Managing your finances and planning for your future do not end when you retire. If anything, you need to be more active in managing your money, because mistakes made in retirement can be far more damaging than pre-retirement slip-ups.
This is the view of Bruce Cameron, the former editor of Personal Finance, who spoke at the Alexander Forbes/Personal Finance Ready Set Retire Club.
Cameron, who is semi-retired, says you make your most crucial financial decisions immediately before and immediately after you retire. You cannot afford to make any mistakes, because it is unlikely that there will be another opportunity to get it right. You have to make decisions about a range of important issues, including what you want to do in retirement and how to structure your income, he says. The main issues you need to consider are:
Your retirement date
Cameron says that, by the time they retire, very few people have saved enough capital to support their pre-retirement standard of living. This means they must postpone their retirement, reduce their standard of living, depend on the assistance of others and/or find another form of employment “in retirement”.
If you are an employee who belongs to an occupational retirement fund, you have little say over your retirement date. To make matters worse, in some cases employers force employees to take early retirement.
“This means you need to start calculating long before retirement whether you can actually afford to retire and what you will do to make up the shortfall in capital. It is not something that can be left for the day you retire or are ‘retired’ by your employer,” Cameron says.
The best way to assess whether you can afford to retire is by calculating the percentage of your current income you will need as an income in retirement. This is known as your replacement rate (or ratio).
Calculating your replacement ratio is not a once-off exercise. It should be done at least annually, or whenever an event has a significant impact on your income and assets.
Debt at retirement
You must pay off all your debt before you retire, Cameron says. Do not use your retirement savings to repay debt, because this will make it even more difficult to generate the income you need in retirement.
Your expenditure
The biggest threat to your finances is living beyond your means or having to fund a large expense for which you did not provide.
Before you retire, you must establish how much you can afford to spend in retirement. This includes calculating:
* Your current and future after-tax cash inflows (income) and cash outflows (expenses);
* How much you need to save to cover expenses that are likely to increase above the rate of inflation, such as medical costs; and
* What you have in reserve (your assets) and debts (liabilities). Your reserves should include an emergency fund equal to between three and six months’ income.
After you retire, you need to:
* Keep a tight rein on your spending to ensure that you do not exceed your budget. When drawing up a budget, be careful not to understate what you are likely to spend.
* Keep saving. As you age, your living expenses may increase if you have to spend large amounts on health care, while inflation may reduce the buying power of your pension. The way to address this problem is to keep saving.
Pension decisions
By the time you retire, you need to have decided how you want to invest your savings to generate an income, Cameron says.
At least two-thirds of any money from a defined contribution retirement fund or retirement annuity must be used to buy a compulsory annuity (see “Your pension choices when you retire”, below). Any discretionary savings can also be used to generate an income.
The main difference between compulsory and discretionary investments is how they are taxed. With a compulsory annuity, you pay income tax on your pension (including any capital you draw down) because you receive tax benefits on your savings while they accumulate in your retirement fund. On income from discretionary sources, you pay tax only on interest, dividends or rental earnings, but not on any capital you withdraw.
Cameron says you may belong to a retirement fund that provides you with a pension (a defined benefit fund). If this is the case, in most cases the pension will end on the death of the last-surviving spouse.
You need to find out how your fund will award pension increases. Most defined benefit funds award average annual increases of 75 percent of inflation, which means the buying power of your pension will decrease. If you do not have other savings, you will have to save some of your pension to keep up with inflation as you grow older.
Investment markets
You will have to make investment decisions if you have discretionary savings or a living annuity, Cameron says. This means you have to:
* Understand the basics of investing.
* Adopt a conservative investment strategy and diversify across the main asset classes of equities, bonds, property and cash.
* Be on your guard against scams and high-risk investments. Retirees are the number-one target of people who sell high-risk investments. You cannot afford to gamble with your savings in the hope that you will receive high returns. For example, thousands of pensioners have been burned by property syndications, which promised higher monthly incomes than guaranteed annuities. But the investors not only received little or no income; they also lost some or all their capital.
* Select products that enable you to take advantage of tax breaks.
Longevity
Many financial plans that include living annuities are based on the assumption that a person who retires at 65 will die at 84, but 50 percent of pensioners will live longer, Cameron says.
One person in a couple aged 65 has a 52-percent chance of reaching age 90. Against this, a living annuity with real (after-inflation) growth of three percent a year and an initial annual drawdown of five percent has a 25-percent chance of lasting until the annuitant turns 90.
Investment costs
High investment costs can ravage your income in retirement, Cameron says. One percentage point may seem low in the saving stage, but every percentage point saved in costs will increase your final benefit by 20 percent after 40 years.
