A good retirement plan is based on clearly defined goals and objectives. Also, planning for your retirement should start from the day you walk into your first job, not after your retirement party. In the fifth article in our series on the recent Old Mutual/Personal Finance Retire Right seminars, Nigel Scott (left), the director of the Wealth Corporation, sets out some ground rules for successful retirement planning.
The most common mistake people make in planning for their retirement is diving into the detail without having the proper principles from which to make decisions.
Nigel Scott says the principles of financial planning have not changed over the past 50 or 100 years, and you should stick to them as they affect the decisions you make about retirement.
To lay the foundation of your retirement plan, you should take the following steps:
1. Set goals
Scott says that setting goals and objectives should be your starting point. Retirement planning is about deciding now on the lifestyle you want to lead at retirement.
When setting goals, consider your current and future lifestyle costs, as well as any capital expenditure. Lifestyle costs include daily, monthly and annual costs, as well as capital once-off costs, such as the purchase of a new car or home improvements.
Scott says you need to make decisions about where you want to live at retirement. For instance, if security is an important consideration, bear in mind that secure accommodation is often more expensive.
2. Do a situation audit
Once you have set goals, you need to do a situation audit to find out how far you are from achieving your goals.
At this stage, check on your financial situation by taking into account your existing investments, retirement funds, lifestyle assets (assets which do not generate an income but are still worth something, such as your house and car) and any income and capital flows (either pension income or investment flows).
A practical way of doing a situation audit is to list all your current income and expenses in one column on a sheet of paper, then in the second column remove the costs that you will no longer have to pay after retirement, such as your children's education.
Scott says you should not try to estimate what a loaf of bread will cost in 10 years. Rather base your cost assumptions on present values.
3. Calculate a rate of return
The next step is to calculate the rate of return you need to achieve your goals. Financial advisers use computer programs to assist you with this calculation. The purpose of building a present value model is to be able to translate future flows of income, expenditure and capital into today's values. You will have set your financial goals in today's values so this process enables you to compare apples with apples.
From these figures, you will be able to derive the rate of return you need to earn on your investments to meet your retirement lifestyle costs.
Scott says it is important to focus on the real rate of return, that is, the return after taking inflation into account. So if your target rate of return is five percent a year and inflation is running at six percent, you will have to get an actual return of 11 percent on your investments.
4. Decide on asset allocation
Once you know the rate of return, you can determine the asset allocation (investment mix) that will deliver the required rate of return over time.
The mix of assets could include shares, bonds and cash, and property, onshore and offshore. This is one of the most important phases of the planning process. You must be satisfied that the advice you are getting and the investment decisions you are making fit into your broader planning objectives and are not being made in a haphazard fashion, Scott says.
Be careful not to confuse the investment with the vehicle that holds the investment, namely a retirement annuity, a unit trust or an endowment. Each of these investment vehicles can invest in the asset classes of cash, property, shares and bonds. In addition, these assets can be either local or international.
5. Consider risk
It is important to try to achieve your required rate of return with the lowest possible level of investment risk, and you should consider this when deciding on the asset mix, Scott says.
Think of risk as your ability to tolerate what happens to your investments should the World Trade Centre collapse, Scott says.
You need to understand that there is a probability of a negative return which is particular for each type of asset class. In one type, the probability of a negative return may be five percent, while in another it may be 20 percent.
If your goals dictate that you need to take on investments which are more risky than you are comfortable with, it may be necessary to go back to step one to re-prioritise, or even, to downscale your goals.
6. Do a reality check
This step involves looking at the big picture. You need to examine each of the following in this context:
- Your investment contributions. You need to determine your present savings capacity and if your capacity to save now is too low to allow you to reach your retirement goals, you may have to cut back on the cost of your lifestyle to increase your capacity to save. Alternatively, you will have to downscale your lifestyle goals at retirement. Once you know what your savings capacity is, you can decide how to save. It is wise, Scott says, to reduce your debt rather than have big debts and divert all your spare money into savings. It is important to have the right balance between lifestyle assets (such as your house and car) and your ability to invest.
Also, when choosing an investment vehicle, you need to consider whether you want to make the investment with before- or after-tax money. In other words, do you want tax relief on your investment contributions now to pay tax when you retire, or do you want to pay the contributions with after-tax money and receive a capital sum tax-free at retirement?
- Targeting a rate of return. Generally, you need time for a strategy to work and the shorter the time, the less the likelihood of achieving the rate of return you need. Scott's advice is not to set unrealistic goals and to make sure your investment strategy is matched by the time you have to reach your goals. Next, you have to decide on the investment process to use. When choosing an investment, make sure the investment has a benchmark return that has some connection to your target return rate.
- Retirement lifestyle costs. Remember that lowering the hurdle (your retirement goal) can have an exponential impact on how long your capital will last. Even a small change in your planned retirement lifestyle (such as one less overseas trip a year) can have a dramatic effect on your capital or the amount of money you require for retirement, Scott says.
7. Do a sanity check
It is time to get into the detail. In this respect you need to consider:
- Accommodation: Work out where you plan to live after your retirement and Scott advises that you make the move before you actually retire. Most people underestimate the major change that retirement brings about in their lives. It is stressful enough retiring, let alone moving house on top of that, Scott says.
- Refine your financial objectives. Iron out the finer details of your financial objectives.
- Prioritise options. This involves getting an accurate handle on what is important for you at retirement.
- Part-time employment. You may find that sitting on the stoep with nothing to do is not as rosy as you thought. It is important to line up possible part-time work before retiring because once you are out of your business network, it may be difficult.
- Exit strategies. If you have your own business, you need to consider how you will exit from the business. Consider whether you will sell it outright when you retire, in which case you need to line up potential buyers. If you have partners and want to sell to them, you should negotiate the terms and conditions now. If you are a single-person operation, you could consider scaling down your business, but you need to put plans into place.
- Timing your retirement. Scott says you should not underestimate the impact on your financial planning of bringing forward or of delaying your retirement date.
8. Implement the plan
Implementing a retirement investment plan is like building a house. The architecture of your house is the planning process and the building is the investment management process.
Retirement planning is often driven by the choice of product rather than by goals and objectives, Scott says. The choice of product in which to invest should be the last step in the process, and tax, liquidity and cost should dictate your choice of product.
Other articles from the seminar: