When it comes to retirement planning, the common advice is to start investing early, make regular contributions and let the compounding work in your favour. But, is it really that simple?
Should the way you approach your retirement planning be same in your early 20s and late 50s? Your cash flows will be different at various life stages. For instance, your ability to invest at the beginning of your career may be quite limited. Closer to your retirement, your ability to invest may be quite high but your risk taking ability may be quite limited.
I read a brilliant article from Michael Kitces recently. Kitces is a well known consultant and public speaker and runs a popular personal finance blog. In the article, he divides the accumulation phase for retirement into four different stages and says that your priority/action (and the investment advice that you get) should depend on the stage you are in. You can (and you must) read the original article here.
In the article, he mentions that the accumulation phase of retirement planning can be divided into four phases/stages viz. Earn, Save, Grow, Preserve. In this post, I will discuss the four stages (as mentioned by Kitces) and your area of focus for the four phases.
I have borrowed the framework of four phases from the aforementioned article and agree with most of the points mentioned. However, my understanding of each phase and recommendations for the four phases may differ slightly from the original article.
#1 Earn: Focus on increasing income
During the early part of your career, there may not be enough potential to save. If your non-discretionary expenses such as food, rent, transport, clothing, mortgage payments, student loan EMIs etc do not leave you with much surplus at the end of the month, your ability to save becomes quite limited. Many advisers like me may keep pushing you to save more but there is limited that you can do.
Therefore, the focus should on earning more, rather than saving more.
Many of us already do that. Many of us switch jobs in search of salary hike. You must have seen a number of your friends taking a break from work to go for higher studies.
One of my clients in his mid-thirties told me that he started to think about investments only once he realized the he had hit his highest earning potential and that subsequent income hikes will be the result of inflation and performance appraisals i.e. he realized there will no quantum leaps. Previous 10 years, he had spent his time and energy going for multiple academic qualifications to increase his earning potential. And he did well. He was able to increase his annual income over 10 times during the last 6-7 years.
So, if you are 23 and can save Rs 1,000 per month, you can contemplate using this amount to acquire new skills through a certification course or anything that results in better professional skills. Again, I am not saying you must do it. All I am saying is that this is an approach worth considering.
I do not mean you should not start saving early. You must. I do not want to undermine the importance of saving and start investing early. Saving is a habit which is not easy for everyone to develop. I am also not saying that you must go for higher studies.
All I am saying is that during the early years of your career, the greater focus should be on earning more.
A percentage of extra return wouldn’t change much for you since the contribution is quite low. Hence, the focus should NOT be on how to earn better returns but on how to invest more. Therefore, it is important to take steps so that you can invest more. And you can invest more in only two ways; spend less or earn more.
I have seen many investors spend a disproportionate time in managing a very small portfolio i.e. constant churning in ever elusive search of finding the best mutual fund. In you are in “Earn” phase, your energies will be put to better use elsewhere.
#2 Save: Control expenses to invest more
Once you are earning enough to easily cover all basic expenses, budgeting becomes extremely important. For some of us, expenses might keep growing with increase in income. To an extent, it is understandable since your lifestyle also improves as your income grows. You may move in to a bigger house or dine out more or spend more on vacations and clothing.
However, some of us take it to another extreme. They simply do not have enough no matter how much they earn.
This is where you need to reign in your discretionary expenses. You have to figure out a way to save.
Remember during “Earn” phase, your income was just enough to meet non-discretionary expenses. During “Grow” phase, it is much greater than the non-discretionary expenses.
You need to make the right choices about fresh investments. Your fresh investments are still a significant portion of your existing corpus and contribute to bulk of the growth in your portfolio. You must save (and invest) as much as you can. Invest in Growth assets.
#3 Grow: Get your investment strategy and asset allocation right
During this stage, bulk of the growth in your portfolio comes from the existing corpus through compounding. Fresh investments become relatively insignificant compared to the growth from the existing corpus.
Thus, you need to ensure that you are invested in the right kind of assets to provide you growth.
Suppose you invest Rs 10,000 every month and earn a constant return of 8%. In the second year, your annual contribution for the second year will be 96% of the corpus of the end of first year. However, after 19 years, annual contribution in the 20th year will only be 2.25% of the corpus at the end of 19th year. Return on existing corpus will be almost 4 times the annual contribution.
Hence, the greater focus should be to manage your existing corpus. Asset allocation assumes great importance. You must ensure that the existing corpus in the right assets.
#4 Preserve: Almost there but guard against market volatility
You are quite close to your retirement. This stage is an extension of “Grow” stage. Return on existing corpus contributes to almost all the growth. Fresh contributions make an insignificant contribution to growth of portfolio.
When you are closer to retirement, you need to guard against adverse market movements. It is not that you do not need to guard in other phases. However, in this phase, you are much closer to your retirement. Your ability to recover from a loss is quite low. At such a stage, you may need to do greater active management.
Managing portfolio volatility is the key. You have already done the hard work. You must ensure the adverse market movements do not fritter away your hard work.
I do not mean that you should put your entire retirement corpus into less volatile debt instruments. But yes, you must reconsider your asset allocation if the equity allocation is quite high. You need to manage volatility in your portfolio. In short term, volatility is risk.
When does one stage end? And the next begins?
I don’t think there is a crisp answer to this.
Depends on how much you can save, your existing retirement corpus and your age. In my opinion, investors till their mid to late 20s will be in “Earn” stage. 30s and early 40s will go to “Save” stage. Mid 40s till early 50s will belong to “Grow” stage. From then till retirement, you should be in “Preserve” stage.
But, I don’t think you have sharp boundaries. For instance, if you start off with a high salary, you may find yourself in “Save” stage right away, skipping the “Earn” stage.
If you have been able to amass significant corpus (with respect to your retirement) by investing more or due to good investment choices or sheer luck, you may reach “Grow” stage much early.
For advisors such as me, this is quite important since the advice offered to clients should depend on the accumulation stage they are in.
Best Retirement Advice depends on Accumulation phase, Michael Kitces