Investing for early retirement

It is heartening to note that a significant proportion of young individuals are working towards early retirement. We received a query from one such individual, living outside India, on whether investments should be different for those wanting to retire early.

This article discusses how early retirement affects the portfolio composition during the accumulation phase (retirement portfolio). It also explains the ideal composition of the retirement income portfolio, as early retirement translates to a longer post- retirement period.

ACCUMULATION PHASE

Early retirement affects the asset allocation process of the retirement portfolio. The reason is obvious.

Such individuals have shorter time horizon, during which period the portfolio has to accumulate the required value to enable their desired post-retirement lifestyle.

This means that the portfolio has to be largely tilted towards equity to earn higher return within a shorter time horizon.

Such a portfolio can be inherently risky. Note that equity allocation is a function of human capital and discretionary wealth of an individual. Human capital, which is the present value of future income streams of an individual, is likely to be unstable for those wanting to retire early. Why?

Such individuals are high income-earners in the private sector, but their cash flows are most likely to be unstable. This is because their employment is typically not “sticky”.

And that means such individuals have equity-like human capital. Logically, their portfolios should have more bond investments. But bond investments, given their lower returns-potential, may not help such individuals reach their early-retirement goal.

Fortunately, such income-earners also have high discretionary wealth (cash flows that are available after taking / meeting other liabilities).

And a high discretionary wealth justifies a high-risk portfolio. Accordingly, an early retirement portfolio could contain 75 per cent or more in equity with the rest in bonds.

The equity exposure can be gradually scaled down as the individual nears retirement. Such a high-equity exposure may be required to allow the portfolio to earn high returns through a shorter investment horizon.

SPENDING PHASE

The contours of the retirement income portfolio will also be different; a longer post-retirement phase subjects the individual to higher longevity risk — the risk that the individual will outlive her investments.

A typical retirement income portfolio would have to meet living expenses, healthcare costs and leisure. The early retiree is likely to have higher living and leisure expenses, and lower healthcare costs, during the initial years of retirement.

Such individuals should ideally map bond assets to leisure expenses for two reasons. One, the investment should be in assets having low volatility and downside risk; for the investment will have less time to recover from losses, as expenses are likely to be incurred in the initial years of retirement.

And two, the investments should be also be largely liquid. Laddered fixed deposits (investing in deposits ranging from one to five or more years) and money market funds help in this regard.

Healthcare costs can be mapped to equity and commodity investments for two reasons. One, healthcare cost increases at a rate higher than general inflation.

And two, such costs are most likely to be incurred in the later years of retirement, giving more room for the investment to recover initial losses. Living expenses can be mapped to a combination of equity, real estate and annuities. Lifetime annuities hedge longevity risk.

Equity, on the other hand, helps the early retiree maintain the desired lifestyle in the face of “normal” inflation, while real estate investment (through rental income) provides stable cash flow to supplement lifestyle needs.

CONCLUSION

An early retirement impacts the portfolio composition. For one, the portfolio should accumulate large wealth to support a longer post-retirement phase.

For another, the portfolio should accumulate such wealth in a shorter time horizon because of early retirement. The retirement portfolio should, hence, have equity tilt for a large part of the accumulation phase.

Moreover, such equity exposure should contain alternative strategies, such as private equity, to generate higher returns.

This, no doubt, subjects the investor to high risk. But that is the flipside to the benefits of early retirement!

(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)