The transition from employment to retirement is a daunting prospect, because some of the financial choices you make at the point of retirement will be irreversible, Paul Leonard says.
During the first phase of your life, you learn how to earn money. During the second phase, you earn money and save as much as possible, Leonard says.
During the third phase, which is your retirement years, you live on the money that you have saved during the first phase.
Leonard says the formula that you use to work out what you can reasonably expect to receive from your capital during your retirement has four numbers:
* Your capital – the amount that you should have saved by the time you reach retirement;
* The return you want to earn on your capital;
* The amount you want to draw as an income; and
* How long you need your capital to last.
“You can work out any of these numbers as long as you have the other three,” Leonard says.
When you reach retirement, your investment strategy will be dictated to a large extent by the type of lifestyle you want to enjoy, he says.
For example, if you want a high-income lifestyle, you may have to risk investing for high returns. Aiming for higher returns implies that you will have to be comfortable with investing in an portfolio with higher risk, Leonard says. However, if you want to invest conservatively and still enjoy a high-income lifestyle, your money is likely to run out before you die.
Leonard uses the example of Bob Jones, who has capital of R1 million when he retires and earns an annual return of 10 percent, or R100 000. If inflation is six percent a year during Bob’s retirement and he draws an annual income of R80 000, he will have a surplus R20 000 in the first year of his retirement.
However, to combat the effects of inflation, Bob will have to draw down a higher amount as an income in future years and the surplus will decrease. After about five years, Bob’s income draw-down will start to eat into his capital, Leonard says.
“You need to ensure that the point at which the income you draw down from your retirement savings starts to eat into your capital is far enough in the future so that your money will outlast you and not the other way around,” Leonard says.
You must also take into account your life expectancy, based on your health and your family history, when you calculate your income needs in retirement, Leonard says.
Couples should base their calculations on the life expectancy of the female partner, because women generally live longer than men, he says.
For example, Leonard says, Bob is married to Margaret. At the age of 65, Bob’s life expectancy is 14 years and four months. Margaret, also aged 65, has a life expectancy of 18 years and five months. “In this scenario, Bob and Margaret need their retirement savings to last for 18 years and five months,” he says.
Your lifestyle, income and expenses will change once you retire. At retirement, Leonard says, you should draw up a budget that shows the difference between your pre-retirement and your post-retirement living expenses.
“Many of your expenses should stop post retirement. For example, your children should be off your hands by then and, with no dependants, you should no longer need to have a life assurance risk policy,” Leonard says.
Some people can get by on 60 percent of their pre-retirement income without sacrificing their lifestyle, Leonard says.
INVESTMENT VEHICLES AND INVESTMENT STRATEGIES
People often confuse investment vehicles with investment strategies, Paul Leonard says.
Examples of investment vehicles are endowment policies and living annuities, whereas an investment strategy can be an investment in shares, property, bonds and cash.
“The investment vehicle and the investment strategy are two different things, but they work hand in hand,” Leonard says.
Investment vehicles
Examples of the investment vehicles from which you might retire are a defined benefit retirement fund, a defined contribution retirement fund, a provident fund, a retirement annuity and a preservation fund, he says.
Leonard says there are five factors to consider when you choose an investment vehicle for your retirement:
* Preservation. Do you want to preserve capital for your heirs?
* Flexibility. A number of people formally retire but remain active in the workplace or take on contract work. If this applies to you, you must be able to decrease the investment income you draw down while you are working. Then, when you stop working, you must be able to increase the income you draw down.
* Longevity. Look at your family history and your personal health – is your potential health status above or below average?
* Responsibilities. Are you responsible for someone else’s financial welfare? For example, do you have a spouse or a mentally incapacitated child who will require an income after your death?
* Inflation. It is easier to earn good returns when inflation is high, but remember that inflation will not always be high.
Ideally, the income that you draw down should increase at a rate that is higher than inflation, Leonard says.
