/ 13 August 2010

Inflation risk vs capital risk

A readers asks: My wife and I are currently 50 and want to slow down by cutting back on work. We will have at our disposal about R2,2-million from which to derive some income for the next 14 years until my retirement annuity (RA) and an endowment mature at age 65.

I wish as far as possible to keep the capital. Please could you provide information on what my options are with my RA on retirement. My RA is with Liberty; I keep asking them to tell me what options are but I seem to battle to get a straight answer.

Maya replies: As an overall comment, now would be a very good time to sit down with a financial adviser and work out a retirement strategy and whether your RA and endowment will be sufficient for your retirement needs.

If you need to supplement it with your current lump sum this would also affect how much income you could afford to draw or whether you need the capital to grow. This is not something you want to find out once it is too late.

With regard to your retirement annuity, you can opt for either a life annuity, which provides a fixed income linked to inflation for the rest of your life, or you can opt for a living annuity, which invests in an underlying basket of assets and you are able to draw a monthly income based on your needs. (See related articles for further information).

Be aware that when life companies convert RAs into living annuities the fees can be astronomical. Make sure you are fully aware of all fees and shop around, don’t just rely on your current life insurer to give you the best deal.

Going back to your question of where to invest, I had two very different views from investment managers which should provide some food for thought

Michael Ronald from Marriot considers capital risk:
The reader seems to want to extract as much income as possible from their R2, 2-million for the next 14 years until age 65 with the capital as intact as possible. This also seems to be their own savings, rather than amounts within a retirement fund, and so any income from their capital will be governed by income tax.

Their first instinct was to preserve their funds in a money market fund. Based on today’s rates, if you are drawing the money monthly you can expect an interest rate of 6,78%. This provides roughly R12 400 per month before tax. Assuming you incur no other tax liabilities, the after-tax income is R11 300 per month (or around 6,2% after tax).

Taking the R22 300 tax exemption on interest and the primary rebate into account, tax might not be a major issue and hence other, more tax efficient vehicles, which might produce more dividend income, may not be as appropriate as a cash investment and may incorporate an uncomfortable level of risk for the client.

Some preference shares may offer a tax-free income of around 8%, looking forward, which would translate into a higher post-tax income but may bring in a level of capital volatility which might not be appropriate.

Managed income products, such as the Income Solution managed by Marriott, may offer higher income levels than that of cash but with lower levels of volatility than other investments. A typical investment would offer R17 200 per month, which translates into R15 100 after tax (or 8,2%) with a low risk of capital erosion. In this way, the client could draw this over the next 14 years without eroding capital but would have full access to the capital at a day’s notice.

The maintenance of an investor’s capital base is paramount in Marriott’s view as it is this that produces the income of the client. You are correct in wanting to maintain this capital balance as much as possible in order to assist when full retirement occurs at 65.

Sunel Veldtman of BJM Private Client Services warns of inflation risk:
Bear in mind that inflation will reduce the buying power of your capital — not only will the value of your capital decline but your income needs will escalate. It is therefore not advisable to leave this investment only in the money market for this period of time.

If you invest the funds into a balanced type of investment including shares, property, bonds and cash, there would be a higher chance of keeping the capital intact because it will include growth assets that are expected to beat inflation. Balanced funds, also known as prudential funds, have long-term track records of outperforming inflation with bearable volatility. I would strongly advise you to consult a financial planner to help you with cash flow planning and to look at your various options.

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