Why plan

You’re young and healthy, you have a good job, you earn well, and no liabilities threaten to attack from over the horizon. Your life is great, right? And it’s just the reason that you don’t ever think about the time you’re not so young, not so healthy, and virtually don’t earn anymore. But not planning for the last decades of your life is like letting the golden years go to rust.

We believe that the fundamental right of every retired person is to do little more than chat with his chrysanthemums and philosophise with the dog. But a heedless youth can mean an old age spent battling financial insecurity and personal anxiety. There’s a simple way to avoid a painful transition from active working life to retirement: plan your retirement.

Planning for your retired years largely means determining how much money you need to live comfortably when you finally hang up your boots -- and ensuring you have it at the time. Retirement planning also helps you weigh your options and identify the best ways to save for retirement, given your financial situation and your capacity for risk.

The government-commissioned Old Age Social and Income Security (Oasis) report presented four very compelling reasons to plan for your retirement:

Life expectancy is going up. With advances in medicine and technology, the average life expectancy of an Indian is expected to rise to 75 years. And with time, will only rise further.

Your ‘savings at work’ may not be enough. A longer life does not necessarily mean a healthier life -- it’s likely that your dependence on health support systems will increase. However, the income-earning vocations available to you as you get older, don’t.

Societal and cultural changes. As the joint family totters on its last legs, within-family support systems for the elderly are likely to be little more than an item for nostalgia. As an elderly person, it is likely that you will have to fend for yourself.

The implication: you are likely to live at least 15-20 years in retirement with nothing but your investments to see you through. Remember that you are never too young or too old to start saving. Starting to save now is the smart thing to do and a good habit to get into. More importantly, if you wait until later, you may find yourself playing catch up in a race that never ends.

Why now

It’s never too early to start planning for your retirement. In fact, the sooner you begin the better your chance of having a secure, stress-free old age. Because the sooner you start investing, the more your investments will benefit from the power of compounding and tax-deferred growth.
Compounding simply means that, over time, the interest you earn on your original investment (your principal) also earns money. The longer you let your money grow, the more powerful the effect of compounding.

An example will help you understand this. Visualise 25-year-old colleagues Whynow and Rightnow, who earn excellent salaries in a freshly minted dotcom. Whynow likes the good things of life and spends easily and liberally. Pushy and ambitious, he knows he is headed up the career ladder fast and, so, postpones his investment plans for when he turns 35. At 35, he decides, he will invest Rs 2,000 every month till his retirement at 58.

Rightnow matches his colleague for professional ability, but believes in putting away something for his retirement, without any delay, even if it means investing only Rs 1,000 every month. Their colleague, Later, does not share the concerns of his friends but thinks himself secure in his plan to allocate a larger sum (Rs 5,000 a month) -- but when he turns 45. Life’s too good to worry about retirement in your youth, you often catch him saying.

Let’s see where these gentlemen stand at a considerably greyer, feebler 58:

Assuming an interest rate of 10 per cent for all investments, Later’s investment of Rs 7,80,000 gives him Rs 15,89,751 on retirement. Whynow’s Rs 5,52,000 has grown to a more substantive Rs 21,31,098. But Rightnow is the runaway winner -- his much smaller amount of Rs 3,96,000 has rewarded him with a stupendous Rs 30,89,331. The sum of the little bits of money he invested over the years has multiplied almost 10 times!

The phenomenal power of compounding bares itself when spread across over a period of 25 years or so. However, too many of us begin thinking of a retirement plan only when we hit our forties, when the first signs of ageing -- a paunch, a receding hairline and slowing reflexes -- begin their inexorable daily-reminder exercise. Rightnow’s single, huge advantage: beginning early.

Here’s how you can replicate his formula.

Reinvest returns. Invest in schemes in which the dividend/interest can be reinvested and which is available only at maturity. This will help you save for your long-term needs and your savings will benefit from a tax-deferred growth i.e. your investment is only taxed at maturity, when you withdraw.

