You may have money in a pension fund, a provident fund, and maybe one or two retirement annuities, not to mention other investments such as a share account, an endowment policy, unit trusts and big deposits with a bank. In addition, you may also have a cottage that you rent out to students, for example.
Any decisions that you make at retirement need to take to take all your different investments into account in trying to get yourself the best sustainable income possible. I harp on the word ‘sustainable’ because in investment parlance it has come to mean an income that can keep its buying power into the future. After all, what point is there in any source of income that gets worth less and less as time passes?
There are several distinct categories of investment and you have quite a few options as to how to use them for your benefit.
We start with investing pension, provident and retirement annuity money for income in retirement. In investing money from these sources, we find there are two types of capital:
- Discretionary; and
- Non-discretionary.
Retirement funds contain both but they need some explanation.
Discretionary capital: When you retire, you may withdraw up to one third of the value of the value of your pension and retirement annuity funds and the full amount of a provident fund in cash. There may be tax to pay on these amounts or there may not. The retirement funds will deduct any tax payable and whatever you get after that is called discretionary capital. In other words, you can invest it wherever you want to. This is exactly the same for any other savings that you may have. If you take money out of a savings account, you can use that to invest in anything you choose.
Please note, however, that you do not have to take the full one third in cash from pension and retirement annuity funds. You can leave all the money in those funds and invest the entire amount in a pension for life. Provident funds have just had their structure changed but anyone who was 55 years of age or older on the 1st of March 2021, could still take all the money in the fund in cash when he or she retired. This amount may be taxed but there is no legal requirement to invest any of it in a pension for life.
Anyone who was younger than 55 years of age on the 1st of March 2021 is able to take all the money saved in the provident fund up to that date out in cash. Any money contributed after that date is regarded as having been invested in a pension fund.
Non-Discretionary capital: At least two thirds of the money in a retiree’s pension and retirement annuity funds must, by law, be invested in a pension for life. Any portion of a provident fund can be invested in an annuity for life.
There are two main categories of pensions for life. The technical name is annuity. They have been discussed at length in Essay 3
This leaves at least two thirds of the full proceeds to be invested in annuities to provide an income for the pensioner and the spouse or partner. It is worthwhile mentioning that if you take one third of the proceeds of a pension fund in cash, the remaining two thirds will provide less pension income in retirement..
Annuity products are available in two varieties.
- The Conventional Guaranteed Annuity;
- The Living Annuity;,
- Or a combination of both.
These products serve different needs.
Discretionary capital: How do you invest discretionary capital for income in retirement?
The financial products that you can invest in seem limitless.
- Tax-free savings accounts;
- Shares;
- Properties;
- Government bonds;
- Deposits;
- Debentures
- Unit trusts;
- Exchange traded funds;
- Preference shares
- Endowment policies;
- And many more.
Income can be produced in the following forms:
- Interest;
- Rents;
- Dividends;
And these investments need management. And this requires managing both income and capital.
For example: if you decide to take an annual income of 10 percent from a capital amount of R1 million, you will draw an income of R100 000 for that year. If you can earn 10 percent interest on that money for that year for that year you will have your R1m at the end of the year. The problem is that thanks to inflation you actually need a higher income in the following year. This means that you either start to dig into capital to support your lifestyle or you find an investment that pays a better income than 10 percent per year. These are difficult to find and this is why older people often get scammed by being offered impossibly high interest rates.
If you can find capital growth that makes up the difference then you are fine but higher capital growth often carries more risk than more modest returns and this is where scammers also operate with great success amongst older retired people.
Lets look at an example: I have free capital of say R1 000 000 and want to draw an income of R10 000 every month. But I can only earn 7 percent interest on my investment. That means I earn R70 000 in the first year and withdraw R50 000 of my capital to make up the shortfall.
This shrinks the capital and in the following year I will need to increase the total amount that I draw in order to protect my living standard from inflation. So I start a vicious circle of my capital shrinking as I have to draw from it. In this example if I can earn 7 percent per year in interest and inflation is 5 percent per year my capital will run out in somewhere between 10 and 11 years. That’s a huge problem as we are living longer on average.
So while you are free to invest wherever you want, there is a useful rule of thumb which tells us that: the more income you withdraw from a lump sum investment, the harder it is to keep your capital growing each year. And growing your capital is vital. Because none of us know how long we will live, we have no idea of how long our capital must last. And that is where the management comes in.
Most investment managers believe that a sustainable annual rate at which to withdraw income from capital is around 4.5%. With 5% inflation and 2.5% costs, this requires investment earnings of 12.9% per annum to keep your capital growing and to protect the buying power of the income you draw.
Bearing the above in mind, you have the following investments to considering investing in:
- Tax-free savings accounts;
- Shares;
- Properties;
- Unit trusts
- Exchange traded funds
- Government bonds;
You can invest in these individually or as part of packaged combinations, called portfolios. There are many of these portfolios offering a very wide range of combinations, some specialising in income producing investments, some specialising in capital growth, and others balancing both aspects. Both actively managed and index tracking portfolios are available and it is worth your while to do your homework on all of them.
Investment portfolios are available as:
- Actively managed unit trusts and exchange traded funds;
- Index tracking unit trusts and exchange traded funds;
- Combinations of the above in what are called multi-manager portfolios;
- Property unit trusts;
- Investment insurance policies both within South Africa and offshore;
- Investment portfolios managed by investment managers;
The choices seem bewildering because they are so many and varied. But the big deal is to plan for income AND capital growth. Remember, if the investments you have are working well, don’t change unless you have very good reasons.
There are financial advisors who can help you make sense of the options, but there is no substitute for a second opinion.
A last word is that it is difficult to assess the price you pay for your investments as these are percentages of capital. I have noticed a trend lately where financial services people tend to downplay the costs of service. Keep in mind that costs are one of the first things to look at and not the last.
D.L. Crawford ®
OUTvest is an authorised FSP. All investments are exposed to risk, not guaranteed and dependent on the performance of the underlying assets. Ts and Cs apply.