Two routes to retirement income

You are about to retire. You want a comfortable post-retirement life with the money you have saved during your working life. You have two choices.

You can follow an expense-bucketing approach to create your retirement income portfolio. Or you can create a stock-bond portfolio. Which should you choose?

In the expense-bucketing approach, investments are earmarked to specific expenses. Your expenses during your retired life can be categorised into three buckets — leisure, living expenses and healthcare.

Your monthly living expenses can be funded by bank deposits and lifetime annuities. You are likely to spend more on leisure during the first five-eight years of retired life. Therefore, map your bank fixed deposits to your leisure bucket. Say you propose to go on a European tour two years hence. Invest in a two-year bank fixed deposit.

Finally, your healthcare bucket. This bucket enables you to provide for major surgeries that you or your spouse may have to undergo.

You can set aside equity investments to this bucket if you are healthy at retirement. But your medical emergencies must already be covered by a fixed emergency fund.

The alternative is to have a conventional stock-bond portfolio. Cash flows from this portfolio come from a combination of interest income on bonds and proceeds from the sale of shares, including realised gains.

This portfolio is based on the concept of sustainable withdrawal rate − the rate at which you withdraw cash from the portfolio should be such that you do not run out of money during your lifetime.

Which strategy should you adopt? Many prefer to have a stock-bond portfolio. The bond portfolio provides the basic floor for your returns while the stock portfolio offers the kicker. From a consumption perspective, the bond portfolio caters to your basic needs while the stock portfolio funds your wants or desires.

So, if your equity investments decline in value, you could cut back on your desires and look to just meeting your basic needs. This way, you will be able to sustain cash flows in your portfolio for your lifetime. But cutting back on your desires is easier said than done. This is where an expense-bucketing approach comes in handy, as it is based on liquidity needs. So if you have planned for a near-term vacation, the cash-flow for this purpose will be funded by short-term fixed deposits, not equity.

Of course, there is a flip side to the expense-bucketing approach; your healthcare bucket will be compromised if equities decline.

So if you are suddenly faced with surgery and the stock market is in a slump, you will have to transfer money from your leisure bucket to your healthcare bucket to bridge the gap. That means you have to cut your leisure expenses. But if you are of sound health, you can enjoy your vacation and hope that your equity investment recovers its losses before you experience any critical illness! Your choice of approach depends on how you fund your desires. If you adopt the equity glide path (discussed in this column last week), you can reduce the impact of a stock market decline on your ability to achieve your desires.

In that case, your choice between stock-bond portfolio and expense-bucketing is more one of operational convenience.

Choose the expense-bucketing approach if you do not want to continually monitor your equity investments.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

COMMENT NOW