How to minimise liquidity risk in retirement
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By Neal Sinclair
What is liquidity risk in retirement, how does this affect you, and what can you do to mitigate this risk?
Liquidity refers to how easily an investor can sell an asset – for example, a house, shares or unit trusts (collective investments) – for cash, which can then be used to meet either ongoing expenses or an emergency once-off expense. If the asset takes a significant amount of time to sell or the investor makes a loss when selling, this is referred to as liquidity risk.
Liquidity risk needs to be carefully considered in retirement, and here I explore how this could potentially play out.
Let’s consider an example. A client, Joe, has the following income streams and assets: a life annuity, which pays him R40 000 a month; a holiday house in Cape Town valued at R10 million; a rental property in Johannesburg, which generates R10 000 a month in income; and a gold coin collection which Joe believes to be worth R4 million.
Joe recently fell and broke his leg, and while the hospital expenses were covered by his medical aid and some expenses covered by his medical savings account, Joe is going to need to raise an additional R3 000 per month for the next eight months to pay for his rehabilitation expenses.
Joe cannot approach the insurance company for an additional R3 000 from his life annuity, as he opted for a traditional life annuity at retirement. He also cannot realistically adjust the rental amount he receives by 30%.
Joe has assets that he can sell. However, they are not very liquid: the house in Cape Town, for example, would take some time to sell and in addition, he may not want to sell the house just to cover R3 000 for eight months.
Joe then decides to sell some of his coin collection to cover the shortfall in income. He approaches a coin dealer who makes him an offer for a portion of the collection. The offer made by the dealer is significantly lower than what Joe was expecting. He had anticipated receiving at least market price for the coins.
Because of his situation, Joe decides to sell the coins to cover the extra expenses for the eight-month period.
What could Joe have done differently at retirement?
I believe that a retirement income stream needs to consider the potential need for emergency and unforeseen expenses.
A strategy that Joe could have adopted was to split his retirement capital among three or four different products:
First, traditional life annuity would provide longevity protection and certainty for expenses such as medical aid premiums, food and accommodation.
In addition, he could have two or three living annuities. This will allow him more flexibility into the future, giving him the option to transfer one of them to a life annuity, thereby guaranteeing a further portion of his income at a later date.
With a portion of the one-third of his retirement savings that Joe took in cash, he could have placed some funds in either a money market fund or a conservative unit trust to serve as an emergency fund.
Life annuity: Also known as a guaranteed annuity, this is a pension you buy from a life insurance company where you receive a guaranteed income for life.
Living annuity: A pension you buy on an investment platform where you take responsibility for the underlying investments and the level of income you receive. If your capital gets depleted, your income will dry up.
Neal Sinclair is a business development manager at Glacier by Sanlam