What Are The Effects of Inflation?
How Much Capital Do I Need To Retire?
March 7 – 8, 2009. What are the effects of inflation on your retirement capital?
There is a common theme that runs through a number of interactions we have with retirees: they invariably wish to leave capital untouched in their retirement, and merely live off the interest.
Their calculation for this is also normally fairly consistent, and follows along these lines:
Peter and Liz have calculated that their lifestyle costs in retirement will be R25,000 per month.
They are bond free.
Assuming they can achieve an investment return of 8% (which may or may not be realistic), they calculate they need capital of R3.75m for their retirement.
Thus they determine that they can live off their investment returns (usually dividends and interest) and leave the capital balance as an inheritance for their children.
Although the intention to leave money to our children is a noble one, unfortunately, it is simply unrealistic for the vast majority of us. Forget the fact that the investment return might be unrealistic, the biggest hole in their plan is that they have not taken the effects of inflation into account.
The effects of inflation are the biggest enemy to anyone’s financial plan. Here’s why.
Let’s assume an inflation rate of 8%, and the figures mentioned by Peter and Liz above.
In year one, they earn an investment return of 8% on their R3.75m capital which realizes them R300,000. They live according to their plan, and life is grand.
However, in year two, due to the effects of inflation their annual lifestyle costs need to increase by 8%, and grow from R300,000 to R324,000. Assuming a further 8% investment return in year two on their R3.75m, they are now R24,000 shy of their lifestyle cost requirements. They need to get this money from somewhere, and that means dipping in to their capital. Although R24,000 might not seem like a big number when viewed in the context of their R3.75m capital, it really is the thin edge of the wedge.
Every year, their investment returns will cover less and less of their lifestyle costs, meaning they need to access more of their capital, which in turn will lead to lower investment income the following year.
Peter and Liz are soon in to a vicious spiral. In the above example, their R3.75m capital will sustain their annual lifestyle costs (increasing with inflation) for 13 years. After this, there will be nothing left.
Effects of Inflation on Retirement Capital
Inflation Matching vs Inflation Beating
To illustrate the effects of inflation as starkly as possible, I specifically chose an inflation-matching scenario. Peter and Liz would be best advised to invest in an inflation-beating scenario. The amount with which they endeavour to beat inflation will be linked to the investment risk they are prepared to take. They should be counseled carefully on the implications of increased investment risk. However, by targeting a 4% real return on their investments, their capital will endure for a further four years. What other options are available to them? Potentially they may need to downscale their retirement lifestyle, and survive on less than R25,000 a month. Another solution is to delay their retirement date, and continue working for a while longer. As a rough rule of thumb, we have found that R1m worth of capital is sufficient to provide R5,000 of income, increasing with inflation, for 20 years.
The table below gives an illustration of the length of time R3.75m worth of capital would last you, taking in to account different draw levels and differing real rates of return. If you wished to draw R30,000 per month, and matched inflation, your capital would last you 11 years. If you rather reduced your draw from R25,000 per month to R20,000 per month and targeted a real return of 6%, your capital would last you more than 50 years! It is imperative that you seek the assistance of a professional to ensure you are adequately funded for your retirement, and that you follow a strategy that is sustainable. The earlier you start, the better your chances of living the retirement you want to, and not the retirement that you have to due to insufficient capital. Perhaps then your noble intention of leaving some inheritance to your children may be achieved.
Effects of Inflation
With world news focused on the financial turmoil, it may be appropriate to engage an independent, fee-based Certified Financial Planner who can provide impartial written advice. If you are unable to secure a referral then visit the website of the Financial Planning Institute on www.fpi.co.za. Meet with a few and select one who is qualified and can demonstrate what process they follow to help you review your own financial plan.
Netto-Jonker, CFP, is founder of Netto Financial Services and was financial planner of the year in 2001. Her business partner Ian Beere, CA(SA) CFP was the financial planner of the year in 2007.
