The great Indian retirement challenge

Of late, any discussion about retirement in India tends to get diverted into the debate on whether the New Pension System or Old Pension Scheme is better. But this question is irrelevant to 96 per cent of Indians, as only about 4 per cent of the country’s workforce is employed with the Central or State governments.

Over 50 crore Indians who are in non-government jobs today will need to save enough during their working lives to fend for themselves after retirement.

Most of them don’t realise that this could be a superhuman task, thanks to India’s high inflation rates, low real returns from debt and rising longevity. Under-funded pensions are among the biggest problems confronting the current generation of Indians. Yet, the great Indian retirement challenge seems to be under-appreciated in policy circles.

Unattainable targets

With the FIRE (Financial Independence, Retire Early) movement taking off in the West, many young people are eager to know the size of the corpus they will need to retire at, say, 45 in India. The numbers that financial planners throw up are so mind-boggling that they tend to give up the idea and resign themselves to a long slog.

If FIRE is beyond the reach of most folks, building a retirement corpus that can outlive them is no breeze even for folks who plan to work until 60.

Consider 25-year-old Suja who earns ₹75,000 a month. She would like to retire at 60 and live on her accumulated savings thereafter. To calculate her retirement corpus, a financial advisor would ask her to estimate the living expenses she’s likely to incur after retirement. Let’s say she pegs it at ₹50,000 a month or ₹6 lakh a year. Adjusting this for 6 per cent inflation over the next 35 years, Suja would need a cool ₹46.1 lakh for her living expenses in her very first year of retirement.

Retirement thumb rules from the West say that the safe withdrawal rate — that is, the proportion of the retirement corpus one may safely pull out in the first year — to fund a retired life of 30 years, is 4 per cent. This means that at 60, Suja will need a retirement fund of ₹11.57 crore (₹46.1 lakh x 25) to draw from.

Getting to that corpus with debt avenues such as the PPF with a 7 per cent return will be quite impossible, as that would require her to invest over ₹63,000 a month for the next 35 years. She has a better shot at getting to that corpus, if she targets a 12 per cent post-tax return with an equity-only portfolio. In this case, she would need to invest ₹17,900 a month for the next 35 years in equity funds. But she will need to pray to the stock market Gods to make it work.

This implies that Suja would need to set aside nearly 24 per cent of her income towards retirement alone. Her living expenses, not to mention emergencies and other goals such as home loan servicing and care of dependents, will need to squeezed into the remaining 76 per cent of her pay.

The Indian problem

However, a recent research paper by Rajan Raju and Ravi Saraogi suggests that the 4 per cent withdrawal rate rule cannot be blindly applied to the Indian situation.

Using empirical data on inflation, FD rates and equity returns in India over the last 23 years, they model retirement portfolios to find that the safe withdrawal rate for an average Indian looking to fund a 30-year retired life is closer to 3 per cent. They point out that a 4 per cent withdrawal rate in India would lead to a high failure rate (where the individual outlives her retirement fund) due to volatile equity returns and a high inflation rate which significantly trims the real returns on safe options like fixed deposits. You can read their research here: https://papers.ssrn.com/ sol3/papers.cfm?abstract_id=4697720.

This significantly raises the bar for people like Suja. If she were to target a 3 per cent withdrawal rate to fund her retirement, she will need to plan for a corpus of ₹15.37 crore (₹46.1 lakh x 33.33) at 60. This will need monthly investments of about ₹23,900 in equities (12 per cent return) for the next 35 years. That would eat up nearly a third of her current income.

Unlike Suja though, most Indians give priority to goals such as home purchases and children’s education early in their career and get to retirement planning only in their forties. The accompanying table captures the astronomical sums that folks starting late, need to invest to fund their retirement.

Policy fixes

If India is to ward off a crisis on under-funded pensions 15 or 20 years hence, this may need significant policy interventions.

One, given the lofty retirement targets they face, Indians cannot afford to have debt-oriented vehicles such as Employees Provident Fund (EPF) or Public Provident Fund (PPF) as their default retirement vehicle. They should instead be leaning on equity vehicles like mutual funds or National Pension System (NPS). Tax sops and laws such as the EPF Act need to be reworked to promote this.

Two, the prevailing view in a section of babudom seems to be that equity returns are free money and that equity investors are getting a bonanza at a 10 per cent capital gains tax rate. But the truth is that Indian investors, irrespective of their risk appetite, have no choice but to invest in equities to meet long-term goals such as retirement. Contrary to the perception that stocks are for the wealthy, it is lower and middle-income households who badly need them to get to a reasonable real return. A friendly capital gains tax regime for equities needs to continue, to ensure this.

Three, tax tweaks in recent years have removed inflation indexation benefits on most financial assets, while gold and real estate continue to enjoy them. This has dealt a body blow to real returns from financial assets. To encourage retirement savings through a balanced portfolio, indexation benefits need to be restored on financial assets. To ensure that only long-term investors benefit, indexation can be made conditional on a holding period of, say, 7 or 10 years.

Finally, income tax slabs for retirees need to rise with inflation, so that they don’t have to over-invest in risky assets that can put their hard-won corpus in jeopardy.