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Why Are Debt Instruments Critical For Retirement Planning?

Debt assets balance the risk from equity-oriented instruments in the portfolio, so proper asset allocation is the key to the success of your retirement plan.

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Sanjeeb Baruah
December 13, 2023
Debt Instruments Critical For Retirement Planning

Debt Instruments Critical For Retirement Planning

When you are in the retirement planning stage of your life—in your 30s or 40s—most advisors highlight the role of equity-oriented instruments, as they give the much-needed kicker to your portfolio. Debt Instruments are Critical when Planning for Retirement.

However, what often gets ignored is the role of debt instruments, such as debt mutual funds, fixed deposits (FDs), National Pension System (NPS), Public Provident Fund (PPF), and small savings schemes in the portfolio.

Debt instruments balance risks and rewards in a portfolio, which is essential for making any realistic plan toward achieving long-term goals, which is why we call Debt Instruments Critical For Retirement Planning.

Says Sumit Madan, head, of retail liabilities and branch banking, at IDFC FIRST Bank: “Debt instruments play a vital role in retirement planning by offering stability, income, liquidity, and a hedge against inflation. Balancing these instruments with other asset classes is key to constructing a resilient retirement portfolio tailored to individual needs and risk tolerance.”

So how does debt provide stability to a portfolio? Dilshad Billimoria, founder, managing director, and chief financial planner at Dilzer Consultants Pvt. Ltd, a Securities and Exchange Board of India (Sebi) registered investment advisor (RIA), explains with an example. Suppose an aggressive investor has 90 percent of her portfolio in equity and the market suddenly falls, or she needs funds in the next eight months, she would lose her principal and would not be able to exit. “Therefore, adding debt to a portfolio is crucial from a goal perspective as well as for short-term funds. Debt lends stability to the portfolio, besides asset allocation, which is an important aspect in portfolio construction,” she says.

But the key is to strike a balance between equity and debt. Says Melvin Joseph, managing partner at Finvin Financial Planners, and Sebi RIA: “Investors should have both equity and debt in the portfolio. Equity is for long-term wealth creation, and debt helps stabilize the portfolio.”

While the importance of equity cannot be ignored, especially in the planning stage, here are some strategies for debt investments. Let’s explore how these debt instruments can play a role in the planning as well as post-retirement phase of your life.

Pre-Retirement Strategy

How your investing strategy for retirement will play out will largely depend on the life stage you are in, your risk-taking capacity and your financial goals. So, finding an optimal balance is important, and planning for investing in Debt Instruments is also Critical For Retirement.

Says Billimoria, “Ideally, someone who is 30 years old and planning for retirement should have 80 per cent of the portfolio in equity and further spread between passive, active index, mid- and small-cap assets, provided one doesn’t withdraw from the portfolio for the next 10 year. However, the rest needs to be in debt for stability and to benefit from different market conditions.”

Though it is advisable for younger people to go heavy on equities, debt plays a crucial role for someone in their 50s. Adds Billimoria: “The equation changes for those in their 50s as they need to ensure stability along with growth; both are considered for retirement accumulation and stability.”

For this age band, Billimoria suggests 30-40 percent allocation in equity and the rest in hybrid and arbitrage (funds), depending on the corpus and withdrawal amounts, and the number of years left to retirement.

When it comes to the choice of debt instruments, younger people have more options in PPF and NPS, which come with a higher lock-in period. Since these are long-term small savings schemes, withdrawals are restricted. In PPF, which has a lock-in of 15 years, one partial withdrawal, up to 50 percent of the credit balance, is allowed after five years, excluding the year of account opening. In the case of NPS, the account matures when the subscriber turns 60, but it can be continued until the age of 75 years, subject to certain conditions.

Joseph says PPF is a good option within the debt category as it offers tax-free withdrawal. “In addition to the Employees’ Provident Fund (EPF), investors should consider PPF too. But I do not suggest NPS. Only 60 percent of the accumulated amount can be withdrawn tax-free at age 60. The rest has to be used for buying an annuity.”

Besides PPF and NPS, FDs, debt mutual funds, non-convertible debentures (NCDs), and long-duration government bonds are other options one could explore, depending on one’s investing horizon and risk-taking ability as investments like Debt Instruments are Critical in Retirement Planning.

Venkatesh Srinivasan, the founder of Rockfort Fincap LLP, a financial advisory firm, says: “FDs, irrespective of the bank’s rating, are currently offering a rate of interest of 7-8.50 percent, while NCDs and bonds offer low to high returns as per their credit rating. For instance, top credit-rated debt instruments and government bonds may offer 7-8.50 percent, while low credit-rated instruments may offer a higher interest rate as per the risk and credit rating.”

Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch assign ratings like AAA, AA, A, BBB, BB, CCC, etc., for bonds, debentures, commercial papers, and so on.

Says Madan: “Individuals who are younger can have more aggressive exposure to debt instruments, while someone approaching retirement can invest in plain-vanilla instruments like deposits. There is a shift from wealth creation to wealth preservation as one gets old in terms of debt instruments.”

However, one should be cautious when it comes to long-term debt funds. Says Joseph, “Long-term debt funds carry interest rate risk; credit risk is also higher in these funds than in ultra-short-term debt funds.”

Post-Retirement Strategy

For retirees, low-risk instruments are safer given their low risk-taking capacity. This is because at this stage, they may need regular cash flow and investments in options, which are not dependent on market vagaries.

Says Madan: “Cash flows act as a ‘centrifugal force’ in the entire exercise of retirement planning. Different debt instruments can have different interest payout frequencies.”

Says Srinivasan, “Considering the current high-interest rate regime, retirees can plan well to maximize and balance their fixed-income returns.”

So what are the investment options suitable for retirees? Says Billimoria, “Withdrawal options range from guaranteed fixed-income instruments to Senior Citizen Savings Scheme (SCSS) to systematic withdrawal plan (SWP) option in mutual funds using the bucket strategy. One should consider the age, requirements, longevity, and estate planning to determine these instruments.”

Seniors can invest up to Rs 30 lakh in SCSS. The interest payout is quarterly. Adds Joseph: “Reserve Bank of India’s (RBI’s) flexi-bonds are offering half-yearly interest. One can also withdraw from PPF. It allows one yearly withdrawal, which is tax-free. Besides these, one can use ultra-short-term debt funds and go for SWP.”

Experts suggest retirees to park some part of their portfolio in medium-risk instruments. However, this will work only if they bucket their corpus for immediate and long-term needs, say, after 10 years of retirement when they are around 70 years of age. However, every few years, the risk capacity and individual circumstances may need to be relooked.

Also, before investing in equities, it is essential to keep a part of the corpus safe for the next few years along with an emergency fund.

“People in the higher income category can try with a minimum percentage of their disposable income with medium-risk investments,” says Srinivasan.

What Should You Do?

Balancing a portfolio between high-risk-high-reward assets and low-risk-low-reward instruments can be challenging. Therefore, one should go for proper asset allocation.

Says Billimoria, “There is a risk of diversification and concentration if one invests in only one asset. Also, investors must understand that FDs do not beat inflation. Then, some instruments carry risk of default, too.”

In short, every investor must balance their investments depending on their disposable income, risk appetite, and their life stage.

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