Why illiquid investments are better for retirees

In this column dated September 1, 2013, we discussed about >reverse-mortgage-linked annuity . In particular, we showed why this product could be useful for retirees who are asset-rich but low on cash. In response to the article, we received several queries from readers suggesting that annuity denies individuals their desired liquidity post-retirement, especially to meet non-budgeted spending and emergency expenses. To address this issue, we discuss in this article why too much liquidity can be counterproductive and why you can still consider buying annuity.

Liquidity costs

There are two reasons why liquid investments may be harmful for your financial health! For this purpose, liquidity refers to investments that you can convert into cash at short notice such as fixed deposits and savings bank account as well as those you can sell anytime during your investment horizon such as equity.

Now, consider the first reason. If you have more money at your disposal, you may be tempted to increase your discretionary spending. This refers to non-essential spending that you can otherwise avoid or reduce and yet maintain a comfortable lifestyle. But does this issue really concern retired individuals? While it certainly applies to working executives, the issue is even more important for retirees! Why? After retirement, you have more time at your disposal. And that essentially means greater opportunity for discretionary spending.

The second reason has to do with returns. The choice to sell your investments anytime could prompt you to take decisions that you may regret later. Why? Your cognitive abilities typically weaken when you are stressed. You could, for instance, take a wrong decision to sell your loss-making equity investments when the stock market declines. And that is not all. You may be tempted to sell when the market goes up! And you may regret that decision if your timing is wrong. So, do you really need the liquidity that equity offers, considering that your priority is to provide for your living expenses?

Liquidity trade-off

To address your concern for liquidity, here is what you should do first. After you retire, set-up an emergency fund before you buy a reverse-mortgage-linked annuity product. How much should you set aside for this fund? You should keep at least 6 times your monthly living expenses in a separate savings bank account. Note that this applies only if you are buying the reverse-mortgage-linked annuity. If you propose to have some investments in equity, your emergency-fund multiplier should range between 6 and 12 times your monthly living expenses.

Importantly, you should not withdraw cash from this account except for the stated objectives- to meet living expenses due to unforeseen shortfall in income or for medical emergencies. You can keep 50 per cent of this money in a savings bank account and the rest in joint short-term fixed deposit with your spouse. After you have attended to your liquidity concerns, buy the reverse-mortgage-linked annuity.

An annuity is an example of what is called as Ulysses contract. That is, an annuity offers you a mechanism to prevent yourself from overspending money in the early years of your retired life and consequently face higher longevity risk — the risk that you may outlive your investments. How? You know that annuity is an illiquid investment during your lifetime. Besides, you have to pay lump-sum money upfront. Therefore, the opportunity to spend the cash you receive from reverse mortgage on non-essential expenses is limited.

Conclusion

You do feel safe when you have liquid investments. Sometimes, however, such liquidity may cause you more harm in the long run! You can moderate your liquidity concerns by first setting up an emergency fund and then buying an illiquid investment to support your desired post-retirement lifestyle. A reverse-mortgage-linked annuity product could fit your requirement, especially if you are asset-rich but low on cash at retirement.

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

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