Pensioners often complain that their pensions don’t keep up with inflation. In fact in the Old Mutual Retirement Monitor in 2013 something like 75 percent of pensioners who have been in retirement for at least five years complained about that.
Let’s examine the causes. Probably the first is that many individuals don’t adjust their budgets to meet their income when they retire. So they continue to live at a certain standard with a lesser pension that may well have Consumer Price Index linked increases each year.
Let’s take the example of a budget of say R15 000 per month and a pension of an after-tax R10 000 per month (That’s a before tax monthly income of R10 850). The first annual Consumer Price Index increase of say 6 percent will increase the pension by R600 per month to R10 600,. To keep up with inflation the R15 000 needs to grow to R15 900 per month but it is only going to be R10 532 after tax. That’s a shortfall of R5 368 every month. This gap widens over time and people dip into their free capital to make up the shortfall. Such dipping in turn reduces their capital and puts them at risk of running out. It also encourages them to keep most of their capital in cash or other short term investments which is probably a bad idea.
Another major cause of the problem is that of not coordinating investments with planning retirement income. Thus a significant portion of many pensioners’ money, both in and outside of living annuities, is invested very conservatively. By that I mean a minimum of money is invested in shares and most of the capital is invested in interest-bearing investments. Yes, you may say, but we are older and we need to be conservative in our investments. Inflation has no respect for even the best rationalisations.
Let’s take the current advertisement for 7.5 percent per year of interest from one of the banks. If inflation is 6 percent per annum and you lived off 5% of the capital your capital should grow by 2.5 percent per year. Considering that inflation is 6 per year that means that your purchasing power is reducing by 3.5 percent each year. Sadly, experience shows that most pensioners live off the full interest earned and experience that problem.
How to get out of those holes?
There are two practical ways out of this trap. The first is to reduce your living standard and the second is to find some way of supplementing your income. Neither is easy but they are vital.
The reason is relatively straightforward. Individuals mostly underprovide for retirement. Much of this is caused by a lack of understanding of what the objectives are and poor planning.
If, for example, one was considering a target income in retirement, of say R25 000 a month before tax one might look at several different rates at which capital converts to income. If income is to be drawn from capital at a rate of 5 percent each year, income of R300 000 before tax would require capital of R6 000 000. If the rate is 4.5 percent R6 666 667 of capital is necessary; and at 4 percent the capital needed would be R7 500 000.
The danger of these flexible arrangements is that it seems easy to just draw a higher percentage of capital to increase your income. But the higher the income that is drawn each year the higher the investment returns that are needed to replace what you draw and provide for inflation.
If you draw an income of 5 percent of capital each year, your costs are 2.5 percent of capital and inflation is say 6 percent per year you will need to earn a return of 7.5 percent per year just to replace what you drew out which looks easy. But that just leaves you with your original capital.
Drawing 5 percent of the same capital in the following year will not provide for inflation in your budget. If you provide for inflation by increasing your percentage draw each year you will start running your capital down. You need to grow your capital by an additional 6 percent each year which brings the annual earnings that you need up to 13.5 percent. (5 percent pension plus 2.5 percent costs plus 6 percent for inflation).
So the less pension that you draw the better your chances are for your pension to keep pace with inflation.
One particular group of advisors recommend a draw of 6.5 percent a year which means that an initial income of R300 000 per annum would only require capital of R4 615 385. For this to work your annual earnings would need to be around 15 percent. You be the judge of what is right here.
So investing your capital at retirement is a major task. Conditions that ruled even five years previously may be different. For example, inflation may be higher, interest rates may be lower, and capital values may be down. It therefore makes good sense to overprovide, if you can afford to and prepare to find a source of income after retirement. Also have a really long look at your standard of living and bring it down as far as possible to maintain a sustainable lifestyle in retirement.
Let’s take Mr Jones who retired last month with R3 600 000 in his fund and another R750 000 in various investments. He estimates that he lived on R40 000 per month after tax, prior to retirement. He takes R500 000 from his retirement fund in cash, because it is tax free and he invests it together with the R750 000 in the 7.5% deposit mentioned above. He has R3 100 000 left to invest in a pension.
If he invests in a living annuity and draws a pension of say 5 percent of the capital his annual pension will be R155 000 per annum before tax. His R1 250 000 invested at 7.5 percent per annum interest yields another R93 750 per annum before tax giving him a maximum possible income of R248 750 before tax. His after tax income is R218 072 (R248 750 less tax of R30 678). That’s R18 172.67 per month after tax to compare with a pre-retirement living standard of R40 000 per month. That’s about 46% of his pre-retirement living standard. Not much fun there.
Even at that level his “pension”, or should we say, retirement income, will have a negligible chance of keeping up with inflation. The 71.26% of income (i.e. the money invested in the living annuity) may keep up with inflation but if costs are high and yields are low it certainly won’t. The remaining portion (28.74%), the income from the money in deposits, has no chance whatsoever of keeping up with inflation if all the interest is used as income.
So the prognosis is poor even if he could live on R18 172 per month. Only the living annuity income has a chance of keeping up with inflation. If the living annuity income grows at 6 percent per year, and the interest income stays level, the total annual increase in pension will be 4.3 percent. To add insult to injury the interest bearing portion is losing buying power every year.
If he does what is also quite common, and supplements his pension by making withdrawals from his deposits to supplement his income he will just run the capital down faster.
Wow! Talk about Cassandra! But that is the position that a growing number of people find themselves in. Clearly the run up to retirement for most people must be about aligning their living standards to what they can afford and looking at ways to supplement their income after retirement. The less income you draw from your own capital, particularly in the early stages of retirement the better off you will be in the later stages.
Saving up to the last day before retirement is worthwhile because a) it increases your savings and, b) by saving more you are reducing your budget, or living standard and possibly preparing yourself for a leaner budget.
Leaving retirement decisions to the last minute can have dire consequences. Trust your common sense and make sure that you understand exactly what you are getting into. You and your family have to live with the consequences, no one else does. Never stop asking penetrating questions.
Dave Crawford CFP®
23rd October 2018.