Retirement Planning: Should You Invest in Equity or Debt Funds?

Retirement planning is often misunderstood as planning of finances during retirement. Although this is one of the aspects, retirement planning starts from the accumulation phase and ends at the distribution phase. Though very few people realise the importance of retirement planning, there are even fewer who understand the right way of saving and investing for retirement. In this article, Henil Shah discusses retirement planning and its importance and illustrates with a case study which asset allocation is suitable for both the phases

Retirement is an unavoidable occurrence and there is a strong probability that one will continue to live even after they retire. As a result, you will incur expenses even after you retire. The expense in this scenario might be both predictable and unforeseen. Home expenditures, discretionary spending, children’s school or college fees, EMI outgo, savings and investments, and so on are all expected costs. Unexpected costs, on the other hand, include items such as a medical contingency reserve, a fund to compensate for job loss, etc. As a result, having a retirement plan in place to handle these expenditures is crucial.

When you hear the word retirement planning, your mind may run with possibilities that might find you in hot water. Additionally, people are often in a quandary when it comes to choosing assets. Although some retirees like being aggressive with their finances, a majority of individuals prefer to minimise volatility. This begs the question of whether equity mutual funds or debt mutual funds are preferable. In this article, we will attempt to discover the same. Nevertheless, before we begin, we must first understand retirement planning, as well as its relevance and phases. 

Defining Retirement Planning

Retirement planning is the act of creating a blueprint of your financial and personal life that will assist you in meeting all of your life’s necessities after retirement. To live a pleasant retired life, your funds must be carefully managed and invested so that you may reap the rewards of your retirement. So, the concept of financial planning is broad and encompasses retirement planning. An organised strategy equips you to deal with a variety of situations such as surpluses, deficits and crises. You understand how fast or probable it is that you will reach your retirement goals. Furthermore, you acquire control over your cash flows, profits and costs and the degree of risk required to fulfil all of your aspirations. In a nutshell, a retirement plan will allow you to acquire a full grasp of your life goals (the ends) as well as determine the route (the means) to attain them.
 

Significance of Retirement Planning

As long as you generate a monthly income, it is simple to cover your costs. Yet, after retirement, you must have enough money saved up to spend the remainder of your life comfortably. Even after retirement, we must all shoulder the essential living expenditures. Due to the fact that life goes on, losing our monthly income may be a nightmare. Retirement planning is an attempt to keep this nightmarish scenario from becoming a reality. After retirement, some people receive pensions or gratuities and those that do usually do not receive enough to meet all of their needs. You may ensure that your family’s level of living is not jeopardised after retirement by investing and accumulating a sizeable retirement corpus.
 

Covering Medical Expenses — The prevalence of health conditions and crises rises as people age. Nevertheless, as you may be aware, medical bills have the ability to burn a large hole in your wallet. In fact, dental treatments can cost a considerable fortune these days. Certain Mediclaim or health insurance policies may not cover all your medical bills. To prevent a financial crisis in your later years, your retirement corpus must be substantial enough to pay for the medical expenses of your own self and family members.
 

Reducing Impact of Inflation — Inflation is defined as an increase in the price of goods and services. Also, it depletes your savings and lowers the purchasing power. As can be seen, the prices of products and services have been steadily rising and may continue to increase till you reach retirement age. This means that in the future you will have to pay more for everything. In fact, everything from groceries to travel to housing will cost you more in the future. It would be hard to attain all your retirement goals without a solid retirement plan that strives to generate a suitable retirement corpus while taking inflation, life expectancy, rate of return and other factors into account. 
 

Dealing with Uncertainties — Life is full with surprises and uncertainties. It may occasionally thrust us into unexpectedly difficult situations and circumstances. Natural disasters, the death of loved ones, financial challenges in the lives of family members and so on may all cause financial and emotional anguish in your life. Having a substantial corpus to deal with such unforeseen circumstances might always come in handy. As you near retirement, it is critical that you have a substantial contingency fund in place so that the interim period of volatility and instability can be better managed and does not jeopardise your long-term aim of retirement.
 

Stages of Retirement Planning

Retirement planning is divided into two stages and effective retirement requires preparation for both. Each necessitates distinct approaches. It is also critical to successfully shift from the pre-retirement to the post-retirement phase.
 

Stage I: Accumulation Phase — This is the stage in which you continue to save money for retirement. This stage can last anywhere from 25 to 40 years depending on when you start working and when you retire. During this stage, one should first establish a reasonable retirement corpus goal and then invest on a regular basis to build the corpus, which will assist providing income throughout the retirement years. Many investing opportunities are available at this stage. Yet, it is not only necessary to select appropriate products but also to have optimal asset allocation. Because most people’s retirement is a long-term objective, it is best to invest heavily in equities to earn inflation-beating returns. During this stage, you will be competing for your savings with other aspirations such as children’s education, buying a home, etc. Hence, with the purpose of retirement planning, a smart financial plan will address all such concerns.

Stage II: Distribution Phase — This stage is rarely mentioned since it only applies to people who have retired or are about to retire. It starts when you retire and begin to use the retirement corpus you built up in the first stage (accumulation phase) to generate an income stream to cover your necessities. During the distribution phase, a smart retirement plan would focus on ensuring that the corpus income and expenditures are handled in such a way that the corpus does not run out too soon.
 

