When planning your finances for retirement, the priority should be to receive a stable, sustainable income that will enable you to maintain your standard of living, says John Anderson, Alexander Forbes’s managing director of research and product development. This is the fourth article in a series of reports by Bruce Cameron, the founding editor of Personal Finance, on the Personal Finance/Alexander Forbes Ready Set Retire conferences that were held around South Africa in March.
Most people face four major risks when they retire: longevity, inflation, spending too much and choosing the wrong investments (also known as income conversion risk).
John Anderson says you have one opportunity at retirement to make the correct decisions. If you get the decisions wrong, it is highly unlikely that you will be able to correct them later.
“You have only one retirement. You have only one chance to get it right. You cannot reset or restart it,” he says.
You should start planning for retirement long before you retire, to ensure you make the correct decisions.
“There is no standard plan for retirement. Everyone has different personal needs and circumstances; they live in different places, with different costs. For example, if you live in Gauteng, you pay eTolls, whereas in other areas this may not apply,” Anderson says.
It is important to establish what you want to do in retirement, because this will affect your financial plans. For example, one person may want to travel extensively, while another may want to play golf four days a week or spend as much time as possible with his or her grandchildren.
Financially, some people prioritise leaving capital to family members, while others want to maximise their investment returns to grow their pension.
Your main financial objective should be a stable, sustainable, inflation-beating income for you and your spouse or partner, Anderson says.
“What you don’t want is a volatile, fluctuating income. You don’t want to worry about whether your income will go up or down, particularly in your later years, when your ability to supplement your income falls. Your primary goal is to sustain your standard of living,” he says.
Most people will never have enough money to meet all their wants in retirement, Anderson says.
You have to balance your needs with your resources, particularly if you have not saved enough. Too often, people who have not saved sufficiently make the mistake of taking too high a pension initially, and fail to consider how this will affect their finances as their retirement progresses.
RISK 1. LONGEVITY
Longevity risk is the risk that you will run out of money, because you live longer than you expected. People are, on average, living longer, John Anderson says. There is a 50-percent likelihood that a person who is aged 60 today will live to age 90; and a person who is 60 in 2075 will have an 85-percent likelihood of living to 90.
Actuaries have historically under-estimated how longevity will improve. Many people under-estimate how much income they will need in retirement, because they assume they will die before their capital runs out.
You must plan your finances so that you will have a stable and sustainable income, no matter how long you live in retirement, Anderson says.
RISK 2. INFLATION
Inflation risk is the risk that your income will not keep pace with the rate of inflation, with the result that you will be unable to sustain your standard of living.
John Anderson points out that in 1970 you could buy a car for R1 000. In 1980, the same amount of money would have bought you a motorbike. In 1990, R1 000 would have bought you a bicycle, and in 2010, a pair of running shoes. By 2020, R1 000 will buy you a pair of socks!
Inflation is a particular danger for pensioners, because the inflation rate of people in retirement usually exceeds the average inflation rate, Anderson says.
The main contributor to your inflation rate in retirement is medical inflation, which out-strips the average rate of inflation.
He says that, on average, you will pay about R20 out of every R100 in income towards medical expenses in the initial years of retirement. This will increase substantially towards the end of your life, and in the last two years of your life you can spend as much as 90 percent of your overall spend on health care throughout your life.
If you have a level (non-escalating) pension, medical costs will absorb 40 percent of your pension after five years and 90 percent after 10 years, he says.
If your retirement planning does not take medical inflation into account, you will have to downgrade your medical scheme option or forego medical scheme membership altogether – at the very time when you most need healthcare insurance, Anderson says.
RISK 3. CONSUMPTION
Consumption risk is the risk of spending more than your income can sustain.
Many retirees depend solely on the proceeds of an occupational retirement fund to provide them with a pension, John Anderson says. Most retirement funds typically target a pension that will equal 70 to 80 percent of your final pay cheque. If this is your only source of income, you will have to be very careful with your spending.
Research by Alexander Forbes a few years ago found that most people do not reduce their expenditure once they retire. “They spend on different things. This is much the same as the change in spending between the ages of 20 and 40,” Anderson says.
Non-healthcare spending generally does not decrease in retirement, while it is likely that expenditure on health care will increase.
Your overall cost of living is unlikely to decrease. You will have to continue saving throughout your retirement, not only to ensure you will have a sustainable income, but also for “emergency” expenses. The only thing that may decrease is the amount of tax you pay.
Anderson says your circumstances will determine the pension you need to target. For example, if you are married, your spouse may continue working when you retire, so you will not depend entirely on your retirement savings to generate an income.
Anderson says that one of the big mistakes many pensioners make is to hold onto properties that were bought as family homes – these properties consume more and more of their income as maintenance costs rise. It is better to downsize early in retirement, because this will cut your overheads and provide additional capital that can be used to generate an income.
RISK 4. INCOME CONVERSION
Income conversion risk is the risk that you will choose the wrong product when you convert your retirement savings into an income (pension).
John Anderson says that choosing an annuity is probably the most important decision you will make in the 30-odd years you spend in retirement.
“You can’t say ‘I made a mistake’ and go back.”
Anderson says the risks associated with income conversion include:
* Considering the wrong type of risk. Your choice of pension must be based on your need for an income stream, not your desire to protect your capital, he says. In other words, you must not place leaving money to your family above generating a stable, sustainable, inflation-beating income.
If you buy a living annuity, the capital value of your investment could increase, but, depending on the type of guaranteed annuity you choose, you could be better off in the long term with a guaranteed annuity, even when interest rates fall.
* Low interest rates. The lower the prevailing interest rates when you buy an annuity, the less you will receive as a guaranteed pension for a fixed amount of money. For example, in 2007 R1 million would have bought you an initial pension of R3 700 a month. However, despite the recent 0.5 percentage point increase in interest rates, in the current low-interest rate environment, the best pension you can buy for R1 million is R3 208 a month.
* Inappropriate annuity. Anderson says that your choice is mainly between a guaranteed annuity, where a life assurance company bears the risk of paying you a pension for life, and a living annuity, where you take the risk that your investments will generate a pension that will last until you die.
With a guaranteed annuity, your main risk is inflation, so you should choose a product that will ensure your income stays abreast of the inflation rate, Anderson says.
With a living annuity, you take on numerous risks to generate a stable, sustainable income. These risks include:
– An inappropriate investment strategy. For every rand you receive as a pension, it is estimated that 23 cents come from your retirement fund contributions, 36 cents from your pre-retirement investment returns and 41 cents from your post-retirement investment returns, because that is when you have the most capital.
– Emotional investment decisions. Many people make investment decisions based on greed or fear. They switch out of investments when values drop and then buy back in at the top of market cycles. Anderson says that international research has found that irrational switching of investments can cost investors up to three percent of their investment values a year.
– Unsustainable drawdown rates. Many pensioners think they can make up for a shortfall in their savings (capital) by selecting a high drawdown rate.
– Dementia. Anderson says research has found that pensioners can struggle to manage their finances from the age of 75. This exposes them to the risk that people, including family members, will take advantage of them. You should ensure that your financial affairs are in order before your reach 75, and that you have appointed a reliable and trustworthy person to help you manage your affairs.