By: Andrew Duvenage – NFB Financial Services Group
In the course of discussions, a question that regularly gets asked by clients close to or around retirement age is around what amount of capital one needs to retire. That in itself is an impossible question to answer, as the size of a capital base doesn’t take into account one’s income needs, and these vary based on individual circumstances and lifestyle decisions. There is no magical number that can be used as a blanket retirement capital target.
A more pertinent question though can be framed around how much income a capital base can generate and for how long. If investors have a realistic understanding of how much income a capital base can generate (either on a sustainable or on a draw down basis), it is possible to understand what sort of capital base will be required to generate the income level that they require in retirement. There are a number of issues that need to be considered and are worth discussing.
We’re living longer
The first issue, and probably the most daunting is the issue of longevity. How long do we need to provide for? With medical advances and lifestyle changes, the reality is that people are living longer. Without the certainty of knowing the period that one is planning for, and given that as life expectancies increase, the time period part of the equation is a major issue and effectively a moving target. It would be fair to say that very few investors wish to outlive their capital and become a burden on their families or the state. As such, while tempting to project drawings for a period of time (say to the age of 85, 90 or 100), a more prudent starting point would be to calculate a drawing rate based on the assumption that one does not want to touch capital, rather living of returns generated by investments. This is known as a sustainable drawing – a rate that will allow the investment to continue to grow in line with inflation, which is the next issue that requires some understanding.
The elephant in the room: Inflation and drawings
The key with a sustainable drawing is that the capital base should continue to grow by at least the rate of inflation AFTER all of the drawings have been deducted. This ensures that the value of the capital retains its value in today’s terms. Importantly what this means is that as a result of the capital base growing in line with inflation is that the income that one draws from the capital base will increase in line with inflation without an actual increase in the drawing rate. The question that one should ask at this point is what does one use for inflation into the future. This in itself is a topic that one could dedicate a SARB meeting or two to! Many people believe that CPI understates the inflation that we as investors and consumers seem to feel at petrol pumps, in medical aid increase, and at the check-out counters. A useful way of looking at future inflation is to calculate implied future break even inflation rates by comparing the yield of long dated nominal bonds with long dated inflation linked bonds (ILBs). The difference between these types of bonds provides an indication as to the markets long term expectation of future inflation. As it currently sits, using 2023 to 2025 nominal and ILBs, the implied inflation rate is well over 7% (spiking drastically recently from 7.08% as a result of the last weeks well documented events). While beyond the SARB upper inflation target of 6%, we feel that 7% is a reasonable long term input for inflation into a sustainable drawing model.
Looking into a crystal ball: Expected future returns
The next issue is equally complex: expected future investment returns. In a low interest rate environment (as we are currently seeing), assets that provide guaranteed or highly certain returns typically provide returns that are relatively low, and often involve the surrender of capital on death. (Although a separate discussion, we warn investors to be careful when considering products that offer unbelievably high “guaranteed”/”low risk” returns. In the current interest rate environment, high yield is unequivocally a function of high risk – please be careful and sceptical).
The historic strategy of “going conservative” at retirement and investing in low/no risk assets in retirement is problematic in that current yields in such assets will either result in incomes that are unattractively low, or scenarios where drawing needs soon outstrip actual returns, resulting in capital erosion. While these type of assets may have a role to play in planning (and are often marketed as a “silver bullet”), investors in many cases need to take an element of risk in their portfolios in order to generate returns that provide them with a reasonable income that will keep up with inflation for an extended period of time. The question though, is how much risk can one reasonably take (given imminent or actual retirement) and what return should be expected? While preferences and approaches to risk and anticipated return may vary, there is a strong case for the view that we are entering a lower return investment environment, excellently articulated by colleague Paul Jennings in “It’s time to get real about real return expectations.” While the focus of this article is not around investment returns, we believe that the prudent investor has no option but to assume a lower return environment when calculating drawing rates.
As a generic statement, most retired investors will typically be positioned in a portfolio ranging from cautious to moderate risk in nature. If one looks at low, medium or high equity multi asset class unit trust funds (Stable funds or Balanced Funds) as proxy portfolios, historic returns over 10 years have ranged from between 12% to 17% per annum – healthy returns indeed. It is however our assertion that responsible planning and projections cannot be based on such numbers as these returns have been generated on the back of rampant, monetary policy fuelled bull markets. A more reasonable long term approach would be to look at the mandates of such investments, which typically range from CPI+3% to CPI+6%. This would imply returns of between 10% and 13% per annum (pre-tax).
So what is the ‘safe’ drawing level?
If one agrees with a projected range of investment performance of between 9% – 13% per annum, the “safe” drawing rate is somewhere between 3% and 6% of the capital value per annum. As an advisory house, we advise clients to stay below 5% as a drawing number wherever possible if they wish to preserve their capital in real terms.
The practical implication of a 5% drawing is eye opening. R50,000 annually (pre-tax) of income per million rand of retirement capital. Thus for every R10m of capital, a pre-tax annual drawing of around R500,000 can be drawn with a reasonable probability of
Minimising the tax burden
The last issue that is worth considering is around taxation. As stated above, a drawing of around R50,000 per annum per million rand of retirement capital can be achieved on a sustainable basis (pre-tax). The final part of the puzzle is understanding what that equates to, in after tax terms. This is where long term financial planning can make a massive difference in drawing rates.
If one assumes that the full drawing (of say R500,000 per annum of a capital base of R10,000,000) came from a living annuity, the full drawing would be taxed as income in the hands of the investor. This would result in an average tax rate of around 25%. Thus an annual income of R500,000 results in a net income of around R32,000 pm. Thus a drawing of 5% pre-tax becomes 3.8% after tax.
If however, the assets had been invested in a blend of discretionary assets, endowments, and living annuities, and the interest exemptions of both spouses (where applicable) had been used, the tax profile could be significantly lower. Using a similar example of drawing R500,000 per annum from a blend of ILLA’s, discretionary assets and endowments, it is possible to bring the average tax rate down to well below 10%, meaning that net income is significantly enhanced. Alternatively, a lower gross drawing rate can be instituted in order to achieve the same net income as a less tax efficient portfolio. In so doing, there is less pressure on the capital base and more growth over time. The key here is that planning in the years before retirement needs to take place in order to minimize the tax burden on the drawings.