Equity and Debt Mutual Funds

While planning for retirement you will come across various investment products such as Public Provident Fund (PPF), Employee Provident Fund (EPF), Senior Citizen Saving Scheme (SCSS), mutual funds, etc. Even in mutual funds we most prominently have equity and debt mutual funds. Most retail investors prefer investing in equity mutual funds. This is evident from the data published by the Association of Mutual Funds in India (AMFI). According to AMFI, equity-oriented schemes derive 89 per cent of their assets from individual investors (retail and high net worth individuals), as per data published in January 2023. However, when it comes to debt-oriented mutual funds, only 42 per cent of the individual investors invest in them. So, should you invest in equity funds or Debt Funds for your retirement?

Accumulation Phase

In the accumulation phase, as discussed earlier, we would be investing to create a retirement corpus. And to understand which one to select among equity and debt funds, we created five portfolios with different asset allocation between equity and debt. Therefore, the portfolios are: 100 per cent equity, 60 per cent equity and 40 per cent debt, 50 per cent equity and 50 per cent debt, 40 per cent equity and 60 per cent debt and 100 per cent debt. Here we have assumed Nifty 500 Total Returns Index (TRI) and CCIL All Sovereign Bonds TRI as the representative of equity and debt mutual funds. The period of study spans from January 2004 to February 2023.
 

The graph above shows how the investment would have moved if you had invested ₹1 lakh in those five portfolios with yearly re-balancing. Despite of a lot of volatility, the 100 per cent equity portfolio has not earned substantial returns when compared with 60 per cent equity and 40 per cent debt portfolio. 

As can be seen from the table above, the 100 per cent equity portfolio earned the highest returns as measured by compounded annual growth rate (CAGR) among other portfolios. However, the risk, as measured by standard deviation, was also the highest. In fact, 60 per cent equity and 40 per cent debt looks better in terms of risk-adjusted returns as it takes almost half the risk undertaken by 100 per cent equity portfolio, providing only 1 per cent lower returns than the 100 per cent equity portfolio. The illustration is for one-time investment. However, what if you invest in a recurring manner? In the following illustration we would be assuming that you invest ₹1 lakh every year. We have not assumed monthly investments in order to avoid complexities.

If we look at the returns of these portfolios with recurring investments, then 100 per cent equity once again gave the highest returns for the obvious reason that it undertakes higher risk. However, for recurring investments, 60 per cent equity and 40 per cent debt and 50 per cent equity and 50 per cent debt performed quite well. Therefore, while in the accumulation phase, investing in either 60 per cent equity and 40 per cent debt portfolio or 50 per cent equity and 50 per cent debt portfolio would make more sense depending on your risk profile. However, higher allocation to equity mutual funds will indeed help you in accumulating a sizeable retirement corpus.
 

Distribution Phase

In the distribution phase, we would be withdrawing from the retirement corpus accumulated during the accumulation phase. To understand which one to select among equity and debt funds, we compared the five portfolios with different asset allocation between equity and debt, similar to what we saw in the accumulation phase. Moreover, here we have assumed that your annual withdrawal would be ₹6 lakhs from the accumulated corpus of ₹1 crore. The other parameters in play are that you retire at the age of 60, your life expectancy is up to 80 years, expected returns on equity funds are 12 per cent, expected returns on debt funds are 7 per cent and inflation is 6 per cent. The annual withdrawal is adjusted for inflation.

As can be seen from the above graph, although the cash flows of 100 per cent equity portfolio seem to be better than the others, the risk is also on the higher end. Here one should certainly avoid 100 per cent debt portfolio as this portfolio leads to negative cash flow. A negative cash flow indicates that you have outlived your retirement corpus. Therefore, in retirement, depending on your risk profile, you can invest in 60 per cent equity and 40 per cent debt, 50 per cent equity and 50 per cent debt and 40 per cent equity and 60 per cent debt. That said, a bucket investment strategy is one of the best methods to use in the distribution phase.

Bucket Investment Strategy

Bucket investing strategy is an investment strategy that breaks your retirement corpus into three buckets. These buckets are dependent on when the money will be needed: short-term, medium-term or long-term. In the short-term bucket, investments are made in debt funds, in the medium-term bucket a healthy balance is maintained between equity and debt funds and in the long-term bucket a larger percentage of investments are made in equity funds. This method allows you to weather market swings while also controlling withdrawals. This approach has been thoroughly discussed in our earlier issues.
 

Conclusion

You retire from work, not life. You may have a new set of dreams for your post-retirement life. At the same time, you may also want to maintain your day-to-day lifestyle without worrying about expenses. By planning in advance, you can define the path to achieve these life goals without any financial dependence. Therefore, it makes sense to plan your retirement in advance. However, while planning for retirement, a lot of people get confused between investment in equity and debt funds. To make things clear, we have carried out a study wherein we compared five different asset allocations between equity and debt in the accumulation as well as in the distribution phase. Our findings suggest that 60 per cent equity and 40 per cent debt is a good asset allocation that helps to have equity and debt in adequate forms to manage risk without compromising much on returns. 

Conservative investors can consider 50 per cent equity and 50 per cent debt in the accumulation phase and 40 per cent equity and 60 per cent debt in the distribution phase. Based on our findings, we also conclude that investing 100 per cent of your assets only in equity or in debt is not prudent. Investing the entire amount in debt would not help you accumulate an adequate corpus for retirement, while during the distribution phase as well there is a high probability of you outliving your retirement corpus. Investing the entire amount in equity would make your investments highly volatile and one big negative event or market correction would wipe out your investments. Therefore, having a balanced approach is advised. Moreover, adopting a bucket investment strategy while retired is advisable.