What is the key difference between a pension plan and mutual funds?
A pension plan gives guaranteed income till death for the person buying the plan. On death, some plans provide some amount of regular payout to the surviving spouse. However, a pension plan does not beat inflation.
A mutual fund, vary rarely offers any regular or guaranteed returns. Instead, the returns fluctuate depending on the type of fund. For example, equity funds generally move up and down more than other categories like debt funds. But on the other hand, equity mutual funds have beaten inflation in India and major global markets over long periods.
This article combines the best features of both products to create a retirement plan that gives guaranteed returns via pension plans every year. Still, the additional yearly return fluctuates like an equity fund to allow for beating inflation.
Investing in equity mutual funds to earn dividend returns
Before understanding how to combine mutual funds with pension plans, we must understand how returns come from equity mutual funds.
Equity mutual fund returns come from two sources:
change in the price of the stocks in the portfolio
dividends paid by stocks in the portfolio, which are then invested back into the same stocks in the portfolio
We are interested in the dividends of the stocks here. As per historical data, dividends are relatively stable, as shown below, unlike the price of individual stocks.
We will consider the BSE SENSEX as a representative of Indian stocks and compare the return of the SENSEX vs that of the SENSEX Total Return Index (SENSEX TRI). In the TRI version of any index, the stock dividends are immediately reinvested into the portfolio.
We have limited data since historical TRI index data was available only since 1996 and therefore restricted ourselves to only 20-year windows for rolling period analysis.
As the chart shows, including the 1-2% dividend yield has drastically improved the value of the SENSEX from 60,000 for the PRI version to more than 90,000 for the TRI version.
Suppose we plot the total dividends from a portfolio investing in the SENSEX TRI, via a mutual fund, for every period of 20 years and calculate the CAGR returns. In that case, we will get a chart like the above one. We have 69 periods, each 20-year long, from Aug-1996 till date. These periods are:
Aug 1996 to Jul 2016
Sep 1996 to Aug 2016
and so on
In most of these 20-year holding periods, the total amount received from dividends has grown faster than an inflation rate of 7%.
Buy an immediate annuity pension plan at the start of retirement to cover the expenses in the first year of retirement
From the dividend return from the equity mutual fund next year, buy a fresh pension plan next year to cover next yearâs higher expenses to keep up with inflation
Keep buying pension plans from the dividend return every year to get inflation-protected guaranteed income
The equity corpus can be used for creating generational wealth by passing it on to heirs
The diagram above shows this plan implemented in practice. There are 20 different pension plans purchased once a year for 20 years, and each produces guaranteed income for life. A few assumptions have gone into the plan above:
Dividends from an equity portfolio that replicates the SENSEX, for example, grow at a rate equal to inflation
Pension plan return rates do not fall faster than inflation
There is adequate starting corpus in the beginning so that the first pension plan purchased is sufficient for the first yearâs expenses
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Here we see a sample retirement plan using data for the 20 years ending April 2023
We have assumed that âč40 lakhs is invested in a pension plan offering a 5% return
The remaining âč1cr is invested in a hypothetical SENSEX index fund that produces a dividend income that we get by selling units every year
This dividend income is then invested further in pension plans, each yielding 5%
The mutual fund value grows to âč10.85 crores in this period
The monthly income, guaranteed since it comes from a series of pension plans, grows from âč16,667 pre-tax to âč73,467 pre-tax in 20 years
We have assumed a flat 5% return from each pension plan to simplify the calculations. In reality, pension plans in this period offered higher returns, which would have led to higher monthly income. Also, as each pension plan is purchased as an immediate annuity, the return increases as the age of the investor increases.
How much should you have as retirement corpus to invest in this manner?
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To implement this scheme of getting guaranteed income from pension purchased from dividends, the starting corpus, as a multiple of first-yearâs expense in retirement, is very high.
We can thus see the trade-off between a secure cash flow from pension and the need to provide inflation indexing on that. Our previous article on combining a pension plan with an SWP from equity also had a similar conclusion. Still, the starting corpus requirement was less demanding: How to mix an SWP from an equity mutual fund with a pension plan in retirement?.
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This post titled How to get guaranteed income in retirement by combining dividends and pension? first appeared on 14 May 2023 at https://arthgyaan.com
