Plan your retirement income carefully to make sure your savings last a lifetime while providing for your spouse and children.
One of the first questions we encounter when we talk to people on the brink of retirement is “Do I have enough to retire?”
Ensuring a sustainable income for life is one of the most challenging conundrums for anyone who relies on investment income in retirement.
When planning for retirement, there are a number of factors to consider. While the list is long, the following immediately come to mind:
How much income would I need to survive in retirement, and how much would I actually like to earn in retirement? A realistic income expectation probably lies somewhere in between these two figures.
What realistic return expectation can I use during my accumulation phase, and does this figure need to change when I retire?
What is the optimal split between compulsory and voluntary funds? Do I really need both?
When I retire, must I invest my compulsory accumulated funds in a guaranteed life annuity or a variable living annuity? Does it make sense to invest in both? What is a hybrid annuity?
How much of my accumulated funds must I leave to my spouse and children when I pass away? What about other family members and an ex-spouse?
In blended families, these challenges become more complicated when one starts to talk about my children, your children and our children.
One of the most challenging conundrums for anyone who relies on investment income in retirement is how to ensure a sustainable income for life. What must I do to make sure I don’t run out of funds?
With limited resources, the challenge grows even more severe if you want to provide enough capital or income for a spouse and children to maintain their lifestyle after your death. Not many people achieve this.
Let’s start at the beginning.
Preparing for retirement should start decades before the big “R-day”. While all savings and investments help with retirement, the planning and the plan should be structured and intentional.
The more thought that goes into the planning, the more flexibility you will have and the less tax you will pay, which ultimately will lead to a lower capital requirement to achieve your disposable income during retirement.
Only you can answer the “how much income?” question. A good starting point is to consider your income requirements at the time you do your retirement planning.
Since the objective will (or should) be to have no debt the day you retire, deduct the amount you pay towards debt each month from your current income. At the same time, deduct the funds you are allocating towards investments from your current monthly income requirement. You can do this because you will no longer contribute to retirement funding once you retire.
Bear in mind that it is always a good idea to maintain an investment contribution strategy when you retire to keep your emergency reserves and holiday money “pool” healthy.
Example:
Current net income (salary paid into your bank account) = R75 000.
(Less) Retirement funding and investments = R20 000
(Less) Bond and car payment = R25 000
Minimum net income requirement in retirement = R30 000 + investment R10 000 = R40 000 net. This aligns with what we observe in practice, where retirees require around 50% to 75% of their final salary.
Grossing up this net pay to include tax will depend on how much of the accumulated funds are voluntary and how much is allocated to compulsory funds. Remember, compulsory funds generate fully taxable income in the form of a pension.
Voluntary funds are taxed only when interest-like returns are generated, i.e. cash, bonds and rental income, either directly through property ownership or Reits. Voluntary funds also trigger capital gains tax (CGT), which compulsory funds don’t.
Using a simple analysis, we can conclude the following:
If all the income is derived from compulsory funds, a 67-year-old retiree will need to earn approximately R605 000 per year to net R 40 000 per month after rebates. This results in a net tax rate of around 26%.
If you can invest all voluntary funds in non-taxable assets, you will need to draw R480 000 annually. Since there will be CGT and some tax on interest, for the sake of this exercise, let’s assume a 10% tax rate, which means that an annual drawdown of R533 000 will be required.
If we extrapolate the above further, then if all the funds were invested in compulsory investments, a capital amount of R12 100 000 would be required, assuming a drawdown rate of 5%.
If all the funds were invested in voluntary funds, a capital amount of 10 660 000 would be required if the 10% tax rate mentioned above applies.
If it is possible to optimise your investments so that no tax is payable, then a capital amount of R9 600 000 will be required.
The difference between the extremes mentioned above is R2 500 000 when we compare the most tax-efficient and tax-inefficient examples. This equates to an additional investment of around R3 200 per month, earning 10% per year for 20 years.
The above is highly simplified and ignores the tax deductibility of retirement fund contributions and the impact of enhanced returns. It also ignores estate duty and estate duty exemptions that apply to retirement funding.
My example illustrates the importance of tax and capital requirements. It also highlights the importance of decent returns. The more conservatively your portfolio is structured, the more capital you will need to accumulate and the more you will need to allocate monthly towards investments.
This does not mean you must plough into high-risk investments. It merely means that you must be aware of the consequences of your choices and plan accordingly.
Exactly the same applies when you choose your income solution, irrespective of whether the income will be derived from voluntary or compulsory funds.
Your decision on how to invest your compulsory funds depends entirely on how much you would like to pass on to your loved ones when you pass away. Guaranteed life annuities die with the annuitant.
