Need for Retirement Planning:
- Retirement planning is essential due to the increase in life expectancy.
- Life expectancy is the number of years an individual is expected to live.
- It is difficult to estimate accurately and is dependent on various factors such as health condition, scientific advancements, etc.
- With the increase in average life expectancy, retirement planning is needed to sustain expenses post-retirement.
- Retirement planning is not only about money accumulation but living a life of one’s choice post-retirement.
- The biggest roadblock for retirement planning is accumulating enough money at retirement.
- Retirement planning has various phases: preparation stage, period of initial retirement/pre-retirement stage, and final retirement.
- Retirement planning is important regardless of what stage of life one is in.
- Retirement planning should start early to take steps towards the retirement income one wants.
Retirement Planning:
Retirement planning is the process of determining the income required to meet living expenses in the period when there is no income being earned from employment, and then planning how to accumulate the corpus required and use it to generate the income.
- Determine expenses in retirement:
- Housing (including utilities, maintenance cost, taxes)
- Living expenses (food and personal upkeep)
- Medical care
- Transportation
- Recreational expenses
- Insurance (life, health, disability)
- Taxes
2. Determine income requirement in retirement:
- Maintain standard of living in retired life
- Consider expenses to be incurred in retirement
- Take into account inflation rates
3. Time horizon:
- Years to retirement: The period from the current point in time to the year of retirement or the period between current age and retirement age
- Years in/during retirement: The number of years from the beginning of retirement to the end of life for which an income has to be secured
4. Determine the retirement corpus:
- Variables considered:
- The periodic income required
- The expected rate of inflation
- The rate of return expected to be generated by the corpus
- The period of retirement, i.e. the period for which income has to be provided by the corpus
Impact of inflation:
- Inflation eats away the purchasing power of money over time
- At the time of calculating the income required, the value of the current expenses has to be adjusted for inflation to arrive at the cost of the expense at the time of retirement
- The income required to meet the same level of expenses during retirement would go up due to inflation, which has to be considered while calculating the retirement corpus
Note: Retirement planning is important to secure one’s financial future during the post-retirement phase. It is important to determine the retirement goal with adequate rigour and periodically monitor and incorporate changes, if any, into the goal. The retirement corpus has to be calculated taking into account the variables mentioned above. Inflation is an important factor that affects retirement planning and has to be considered while determining the retirement corpus.
Estimating Retirement Corpus
Estimating retirement corpus involves determining the income required post-retirement to maintain one’s standard of living. There are two methods to estimate retirement corpus: Replacement Ratio Method and Expense Protection Method.
- Replacement Ratio Method
The replacement ratio method assumes that an individual’s standard of living remains the same before and after retirement. This method helps to define the target income more accurately. The replacement income is calculated based on the pre-retirement income and the assumed replacement ratio.
Formula:
Replacement Income (Year 1) = Pre-retirement Income * Replacement Ratio
Replacement Income (each subsequent years) = Pre-retirement Income * Annual rate of Inflation * Replacement Ratio
Limitations:
- The longer the period of retirement, the less accurate the income replacement estimate becomes.
- Speculation is involved in estimating future retirement expenses.
2. Expense Protection Method
The expense protection method determines the retirement income based on an individual’s retirement expenses. This method involves tracking monthly expenses to estimate the retirement corpus accurately.
Formula:
Retirement Income = Retirement Expenses / (1 – Tax Rate)
Limitations:
- Estimation of future retirement expenses becomes difficult with a longer period to retire.
- Speculation is involved in estimating future retirement expenses.
Employee Benefits and Superannuation Benefits:
Employee benefits refer to non-wage compensation provided to employees in addition to their regular salary or wages. These benefits can take many forms and may include insurance, retirement benefits, leave policies, and other perks. Superannuation is a specific type of employee benefit that is designed to provide retirement income for employees.
Superannuation
Superannuation is a type of pension program established by an employer to provide retirement income for employees. These programs are also known as company pension plans. Funds are deposited into a superannuation account and typically grow without tax implications until the employee retires or withdraws the funds.
Employers have a legal liability to meet the superannuation benefits they have promised to their employees. In India, there is no legislation providing statutory superannuation benefits except to those employees covered under the Employees’ Pension Scheme, 1995. Therefore, employers can arrange for superannuation benefits either through payment or through a trust.
Payment by the Employer
Employers can arrange to pay superannuation benefits to their employees through two methods:
- Lump sum contribution: Employers can choose to arrange for superannuation benefits for one or a few employees as a reward for their dedicated services by paying a lump sum contribution out of current revenue to buy an immediate annuity from a Life Insurance Company.
- Pensionary benefits: Employers can establish a superannuation scheme for their employees and pay pensionary benefits out of current revenue. However, this method is not satisfactory as it depends on the financial health of the employer, and the likelihood of payment of pension to retired employees may be in jeopardy if the employer does not make enough profits in a given year to pay the pension disbursements.
Funding through a Superannuation Trust
The second method for administering a superannuation scheme is to do it through a trust. The employer should create an irrevocable trust for funding the pension liability and appoint trustees for the purpose. The employer should transfer the contributions for the superannuation benefit (both that of the employer and employees, if the scheme were to be contributory) to the trust fund.
Approved Superannuation Funds
Employers can get tax exemptions for contributions made to approved superannuation funds. These funds must be approved by the Commissioner of Income Tax in order to receive tax exemptions. Once the fund is approved, employers can treat the contributions made to the fund within the limits prescribed in the Income Tax Act as business expenses and deduct them from profits made for income tax purposes.