What if your money disappears before you do?
It is wonderful that modern medicine not only saves many young lives that even 50 years ago would have been lost, but it is extending our life expectancy out into the nineties. Many of us can expect to see not our grandchildren grow, but our great-grandchildren too (unless the continued postponement of birth into the late thirties continues of course). For years financial planners assumed that most people would only live twenty years past retirement at age 65, but that is no longer true, and this assumption is now out by a good ten, if not 15 or 20 years (for people who are currently in their forties). This radical change in our reality needs a complete rethink when it comes to investing for retirement and how we plan for an income in retirement.
Let’s look at some of the implications of living longer:
- Governments and companies are already pushing out the pensionable age to take the burden off the State. If you’ve been winding down in anticipation of retirement, suddenly having to push that out another couple of years is not fun.
- The income purchasing power for your retirement funds has to be maintained through the whole of life after retirement. This isn’t a simple matter of keeping up with inflation, because some key expenses that are vital as you get older, like health care, have been increasing faster than inflation for the last two decades, so it is reasonable to assume it will continue to do so. The cost of energy is also increasing above inflation.
- Past age 80, one often needs additional care and that can double the monthly income requirement. There is more than one way to plan for this but it is going to expensive and needs to be considered.
- The older you get, the greater the chance that you will get a severe illness that will require expenses over and above medical aid, who lamentably decrease in benefits every year. This requires additional capital/income or payments toward a risk premium to cover those expenses, and the foresight to get into those products while we are still healthy.
- Your capital in your retirement fund may have to last double the time that was assumed when you started your planning, and if you’re closing into retirement accumulating more may just not be possible. If you work for a company that has a pensionable age, you could be forced out whether you like it or not. Starting a new career as a ‘pensioner’ is difficult.
- If you get close to retirement and it becomes clear that your pension pot is just not big enough you have a few options:- You can keep on working longer, put away more of your current income, take less at retirement and use smart asset allocation to ensure your capital is going to yield an income for the whole of your life.
What can you do to get your retirement plan back on track?
Obviously, the first step is to have a plan – and the longer you delay that, the slimmer the chance that your retirement dreams and expectations will be met. That plan needs to be revisited at least once a year. Cookie cutter plans from computer programs are almost irrelevant in this new era, but if you’re a youngster with little to invest, you might battle to get a professional planner to put one together for you free of charge. I know I am biased, but investing in a good plan early could save you years of additional ‘accumulation’, or just spend time really understanding and researching how basic financial modelling works. The financial advice for the long term cannot be boiled down to a few simplistic assumptions, with the investments popped into flavour-of-the-month ETFs or Unit Trusts and the plan allowed to play out. Longevity will play havoc with that sort of quick-and-dirty plan.
The end objective has to be the primary focus of a retirement plan that considers potential longevity. This objective has to be the production of an income for the whole of life after the ‘accumulation’ phase (working) is over. Ideally, capital should remain intact during retirement, but that is not always possible, especially if the future retiree has not accumulated enough in his investments during their working years and time is running out. Financial stress is unpleasant at any age, but as you get older and income opportunities decline, it can be a serious health risk.
A smart, professional retirement plan will optimize the tax breaks and regulations in the decades leading up to retirement and will be adjusted as those change. This will probably lead to the recommendation of a suite of investments (over time) including traditional retirement funds (with tax breaks), flexible investments, money market accounts for emergency funds and perhaps even endowments – if it makes sense from a tax perspective once the annual limits on interest and CGT have been tapped out.
The inflows and outflows of capital into the plan (and where the funds will come from) can be important but the underlying assumptions should be questioned. The assumption that one can liberate large capital sums from the sale of the home needs to be looked at realistically after all the costs associated with the sale and purchase of a replacement have been factored in. That home, presumably bond-free, replaces the need to rent – so while the capital may increase from a sale, so may the income need. In the past one has often had to assume the replacement of a car several times in retirement, today with almost everything available for home delivery and inexpensive ride-sharing this capital is often best left in the investment earning a yield – but requires a change in mindset.
You will notice that I keep talking about the ‘yield’ of an investment rather than the ‘drawdown’. The ‘drawdown’ is a term used in the retirement industry when you designate what portion of your compulsory annuity you will take on a monthly/annual basis (legislated between 2.5% and 17.5% in RSA). “Yield” is found in almost every investment – as interest from money market and savings accounts, bond yield (retail bonds, government bonds, debentures and corporate bonds), dividends and rental yield. Some investments don’t have a yield – gold for example, or a dormant property (which will actually have a negative yield).
In the years running up to retirement this yield is reinvested in the fund – in regulated retirement funds these are tax-free, and even the dividend withholding tax is rebated back. After retirement, if the investment has been structured with yield as the primary objective, then there does not need to be a sell-off in capital (shares, unit trusts, ETFs) because the investment produces this income, with some to spare to be reinvested to make sure the capital keeps on growing and so that the yield keeps up with inflation. For example, a portfolio can be structured to yield around 7.5%, 5% which pays out to the retiree, and the other 2.5% goes back into the investment. Properly balanced this ‘yield’ will not be as volatile as stock markets because the sources of that yield are diversified.
The sooner you ‘diversify’ your retirement investments, the more certain your retirement income will be. While it is going to be less easy to manage, your income should probably come from different investment types as well as asset types in retirement, and perhaps tapped into at different times to reduce the tax burden. There is no donations tax between spouses, so it makes sense that the income is distributed between both of you (where possible), again optimizing the tax and taking advantage of the double annual allowances. A rental portfolio is a good way to produce an inflation-related increasing income over time but it ties up capital in large chunks and is far from risk-free. Properly done you need a quality portfolio of at least 6 properties, and that can take a few decades to put together (and the uncertainty around ‘appropriation without compensation’ needs to be clarified). Retirement funds under the Pensions Fund act will give you a nice rebate in your accumulation years, but 2/3 of that will have to go into a compulsory annuity and be treated as ‘income’. The allowable contributions to these tax-friendly funds are capped at R350k pa or 27.5% of your taxable income, and while they are an important aspect of retirement funding you need to have more diversity. The marginal tax rate is 45%, so if you’ve tapped out of your annual allowances (interest, CGT), then an endowment (taxed in the fund at 30%) might be an alternative. A good plan will go into all these details, tailored to your needs.
Action: Proper planning for retirement is changing to ensure an income for the whole of your life and requires more finesse than just reducing the ‘drawdown’. The sooner you understand the dynamics of your plan, the easier your retirement will be.