Financial Planning for Dummies – Part 3
The first article in the “financial planning for dummies” series identified the 5 most common risks people face, namely:
- Dying too soon and leaving debt or dependents.
- Living too long (insufficient funds on which to retire).
- Disability (over a short or extended period).
- Funds for short term emergencies.
- Debt!
This article looks at the second of these risks; Living too long – the risk here is that of outliving your funds.
From a financial planning point of view, one of the major risks that people face is living too long. This may seem an odd thing to tell someone in the prime of their life, but very few* South Africans will retire financially independent. In fact, by far the majority will be dependent on either the state or their families because they will have failed to make adequate provision (not a pleasant thought given that the state old age pension is currently ±R1010 per month).
Add to this the fact that the number of people living beyond 100 years is now doubling every 18 months and that children born in the 90’s and 2000’s have life expectancies in excess of 120 years** and it is possible that you could be retired significantly longer than you ever worked. So just how much will you need in order to retire financially independent?
There is little rocket science involved here. Remember the power of compounding; so the sooner you start saving for your retirement the better (even if it is in the very distant future). In order to determine the capital lump sum you will need at retirement you will need to determine your (equivalent) income at retirement. This is a simple future value calculation and is dependent on your current income and inflation over the period. The future income value will allow you to determine the capital required. The longer the period to retirement, the greater the effect of changing inflation and investment returns over the period so you should review these figures on a regular (annual) basis.
A seemingly insignificant 1% difference in the rate of inflation over a 20 year period can result in 22% more capital being required at retirement, while a 2% difference in the rate could mean a 49% increase in the capital required. An annual inflation rate of 6% (the upper limit of the current inflation target for SA) will mean that a current monthly income of R10000 will equate to just over R33000 in 20 years time. This will increase to just under R50000 per month if inflation is 8% per annum over the period (see table below). It is not difficult to see therefore, why every investor needs to outperform inflation.#
Current Monthly Income Needed R10 000 R10 000 R10 000
Years until Retirement 20 20 20
Assumed Inflation Rate % p/a 6% 8% 10%
Mnthly Inc Needed at Retirement R33 102 R49 268 R73 281
The scope of this article does not allow for specifics, but assuming you were to retire in 20 years time on an income equivalent to R10000 pm today (8% inflation) you would require a capital lump sum in the region of R11.8 million rand to fund a monthly income equivalent to your current income need of R10000. (This depends on the type of annuity that is purchased of course.)
Cap Required (inc draw represents 5%) R7 944 491 R11 824 327 R17 587 377
This is a lot of money so just how do you get there?
In South Africa, there are essentially 3 pre-retirement vehicles available; pension and provident funds for employees, and retirement annuities for the self employed and employees with non-retirement funding income such as commission. Apart from the obvious things like the tax incentives, retirement funds also have many associated legislative benefits which specify how and by whom the funds may be used. Chances are that if you work for a company that you belong to the pension/provident fund. If this is the case then unless you are a commission earner you will have a very limited ability to use a retirement annuity from a tax efficiency point of view and you should consider other investment vehicles such as unit trusts and exchange traded funds to supplement your investments.
So how do you go about planning for your retirement?
For starters you need a financial plan. Financial planning is a process and not an event and your plan should be reviewed annually (at least). While financial planning is not as complicated as some would have us believe and many people have successfully planned for their retirement themselves, there are definite advantages to working with a financial planner. Just be sure that you are working with a financial planner that is not just dependent on selling products to you but who can provide you with objective (independent) advice for which you should be prepared to pay if necessary.
One of the mistakes many people make is that they assume their income requirements will decline significantly in their retirement years. The evidence suggests that the opposite is in fact true and a good financial planner should be able to help you identify as well as quantify what your expenses are likely to be. Many advisors/planners are using complex models – make sure that you understand the output and ask questions about anything you don’t understand.
The planner should also be able to advise you as to the appropriate asset allocation (split between the various asset classes) given your time frame and your required rate of return and should also serve as your coach when you are tempted to make those emotional decisions like moving everything into cash because the markets have fallen.
For those of you that have not yet started planning or saving for retirement, start now. It is never too late! For those with 10 or more years to retirement – capital growth should still be your primary aim. For those with shorter period to retirement, capital growth and preservation should be your primary goals.
In the next article I will look at Retirement Annuities as a retirement savings vehicle.
Remember, if you have concerns about your finances or financial positions, you should be speaking to your financial planner.
*the stats are quite vague around this issue, I have seen figures as lows as 5-6%; suffice to say that by far the majority of South Africans will not retire financially independent.
**I remember hearing this at a conference but could not find the source
# typcially cash does not outperform inflation over time