For example, if you buy a guaranteed pension with an escalation of five percent a year, your income will increase by five percent each year. However, you will have a problem if inflation hits seven percent, because the cost of living will have increased at a higher rate than your income, Leonard says.
When you retire, you have to invest two-thirds of your retirement savings in a compulsory investment vehicle, he says. Examples of compulsory investment vehicles are living annuities, with-profit annuities and joint guaranteed escalating annuities.
You can invest the remaining one-third of your retirement savings as you see fit, Leonard says.
Investment strategies
Leonard says according to the book How Much is Enough? by Arun Abey and Andrew Ford, a good investment strategy consists of four pillars:
* Quality. A good-quality investment strategy has the potential to earn income over the long term, offers you a good return on your investment, is run by capable management and has a healthy balance sheet.
* Value. You pay a good price relative to the returns you earn.
* Diversity. Diversification is not simply a matter of investing in different stocks. For example, if you invest in different mining shares, that is not diversification, Leonard says.
“Diversification would be, for example, investing in an ice-cream company and a hot chocolate company. The ice-cream company will earn high returns in summer, while the hot chocolate company will earn high returns in winter. By investing in both, you will ensure that your investment portfolio is earning a good return all year round,” he says.
* Time. You must invest for the long term. You must not be ruled by your emotions but must give your investment time to perform.
Investors often sell when markets dip, because they are nervous of losing more money, and they buy when markets are high, because they are confident that markets will continue to rise, Leonard says.
“If you were able to time the market, you should be doing exactly the opposite. However, since market timing has proved to be an ineffective investment strategy, over the long term it is best to build a portfolio based on solid principles, and then to stick to the strategy and ride out the ups and downs,” he says.
CASE STUDY
Bob Smith retires at the age of 60 and wants his retirement capital to last until he turns at least 85, Paul Leonard says.
Let us assume that the average inflation rate is six percent a year.
Bob’s living expenses in retirement are R23 000 a month. His medical expenses are R3 000 a month, and they are expected to increase by 10 percent a year.
Bob’s other living expenses are:
* Home maintenance – R40 000 every two years;
* Holiday in South Africa – R36 000 every year;
* International travel – R60 000 every two years; and
* Replacing his car – R250 000 every four years.
Bob’s capital at retirement is R7 million, Leonard says.
Bob has R4.5 million in his provident fund, and he transfers R4.2 million into a living annuity, Leonard says.
He withdraws R300 000 tax-free from his provident fund savings and adds it to his unit trust investments. As a result, Bob has discretionary savings of R2.5 million in unit trusts, shares and cash, Leonard says.
If Bob invests his retirement and discretionary funds so that they earn a return of inflation plus two percent, his money will last to age 76, Leonard says.
If Bob increases his investment risk and invests at inflation plus four percent, his money may last to age 80. For Bob’s money to last to age 85, he must increase his risk further and invest to receive a return of inflation plus six percent, Leonard says.
But Bob is not comfortable with a high-risk investment strategy and prefers to invest to receive a return of inflation plus two percent. As a result, he will have to change his lifestyle if he wants his money to last until 85, Leonard says.
Bob’s R7 million invested at inflation plus two percent can last until he turns 85 if he reduces his expenses as follows:
* Normal living expenses – from R23 000 to R20 000 a month;
* Medical expenses – from R3 000 to R2 000 a month;
* New cars – from R250 000 to R150 000;
* Overseas travel – from every two years to every five years; and
* Local holiday – from R36 000 a year to R24 000 a year.
Another option, if Bob wants to maintain his lifestyle and invest to earn a return of inflation plus two percent, is for him to take on a part-time job, Leonard says.
If the part-time job earns Bob an annual salary of R240 000 and he works for seven years, this money, together with his R7 million invested at inflation plus two percent, will last until Bob turns 79, Leonard says.
If Bob holds down his part-time job for seven years and at the age of 75 sells his holiday home valued at R2 million, his R7 million invested at inflation plus two percent, together with the money from the sale of the holiday home and the income from his part-time job, will be enough for Bob to maintain his standard of living until the age of 85, Leonard says.