Understanding the (rising) cost of retirement
01 October 2012 | Magazine Archives FAnews & FAnuus | Life | Jason Sharp, Paramount Life
Financial commentators frequently discuss the need for retirees to manage expenses more efficiently through retirement. Their concern centres on the retiree’s inability to generate new income streams in an uncertain retirement environment...
Balancing the retirement budget is complicated by the unknown duration of retirement as well as uncertainties over inflation and investment returns on retirement capital. Particular consideration needs to be given to essential or so-called "must have” expenses.
Ensuring adequate capital
It is important for financial advisers to understand the expected capital required to fund these expenses as well as whether the payment of these expenses can be guaranteed. In ascertaining the quantum of capital that needs to be allocated to funding expenses, four key questions need to be asked.
QUESTION 1: What is the retiree’s age and gender?
? The average female’s life expectancy is longer than that of an average male of the same age.
For a 65 year old, The capital required today to guarantee a lifetime of expense payments (assuming average annual inflation of 6%) is 10% greater for female retirees. This differential increases if the expected inflation is higher.
? The older you are the shorter your life expectancy.
What this means is that older retirees require less capital today to cover their expense payments for life. To pay R10 000 monthly, increasing by 6% per annum for life, a healthy 60 year old would need approximately 65% more capital than a 75 year old.
QUESTION 2: What is the retiree’s health and lifestyle situation?
? Healthy clients have a longer life expectancy than clients who have medical conditions.
For a 65 year old male, moderate bad health can result in the capital required reducing by 22% while a serious health diagnosis can reduce the capital requirement by as much as 85%.
? A client’s life expectancy varies based on occupation and income levels.
A manual occupation (or lower income) reduces the expected cost of a retiree’s future expenses. A 65 year old construction worker would need 22% less capital for the same expense when compared to an accountant of the same age assuming expense inflation of 6%.
? If you have never smoked then you have a longer life expectancy than a person of the same age who has quit smoking or is currently smoking.
A 65 year old smoker would need 16% less capital for the same expenses when compared to a non-smoker of the same age. In fact the question can be extended to ask whether a client has quit smoking. If the client has quit smoking within five years then the capital required will reduce.
QUESTION 3: What is the expected annual expense inflation?
? High expense inflation means more capital is required
When considering a 65 year old male, a 5% annual increase as opposed to a level expense means an additional cost of more than 55%. If expense inflation climbs to 10% that would mean more than 80% additional capital would be required. The additional capital required for retirement increases exponentially as inflation increases.
QUESTION 4: For whom the expense needs to be paid?
? Consider all the lives for whom the retirement expense will be paid.
If a retiree needs to take account of paying an expense until the later of his/her death and the death of a spouse of the same age, the capital cost of the expenses can increase by 25%. This increases to 33% if the age difference is four years and to almost 50% if the age difference is 10 years.
The ultimate solution
The above situations are best provided for through the use of a guaranteed annuity. Guaranteed annuities, and in particular underwritten annuities, allow financial advisers a tool with which to accurately illustrate to clients the potential capital cost of specific expenses.
This may translate into a combination of a guaranteed annuity and discretionary/living annuity investments at retirement, ensuring that a client’s ability to pay expenses is guaranteed without sacrificing the potential upside from market linked investments.
