Equities can be a great tool for retirement planning

Equities can be a great tool for retirement planning provided you look at the cash-flow aspect of it. Unfortunately, equities are most often sold as trading opportunity to investors, which is hardly helpful

"Retirement can be a great joy. If you can figure out how to spend time without spending money." Retirement can be the beginning of a new life, but what comes in way of fun is the money. What''s needed is retiree ability to maintain his/her lifestyle and monetary pride even after monthly salary cheques stop arriving. This requires a long-term investment strategy, spanning at least 15-20 years. Though capital appreciation matters, key is to plan for post-retirement cash flows. Here I am assuming that a typical retiree would have done with big-ticket expenses, such as buying a house, kids'' marriage, among others, by the time he/she turns 60. This needs choosing a matching asset class. Equities are considered to be classic long-term assets. Companies raise shareholders equity and use it to build up businesses that may typically last a life-time or longer. And shareholders are rewarded for their patience with regular and dividends payments. Over time share price also appreciates as the earnings and dividends grow. This means that equities are both a store of wealth (or value) and a source of consistent cash flows. This separates equity from other asset classes, such as commodities and gold, which are only store of wealth with no underlying cash-flows. This aspect of equities is, however, not equally highlighted. For equities, the only principle that discussed is buying when it''s low and selling at high. Trading advisors, however, forget to mention that (trading) profit is a slave of timing that you may or may not get right. Further, trading also requires constant monitoring and portfolio churning to stay ahead of the market swings. This is beyond the capacity of a typical retail investor, who has a regular job to attend to.

Given this, a retirement plan should depend on dividend-income rather than capital returns. But you may ask, can dividend payments be sufficiently large to help you retire with pride. We at ETIG decided to test this idea by building a model portfolio of 20 stocks and tracked their dividend record over the last 15 years. The portfolio is equally divided between defensive stocks (belonging to non-discretionary consumer goods sector) and cyclical stocks. Further, we gave equal weightage to every stock in our portfolio, i.e. investor will invest equal amount in all stocks. Click here to view "The Model Portfolio" What we found out that, the dividend strategy works the best, when you invest in bear phase as was the case in 2002-03 or now. As stock price falls, dividend yield improves dramatically. If you had invested Rs 1,500 per stock (Rs 30,000 in all) in 1994, you would have earned a total dividend of Rs 4,381 during the year ended March 2008. In contrast, if you have invested in 2002, a year before the market bottomed out, your dividend income at the end of 15 years would have topped Rs 15,000 for the same rate of growth. This is shown in the chart (Money Plant) where we show the relative growth in dividend and market-cap of our portfolio of companies. As is evident, in the last 15 years, dividend receipts jumped by 15 times, while capital value of the portfolio grew by 9 times its initial value. The total annual dividend payments by our portfolio grew at a compounded annual rate of 21.2% during the period between FY94 and FY08.

A hybrid Approach
Now that the model is tested, we are suggesting investors to follow a "hybrid-approach" for retirement planning. This means taking an advantage of both the equities and the fixed-income instruments for example public provident funds (PPF). For example, if your investment horizon is 20 years, deposit an amount equivalent to your annual dividend income in PPF for the next 20 years and let its grow there. The cumulative impact of this strategy is shown in the second chart (Figure Watch). The chart is based on the following two assumptions. You invest one and for all Rs 200,000 in the first year (equally divided between 20 stocks) and that dividend receipts grows at the historical rate. Additionally, we expect you to invest when dividend yields high as in 2002-03. As can be discerned from the chart, in the first year, total dividend income is just Rs 7,000, which works to be yield of just over 3.5%, too low to be noticed. But if you wait, the annual booty steadily grows to Rs 3.2 lakh in the 20th year. But what makes this strategy magical is growth in accumulated dividends, which are invested in PPF in the interim period (earning an annual interest of 8%). By the end of 20th year, the cumulative dividend income grows to a whopping Rs 25 lakh. And remember, this is over and above the then market value of the stocks in your portfolio.

Another beauty of our "hybrid-model" is that the entire gains are tax-free. Both dividend income and PPF are tax-free, which saves you from the hassle of filing returns every year. Besides, there is hardly any cost of time involved in managing this strategy. Dividends are credited to your bank account electronically. This brings us to the current market situation, where the dividend yield on most stocks has shot up to historic highs levels. This is the time you start thinking of retirement planning. You should not necessarily copy our "model" portfolio. We picked this portfolio just to illustrate the point. The exact composition of your portfolio should depend on your specific requirement and risk appetite. So, what are you waiting for?