Unless the capital is backed by life cover (which costs money), no capital will be payable to surviving beneficiaries. It is possible to nominate a joint life annuity when you buy your pension, in which case income will be guaranteed for life for both you and your spouse. The income will be determined by the age of the younger of the two.
For the sake of this exercise, I will assume both spouses are aged 67 and that R12 000 000 was accumulated over time. The funds are split 60/40 between compulsory funds and voluntary funds.
That means that R7 200 000 must be used to purchase a compulsory pension, and the balance of R4 800 000 can be applied in any way desired. The couple needs R40 000 net of tax per month, and they would like their children to inherit at least R6 million upon the last death.
Reminder – compulsory funds must be used to buy a compulsory income (pension fund). Although one can commute one-third of the proceeds to cash, at least two-thirds must be used to buy either a living annuity or a life annuity, or a combination of the two.
Upon death, a living annuity transfers to nominated beneficiaries, and, as I mentioned, a life annuity does not offer any capital payout on the annuitant’s death.
You can nominate a joint life annuity (spouse), or you can nominate a minimum guaranteed period, in which case the income will pay for the longer of the annuitant’s life and the guaranteed period.
I assume the full proceeds of the compulsory funds will be invested in a compulsory annuity of sorts.
Scenario 1
Purchase a guaranteed life annuity with the full amount of R7 200 000
Annuity payable for a 67-year-old annuitant on a joint life basis (both parties 67 years old), taking a 5% annual escalation into account, a gross income of approximately R40 000 will be payable.
If a level income (no escalation) is chosen, an income of approximately R55 000 per month will be payable. Both these amounts are pre-tax. If we consider tax, then a respective net income of R33 129 and R43 938 will be payable monthly.
Or
Invest in a living annuity and draw 6.7% to match the R40 000 above. Cautionary: Living annuities are exposed to market and investment risks. Prolonged negative returns and the sequence of returns can cause capital depletion if consistent returns are less than the income drawn.
In our example, if a consistent return of 10% per year is achieved and income increases by 5% per year, capital will increase for nine years and then start to decline, while income will increase for 17 years and thereafter start to decline.
The scenario above should not be expected, since returns fluctuate and it’s highly unlikely that the consistent returns illustrated will occur.
If capital preservation is a prerequisite, it is recommended that you draw no more than 4% of income. There are also different strategies that can be applied to provide a more certain outcome.
Scenario 2
Make use of a “hybrid” solution where a living annuity and a life annuity are combined but administered as a living annuity. In this scenario, the following will apply:
Life annuity purchase sum = R3 600 000, providing income of R20 000 + 5% escalation guaranteed.
Living annuity component = R3 600 000, draw maximum 5%, providing income of R15 000 + 5% escalation, variable.
The 5% drawdown has a much better chance of resulting in capital appreciation than when drawing 6.7% as in the previous illustration.
The total tax less rebates in the above scenario will come to R5 321, leaving a net income of R29 679 per month.
The balance of R10 321 can then be drawn against the voluntary investments of R4 800 000, which means drawings will be at a rate of less than 3%.
This scenario offers potential capital growth and ensures sufficient capital for inheritance, especially if the living annuity residue, which is expected to continue to grow, is added to the voluntary fund value. Taxes on the voluntary investment will be based on the structure of the investment.
If you can structure your overall portfolio so that you derive income from three different sources in retirement, it will not only diversify and de-risk your portfolio but also enhance your overall wealth with less volatility.
Assets like dividend-paying shares and rental property come to mind. Be careful with rental property, though. It only makes sense to let someone else pay your bond prior to retirement. It is not advisable to buy property cash for rental purposes when you retire.
Also remember that your primary residence should not be considered an income-generating asset. Many South Africans place too much value on their primary residence and see it as a future asset they can sell to fund retirement, this is a cardinal mistake.
In the perfect world, a suitable portfolio may look as follows:
Overall wealth from which income can be drawn:
Compulsory funds A = 20% in a life annuity with a variable escalation, with either a joint life structure or a minimum period guaranteed. The older you are, the higher the annuity rate will be. It may make sense to convert a living annuity in the future.
Compulsory funds B = 20% in a living annuity with income drawn at below 4%. A trust can be nominated as the beneficiary of the proceeds if required.
Voluntary funds = 30%, from which you can fund emergency funds, holidays, and income shortfalls.
Property = 30% to supplement income and enhance the estate value. Can be bought in a trust to reduce estate duty. This should not be your primary residence.
I hope this helped – plan wisely and realistically.
