My friend Jaswant is a trained pilot. “1 in 60 rule” is a rule of thumb in air navigation, he told me over a cup of coffee.
For every 1 degree a plane veers off its course, it misses its target destination by 1 mile for every 60 miles flown. So the further you travel, the further you will be away from the destination.
On a flight from Delhi to Bengaluru (roughly 1000 miles), you might land up in Mysore (85 miles away) if you are off by five degrees. Small actions accumulated over a long time make a huge difference and need a timely course correction.
Similarly, in retirement planning and other financial planning approaches, some critical triggers call for a course correction:
Trigger no. 1 – Change in the financial position
When you chase a financial goal, you typically arrive at the financial target and work back the savings and the asset allocation. For instance, if you plan to save Rs 2 cr for a child’s higher education in 15 years and invest up to Rs 50,000 every month. You would need to earn at least 9.5% returns per annum. Achieving this goal would be possible only with a high allocation towards equities.
However, if one loses a job midway, his investments will be affected temporarily. It implies a delay and compromises the goal under consideration. If financial difficulties persist, investors would have to relook their plans. Or they’d have to make necessary amendments to their spending.
Similarly, one can alter the financial position by accumulating liabilities or increasing family responsibilities.
Trigger no. 2 – Changing market environment
While calculating the risk need of an investor, one assesses the market environment. It includes looking at current and historical averages of equity, fixed income and cash/cash equivalent returns, and past and projected inflation.
Ideally, if there is a fundamental altering in the capital market return expectations, one should account for it by looking at associated trade-offs.
For instance, if long-term market return expectations are lesser than before, one might have to court higher portfolio risk to reach the same goal amount.
Alternatively, solutions exist in the form of
- Saving more
- Spending less
- Working longer or
- Reducing bequest
Course correction based on which phase you are in
If you are saving for retirement, typically, the three phases are
Phase 1 – Accumulation
Phase 2 – Preparation and Preservation
Phase 3 – Distribution Phase
In the accumulation phase, you build a corpus by saving and investing from your earned income.
Since retirement is far away, there is room to tweak portfolio risk. If you fall short of your target, – you can consider increasing allocation to equities or saving more to get there. Furthermore, you need to rebalance your portfolio every year to be on course.
In the preservation phase, careful attention is given to the retirement portfolio. One also looks at anticipated living expenses after retirement, debt profile and potential tax obligations.
Since you are only 5-7 years from retirement, you need to take risks prudently.
For instance, increase the equity component up to 50% post-retirement if you fall off target or delay retirement to accumulate more.
In the distribution phase, the attempt is to create an income stream that will outlive you.
This is when you reap the rewards of your retirement planning efforts and course correction. The chief among them is cutting expenses to fit the budget. Then, if you have accumulated more, you can upgrade your lifestyle.
Three types of course corrections
All course corrections need a plan. ‘Can’, ‘should’, and ‘must’ are actionable distinctions.
- Can – You can act on it, but it might not be required since it might produce a similar effect. For instance, shuffling equity components in a portfolio by moving away from Large Cap index funds to Large Cap equity funds may be sub-optimal.
- Should – Should act as it improves position and enhances a goal or mitigates a negative. Take higher portfolio exposure to equity to make up for short-fall, for instance.
- Must – Must act to protect a goal that otherwise is in jeopardy. For instance, cutting expenses to adjust for lower retirement income.
Financial planning, in many ways, is like flying a plane. Minor but timely course corrections will take you to your destination safely and quickly.