Comparing this rand value to the after-tax value of the retirement income that you can anticipate from your retirement investments gives you a good guide to what your retirement budget will be and how close it will come to your present living standard.
Is it as simple as that? Not entirely, because your after-tax income in retirement needs to be sustainable in our inflationary environment. This means that your retirement income needs to have the capacity to give you annual increases that should match or beat inflation over the long term.
Therefore, the earning assumptions you use in calculating anticipated retirement income need to be modest. Call them conservative. All retirement investments need to be considered in the light of their characteristics. A general rule of thumb for non-pension investments is generally that you do not draw regular investment income of more than 4 percent of capital to start with. If you have consistent spectacular investment growth over time, this minimum can probably be increased.
You may find tax a little lighter on income that is made up of rent, interest, and dividends, compared to a straight pension, which is taxed as any salary. Annual increases depend entirely on how well your capital can grow, because if you take increasing income amounts from a lump sum that isn’t growing, you will run the capital down sooner. And if you are to combat inflation or at least sustain your chosen lifestyle, you absolutely must have annual increases.
Living annuities need to be managed in exactly the same way. And similarly, annual increases are what protect your capital. Life annuities often offer a higher income than the basic 4 percent suggested for the living annuity. They also offer contractual annual increases which do not affect the length of life of the capital. That’s because, when you sign a contract for one of these pensions, you surrender your capital in exchange for a lifelong income for you and your spouse.
There are several different ways of granting annual increases to guaranteed annuities. All of these systems increase the pension’s minimum guaranteed pension. This means that they are very effective in combatting inflation because the pensions never reduce, and compound interest keeps them growing in value.
Add up your estimate retirement income and deduct the tax that it will incur. The figure that you are left with can then be compared to your living standard so you can see how your retirement living standard will compare to where you are now.
From this, you can review how you want to live and draft your budget. If you compare your after-tax expenditure year on year, you will have a very good idea of what your inflation rate is and how well you are managing it. You can manage it if you have something to compare it to - it’s pure budgeting. At the end of the year, knowing what your last year’s inflation rate was will ensure you have a benchmark of some value.
If, and here’s the problem, inflation is increasing faster than your increases, you may have to adjust your income down in order to afford those increases, and that may mean rethinking some aspects of how you live. As these adjustments are made, remember that cutting medical aid commitments needs very careful thought.
The rule of 72 was first heard of in 1494 when an Italian mathematician called Luca Pacioli wrote about it. This rule allows you to work out how long it will take your money to double if you invest it at a particular interest rate. You divide 72 by the interest rate that you can earn on your money, and the answer will be the number of years that you need to invest your money at that interest rate to double it. For example, investing money at 12 percent per annum will double it in 6 years.
Professor Burton Malkiel, Chemical Bank chairman's professor of economics at Princeton University in his book ‘A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing’ (Tenth Edition) had this to say about the rule of 72.
’A useful rule, called “the rule of 72,” gives you a shortcut way to find out how long it will take to double your money. Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money. For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years).’
In Adam Smith’s book ’The Money Game’, he suggested using the rule of 72 in appreciating the destructive and awful effect of inflation. If you take what you believe the inflation rate percentage to be, and divide it into 72, the answer will be the number of years that it will take for the purchasing power of the rand to lose half of its value. For example; if we divide 72 by an inflation rate of 6 percent per year, we will find that the rand will be worth half in 12 years. And from what I have seen of personal inflation rates they are closer to 9 percent per year. Dividing that into 72 tells us that, at that inflation rate, the rand’s value will halve in eight years.
And finally, if someone tells you that they can double your money in 5 years, you can divide 72 by 5 and it will tell you that they will need to earn 14.4 percent net of costs per year in order to be able to do that job. It’s a neat shut down for a financial blowhard.
The reason that understanding how to measure inflation is so very important is that inflation is changing all the time and so are investment returns. Neither can be predicted but you must keep track of them or you can get into deep trouble.
I have counselled pensioners about this for many years and have found that quite a few don’t pay attention to how much retirement income is sustainable, and what they can afford. They just go on living the way they feel that they are entitled to, even though they cannot afford to. They sometimes have an awful wake-up call when they discover that their capital - whether in a lump sum deposit, share portfolio or living annuity - is diminishing and inflation is forcing their expenses up. They can and do become financially strapped, something that spoils the dream of retirement being the great reward.
D.L. Crawford CFP ®
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