RETIREMENT

Can the 4% rule help you achieve early retirement?

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Most people would retire early if they were given the opportunity to do so, however, the latest statistics by the National Treasury indicate that only 10% of South Africans are able to retire without financial assistance. For many who chase early retirement, financial advisors have advocated applying the '4% rule' to ensure that investors have enough to fund their retirement. However, while this rule may help some retirees, there are a multitude of other factors that need to be taken into consideration to ensure a successful early retirement. 

This is according to Tracy Jensen, Product Architect at 10X Investments, who says that many financial
planners and retirees rely on the '4% rule' to determine a safe retirement income. "Created in 1994, the rule advocates that if you draw 4% of your savings in the first year of your retirement and adjust this income each year by inflation, then your money would last for at least 30 years."

She says that the '4% rule' is applicable to retirement products where your money remains invested at retirement and where you take the risk of running out of funds. "This is known as a living annuity."

As an example, Jensen says that if a person has R1m at retirement then 4% of this is an income of R40 000 per annum. "According to the rule, in the first year you could draw R40 000. The following year you would draw an income of R40 000 plus inflation and so forth. The rule proposes that you could continue to do this for at least 30 years before you risk being unable to increase your income with inflation."

She says that whilst the '4% rule' still applies to retirement investing, South Africa is unique in that regulation restricts the income drawn each year from 2.5% to 17.5% of your investment balance. "As a result, investors could have sufficient money to draw the income they desire but are restricted once they reach the 17.5% cap. Therefore, it is important to include this capitation when testing the rule."

There is much debate regarding the income level that is sustainable so as to mitigate the risk that the money is depleted.  Jensen says that you cannot determine a sustainable income without considering fees. "For every 1% in fees you can save each year pre-retirement (as a % of your investment balance), you will have 30% more income in retirement. It is the total amount withdrawn each year that is critical to how long your money will last. Investors need to calculate the gross drawdown percentage - this is
the income plus all fees expressed as a percentage of the retirement pot. The rule of thumb is that your gross drawdown percentage should not exceed 5% if you want that income to grow with inflation over a period of 30 years. Inflationary increases are critical because in 13 years' time, a level income will be worth half of what it is today - based on current inflation rates."  

Jensen suggests that investors must view their retirement products and goals holistically and not in isolation. "This is especially true in the case of a living annuity where investors need to select the income to be withdrawn from their savings each year."  

There are three key decisions investors need to make when considering a living annuity including; asset allocation (portfolio selection), fees and drawdown percentage. "Ask your provider if they can provide you with tools that account for all three decisions above. It is also vital that the tools incorporate market movements and do not simply assume a constant return. Without appropriate tools it is impossible to make these decisions," she says.

Jensen advises that individuals should save as much as they can, for as long as they can. "This should equate to at least 15% of your gross salary over a period of 40 years. In doing so, this should give you an income of approximately 60% of your final salary in retirement." 

She adds that for those who are within a few years of retirement there is little that can be done to increase a savings balance in order to retire earlier. "For those who have a while to go before retiring, a good rule of thumb is that for every 10 years earlier you retire, on average you need about 30% more money. If you are saving for 30 years instead of 40 years, you need to increase your savings from 15% to about 25% of your gross salary. Even though you need 30% more money, your contributions need to
increase by more than 30% to take into account the missed investment returns due to a shorter savings period. This assumes you are only paying a fee of 1% pa or less."

Jensen says that if you are a long-term investor a high equity portfolio is typically most appropriate and if you are a short-term investor a low equity portfolio is typically best. "On average, your income in retirement would double if you invested your retirement contributions into a high equity portfolio instead of a low equity portfolio."

Cautioning investors saving for retirement, Jensen warns against chasing investment hype. "Just as fad diets do not work for long-term weight loss, fad investments do not work for retirement savings.  There is no easy answer to the retirement savings or miracle fix. If someone promises you returns
that are too good to be true, it is probably because they are."

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