The key financial risks you will face during retirement are outliving your capital and inflation eroding the buying power of your money. It is important to take an honest look at your financial situation and formulate a plan, which will ensure that your money lasts during retirement.
Keeping up to speed with the latest investment news will always help in making informed progress. Aside from that here are five decisions you will have to make to guarantee that your money lasts:
- Living or guaranteed annuity?
You don’t have to choose between a living and guaranteed annuity. Depending on your circumstances, you may find that combining the two satisfies your requirements.
A guaranteed annuity insures you against the risk of living too long. You are paid a pre-determined sum for the rest of your life. Your income is determined by the current interest rate and your age. If you are older (and have a shorter life expectancy) then it’s more likely that you’ll receive a higher income. Guaranteed annuities are not transferrable to living annuities and usually make no provisions for an inheritance. They eliminate the risk of making unsuitable investment decisions and also protect you from drawing too much income during retirement (especially early on). The terms are set once the annuity is purchased and there is no flexibility.
You have more flexibility with living annuities. They allow you to set your income (within the legal limits) and choose the underlying investments. You can receive less income early on, allowing your capital to grow and you can leave capital behind as an inheritance. They are highly flexible, but you can outlive your saving and/or be hurt by a falling market. Choosing a living annuity requires that there is no disconnection between your expectations, your portfolio construction and the income you draw.
- Choosing an appropriate drawdown rate
When investing in a living annuity, you will be faced with an important decision: What income do you require to live comfortably? This is known as your drawdown rate. Drawdown rates are constrained by the legal limits between 2.5% – 17.5%.
Research, conducted by William Bengen (US financial advisor), suggests a drawdown rate of 4% and this has since become a rule of thumb. Bengen suggests that, starting at the end of the first year of your retirement, you withdraw 4% of your capital. You then decrease or increase the absolute cash value of the withdrawal by inflation each year.
The latest research suggests that 4% may not be enough to fund most living annuitants’ lifestyles. In other words, they simply haven’t saved enough.
Everybody has unique needs and goals. If you’re faced with any uncertainty then the best thing to do is visit an independent financial advisor.
- Choosing your asset allocation
Asset allocation is of particular importance to living annuities. It influences your investment growth, how long it lasts and your standard of living. Therefore careful asset allocation is essential to making the most out of your savings. Bengen suggests that one should maintain a minimum of 50% of the allocation to equities. Many investors tend towards the conservative stance. Longer lifespans mean that at least a portion of you savings should be positioned for growth.
- Take inflation into account
Protecting the buying power of your money is very important. You would require a minimum return of 9% a year, assuming inflation sits at 5% and you draw an income of 4%/year, to protect your money’s buying power. Your capital would decay for anything less than that.
The reality is that a large portion of your investment’s return compensates for inflation. Never underestimate the negative effects of inflation. This is particularly true when inflation is high and interest rates are low. You may find that inflation has eroded the seemingly secure fixed interest you receive on cash and bonds.
- Increasing your withdrawal rate
Be sure that you understand the risks associated with increasing the percentage of your annual income during retirement.
Bengen’s research shows that if one maintains a 50% asset allocation in equities, a drawdown of 4% and only annually adjusts by inflation, then you will enjoy (in nearly all circumstances) an income for at least 30 years.
A drawdown rate of 4% is sustainable for most scenarios. A rate of 5% would not last 30 years for one third of the scenarios considered. In order for the 4% rule to hold, one needs to increase annual withdrawals by inflation alone and rebalance annually.