How to bridge the cash flow gap

On retirement, you can consider income-earning assets such as reverse mortgage

Interest rates are currently low, yet retirement-cost inflation is high. In such an environment, what should you do as a retiree? In this article, we discuss why in the absence of alternative income-earning assets, bridging cash-flow gap arising from retirement-cost inflation may be difficult.

Retirement-cost inflation

By retirement-cost inflation, we mean inflation relating to healthcare and leisure costs, as these are two important spending buckets for a retiree. Inflation on your living expenses is not such a cause for concern, as price increases are typically in accordance with baseline inflation.

Now, consider the issues relating to retirement-cost inflation. Suppose you have ₹10 crore in your investment account at retirement. You accumulated this amount assuming a retirement-cost inflation of, say, 10 per cent. What if actual inflation is 12 per cent instead?

You have to now invest some of your retirement savings to bridge the cash-flow gap of 2 percentage points in your retirement account. The issue is that ₹10 crore of retirement savings that you accumulated has to anyway earn certain return during your retired life to meet your post-retirement expenses! Suppose you assumed that your retirement assets would earn 4 per cent post-tax returns during your retired life. Now, because retirement-cost inflation has increased from 10 per cent to 12 per cent, your retirement assets allocated for leisure and health-care must earn 6 per cent return.

That is the problem. Why? You can only increase cash flow on your retirement assets in three ways. One, you have to invest more in equity to earn higher returns. But most of you consider equity to be very risky. In any case, given the current price levels, it may not be wise to increase your equity exposure to bridge the cash-flow gap. Two, you could contribute capital to your retirement account.

Again, this is not a choice for most of you because you are now retired and do not earn active income to contribute additional capital. This leaves you with the only one choice — increase your bond investments.

For most of you, bond investments would typically mean bank fixed deposits. Interest rates on fixed deposits have continually declined based on the argument that baseline inflation has decreased. In this scenario, how can you expect to earn 2 per cent higher return on your deposits to bridge the gap?

Income-earnings assets

You should, therefore, look for alternative avenues (especially income-earning assets) to increase your cash flows. You can consider taking a reverse mortgage to bridge the cash-flow gap. What about rental income from real estate? The issue is that yield on real estate is low because of high property prices.

Even if you buy several smaller properties instead of one large property, the rental yield is unlikely to be upwards of 3 per cent. And that is lower than the return on bank fixed deposits.

Fortunately, unlike living expenses that you incur every month, health-care expense is only a contingency; you will incur such costs only if you or your spouse suffer from major illness.

But an increase in retirement-cost inflation can upset your plans of spending on leisure. Why? For one, you would typically incur leisure expenses in the first 5-10 years of your retirement.

That means you have less time to bridge the cash-flow gap. And two, when faced with inflation, you may be tempted to cut leisure costs to meet non-discretionary expenses.

Therefore, cash-flow gap in health-care and leisure expenses caused due to increase in retirement cost inflation may be difficult to bridge, given declining interest rates and possible increase in stock volatility. Reverse mortgage and reverse mortgage line of credit may be your best bet yet.

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

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