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Do you really have enough to retire?

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CAPE TOWN – Anyone saving for retirement is at some point going to start asking: ‘do I have enough yet’? After all, the whole reason for building up your retirement capital is so that you can eventually put it to use.

The problem, however, is that nobody actually knows the answer. It is impossible to know exactly how much you will need, because there are three variables in play that nobody can predict: how long you will live, what inflation will be in the future, and what return you will earn on your investments.

The best anyone can do, and good financial planners should tell you this, is make an educated guess. There are broad ranges and guidelines that can be used to give you some idea of what should be enough.

The 4% rule

The most commonly used calculation is the 4% rule. This was first established by financial planner William Bengen 20 years ago.

Using a portfolio that was split 50-50 into US stocks and bonds, Bengen ran a number of calculations using historical data to work out how much of a person’s retirement capital they could safely withdraw every year if they wanted it to last at least 30 years. He worked out that for 95% of the time, an initial withdrawal rate of 4% adjusted every year for inflation would have lasted.

So what does that mean in practice? If you stuck to the 4% rule, how much retirement capital would you need? 

The below table shows the starting monthly income you would receive from different capital amounts if you retired now. 

 

Retirement capitalMonthly income
R1 000 000R3 333
R2 000 000R6 667
R3 000 000R10 000
R5 000 000R16 667
R7 500 000R25 000
R10 000 000R33 333
R12 500 000R41 667
R15 000 000R50 000
R20 000 000R66 667

 

Income replacement ratio

Most financial planning works on the assumption that you will not need the same monthly income after you retire as you are earning when you are still working. In South Africa, generally it is assumed that you will need to replace 75% of your income.

This is probably something that is not scrutinised closely enough. If you are currently earning R20 000 a month, is R15 000 a month going to be enough just because you are retired?

Certain expenses may be lower certainly, but you still have fixed costs like water, electricity and medical aid that don’t get any cheaper just because you aren’t working any more. A 75% replacement ratio might work for much larger salaries where these fixed costs make up a lower percentage of the whole, but it’s a lot more difficult lower down the scale.

A number of financial planners are rather proposing that we should be working on at least a 90% replacement ratio. If we can achieve that, we can assume that we will be in a good position to maintain our standard of living into retirement.

Putting that into figures, to achieve a 100% replacement ratio, you would need to have saved 25 times your final annual salary if you stick to the 4% rule. For a 90% replacement ratio, you would need to have saved 22.5 times you annual salary.

These numbers are far higher than the 12 times or 16 times your final annual salary that you often hear bandied about. If you stick to the 4% rule, having retirement capital of 12 times your annual salary will actually only give you a replacement ratio 48%.

The below table illustrates the capital you need to have saved to match up with your current salary:

 

Current monthly salaryCurrent annual salaryCapital required for 100% replacementCapital required for 90% replacementCapital required for 75% replacement
R10 000R120 000R3 000 000R2 700 000R2 250 000
R15 000R180 000R4 500 000R4 050 000R3 375 000
R20 000R240 000R6 000 000R5 400 000R4 500 000
R30 000R360 000R9 000 000R8 100 000R6 725 000
R40 000R480 000R12 000 000R10 800 000R9 000 000

 

These numbers are probably quite sobering to many people. It is unfortunately true that the majority of us underestimate how much we will actually need.

That being the case, rather than asking how much you will need, the more relevant question may be how much you can get with what you have. Next week we’ll look at different scenarios that illustrate how long different amounts will last at various withdrawal rates, in different inflation environments, and at different rates of return.

Retirement savings: how far can you get with what you have?

Last week we looked at the amount of capital you would need to retire at your current level of income. Using the 4% rule, you would need to have accumulated 25 times your final annual salary if you wanted a 100% replacement rate.

The truth is that very few people will actually have saved that much. So perhaps the more necessary question to ask is how much you can get with what you have.

Calculating this is something of a best-guess exercise, because it involves making assumptions about the future. We cannot know what inflation will do over the long term, and we also cannot know what returns you can expect on your investments.

Markets also don’t move in straight lines, and when they go down or up could have a significant influence on long term performance. Big market movements in the early years of your retirement in particular can have a significant impact.

For instance, if you retire with R5 million and in the first six months the stock market falls 40% which results in you losing 20% of your capital, suddenly you are really only retiring with R4 million.

