Why not work out the value of your present living standard before your retirement day? You can compare it to the sustainable income that you can expect from your retirement investments and then approach the job of budgeting for the future with a clear idea of what your financial situation is. Earnings from both members of a couple should always be considered together.
We all think that we know what the value of our standard of living is but seldom quantify it. Because this figure is so important for you to know, we have set out how to calculate your monthly living standard below. It’s important because it sets out the buying power target of your retirement income in today’s Rands.
The reason why you calculate the value of your living standard first is to have a target to aim at.
Your living standard is the value of your income less the following items:
(The value of your income must include all sources of income including salary, rent, interest, fees, dividends, and pensions).
- The income tax you pay;
- Any savings contributions that you make. (Savings include contributions to retirement funds as well as any other savings.); and,
- Any mortgage payments that you make.
Add up the present value of all your retirement investments, including pension, provident, retirement annuity funds, preservation funds, tax-free savings accounts, shares, deposits, and any other savings accounts, which we will refer to as the total retirement capital amount.
The next step is to work out how much sustainable after-tax income you can expect to receive from your investments. By sustainable, we mean an income that will be capable of protecting its own buying power with adequate increases. For this, we must multiply the total retirement capital amount by an annuity rate (a rate at which income can be earned from capital). To this must be added rentals and other income that will continue to be earned after retirement. From this income, the tax must be deducted in order to show the value of the retirement income you would earn if you retired today.
When you compare your after-tax retirement income (as if you retired today) with your living standard, you have a very clear idea of how adequately you are prepared for retirement right NOW!
For example, if you do the calculation today and the value of your living standard is R45 000 per month, while the retirement income you could expect if you retired today was R20 000, you would be 44.44 percent ready for retirement. That’s your retirement readiness score!
Let us assume, for the purpose of the example, that you are 45 years old and plan to retire at age 60. This means that you have 15 years in which to improve your score.
What is important to understand is that it is impossible to project how much more you need to save because you can’t predict either future inflation rates or future investment growth. This is why you need to do this exercise once a year when you can take the following into account:
- How much your salary increased in the last year;
- How much your capital grew over the same period.
If your living standard grew to R48 000 per month and your retirement income grew to R23 500, you will know exactly where you are. Your living standard would have grown by 6.667 percent, your notional pension income by 17.5 percent, and your retirement readiness would have grown to 49 percent (rounded up). That’s improvement. If you can’t measure whether you are improving or not, where does that leave you?
The above method is designed for salaried employees who are or are not members of pension or provident funds.
The problem for entrepreneurs, owners of very small businesses and commission only earners is to figure out how to keep track of their retirement provision. It’s actually easier for entrepreneurs and self-employed people to work out their living standard figure which is the buying power target to be aimed at for retiring.
A budget is not equal to their living standard for most employed people because of things like employers contribution to medical aid. In retirement employees, other than in exceptional circumstances, now have to find the extra income to pay the portion of their medical aid that employers pay, and which often goes unnoticed.
Self employed people are very aware of every cent that they have to pay to maintain their living standard so it’s a process that they understand. Otherwise, all types of income are treated in the same as salaried people doing this calculation. They also are more likely to have lower tax bills.
In determining the income that they would have if they retired immediately (as is done as part of measuring) all retirement capital is included. Where difficulty arises is in how to account for the value of a business that is currently providing a present salary. Can the business be sold just prior to retirement? Can it be sold for a capital amount that will provide an adequate income for retirement?
We have found that the best way of such a self-employed person estimating such retirement income is for him to do two calculations. One to include the value that the owner thinks he could get if he sold the business today and a second one in which a half of the value of the business used in the first exercise is used. This demonstrates the owner’s vulnerability to the value of the business being volatile.
Budgeting for retirement
If your retirement income is much less than your accustomed living standard, you may have challenging decisions to make. Shrinking your living standard to meet your income will be unpalatable in any circumstances but if that is what the situation demands you need to take it seriously. There may be opportunities to earn extra income through additional work; you may have a lucrative hobby; your old employer may suggest that you do contract work for them; or you may find another source of income to make up the gap. This is not a happy situation but one that needs clear thinking. It’s also something that you need to be aware of sooner rather than later.
In November 2019, the Alexander Member Watch produced figures that showed that approximately 6 percent of retirement fund members could expect to retire on a pension of 75 percent or more of their salary at the time of retirement.
Unfortunately, most people elect to keep going as before and hope that everything is going to work out well. Sadly, that is not a winning strategy.
If there is a shortfall of income in retirement compared to your customary living standard, you will need to adapt your budget to the new reality. People are often forced to make substantial changes to their lifestyle. The trick about successful budgeting is to reduce expenses without doing too much damage to your lifestyle.
There is sometimes room to reduce medical aid costs. Unless you have a substantial post-retirement medical aid subsidy from your employer you will now be paying both your old employer's contribution and your own contribution to that medical aid. If you are not allowed to continue on your old employer’s medical aid there may be opportunities to find more affordable medical aids, taking things like hospital plans and gap cover into consideration.
People who have a mortgage outstanding at the time of retirement often want to repay substantial capital amounts. It may be more practical to keep making the regular payments rather than deplete your capital early on.
If you have two or more cars, you can maybe look at the option of possibly scaling down to one car.
Travel is something people dream of doing in retirement. It’s expensive, but if you can provide for even a little travel, no matter how little, it will give you good memories to look back on.
If you move into a retirement village your costs may come down, but you need to research this thoroughly.
Budgeting for a life in retirement with a reduced income is hard. And avoiding spending money is also hard when you have time on your hands. Volunteering can lead to greater things and even jobs, but it also keeps you occupied and engaged which helps keep spending down.
D.L. Crawford CFP ®
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