Planning retirement? Index it

The need for retirement planning dawns upon several individuals and families only when they are in their early 40s. For others, it starts only in the 50’s.

Depending on the context, these might be appropriate times to start planning for retirement. However, we believe that retirement planning should start fairly early in life.

There are two reasons for this:

• The power of compounding works in your favour if you start saving early - and the effects are really dramatic over a 20-25 year horizon. In other words, the cost of retirement in terms of foregone consumption (money you cannot spend today) is much lower if you save early.
• You have the benefit of mental accounting. When you create an asset pool targeted at retirement, your thoughts and actions become lot more refined in the matter of retirement planning. This is useful in taking retirement planning to the next stage where instead of passively saving money for retirement, you can actually think of retiring early, switch jobs if required and so on.

Asset allocation

What is the appropriate asset class for retirement planning investments?

The common mistake made by many individuals is that they do not plan for retirement early enough. The less common mistake made by those who do start the investment is that they choose fairly conservative debt instruments for their retirement fund.

The issue with this approach is that the returns on debt instruments are only 2-3% above the inflation rate. Hence, the real value of the savings grows rather slowly. The reasoning investors follow is that the retirement corpus is something they do not want to take risks with. However, portfolio risk is driven as much by volatility of the assets as it is by the tenure of investments.

Over periods of time as long as 20-25 years, the risks in equity or such riskier asset classes are more than offset by the superior long-term returns.

Hence, one can expect a 15% average return from equity investments over a long period with much lower risk than that in the expectation of 15% equity return in a 1-2 year horizon.

This, in turn, means you can manage to get ~10% growth in the inflation adjusted value of your retirement savings through equity investments.

The impact is shown in the table (see table: assuming the investor is trying to build a corpus of Rs 50 lakh for retirement in the next 20 years).

He will grow his contribution every year by 10%. Depending on the instrument chosen by the investor, the monthly contribution required for the retirement corpus varies widely.

A word of caution here: as retirement approaches, the corpus should be gradually moved into debt assets over last 3 years. Also, if retirement is less than 5 years away, 100% equity investments are not a good option.

Instrument selection

Now that we have chosen equity for building a long-term retirement corpus, the next question is which specific instruments suits the purpose. Here are the attributes our preferred instrument should have:

• It should be easy to invest in
• It should enable regular investing
• It should minimise the efforts required in tracking
• It should match our long-term investing approach
• Given these, among the wide variety of option within equity investing, index funds fit the bill quite well. They are as easy to invest in as any other mutual fund.

Regular investing can be enabled by 3-4-year-long SIPs.

Index funds by definition invest in the broad market index and mimic its behavior in terms of risk and returns. Hence, you do not need to track them anymore than knowing the performance of the market index itself. Unlike active mutual funds, there are no stars or laggards in index investing. This eliminates the need to actively track the performance of the fund and switching to a better performing fund.

Also, the long-term investing approach is more in sync with index investing than active investing.

Thus, index funds get your retirement corpus exactly what you need — equity exposure without the hassles of active management.

The metrics to evaluate an index fund are different from those used in case of actively managed mutual funds.

For index funds, tracking error (how much their performance differs from that of the index) is most important, followed by expense ratio and entry/exit load structure.

Unfortunately, the choice is limited in terms index funds in India. One of the better performing index funds is ICICI Prudential Index Fund, which has a low tracking error, 1% entry load and no exit load. Hence for a long-term investor, the costs of index investing would be fairly low.

The author is an MBA from IIM Ahmedabad and director, PARK Financial Advisors (www.parkfinadvisors.com), Mumbai. He can be reached at info@parkfa.com.