Role of equities in building retirement corpus
With falling interest rate, it’s perilous to rule out equities, especially based on investor’s age
There're many ways to achieve long-term goals, particularly for retirement planning. This would encompass arriving at the desired corpus through various investment avenues including real estate, stocks, bonds, PF, NPS and Insurance. The primary idea at the time of investing or wealth creation is to achieve the desired corpus and then at the required time distribute or utilise the needed cashflows from the corpus. This seems easy but when the actual implementation is fraught with some hidden minefields.
I'm not trying to imbibe any complexity here though inflation is not the only thing one needs to worry. While projecting the corpus required in the future, one could make an assumption of the possible inflation adjusted requirements but what mostly is ignored is the returns from the corpus generated. So, retirement planning or reaching the corpus is just the beginning of the journey and not the destination, the real crux of planning involves in the effective distribution and the estate transfer thereafter.
In the developed world, investors do prefer target dated investment funds which modify the asset allocation within the investment automatically as the target date approaches. According to Investopedia, these are usually mutual funds or ETF (Exchange Traded Funds) structured to grow assets in a way that is optimised for a specific timeframe. These funds periodically rebalance the asset class weights in their exposure to optimise risk and returns for predetermined timeframe. The asset allocation is designed to gradually shift to a more conservative profile as to minimise risk when the target date approaches. This provides for an auto-pilot mode in investing.
In India, we've the National Pension Scheme (NPS) with two options of active mode and auto choice mode of investing. In the auto choice or the life cycle fund, the portfolio of the subscriber and the asset allocation varies with the age i.e., as the age increases the proportion of equity in the invested portfolio comes down. This is a very good passive ploy by an investor. Even in active management strategy, advisors tend to move part of the gains to a secured or fixed-income investment as the target (date/period) nears. Thus, the gains made from the equities are retained and also avoid the volatility associated with the equity as the need arises.
The auto mode is a very convenient way of approach to especially in a passive investing mode. The idea of this classic asset mix of debt and equity is due to their low correlation i.e., they don't move in same direction, at least in majority of the times. This has given greater benefits for investors in terms of the risk adjusted rewards. But this shouldn't keep investors shunning away from equities altogether purely based on the age criterion.
The proportion of equity in an individual's portfolio can't alone be from the age but from other factors too. In an increasing falling interest rate world and fast paced lower interest rate regime across countries, it's perilous to rule out equities especially based on the age of the investor. While equities have always been associated with volatility, the dividend yields are always attractive in falling interest rate periods simultaneously act as a tax-efficient tool.
The tax arbitrage could work in the benefit of the investors. While the stock prices are volatile, the dividend income is within a standard deviation which helps the investors to assess a pie of their income, though they're non-guaranteed like that of the interest on the bonds.
We could take a leaf out of Japanese investors to learn some important lessons on equity investing especially in a low interest rate regime of the world which is gaining pace across many countries. What the developed world is currently experiencing has been a reality for Japan for the last two decades, with interest rates near zero and also lurching into negative rates. And then the demographic burden of ageing population which the Europe is slowly leaning to and also the US and later estimates to put with China in about a decade-and-half.
The Japanese investors have compensated their fixed income return from the high dividend yields of their stock portfolios but that doesn't mean we need to imitate it blindly. But, the macro factors of demographics and Zero Interest Rate Policy (ZIRP) has been a feature in Japan for two decades, serving us a decent case study.
(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at firstname.lastname@example.org)