Early retirement is tempting – but can you afford it?

Kerry King, Advisory Partner, Citadel

The temptation to retire early and adopt a life of leisure can be particularly seductive as you enter your fifties and sixties, especially after many years spent with your nose to the grindstone. But can you afford it?

There are two main drivers which determine if early retirement is even an option for you. They are:

·       How much capital you have, and

·       How much you need to draw to sustain your standard of living.

Clients often ask us “How much capital will I need to retire”?  However, the answer is directly related to how much you require on a monthly basis to sustain your current standard of living.

One of the very basic calculations I give my clients is to take their current monthly expenditure, divide this number by four and multiply it by R1,000. This calculation works when you are still trying to accumulate your capital and need to set a retirement savings target.

If you are already at retirement age, however, ensuring that your capital will last your entire lifetime, which is generally unknown, becomes more important. To be conservative, I would suggest that you draw no more than 4% of your retirement capital on an annual basis.

To demonstrate the significance of this, the graph below shows how withdrawal rates affect how long your capital will last.

The graph is based on the example of an individual who retires at 55 years with capital of R10 million, and further assumes that inflation rises by 6.0% per annum and that their investment achieves annual growth of 8.5%:

By keeping their withdrawal rate to 4%, their retirement capital would sustain them until the age of 95 years. However, by increasing their withdrawal rate to 4.5%, their capital would be depleted by the age of 87 years. A 6% withdrawal rate would mean that their capital would run out at the age of 77 years – nearly twenty years earlier than had they stuck to 4%.

The exponential benefits of delaying retirement on savings

If a 4% withdrawal rate will not provide you with sufficient income, it may be worth giving serious consideration to delaying your retirement.

Remember, your salary and therefore retirement contributions are usually at their peak in the years just before your retirement, and when combined with the added effect of delaying dipping into your capital, these last few years can make a huge difference to your portfolio through the power of compounding.

To demonstrate the enormous impact of an extra few years on your savings, the graph below compares three scenarios involving the same investor who has accumulated a R10 million capital lump sum at age 55 years.

1.     Retires at 55 years

In the first scenario, the individual retires at the age of 55 years, and chooses to adopt a 5% annual withdrawal rate. Assuming that inflation rises by 6% every year and that their investment achieves growth of 8.5% every year (or 2.5% real growth), their capital would be depleted at the age of 83 years.

2.     Delays retirement until age 60, does not add to capital

In the second scenario, the individual chooses to delay their retirement for five years, or until the age of 60. However, instead of working full time, they choose to slow down and cut back on their hours, meaning that they only earn sufficient income to cover their monthly costs. They do not add or withdraw any amounts from their retirement pot during this time, but their capital continues to achieve real growth of 2.5% after inflation.  

Even without making any additional contributions, by choosing to delay their retirement and simply allowing their capital to grow for an additional five years without eating into it, their retirement savings would then comfortably last until the age of 94 – even assuming the same 5% withdrawal rate, but at a later date, as the first scenario. 

3.     Delays retirement until age 65, continues to save

In the third scenario, the individual continues to work until the age of 65, and also chooses to keep contributing towards their retirement savings in order to increase their capital base to a greater degree.

Assume that this individual adds just R5,000 per month to their investments while still working, and that the capital also sees real growth of 2.5% a year, their capital base would grow to over R11.5 million by the time they retire ay 65 years – a R1.5 million increase in real terms from the R10 million they would have retired with had they retired early at the age of 55 years.

Given the increase in their retirement capital, the individual then chooses to draw down only 2.5% a year on their capital for their income, increasing this amount by 5% each year to keep up with inflation.

This means that their capital would last until they are 105 – in today’s era, a more likely age for the individual to reach than the 83 years outlined in the first scenario.

It’s therefore vital to make sure that you’ve done all the proper planning and calculations before you take the big step, not forgetting to add a buffer for any emergencies or unexpected expenses. It’s important that you don’t rush such a big decision, and rather take the time to consider all the implications before you opt to retire early.

For instance, you are most employable when you are already employed, so it could be difficult to re-enter the job market in ten years if you realise that your money may be running out. Also remember that advancements in medical technology and healthier lifestyles mean that people are increasingly living to 90 and even 100 years old.

However, if you are desperate to escape the daily grind, rather consider cutting down your working hours or look for a less strenuous position, even at a lower salary, simply to cover your current living expenses and avoid falling back on your savings.

What else do you need to consider?

·       Inflation

Inflation is a key risk that needs to be factored in when examining whether you have enough to retire. With future inflation an unknown – and impacted by variables beyond our control, such as the rand exchange rate – having a buffer is absolutely key.

Many people allow for a 4% increase in spending per year to account for inflation, but for many of our wealthy clients, their inflation rate is actually closer to 10%, meaning that they’ve had to dip into their savings more than they had originally anticipated.

·       Is your pension/ provident fund appropriately diversified

There are many companies that use life-staging analysis when performing retirement planning for employees and, as employees approach their retirement, an increasing portion of their pension or provident fund is moved into cash. However, cash investments do not offer inflation-beating returns over the long term.

Engage the services of a professional financial advisor sooner rather than later to check on your behalf that your retirement savings are appropriately diversified, and that your capital should continue to achieve real returns and growth above inflation.

·       Outstanding debts

Another important point to consider is whether you have any outstanding debt that still need to be paid. Monthly vehicle repayments, for instance, could eat into your capital very quickly. Concentrating your focus on repaying any debt before you retire could therefore make a huge difference to your monthly expenses and thus your draw from your pension fund.

·       Future cash flow

While no one can predict how long they may live or how markets may change, a professional financial advisor should be able to identify whether you may be running out of money 10 or 15 years ahead of time, while you still have time to adjust your lifestyle and spending.

It can be extremely difficult to identify potential problems with your future cash flow yourself, and the chances are that you might realise you have a problem too late. That’s why it’s absolutely crucial to engage the services of a professional to do the calculations and necessary planning on your behalf, both before and during your retirement.