Investopedia defines an annuity as a contract between you and an insurance company in which you make a lump sum payment or series of payments and, in return, receive regular disbursements, beginning either immediately or at some point in the future. This enables you to earn a regular income for Retirement. Irrespective of the age when you plan to retire, you need to have a source of regular income that can be used to meet your regular expenses in Retirement.
In this blog, I am sharing a way you can create an inflation adjusted annuity for yourself.
Before I discuss the manner in which you can create your own annuity, I would like to revisit the challenges that you are likely to face in retirement.The biggest challenge of all is to generate an inflation adjusted regular income.
Inflation combined with longevity is a perfect recipe for a disastrous retirement. Let me illustrate this with a simple example. If you retire at age 50 and live to age 100, with an inflation rate of 4% p.a. (which is indeed very low), you would lose 85% of the initial investment value in 50 years in real terms. In other words, Rs 100,000 of today is only worth Rs 15,000 after 50 years. At 6% p.a. inflation, you would be left with practically nothing. The table below illustrates the fatal impact inflation can have on your purchasing power. The picture looks truly grim!
You may argue that this is all theoretical and who is going to live to age 100? Well, I can only say that some of us will live till that age but I cannot say who exactly will live. Irrespective of how long you believe you will live, you need a regular income in retirement and you need to make some adjustment for inflation as well.
How can you create a perpetual inflation adjusted annuity?
First, let us start with a typical plan that most retire people use to generate a regular cash flow. The investments are either in Bank Fixed Deposits and Bonds. Some people buy Debt Funds and set up a Systematic Withdrawal Plan (SWP) to generate a regular income. Last year, a few insurance products gained popularity as they allowed for savings for 10 years and then guaranteed a payout for the next 25 years. All these products have one big limitation. Over time, inflation eats into your returns and you end up losing value in real terms. We need to have a plan that helps us adjust for inflation.
There are only two ways of adjusting for inflation. Either we save more or we generate a higher return on our investment. Let me share how generating a higher return can contribute meaningfully in combating the impact of inflation.
In the table, I have shared the maturity value of Rs 100,000 after 10 years at varying rates of investment returns. As you would notice, the amount invested could grow anywhere from 2x to 4x in 10 years. If you earn 7% p.a., your money almost doubles in 10 years. If you could earn 12% p.a. (let us not worry about the strategies that can generate these returns), your money would grow 3 times your initial investment. We can use this information to create an inflation adjusted annuity.
Here is an example. There is an initial savings period. Let us assume you decide to save Rs 100,000 every month for the next 10 years. Your total savings would be Rs 1.2 Crore. (Rs 12 lac per annum X 10 years). At the end of the 10th year, the investment you made in the 1st month would triple at the rate of 12% p.a. As a result your first investment of Rs 1 lacs would have grown to Rs 3 lacs. All you need to do is withdraw 50% of the amount and you have Rs 1.5 lacs that you can now withdraw to meet your regular expenses. The balance Rs 1.5 lacs is reinvested and if you could earn 12% p.a. then you triple your money in 10 years. By repeating this process, you can create a perpetual annuity that can grow by 50% every 10 years.
The adjustment for inflation would depend on the rate of return that you generate over the investment period. A return of 12% p.a. plus can make a meaningful adjustment for inflation.
What are the risks associated with this strategy?
Any investment strategy that is attempting a higher return would have associated risks that need to be managed. Typically you would have to consider investing in equities to generate a higher return. Let us evaluate the risks associated with the investment options and ways to mitigate them.
Investing in guaranteed and safe investments are helpful but in the long run, it would hurt badly due to inflation. Clearly the impact of inflation is not as harsh in the initial period and hence you can safely use these products to manage your regular expenses in the short run.
We also know from experience that investing in equities make sense only if you can bear the short term risks and have a longer term horizon, though there is no assurance or guarantee that your return expectations would be met.
There is a lot of data that shows that an investment horizon of 10 years and a investing through SIPs (basically staggering your investments) can mitigate the risks substantially.
It is also worth noting that your monthly expenses could be split into a core component (a minimum you must have!) and a discretionary component (where you have some flexibility in spending). You could use a self created perpetual annuity to meet with your discretionary spends.
Conclusion
Increasing Longevity is a reality. When combined with inflation, it can wreak havoc with your finances in retirement. Your investment plans must incorporate ways to address these challenges. Creating an inflation adjusted annuity is an option that can be helpful, provided you manage the risks associated with it.
This is my idea of dealing with longevity and inflation in retirement. I would love to know your thoughts on the same. Wishing you a financially abundant long retired life!