It is still however possible to put some general guidelines in place that will help those entering retirement to understand how much they can reasonably draw from what they have.

Once again we will start with the 4% rule, which says that you should start with an annual income equal to 4% of your capital. Every year after that, you should adjust your income upwards for inflation.

If you are able to earn a steady 8% return on your capital and your annual increase to your income is 6%, your money will last 37 years and 9 months at this rate. In other words, if you are able to live on a 4% draw down you can invest in a pretty conservative portfolio, and be fairly confident that your money will last.

However, if inflation is higher, the picture changes. The below table illustrates how long a 4% initial draw down, adjusted for inflation every year, would last in different inflation scenarios, if investment returns stayed at 8%.

 

Estimated time retirement capital would last
Initial withdrawal rateInflationInvestment returnsPeriod
4%7%8%31 years, 3 months
4%8%8%27 years, 2 months

 

This really shows two things. The first is what a significant impact inflation can have on how far your money will go. A 2% increase in inflation over your retirement, will cut 10 years off how long your money lasts.

Of course you may choose to mitigate against this by deciding at the start to only ever increase your annual income by 6%. That will make things slightly more predictable. But if inflation does stay higher over a long period, your purchasing power will be eroded.

The second point to make is that a conservative 4% draw down at the start will still see your capital lasting for a fairly long time, even if inflation does surprise on the high side. Earning 8% on your money should not be too onerous. The average annual return of local trusts in the multi asset income category over the last ten years has been 8.16%.

That 4% withdrawal rate might, however, not be enough for many people. To sustain their standard of living, they might have to start at a higher number.

The below table shows how long retirement capital would last at a draw down rate that starts at 5%, in different inflation and different investment return scenarios.

 

Estimated time retirement capital would last
Initial withdrawal rateInflationInvestment returnsPeriod
5%6%8%27 years, 5 months
5%6%10%> 40 years
5%7%8%24 years
5%7%10%34 years, 2 months
5%8%8%21 years, 7 months
5%8%10%28 years, 4 months

 

What this shows is that if inflation stays at 6%, an annual income starting at 5% of your retirement capital is probably still manageable. Over the last ten years, the average return of unit trusts in the local multi asset low equity category has been 10.06%.

In other words, it is possible to secure that return without taking on too much risk.

If however, inflation were to average 8% and you remained invested in a more conservative portfolio, a 5% starting rate might cut your capital’s lifetime to just over 21 and a half years. If you retired at 60, that would mean it would be gone by your 82nd birthday.

What happens, however, if you need to withdraw much more? To illustrate this, let’s presume retirement capital of R2 million. What percentage would you have to draw off that in the first year to reach a certain level of income?

 

Starting income from R2 million retirement capital
Initial withdrawal rateMonthly income
4%R6 666
5%R8 333
6%R10 000
8%R13 333
10%R16 666
12%R20 000

 

A monthly income of R10 000 off R2 million might not sound like much, but R120 000 a year is a fairly substantial chunk of money to replace. At an 8% investment return and 6% inflation, it would take only 8 years before you were withdrawing more every year than you were able to earn. It would however still take 21 years for your money to deplete completely.

When you start to withdraw higher initial numbers however, the investment returns you need to earn to secure your capital for the long term start becoming more difficult to obtain. The below table shows how long your capital would last, keeping inflation at 6%.

 

Estimated time retirement capital would last
Initial withdrawal rateInflationInvestment returnsPeriod
8%6%8%15 years, 2 months
8%6%10%18 years, 7 months
8%6%12%25 years, 8 months
10%6%8%11 years, 10 months
10%6%10%13 years, 7 months
10%6%12%16 years, 5 months
12%6%8%9 years, 8 months
12%6%10%10 years, 9 months
12%6%12%12 years, 4 months
12%6%15%17 years

 

Over the last ten years, the average return of unit trusts in the multi asset high equity category has been 13.51%. Over the same period, the average fund in the general equity category returned 15.74%.

In other words, to earn returns in that ball park you will have to take on a lot more risk, and that naturally means more volatility. And as mentioned earlier, that volatility can cause even bigger problems.

What any person entering retirement needs to do is balance their income needs with what they can realistically withdraw without compromising their capital over the long term. That means both withdrawing a sustainable income and not taking on too much investment risk. If you don’t follow that path, you could well run out of money.

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