Retirement Planning and Stock Market Returns

Retirement planning is good.

It helps you in having adequate funds when you retire from active worklife and in the rest of your life thereafter. It ensures that retirement is pleasant and you can goof off all day long without getting caught at it.

But any planning involves assumptions.

And retirement planning involves assumptions of returns on money deployed, among other things.

Today, there are a host of products that are available to help you plan for retirement. Without passing judgements over whether such products are good or not, we have many products sold by reputed names. Almost all have a 'paper asset' (stocks and bonds) inclination, that they will invest your money in equities or in debt or a combination of the two.

In the past 5 years, the Indian stock markets have seen spectacular returns and the frontline indices have given 35%+ returns compounded.

Buoyed by such handsome returns, Sales departments of many fund houses have been selling their retirement products on the basis of high return assumptions. While nobody talks about 35% returns going into eternity (such a return would leave the BSE sensex at a level of 11.8 crores after 30 years from its value of 14600 today!!), is the commonly assumed return even of 15-20% possible?

Fund managers would have us believe that a 15-20% return from the stock markets of a fast growing country like India is imminently possible over the long run. After all, they demonstrate that the BSE Sensex has grown from 100 in 1979 to 14600 today. This translates into a return of 18.75% compounded over 29 years. So why should it not grow, if not faster, at least at the same rate in the future?

India's GDP grew in nominal (real terms + inflation) terms at the rate of 13.8% from 1979 till 2008(estimates). Going into the future, it is difficult to imagine nominal growth rates higher than 13-14%. Why? Here is why.

If India grows at 10% in real terms, it is likely that inflation would have to be low, at around 4% or so. But since growth brings in inflationary pressures, a higher inflation would be met by higher interest rates, which would drive down growth rates (as also cut down corporate earnings). The best we can hope for is a high growth rate (7-9%) and low inflation (4-6%) thereby giving a nominal return of 13-14%.

To see what has happened over the last 5 years of high growth, India's GDP has grown at a nominal rate of 13.6%. In the past, we have occassionally grown at 15-16% nominal, but in all cases, it was because inflation was high at 9-11% with real growth being at 5-6% or less. Such period of high inflation were followed by periods of low real growth.

Ok, but why is it difficult to get 18% from stocks over a 30 year period?

Currently the market capitalization of India stocks (value of all stocks listed on the stock exchange) stands at around 1.1 times India's GDP (market cap to GDP ratio = 1.1). Whether this ratio suggests overvaluation or undervaluation is a matter of debate. Some people argue that this is a high number sugesting stocks are overvalued. Others respond by saying that this tool is not a accurate measure since new companies get listed and also corporate debt gets replaced by equity boosting the market cap of stocks.

Regardless of arguments and counterarguments, we note that this ratio stood at about 0.25 in March 2003. It stood at about 0.6 in March 2000 at the height of the technology bubble. It stood at 0.32 in 1979 (considering Sensex growth as the proxy for market cap growth).

It also stood at around 1.5 in January 2008.

We got handsome returns from stocks over the last 5 years because stocks were indeed deeply undervalued. We got our 18.75% returns from stocks since 1979 because stocks were undervalued.

We got a drubbing on the stock markets since January this year because stocks were overvalued. I reckon at at 1.1 times, we still are not undervalued. (With a PE ratio of 18.2, a Price:Book ratio of 3.8 and a dividend yield as low as 1.26, stocks still do not look cheap to me).

Even during the 'mother-of-all-bubbles' technology bubble in the USA, the market cap to GDP ratio of all US stocks was 1.9.

While we may not be able to say whether stocks are somewhat cheap or expensive using this ratio, very high values (>2) have perhaps not been attained even in prior bubbles. Similarly, very low values perhaps suggest undervaluation.

So if the Indian stock markets keep growing at 18.75% for the next 30 years and the Indian economy grows at 13% nominal, at the end of 30 years, the market cap to GDP ratio of Indian stock market would become an improbable 4.8!! Thus Indian stocks would be valued at 4.8 times the total output of the country. A extremely unlikely event considering that it has never happened.

It is more likely that market cap to GDP ratio would be around 1 after 30 years, giving a likely return of 12.6% on the stock markets. Even if you assume this ratio to be 1.5, stock returns would then be 14.1%.

Thus, the likely scenario for stock market returns for long retirement durations is likely to be between 12 and 15% and not the 15-20% as many assume.

Note also that since most of our money would be with fund houses (through retirement accounts and ULIPs and such), returns post their expenses and mortality charges (for ULIPs) would be lower to the tune of 2-3%. So on average, such retirement funds would generate 10-12% over the very long run.

There definately will be some outperformers. But most accounts will not outperform the broader markets. In addition, it is also very difficult to generate outperformance over long periods consistantly. Many funds perform well and then slip up later.

As far as building a corpus is concerned, a difference of 3% per annum in returns (between 12% and 15%) makes a lot of difference to the amount required to be saved per month. At 12%, to achieve a corpus of Rs.10 crores after 30 years, you would need to save aproximately Rs. 34500 per month. The same figure would be Rs.19100 per month at 15% rate of return, Rs. 10500 per month at 18%. Small differences in returns does make a big difference in the amount required to be saved and invested.

In closing, I would like to say that it is always a prudent practise to have a realistic (perhaps even conservative) estimate of returns you would get on your retirement money. You dont want to overestimate expected returns and realise at retirement that you will fall short of the money you need into retirement.