It’s about the income, not the lump sum.
I recently received an email from a reader who had taken early retirement and was concerned that the value of his final pension benefit was significantly lower than the amount indicated in his benefit statement six months earlier.
The pension benefit, which was partly a lump-sum payment and partly a monthly income, was actually correct; he had misunderstood the value of his lump sum once it was turned into an income for life. In fact, because he was part of the Government Employees Pension Fund (GEPF), his income was actually higher than what he would have received through purchasing an annuity in the private sector.
Understanding what your retirement fund really means is undoubtedly one of the greatest challenges when it comes to retirement planning. When we look at our retirement funding as a lump sum it seems like such a lot of money – until you realise that it actually represents your entire future income.
Take for example a 25-year-old who earns R20 000 per month from the first day of work. She works for the next 30 years until age 55 and only ever receives an inflation-adjusted salary increase. Over that period she will receive 360 pay cheques. Those future pay cheques at the age of 25, in present value, are equivalent to R7.2 million. Yet while R7.2 million sounds like a great deal of money, it only represents an income of R20 000 until age 55.
The same applies in retirement. Considering that if you take early retirement at the age of 55 and you live until the age of 75 – which is relatively young nowadays – you have to have enough money to pay for 240 pay cheques. If you needed an income of R20 000 per month, that would equate to around R4.8 million paid out over that time. So R4.8 million is not such a lot of money when you realise how long it has to last, and unfortunately very few people retire with anywhere near this amount of money.
To provide an illustration of the income that can be purchased at retirement, Alexander Forbes kindly provided us with the following examples.
In this scenario we assumed a male retiring at age 60 with a spouse who is four years younger than him. We assumed a joint life annuity which means that his wife would continue to receive the income should he pass away first.
If he purchased an annuity income which increased each year by 5%, then for every R1 million of pension value, he would receive an income of around R4 500 per month guaranteed for life, increasing by 5% a year. If inflation runs significantly above 5% a year, his purchasing power could be reduced over time. That means in order to have an income of R20 000 per month, he would have to have at least R4.5 million at retirement.
Alternatively, he could purchase a living annuity and draw down 6% of the capital each year (this is the maximum recommended drawdown). A fund value of R1 million would provide an income of R5 000 per month. At this rate his income should increase in line with inflation, however by age 82 he would start to experience a loss in purchasing power. This also means that if his wife outlives him, at the age of 78 she would start to experience a reduction in income. In order to have an income of R20 000 per month, he would have to have R4 million at retirement.
In order to understand exactly what your retirement fund actually means in terms of providing an income, you need to get some good advice well ahead of retirement – especially if you are considering early retirement, as you will then have more years to fund. Don’t just look at the fund value and believe that it will be enough.
This article first appeared in City Press.