The importance of establishing the cost of your retirement income

Tracy Jensen, Chief Product Architect at 10X Investments.

What is the cost of your retirement? Knowing this number is a critical part of the retirement planning process. If you don’t find out, then you will not be able draw a savings plan that has a high probability of meeting this target, or to monitor your progress, and take corrective action when necessary.

According to Tracy Jensen, Chief Product Architect at 10X Investments, when it comes to financial planning, most people don’t spend enough time understanding how much income they will need in retirement, and how much it will cost, to secure that income.

As a rule, Jensen says that investors should target a retirement income that replaces at least 60% of their last pay check. “You would not need to replace all your income as your house is typically paid off by that stage, you no longer need to contribute to a retirement fund and your children should have left home. Plus your average tax rate will be lower. Alternatively, keep track of your monthly expenses for a few months, to determine your income requirements.”

The more difficult part is determining the lump sum required to fund your desired income, remembering that your income must at least keep pace with inflation. “At a 6% pa inflation rate, the purchasing power of money halves within 12 years. Your lifestyle quickly becomes unaffordable if your income does not keep pace with inflation,” says Jensen.

In determining the cost of your retirement (lump sum needed), you also need to consider your expected retirement age, your gender, and possibly your spouse. “The longer you – or your surviving spouse – expect to draw a retirement income, the bigger the retirement cost, and the more you will need to have saved,” explains Jensen, noting that women generally live longer than men.

“Your retirement goal will also depend on the type of annuity you plan to use in retirement,” Jensen says. “You must decide whether you plan to use a guaranteed or a living annuity, to secure a steady income.”

In comparing the two, she says that a guaranteed annuity provides a pre-determined income that lasts for life. It insures you against the financial risk of living longer than expected. “Depending on the current cost of such an annuity the income it pays may be insufficient to meet your needs.” The cost thereof hinges mainly on your gender, interest rates, whether you want the income to grow with inflation and whether you have a spouse or not.

The alternative, says Jensen, is a living annuity, which allows investors to choose their income, provided it is between 2.5% and 17.5% of the investment balance per year. She warns however that in return for this flexibility, investors bear the risk that their income may drop below the required level, and that their lifestyle will suffer.

The amount of money you need to invest in a living annuity, to fund your required income will depend on how long you – or your surviving spouse – expect to draw this income. But Jensen says that investors also need to consider two other important variables in this case: their portfolio’s asset mix and costs. To do this, they need the help of a reliable living annuity calculator, such as the one found at www.10xcalculator.co.za.

“Such a calculator will guide you as to how much income you can safely draw every year from your living annuity, for the required period, without risking a drop in income. But in doing so, it must factor in your chosen portfolio – either high, medium or low equity – and the level of fees you pay every year. If you plan to invest in a low equity portfolio paying high annual fees, then you will have to save more before retirement, or settle for a lower income thereafter, than if you plan to use a high equity portfolio paying low fees. The higher the net (after fee) returns you earn on your investments post retirement, the longer your savings will last, and the less money you will need to have saved beforehand. You need to factor this into your savings plan.”

Choosing a high equity portfolio in retirement may seem risky, given that such portfolios deliver volatile returns short term. But as Jensen explains, “Given average life expectancies, you are effectively still a long-term investor at retirement, so you can afford to ride out short term market volatility, in exchange for a higher long tern return.”

Jensen says that the retirement planning process should start sooner rather than later. “As a retirement investor, you should estimate your retirement goal early on in your working life, and regularly track your progress towards this goal. Your goal may change over time, which means you may have to adjust your savings plan. With investing, time is your biggest allay. If you have time on your side, then small changes to your savings strategy will have a dramatic impact on your savings outcome. Later in life, you have to make dramatic changes, to effect the outcome you want.”

“The key is to use suitable financial planning tools through-out your working life, to project how much money you will have at retirement, what income this money will afford depending on your choice of annuity, and whether this will suffice to maintain your standard of living. This is simply the best way to manage your retirement planning,” concludes Jensen.