How do you do this? Instead of taking your mutual fund's distributions in cash as dividend, instruct your fund to let them remain in your account under a growth option or as a dividend reinvestment option.

Invest regularly. Develop the habit of investing on a regular basis, perhaps monthly or quarterly. You can do this by setting up a Systematic Investment Plan (SIP) with your mutual fund. By investing regularly you take advantage of a strategy called rupee cost averaging. Regular investing in the stock market , however, does not ensure a profit or protect against a loss in declining markets.

Make friends with time. The longer your money works for you, the better the effect of compounding. Rs 1,000 invested at 8 per cent interest rate earns Rs 80 in a year. Left to compound, the original Rs 1,000, plus accumulated interest, will earn Rs 172 in the 10th year and Rs 1,700 in the 40th year. All this without further investments beyond the initial Rs 1,000. Such is the power of compounding.

Don’t unlock your investments. When you have set aside funds for the long term and have invested them with that longer perspective, avoid the temptation to break the deposit for less-than-urgent needs. Doing so severely dilutes the effect of compounding. And starting from scratch denies you the benefit of the headstart you had earlier.

Coping with inflation
Inflation is often described as the ‘silent enemy’ -- it creeps up stealthily on you to erode the value of your retirement portfolio, irrespective of the instruments you chose. As a prudent investor you ought to ensure that your investments factor in inflation in the long term.
The most important -- and most visible -- impact of inflation is the way it erodes your purchasing power. Let’s say you spend Rs 500 a month on food for your household. If the annual rate of inflation on food is 5 per cent, the price of your bill for the same purchases will have increased to more than Rs 638 per month after five years.

In order to maintain your standard of living, the growth of your income must beat -- or at least keep pace with -- inflation. This is especially important for those investing for their retirement or are already retired, when the bulk of your income will likely come from the price appreciation and current income provided by your investments.

Many investors, particularly retirement investors, postpone consumption today in order to pay for something in the future. However, inflation may make your goal a moving target: a house that costs Rs 2 lakh today may cost more than Rs 2.5 lakh in five years at an inflation rate of 5 per cent.

If you are a conservative investor you may not earn enough to beat inflation, which actually means you will be unable to accumulate enough savings on retirement to cover even your monthly expenses. Consider this example. Let’s assume inflation at 8 per cent and that the monthly basket of goods requires an expenditure of Rs 15,000. Twenty-five years hence you will need Rs 1.7 lakh to buy the same basket of goods.

Beating inflation, as you can see, is a lot like running up a down-escalator -- it takes quite a bit of running to stay in the same place; to move up, therefore, you must run extra hard.

Mix your investments. The purchasing power concept extends to interest rates too. The returns you get from financial instruments -- your bank deposits, company deposits and such like -- are pegged to nominal interest rates, and are not adjusted for inflation. To know what your investment is really worth, you must look at real returns (which is the nominal interest rate minus the rate of inflation). Given the high rate of inflation, real returns from fixed-income instruments are abysmally low.

Usually, your post-tax returns from fixed-income instruments will just about offset inflation. As a result, every year, you'll have to dig into your capital base. That’s a bit like gradually dismembering the goose that lays the golden egg. What's more, since the purchasing power is falling forever, you'll end up digging deeper and deeper into this base. Your retirement funds, therefore, need to be invested in such a manner that it not only matches the withdrawal rate, but exceeds it. This is particularly important for people who expect to lead a longer retired life.
To protect your retirement savings against inflation, maintain a diversified investment portfolio. Your portfolio should consist of instruments that give regular returns, as well as those that offer growth potential. The first category of instruments (fixed deposits, bonds, debt schemes of mutual funds) will provide you with regular income at low levels of risk, while the latter (equities and equity-oriented mutual fund schemes) will provide the cushion against inflation.

How much you should invest in each category should be a function of the stage of life you are in and your risk-taking capacity. In your early years, your investment strategy should be weighted in favour of growth. As you approach retirement, switch to less risky investments. You'll learn more about asset allocation for these different stages, in the Countdown section.