Many of the previous blogs have had a heavy emphasis on share investment (mainly about how to have a robust share component to your portfolio) and to a share market tragic like me maybe the share market is the end however to most investors shares are just a means to an end and part of a portfolio designed to achieve financial objectives, In retirement the most common objective is to have a portfolio of investments, whether this be shares, term deposits, international shares or more commonly a mix of these asset classes, that have the potential to produce returns sufficient to enjoy a certain standard of living.
A common question then in retirement planning is how much income is needed by you to have a comfortable retirement lifestyle and do you have the financial resources to achieve this income. I dutifully asked this question of retirees for a number of years until I realised that in some ways I was asking an irrelevant question.
There are a number of potential problems with this type of question. Some people do not know how much income they need. Also the answer to this question is not necessarily as obvious as it sounds. Yes there is a certain base level of income needed to meet the basic needs of living like bills, food and so on. However beyond that we get into more discretionary spending like travel, extra lifestyle items like clothing, how often you eat out, heading over to Melbourne to see Justin Timberlake or Lady Gaga concerts or whatever else is your thing. As a piece of trivia apparently Lady Gaga has many more followers on Twitter than Pope Francis. Not sure what that tells us about ourselves but let’s not go there. And then beyond that we can get into potentially much larger ticket items like giving to charities and bailing out prodigal children who have run into financial difficulties and are looking to their most approachable creditor mum and dad. Or just helping their children while they are alive rather than leaving it all in the estate. For many retirees these more discretionary items are not must haves but are most definitely desirable if they can comfortably afford it.
So to me the question should not be how much income do you need but rather what can you afford to spend without running a significant risk of ending up in soup kitchens down the track. Spending too much and impoverishing oneself is a potential trap. However most people I have met are well aware of this and are quite concerned about managing their money so that they do not run out of money one day. A more subtle (and common) retirement trap is to unnecessarily deprive oneself of some of those things in life that are not absolutely essential but certainly add to the quality of life.
One of my clients was a widow in a nursing home and owned a substantial share portfolio. She had no hope of spending her income now so she would ring up twice a year to reinvest the dividends. Not a problem as such except that when many years ago she became a widow she had no idea of what she could afford to spend. As a result she lived a frugal Spartan lifestyle when this was unnecessary because of the fear of running out of money. I have had clients well set up only to suffer major ill health which then prevented them from doing many of the things that they wanted to do in retirement. It is also the case that the older we get the less money we need for living. For many people this starts happening in their seventies. And it’s a cold hard fact that you can’t take it with you.
So my philosophy when advising clients in retirement is to enjoy your money while realistically minimising the risk of running out of money. How do we do this? One approach is to estimate what your ongoing net income (i.e. net of taxes and fees) is from all sources including investment income, superannuation pensions and the age pension if relevant. This is much easier with a direct investment portfolio where term deposit interest and share dividends can be estimated with a reasonable level of accuracy for the next twelve months. If you invest in managed investments (either superannuation or outside of superannuation) it’s not quite as easy but estimates can still be made. What we then do is estimate what is a prudent amount of capital that can be used in a year without jeopardizing the sustainability of your retirement lifestyle over time.
Now we don’t know what future investment returns, government policy on age pensions etc. will be. We also don’t know when we are going to die so we don’t know how long our money has to last. The most satisfactory solution to this is to assume that you are going to live at least to your life expectancy. Which is the average so what the heck one has to be positive about this and assume that you will do better than your life expectancy so let’s add on five years to come up with a reasonable and prudent time frame. Just remember that when you look at your peers and say to yourself that you will do better they are probably thinking the same thing. Next we have to make assumptions about investment returns. As said current income estimates should be reasonably accurate but future capital returns are uncertain. Nevertheless for the sake of the exercise an assumption needs to be made. They cannot be too aggressive however equally they cannot be too conservative otherwise the point of the exercise (to have the best chance of enjoying your money while you can) is defeated. And at the end of the day it’s your total return (both income and capital returns) that is relevant in determining what you can afford to spend. It is also why a well constructed portfolio should not overly focus on income at the expense of potential capital returns. And the estimate of capital returns should also reflect the relative proportions of defensive and growth assets in your portfolio. If you have a very defensive portfolio e.g. a high proportion of term deposits then the estimate of capital returns used should be lower than a portfolio that has a higher proportion of growth assets like shares.
What we end up with is a financial resources report that says (much simplified) something like your ongoing net income will be $30,000. On top of this you can afford to spend an additional $20,000 of capital if you so choose resulting in total potential spending of $50,000. While this is based on a particular set of circumstances your own figures will be different of course because they are based on your specific circumstances.
Now the one thing we can be certain about is that the assumptions used will be incorrect. It doesn’t matter how complicated we make the financial model it won’t result in a better conclusion it just means that the assumptions are both incorrect and more complicated. The assumptions will be incorrect because it may be that this year you spend more or less than what you could. Returns may also be higher or lower than the estimates.
What this means is that, using the above example, we can’t spend $50,000 a year indefinitely. To allow for the fact that assumptions will be incorrect we then redo the exercise every three years or so. It may be that at that time your ongoing income will be different (hopefully higher). The amount of capital that can be used may now be higher or lower than the $20,000 in the above example depending upon what your actual expenditure has been and the investment returns that you have received. If the original estimate of $50,000 is now too low well that’s both not a problem and worth knowing. It may be that it is lower e.g. maybe it comes in at $45,000 next time the exercise is done. While this means that if you were spending $50,000 a year you may need to slightly reduce your expenditure it also results in any adjustments to your spending will be gradual rather than waking up one day to find the kitty is empty. It also means that you are giving yourself the best chance of enjoying your money while you can. Recurring golden retirement income eggs indeed. It will also empower you to know what you can and cannot afford to do. Do you know how many retirement eggs you can consume? Forgive the expression I must still be in Easter mode.
And the exercise can also be done before retirement. Based upon my current resources, level of super contributions and savings capacity if I take my gold (or Apple maybe if we are to get with the times) watch at age x what can I afford to spend in retirement.
Now this exercise presupposes that you have a successful investment strategy and portfolio. The next blog will discuss the four critical elements that exist in a successful investment strategy. Until then enjoy your lifestyle. For more information about Lifestyle Financial Services go to www.lifestylefstas.com.au