Recently, we were asked how conservative investors should plan their investments to achieve their desired lifestyle post-retirement. In this article, we discuss why annuity products should be an important component of a conservative investor’s portfolio. This article can be read along with the one published under this column dated September 16, 2012 about synthetic pension.

Income replacement

Your objective is to replace your working income during your post-retirement phase. We believe annuity is the optimal choice to replace such income. Why? Bear in mind that your replacement income has to last till your lifetime or that of your spouse, whoever lives longer. As a conservative investor, your objective will be to reduce your longevity risk (risk that you will outlive your investments). Traditional annuity hedges your longevity risk, as it offers you fixed cash flows for life.

Besides, investing in equity could pose two problems. One, being a conservative investor, the pain you suffer from, say, Rs 1 lakh loss in your portfolio will be much more than the happiness you derive from Rs 1 lakh gain. This means equity may not be best suited as your primary investment, as it offers upside potential as well downside risk. And two, equity subjects you to higher longevity risk. Why? You have to sell part of your equity investments periodically to withdraw cash from your investment account. If you withdraw too much, you may run out money during your old age. Further, when you withdraw cash from a portfolio that has already declined in value due to a market crash, you have less chance of your investments recovering losses.

Your objective then is to create a portfolio that has significant investment in annuities. The question is: How much annuity should you buy? And when should you buy such products?

Stable-risky combination

The cash flow that your require post-retirement has to fund your monthly living expenses, health-care costs and leisure activities such as vacations. You should buy annuities to cover your monthly living expenses and basic health-care costs (costs that you incur every month towards medicines as well as the premium on your medical insurance).

You can buy annuity products with return of purchase price to meet these expenses. And if you have a spouse who is at least five years younger, buy a joint-life annuity. To meet your leisure activity, invest in short-term bank fixed deposits just after you retire. Why? For one, you will most likely travel during the initial years of your retirement and will need the money in the short term. For another, you do not want to suffer any loss on your investments.

What about money to fund any major illness? You have to invest in equity for two reasons. One, health-care inflation is higher than general inflation. And equity investments are better suited to meet such inflation risk, as they offer higher expected return than bonds. And two, you are more likely to suffer major illness when you are past 70. Given that you will most likely retire at 60, this gives you a time horizon of 10 years or more. Equity investments are appropriate for such long-term horizon, as it offers you more time to recover any losses suffered during the early years of your retired life.

As a conservative investor, your post-retirement income should be generated by annuity, need-based bank fixed deposits and some equity. You should buy annuity products starting 10 years before your retirement date. This will enable to shop for annuity at attractive rates. Bear in mind that you have to invest a higher proportion of your investments in equity during your working life to accumulate the wealth required to buy annuity products for your post-retirement needs… even if you are a conservative investor.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. Feedback may be sent to >knowledge@thehindu.co.in )

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