One can get very philosophical about the question of how much is enough – it encompasses happiness, well-being, financial independence and the relationship between time and money.
This article will only focus on the financial aspect of this question. In other words, will your retirement savings generate an income that is greater than your expenses when you retire and, importantly, will your savings last until you pass on?
For people using pension, provident or retirement annuity (RA) structures to save for retirement, an investment-linked living annuity (ILLA) with underlying unit trusts is a popular investment vehicle to use in the retirement process.
Data from the Association for Saving and Investment South Africa (Asisa) suggests the preference for ILLAs as opposed to more traditional life annuities to be as high as 90%. When using this type of vehicle, it is however important the retiree understands the following important concepts:
- Income drawdown rate:
In terms of legislation, an ILLA holder may withdraw an annual income of between 2.5% and 17.5% of the residual retirement savings capital. Research however indicates that a retiree should not withdraw more than 5% of their retirement savings capital per year.
It is important that retirees (together with their financial advisers) select income levels that would be sustainable for the rest of their lives. These income levels need to be maintained relative to the investment return of the savings capital.
As an example: According to guidelines from Asisa, a retiree whose investment growth is 7.5% and draws an income of 5% per year can expect to maintain a real level of income for 19 years, after which the retirement savings will erode rapidly.
- Investment growth rate:
Even though past performance is not a guarantee of future performance, using stable funds from the bigger asset managers in South Africa, retirees can expect an annual growth rate of 10% (after the fund manager’s fee). The cost associated with ILLA has a massive impact on the actual returns of the investment. At Vista Wealth Management, we feel the following annual fees associated with an ILLA is acceptable: Administrator platform fees of not more than 0.5%; unit trust manager fees of not more than 2%; and financial adviser fees of not more than 1%.
- Income growth rate:
Often retirees do not take inflation and the impact it has on the power of their money into account. In their planning with their financial adviser, retirees should increase their income annually with at least inflation as this will ensure they will maintain a real level of income. At Vista Wealth Management we use an inflation rate of 6% in our retirement planning as that is the higher end of the Reserve Bank’s inflation target rate.
Putting it all together
To illustrate retirement savings capital and monthly income, let’s use the example of a retiree with R10m retirement savings from age 60 to 95. The retiree’s drawdown (income) in the first year is 4%, which then grows by 6% per year. It makes use of two investment growth scenarios to illustrate how the retirement savings capital erodes if the investment growth (after fees) is 8% as opposed to 10%.
With the 8% growth scenario the retirement savings grew for 23 years (between the ages of 60 and 83) while the retiree was drawing an income. At age 84, the retirement capital stopped growing as the retiree started using portions of the capital as income. From that point, it only took 11 years (between the ages of 84 and 95) to erode the retirement savings capital in total.
In the 10% growth scenario, the retirement savings kept on growing while the retiree was drawing an income.
This example illustrates the importance of selecting the correct underlying investments. It shows how quickly the retirement savings capital erodes if your investment is not growing at the required rate. It also shows the danger of using your retirement savings capital as income and how quickly you can run out of capital once you start doing this.
So how much is enough?
It is important to note that in both scenarios the retiree was drawing the same amount of income monthly. A 60-year-old retiree with R10m of retirement savings can expect a monthly income of about R33 000 (before tax) with a 4% drawdown in the first year of retirement. This income will grow with inflation (6% per year in this example) until the age of 95. If the retiree only had R5m retirement savings, they can halve this expected income, or if the retiree had R20m retirement savings he can double this income amount to get to the applicable monthly income (before tax).
An easy way for younger readers to associate with the above amounts is to think about their current monthly expenses and then select the capital amount that would be required to provide that level of income if they had to retire today. Quite scary, but that is a good indication of how much is enough.
Magnus de Wet is a director at Vista Wealth Management, a representative under supervision of Accredinet Financial Solutions. Visit Vista Wealth's website here.
This is a shortened version of an article that originally appeared in the 18 August edition of finweek. Buy and download the magazine here.