28 October 2020
Capital in retirement: It's time to listen to my mother
My mother always said that when she died, the cheque to the undertaker was going to bounce – that is, she would go out on the last dollar. Interestingly, my mother nearly achieved this whereas my father was still saving on the day he died. Together, they showed the wide range of attitudes towards spending capital in retirement.
The amount of capital that you are going to spend (and, therefore, the amount that you are going to leave) is one of the most important things to resolve as you face up to retirement.
The hardest thing in all of finance is to take a lump sum and try to turn it into a steady and reasonably reliable income. It hardly needs saying, but this task just got harder with interest rates so low.
On retirement people go from receiving a regular pay cheque to using their life savings to generate an income to supplement New Zealand Superannuation. Effectively retirement means that you stop doing the work that you have always done and, instead, become an investor. In the majority of cases, new retirees are asked to start to invest even though they may have little or no experience in investment. And, of course, investment experience or not, many people’s life(styles) depend on how well they do with their money – they are completely reliant on investment performance.
This really is a case of being thrown in at the deep end with no floatation device in sight to teach you how to swim.
The problem now is that not only are interest rates very low and likely to stay low for some years, but many experts predict that investment returns across most asset classes are likely to be low. Given that many asset classes have had a major run up in values, lower returns from investments seems fairly likely.
Putting together low interest rates with lower future returns from other investment, it seems to me that fewer people are now going to be able to live solely on investment returns and leave most of their capital intact for future generations.
Instead, to maintain a decent retirement, more people are going to have to be like my mother and spend capital – living solely on the returns from investments will simply not be enough.
It does not matter whether you have just sold the farm and have millions, or whether you have $85,000 that you have quietly squirrelled away over the years, the problem is the same: for most, lower investment returns means spending capital becomes an essential.
Spending capital raises our biggest fear: that the money will run out before we do. Over the years I have seen quite different approaches to planning this, but they all carry some risk and the rate for drawing on investments is never certain.
For a start, I know people who have decided that they will put everything in the bank and, ignoring low returns, simply plan to take out a certain amount each year. For example, someone who had $300,000 and expected to live about 30 years had a plan that was simply to take $10,000 out each year to supplement NZ Super.
Of course, this most basic plan still carries considerable risk: first of all, she may live longer than 30 years (this is called longevity risk). Second, the world could see a round of high inflation which may quickly wipe out the real value of her saving.
Other people may invest their money in a diversified portfolio with some shares, property, fixed interest and cash. This is certainly better as a spread of different investments manages a variety of economic and investment risks.
However, it is still not entirely risk free: there is still longevity risk as well as something called sequencing risk (the risk that there is a major adverse market event at the beginning of retirement which reduces the amount invested).
Whichever way you decide to invest, unless you have a very large amount of capital and relatively modest drawing requirements, you will most likely have to spend capital.
You can play with the numbers – assume higher investment returns, a shorter life, or lower drawings. However, almost inevitably given the times we face, many of us will have to spend some of our capital to fund a decent retirement.
What could your income be?
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