Inflation Retirement - No One is Immune

The Weekender / Business Day 22/23 April 2006

With inflation retirement planning can be interesting – every investor has their unique set of financial circumstances, attitudes and issues. There are, however, common attitudes that we financial planners encounter often.

One of the more common attitudes (or hopes) is an investors desire to leave capital “untouched” upon retirement. The objective is to live solely off the investment returns, usually in the form of dividends and interest, and to leave the capital invested.

The motivator in most cases is to leave the capital behind for future generations. This may be a worthy goal, but is it realistic?

Richard Sparg, a chartered accountant, says this thinking is very common and follows a standard pattern. A couple, lets call them Thomas and Juliet, will first estimate what their annual retirement requirements are – say, R120,000. Then, using an assumed investment rate of return (which may or may not be realistic) they will calculate the capital required to generate the desired return.

Thomas and Juliet may assume that an investment return of 8% a year (after fees and costs) is reasonable and sustainable in today’s low-inflation environment. An initial capital amount of R1,500,000 would then be required to produce their requirements. They would then determine whether this amount of capital was available. If it was, they would assume it would be feasible to retire successfully and leave their capital untouched.

There is, however, a major flaw in their approach. The effect of inflation has been ignored. Even though inflation fallen significantly over the past few years, it is still most investor’s enemy number one. It can still erode wealth over time. We refer to this as “investing oneself poor“.

In the example above, assuming an inflation rate of 5%, their annual requirements in the second year of retirement will increase to R126,000. This rise may go largely unnoticed as it is not significant and is diluted over the course of a year.

What is important is that the underlying capital will now not produce enough returns to fund the increased requirement. Thomas and Juliet will need to dip into their capital. Of course, this process will repeat itself in future years, but at an escalating rate: a lower capital amount will produce lower returns, which in turn requires higher draws on their capital.

It is certainly a vicious cycle that they would prefer to avoid.

In our example, the R1,500,000 capital will sustain their annual requirement of R120,000 (increasing with inflation) for just over 15 years. After this, there will be nothing left.

This may come as a shock to them. Some difficult decisions may have to be made: retirement expectations may need to be downscaled, or retirement may have to be delayed. Thomas and Juliet might even consider taking on more investment risk to achieve better investment returns. They would have to be counseled carefully on the implications of increased investment risk, however.

The accompanying table illustrates some of the potential trade-offs that they would need to consider. It examines how long an investors’ capital will last at different investment returns and retirement expenditure level. Their financial planner will need to help them find a combination with which they are comfortable.

An independent certified financial planner must undertake a detailed study of all the real objectives of your retirement portfolio and then counsel you on the risk versus return of that potential investment strategy before any decisions are made.