Will my money last?
That’s the burning question many pensioners have in the back of their minds. With increased longevity many face the prospect of running out of money before they run out of life. If one considers a retirement age of 65 and a life expectancy of somewhere around 90 (it differs slightly for men vs women, but let’s keep it simple), it means that you need to have enough money to last 35 years or so post retirement! And if you started working somewhere around the age of 20, in 45 years of working, you would have needed to accumulate enough money to financially support yourself for another 35 years post retirement.
It’s a complex problem, and the truth is that many (if not most) people simply do not have enough capital at retirement. And the investment decisions that you make at retirement will remain with you for many years.
How does the process work?
You have an amount of capital that needs to be invested to generate an income. This capital or money could be compulsory (meaning that it comes from a retirement funding vehicle – pension fund or retirement annuity) or it is discretionary (meaning that it is the result of savings that you have accumulated).
With compulsory money, you need to invest it either in a life annuity or a living annuity. A life annuity is a policy with an insurer, and they guarantee to pay you out a predetermined amount each month. The insurer carries the risk as they contractually undertake to pay you a set amount until death.
There are options here which include having this annuity guaranteed for a period of time, paid until the death of the last living spouse, include annual increases, etc. This income is taxed according to the individual income tax tables.
While this is the ‘safest’ way to ensure that you will always be paid an income until your death, many people do not opt for his because their capital is too low to provide a livable income. They rather opt for a living annuity where they have control over how much income they take, as well as where their money is invested.
With a living annuity, the risk is entirely on the investor as the lump sum grows according to where it is invested, and the income is offset against this. So if the investment performs poorly or the investor draws too large a percentage of capital, the money could be depleted way before death, leaving the pensioner destitute.
Investors are allowed to withdraw between 2,5% and 17,5% of the capital amount per year. This can be taken annually, or monthly and the percentage is revised every year.
So if you have a living annuity, it’s a delicate balance between the investment growth and the amount you are withdrawing. This will determine whether you will in fact have enough money till your death. The same principles apply for discretionary money – if you invested this and drew a regular income, the same two variables will determine how long your capital would last. The only difference is that with discretionary money, you could invest it in a unit trust fund or market linked investment, and make regular withdrawals, and not be bound to the restriction of a maximum of 17,5%.
For simplicity sake, let’s ignore tax and costs and look at how long a set amount of capital will last. There are two variables that affect the issue:
- The income that you withdraw (also called the ‘drawdown rate’) – this you have control over
- The return on your investment – this is out of your hands although you can switch to different funds if the investment is not performing well, but you have little control over how well your investment will perform.
So let’s take a real life example, and look at how these two variables impact on the question at hand. Let’s assume a man, aged 65 with a capital amount of R2,000,000. He needs an income of R20,000 per month. How long will his capital last?
If he starts out with R20,000 per month and increases his income by 6% per annum to keep pace with inflation, and his investment grows at 10% per annum on average, his money will last 10 years. If the investment grows at 12%, it will last 11 years.
If he reduces his annual increases to 3%, and the investment grows at 10%, it will last 12 years and if it grows at 12%, it will last 15 years.
This is a very simplistic illustration and ignores tax and investment costs, but illustrates the point vividly that the issue of having too little capital to sustain a lifestyle is a huge problem. If one assumes a 10% growth rate (which is fair), and he took a smaller income, let’s say R15,000 per month, from the start, takes a 6% annual increase, his money would last 14 years.
If he started out with a lower income of R12,000, and takes a 6% annual increase, his money would last 20 years.
If he started with an even lower initial income of R9,500, his money would last 30 years. So the less he takes as an income from the outset, the longer his capital will last.
It’s often a difficult concept to understand, as these types of investments are unit based and the value of the investment is determined by how many units there are and what the unit price cost is (i.e. units X unit price). As the regular withdrawals are made, units are sold to provide the cash, so in effect the number of units decreases over time. If the unit price increases at around the same rate as the withdrawal, the capital may last the lifetime.
This is the great risk with living annuities or market linked investments – withdrawing too much from the outset. The thing is, though, that once you are at retirement, there is little you can do about how much capital you have. It’s no use crying over spilt milk. What one can do, though, is look to generate additional income. Draw as little as possible and supplement this with additional income. Reskill yourself – look for freelance work – the world of freelancing and virtual employment has burgeoned over the past years. Work as long as you can – even if it’s only part time – to reduce the pressure on your capital, and make it last as long as you possibly can.