Investing to meet various post-retirement expenses

Last week, we discussed how benchmarking a retirement income portfolio (stock-bond-annuity) to a pure-annuity portfolio can moderate longevity risk. Of the several responses we received for the article, one pertained to wealth mapping. Specifically, a reader wanted to know if wealth mapping can be applied to retirement income portfolios. This article discusses how post-retirement lifestyle can be divided into buckets based on expenses and how such buckets can be mapped to age. Then, we show how retirees can custom-tailor their portfolio to meet their objectives during each stage of their post-retirement phase.

Retirees typically have three types of post-retirement expenses — basic living expenses, leisure expenses and health-care costs. Basic living expenses include food and clothing. We have assumed that retirees live in their own house, mortgage paid off. Leisure expenses include entertainment and travel. Health-care costs refer to medical expenses.

Now, suppose an individual retires at 60 and lives till 90. The 30 years of post-retirement lifestyle can be divided into three age buckets. Between 61 and 70, the individual will require more money for leisure activity. This activity is likely to decline between 71 and 80 years and even more between 81 and 90 years. Basic living expenses are likely to decline gradually, as individuals consume less food and clothing as they age. Health-care costs increase significantly with age.

Typical retirement planning considers replacement ratio — the proportion of pre-retirement lifestyle a retiree desires during her post-retirement life. Often, advisors adopt between 75 and 90 per cent of the pre-retirement lifestyle as the post-retirement objective. The desired post-retirement objective considers a general inflation rate to ensure that retirees do not suffer a shortfall in meeting their living expenses.

The problem is that the year-on-year increase in health-care costs is more than the general inflation level. Taking the general inflation rate could, hence, expose the retirees to longevity risk — the risk that they may be outlive their investments, yet have medical problems. Wealth mapping moderates longevity risk by creating a retirement income portfolio that maps the expense buckets with investment assets.

Retirement income mapping

Wealth mapping divides individual's post-retirement needs into protection assets, lifestyle assets and aspiration assets. For the purpose of this article, we continue with a portfolio that contains stocks, bonds and annuity.

Protection asset should be mapped to basic living expenses. Annuity can be used as a protection asset during post-retirement life (insurance is a protection asset during pre-retirement life). This is because life annuity ensures that retirees receive stable cash flow through their life time. We did mention that basic living expense declines with age whereas life annuity typically pays the same cash flow through life. Most annuities in India, however, are not indexed to inflation. We assume here that the savings due to decline in basic living expenses may be more or less offset with the increase in general price levels.

Lifestyle assets can be mapped to health-care costs and requires increasing cash flow as the individual ages. The appropriate investment asset will be equity for two reasons. One, equity as an asset class offers higher expected returns, which enables individuals to meet the increasing health-care costs. And, two, the individual's health-care costs is likely to go up from the second age bucket — 71-80 years. This provides retirees scope to be somewhat aggressive with their investments.

Finally, aspiration assets can be mapped to leisure expenses. Aspiration assets require investments in bonds as such assets have low risk tolerance. This is because leisure expenses are higher in first phase of retirement, which gives little time to recover large investment losses. Bonds provide the necessary cash flow with low downside risk; bond investments primarily refer to bank fixed-deposits, not bond funds.

Mapping expenses to investments helps retirees moderate longevity risk. This article reiterates our discussion on why retirement income portfolios should have exposure to equity.

The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com

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