Why equity investment is necessary for retirees bl-premium-article-image

B. Venkatesh Updated - September 27, 2013 at 03:45 PM.

Fixed deposits typically fall short of the minimum return you require. You need to, therefore, invest in equity.

Last week, we discussed about how you can retire despite shortfall in your retirement portfolio. Several readers expressed their surprise regarding our suggestion that retirees should have equity investments in their portfolio, especially to meet their health-care expenses. After all, equity is risky, and retirees prefer stable investments. So, why invest in equity? In this article, we discuss the reasons why, as a retiree, you should have equity investments in your portfolio, whether or not you buy annuity!

Moderating inflation risk

If you use the bucketing approach that we discussed last week, you will use lifetime annuity to fund your post-retirement living expenses. In such a scenario, you should consider buying equity for two reasons.

The first reason: you should map equity investments to your emergency health-care needs such as major surgeries. Why? For one, as we discussed last week, you or your spouse may not incur large surgery-related expenses during the initial years of your retirement. And equity investments could provide higher returns than bonds during such long time-periods. Moreover, 10 years is reasonable time for you to recover losses that your equity investments may suffer during the initial years of your retirement. For another, health-care inflation is higher than food or other inflation that affects your basic living. So, you need higher return on your investment to compensate for higher health-care inflation.

The second reason: you need equity because annuity at present does not pay inflation-adjusted cash flows. This means that you will receive, say, Rs 50,000 through your lifetime, even if price levels increase by 7-10 per cent every year! So, even if you receive monthly cash flows for life, you may be forced to cut your living expenses because Rs 50,000 ten years hence will buy you lesser groceries than today. Equity investment may help generate higher returns to compensate for the increase in price levels.

Moderating longevity risk?

If you are like most individuals, you may prefer to invest in bank fixed deposits. But, you still require equity in your retirement income portfolio. Why?

When investing in fixed deposits, your interest income will most likely fall short of annual cash flow required to fund your post-retirement lifestyle. Because interest rate on fixed deposits is low, you may have to withdraw some of your investment capital every year to fund your lifestyle expenses. And as you withdraw capital every year, the interest income in the next year will be lower. This, in turn, will force you to withdraw more capital in the subsequent year and so on… till you run out of money. This is because your portfolio should earn minimum return every year to ensure that you do not wipe-out your investment during your lifetime. And fixed deposits typically fall short of the minimum return you require. You need to, therefore, invest in equity; higher returns on equity could reduce the quantum of capital you withdraw every year during your retired life.

But investing in equity creates another problem- you can still run out of money when you withdraw capital in years when the equity market is down! You can moderate this risk by setting aside 12 times your monthly living expenses in emergency fund. You should use this fund during years when your equity investment loses substantial value.

Conclusion

As a retiree, you should invest in equity for two reasons — to help you manage inflation effects on basic living expenses and health-care costs when you use annuity products, or to generate higher return when you use bank fixed deposits as your primary investment. In either case, you may suffer lower-than-desired lifestyle if you chose to avoid equity. This is not to say that equity is not without its associated risks; you can moderate your equity market risk by creating an emergency fund.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to knowledge@thehindu.co.in )

Published on September 27, 2013 10:14