Retired? The five most important decisions to ensure your income lasts

By Janice Roberts

Jeanette Marais

Only a small number of South Africans begin retirement with sufficient capital that will comfortably last the rest of their lives. Planning is essential to ensure that your money lasts as long as you do.

This is according to Jeanette Marais, director of distribution and client service at Allan Gray, who says that it is only after a number of years into retirement that the consequences of earlier decisions begin to show.

“Before you retire, it is crucial to have a frank look at your finances to assess what your needs will be during this phase of your life, and plan accordingly,” Marais notes.

Below she discusses the five most important decisions to take to ensure that your retirement income lasts.

Decision #1: Guaranteed or living annuity?

She says that there are two risks facing retirees when it comes to financial matters: You could outlive your capital or inflation could erode your money’s buying power.

“Investors often feel that they need to choose between a guaranteed life annuity and a living annuity, but both vehicles can actually combat these financial risks, and a combination of both may also work in some circumstances.”

A guaranteed life annuity will pay you a pre-determined income for as long as you live, effectively insuring you against the risk of living too long. The income you receive is influenced by your age and the current interest rate. The older you are and the shorter your life expectancy, the higher the income you’re likely to receive. A guaranteed life annuity does not allow you to leave money to your beneficiaries, and once you have purchased a guaranteed life annuity you cannot transfer to a living annuity. You get no flexibility, no capital preservation and you cannot adjust your income.

“Guaranteed life annuities remove the risk of selecting inappropriate investment choices and protect you from drawing too much of your capital in the early years as well as insure you against living too long. Once you’ve bought your annuity, your terms are set for life, and there is no flexibility,” says Marais.

Living annuities, on the other hand, give investors flexibility. They allow you to choose your underlying investments and to determine your income rate (within the legal limits). They allow you to take less income now, so that your capital can grow for later in life, and leave capital behind for your dependents. However, with flexibility comes market and longevity risk.

“If you go the living annuity route you need to make sure there is no disconnect between your expectations, the way you construct your portfolios and the amount of income you draw,” says Marais.

Decision #2: What is an appropriate drawdown rate?

If you are invested in a living annuity, the most important decision you will make is to decide what level of income you can live on, also known as a drawdown rate, within the confines of the legal limits (between 2.5% to 17.5%).

US financial adviser William Bengen’s research suggests that 4% is an appropriate drawdown rate, and this has become a rule of thumb.

Bengen suggests:

· Withdraw 4% of your capital, starting at the end of the first year of retirement
· Increase (or decrease) the absolute cash value of your withdrawal only by inflation each year

“However, many of our living annuitants report that 4% of their investment is not enough to fund their lifestyles. Most retirees are careful in their spending habits, so a shortfall normally means that they simply have not saved enough,” says Marais.

She says that personal circumstances and needs are unique, so if you are uncertain about what your withdrawal rate should be, the best is to seek help from a good, independent financial adviser.

Decision #3: Choose your asset allocation

Careful asset allocation is particularly important in a living annuity, because the decisions you make will influence how much your investment will grow and last and what standard of living you will be able to afford over time.

Bengen’s theory suggests that investors should maintain at least a 50% allocation to equities.

“Many retirees make the mistake of investing too conservatively,” says Marais. “People are living for longer, which means you need at least some of your investment to be positioned for growth. If you don’t want to worry about your own asset allocation, you could invest in a balanced fund, which puts asset allocation decisions in the experienced hands of your asset manager.”

Decision #4: Account for inflation

Marais says that you must account for inflation to ensure that your capital lasts.

“You need to protect the buying power of your capital. Assuming inflation is 5% and you draw an income of 4% per year, the required rate of return on your investment has to be at least 9% to protect the buying power of your capital. Anything less than that and you are effectively losing money.”

The reality is that a significant portion of the total return of an investment compensates for inflation first before any real return is earned.

“Investors shouldn’t underestimate the negative effect of inflation on their capital, particularly when interest rates are low and inflation is high. Inflation erodes the seemingly secure fixed interest return received on bonds and cash.”

Decision #5: Should you increase your withdrawal rate each year?

Marais cautions against being tempted to increase the percentage of your annual retirement income without understanding the risks.

She cites Bengen’s research that concludes, if you follow his theory by maintaining a 50% allocation to equities, drawdown 4% and only adjust your figure by inflation each year, you will enjoy an income for at least 30 years in nearly all circumstances.

“While 4% proved sustainable in almost all scenarios, 5% would have run out before 30 years in one third of the time. Increasing annual withdrawals by inflation alone and rebalancing annually is essential for the 4% rule to hold,” she concludes.


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