We often come across young executives who do not appreciate the need to start early on their retirement savings. In a world of consumerism, this is not surprising. After all, why think about retirement when you are young? As you will see, there are obvious benefits to starting early on your retirement portfolio. But doing so can also expose you to higher risk compared to a person who starts late! In this article, we discuss the benefits and the risk of starting early and suggest a process that you can adopt to moderate the associated investment risk.
Benefits
The obvious benefit of starting early is the time factor. Suppose you set aside Rs 5,000 from age 25 till your retirement at 55. You would have accumulated Rs 1.25 crore in your portfolio and, perhaps, more if you increase your contribution after 40. On the other hand, you will have to save approximately Rs 29,000 every month to accumulate Rs 1.25 crore if you start at 40. In both cases, we have assumed a return of 10.5 per cent on your portfolio. The difference in your contribution arises due to the compounding of returns over a period of time.
Another benefit of starting early is that you do not have to be too concerned if you suffer losses on your retirement portfolio during the initial years of your career. Why? For one, your losses will be small as your portfolio will be small in the initial years. And two, you will have a long career ahead. This gives you the opportunity to contribute additional capital to bridge losses and accumulate the required wealth in your portfolio.
You do not have this luxury if you start late. The impact on your portfolio will be significant if you suffer capital losses immediately after you start saving at 40, as your initial contributions will be higher. Besides, recovering losses will be difficult, as the time to retirement is shorter.
Flip side
There is flip side to starting early! Suffice it is to know that compounding can hurt your equity portfolio value because of negative returns, especially in the later years.
Suppose you have accumulated Rs 1.25 crore in your retirement account. A 30 per cent decline in value will bring down your retirement portfolio to Rs 88 lakh. To recover the lost value, the assets in your portfolio will have to increase by 43 per cent! That is, the percentage price-change required to wipe out the unrealised gains in your portfolio is lower than the percentage change required to recover losses! This effect has a significant impact on your portfolio when you start early. Why?
Compounding of returns over a longer period means that a significant proportion of your portfolio value in the later years will be driven by returns, not by your contributions. In the above example, your monthly capital contribution of Rs 5,000 for 30 years would total to about 15 per cent of the portfolio value of Rs 1.25 crore! As you are relying more on market returns to achieve your objective, you are likely to fall short of accumulating your required wealth even if actual returns are positive, but lower than required returns. The effect of lower returns on your portfolio will be less significant if you start late because your capital contributions will be higher.
Conclusion
You can moderate returns-compounding risk by continually reducing your equity investments after 45 and buying bonds that mature at retirement; returns-compounding on bonds is positive if held till maturity. This positive feature of bonds is useful as you can apply the >rule of 72 (72 ÷ return is approximate years to double your investment) to achieve your objective, especially in the 10 years leading to your retirement. So, start your retirement savings early!
(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 )