Does your nest egg need a health check?

Your portfolio, just like your physical body, needs an investment health check periodically. In this article, we discuss how to diagnose the investment health of your retirement portfolio.

You should review your investment health when you are five years from retirement. For one, it is not easy to fill shortfall, if any, in your target retirement wealth.

Your active income will stop at retirement; you will have to depend on your passive income thereafter. And increasing this income is typically possible only if you increase the size of your invested capital.

Such shortfall can affect your retired life. Now, you work hard and save during your working life to have a desired post-retirement lifestyle. Realising that you will be unable to lead your desired lifestyle because investment returns are lower-than-required can hurt you emotionally and physically.

Running investment diagnostics five years before retirement may not always help you fill the shortfall.

But it can help you take preventive action to stop further deterioration in your investment health. The self-check discussed below is based on a retirement age of 60.

First, do not harm your existing investment health. To diagnose your investment health, check the value in your retirement portfolio at age 55.

If the investment value is greater than the target retirement wealth, first protect the capital that will help you fund your living expenses and leisure during your retirement.

You could either shop for life-time annuity with return of purchase price or invest in bank fixed deposits that will pay the required cash flow as interest to meet your living expenses.

Next, set aside money in a bank fixed deposit for leisure expenses. This would be the amount you expect to spend within the first ten years of your retirement. The balance can be invested in equity to meet major medical expenses such as surgery that you may require later.

Your equity investment should not, however, be more than 25 per cent of your target retirement wealth.

Second, check your investment health at 55 to detect possible shortfall in your retirement portfolio at 60. This diagnostic test should be based on your total wealth at age 55, earning taxable interest on 5-year fixed deposit till 60. If the anticipated shortfall at 60 is less than 20 per cent of the target retirement wealth, adopt the contingent floor rule. This rule is based on the logic that you can assume risk on your portfolio as long as you have enough money to meet your living expenses.

If you expect a shortfall in your retirement portfolio, protect your capital by transferring the amount you require to finance post-retirement living expenses into bank fixed deposits or life-time annuity.

But what if the diagnosis suggests that the anticipated shortfall is more than 20 per cent? Or what if your retirement portfolio wealth is not enough to buy your post-retirement living expenses?

In this scenario, consider taking a reverse-mortgage-linked annuity at age 60 to fill the gap.

Of course, this suggestion presupposes that you have a house, free of mortgage!

If you do not own a house, you may either have to cut your desired post-retirement lifestyle or seek your children’s support to fill the gap.

Diagnosing your retirement portfolio requires the following inputs − inflation rate, interest rate expectations, and life expectancy.

You can consider 8 per cent inflation for living expenses, 15 per cent inflation for both leisure and health-care expenses, 8.5 per cent taxable interest on fixed deposits and life expectancy of 90. Finally, it may not be wise to assume that you can work longer to fill anticipated shortfall in retirement wealth!

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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