Inflation
Cameron says if you are 65 now and have an income of R20 000 a month, to keep pace with inflation of six percent a year, you will need double that amount when you are 77. You will have to lower your standard of living if inflation rises at a faster rate than your income.
Accommodation
Deciding where you want to live in retirement may include downscaling, Cameron says. You should take a number of factors into account, including the cost of maintaining your existing property and the type and location of a retirement village where you may want to live. Do not leave this decision until you are forced to sell because you can no longer afford the upkeep and rates.
Physical and mental health
Poor health, particularly poor mental health, is a significant threat to your financial security in retirement, Cameron says. You must plan for lifestyle changes that result from ill-health.
Estate planning
You should make your standard of living in retirement your priority, not how much you want to leave to your heirs, Cameron says.
However, you should make provision for people who depend on you now and who will depend on your estate after your death.
Tax
Cameron says you need to make a number of tax-related decisions before retirement and in retirement. These decisions include how much of your retirement savings to withdraw as a cash lump sum at retirement and how to invest discretionary savings.
Advice
One of the biggest threats to your financial security in retirement is receiving bad advice, Cameron says.
The most trustworthy advisers have the Certified Financial Planner accreditation and are members of the Financial Planning Institute.
To find a qualified planner in your area, go to www.fpi.co.za
YOUR PENSION CHOICES WHEN YOU RETIRE
If you must buy a pension, your choice is mainly between a guaranteed life annuity and an investment-linked living annuity.
Guaranteed life annuity
This is a pension provided by a life assurance company. The pension you receive depends on:
* Your age. The older you are, the more you will receive, because your life expectancy is shorter than that of someone younger than you. For example, a man who buys a level pension with R1 million at age 55 will receive almost R8 000 a month, but he will receive almost R10 500 a month if he buys the pension at 70.
* Your gender. Women receive a lower pension for the same amount than men, because women, on average, live longer than men.
* Interest rates. Most of your money is invested in interest-bearing investments. When you buy a guaranteed annuity, the calculations for the pension are based on the prevailing interest rates.
* Choice of annuity. There are a number of types of guaranteed annuity. The more bells and whistles, the lower your initial pension will be, but the pension will be more sustainable as you get older.
Once you have bought a guaranteed annuity, you cannot change your mind: you have entered into a contract which ends only on your death or the death of your surviving partner.
The main choices of guaranteed annuity are:
- Level. You are guaranteed the same monthly income for the rest of your life. Inflation will rapidly reduce the buying power of your pension. An inflation rate of six percent a year will reduce the buying power of your pension by 25 percent every five years.
- Escalating. Initially your pension will be lower it would have been had you chosen a level annuity, but an escalating annuity that increases by 10 percent a year exceeds a level annuity after nine years.
- Guaranteed and then for life. Your capital is guaranteed for a certain period. If you outlive the period, your pension will continue to be paid until you die.
- Joint and survivorship. These pensions are paid until the death of the last-surviving spouse. You decide whether you want the pension to decrease or stay the same after the death of one partner. The higher the pension required for the surviving partner, the lower the initial pension.
- With-profit annuity. These pensions are guaranteed, but the increases depend on the investment returns. The main features are:
* The initial pension is guaranteed for the rest of your life;
* The increases are based on the returns earned on the initial investment, less costs and the profits taken by the life assurance company;
* The increases are declared as bonuses and are guaranteed for remaining contract period; and
* The increases are smoothed, which means that some of the returns earned when markets are performing well are held back to pay better increases when markets are performing poorly.
I nvestment-linked living annuity
This is an annuity provided by an asset manager or investment platform. The main features of this type of pension are:
* You must draw between 2.5 percent and 17.5 percent of the value of your capital annually. If you withdraw more than five percent initially, depending on your age, your capital is unlikely to last until you die.
* You choose the investments, which means you need to be conservative in your choices, because volatility or market slumps will undermine your capital and your pension.
* You take the risk that there will be sufficient capital to maintain your standard of living until you die.
* The residue of your capital goes to your heirs when you die.
What’s best?
Cameron says you must take a number of factors into account when deciding which type of annuity to buy. These factors include:
* Your age. Low guaranteed annuity rates are paid to young annuitants, but the older you are, the better the rate, so a living annuity may be the better option if you retire relatively young.
* Interest rates. The higher the prevailing interest rate, the higher the guaranteed pension will be, and this higher rate is “locked in”.
* Longevity. A guaranteed annuity is a form of insurance in case you live longer than expected.
* Responsibility. If you have a living annuity and suffer from dementia, you are at risk of self-inflicted losses or fraud.
* Switching products. You can switch from a living annuity to a guaranteed annuity, but once you are in a guaranteed annuity you cannot switch out of it.