Consuming income in retirement

An MID is a bank deposit that pays interest every month till maturity. So, the amount you invest in the deposit must be such the monthly income covers your living expenses

Retirees prefer bank monthly income deposits (MID) to fund post-retirement lifestyle. Here, we discuss some features of MID that you must consider before parking retirement savings in such deposits.

If you are retired or about to retire, it is natural to look for investment products that generate stable cash flows; you must substitute your active income (from work) with a steady stream of passive income (from investments) to sustain your post-retirement living. Two products typically discussed in this context are MID and joint-life annuities.

An MID is a bank deposit that pays you interest every month till the maturity of the deposit. So, the amount you invest in the deposit should be such that the monthly income covers your living expenses.

There are several benefits with such investments. One, bank deposits are easy to understand, unlike annuities that you can buy from life insurance companies. And two, cash flows are not subject to market uncertainties.

The flip side is that you are exposed to reinvestment risk. Banks typically offer deposits for a maximum of 10 years. Suppose you retire at 60 and invest in a 10-year MID, you must renew the deposit at 70 and at 80. The risk that you may have to renew the deposit at a lower rate is called reinvestment risk. Empirical evidence suggests that your living expenses, even adjusted for inflation, decrease when you are past 75 years. So, even if MID is renewed at a lower rate, you may not face a significant shortfall in cash flows to manage your living expenses. Note that your MID runs credit risk, although the risk is low. This is the risk that a bank could fail to pay your interest on time or fail to return your capital for lack of sufficient funds. So, carefully choose the bank in which you keep your MID.

The monthly cash flows some banks pay on MID include interest and a portion of your initial capital. Such deposits may not be behaviourally optimal. Why? Retirees are exposed to longevity risk — the risk that they will outlive their investments. Now, consuming capital could lead to increased longevity risk. What if a retiree runs out of capital because she lives past her life expectancy? Retirees are comfortable consuming income and preserving their capital. This also helps in intentionally transferring the unconsumed capital (deposit) to the next generation as legacy investment.

(The author offers training programme for individuals to manage their personal investments)