio without increasing the longevity risk. But fixing SWR is easier said than done.

You can reduce the longevity risk by mapping your expenses to appropriate investment products. As part of this process, you should map stable income products to your living expenses bucket. This would, of course, require you to take more investment risk on your healthcare expense bucket. But the bucketing approach is more focused and meaningful than having a single stock-bond investment portfolio to meet your post-retirement needs.

The question is: should you invest in fixed deposits or buy lifetime annuity to meet your living expenses? Consider a 10-year bank fixed deposit and a life-time annuity with return of purchase price.

Currently, such a deposit pays 9.5 per cent and the annuity pays 7.2 per cent. The choice then depends on whether you expect interest rate on the deposit to fall by 2.3 percentage points during your lifetime.

Suppose your life expectancy is 90 and you retire at 60. This means you have to renew your deposit twice — at 70 and at 80. The risk is that you may have to renew your deposit at a lower rate on both these dates (referred to as reinvestment risk).

But can deposit rates fall below 7.2 per cent? If your answer is no, you should consider fixed deposits over annuity.

But before you reject annuity, consider two related issues. If your life expectancy is higher, your reinvestment risk is also higher. This is because higher life expectancy could lead to more renewals. And the final factor: Can someone assist you with your investments during your retired years?

Most individuals underestimate the gradual decline in their cognitive abilities as they age. The issue is that you may have fixed deposits in, say, three to five banks. Will you remember to renew your deposits on time? If not, think of the lower annuity rate as the cost of dementia insurance; for your annuity pays cash flows for life.

We discussed about how you should choose between fixed deposits and annuity to fund your living expenses.

Of course, you can decide to have a combination of both the products in your portfolio; this could lower the dementia insurance cost from annuity as well the reinvestment risk in fixed deposits.

The bottom line? You should be careful while choosing products to meet your living expenses, as this bucket meets your primary needs during retired life.

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