In last week's column, I listed some of the important issues you must consider in deciding when is the right time for you to retire. This week, I look at these issues in more detail.
The issues are:
- Loss of future earnings.
Not only do you start losing income from the day you retire, you also start drawing on your retirement savings. When you stop working, you lose the opportunity to increase your retirement savings. The earlier you retire, the more certain you need to be that you have sufficient retirement savings to maintain your standard of living until the day you die.
- Reduction of income.
Apart from losing your basic salary or wage when you retire, you may also forfeit your fringe benefits, such as motor vehicle, parking, telephone and housing allowances.
At the same time, some of your expenses may decrease or disappear. For example, you may no longer be contributing to a retirement scheme or retirement annuity, and your lifestyle may change. You may no longer need a second car. Your transport and clothing costs may decrease.
Nevertheless, very few people receive a post-retirement income that equals their salary. So, unless you are very wealthy, the longer you can continue to earn an income and build up your retirement savings, the greater the likelihood that you will retire financially secure.
- Loss of salary benefits.
These benefits include:
* Employer contributions to a medical scheme;
* Employer contributions to a retirement fund; and
* Allowances, such as a motor vehicle allowance.
- The best financial years of your life.
The 10 years before retirement are normally the time of your life when you are less likely to have dependent children. The result is that you are able to amass capital more easily.
- Retirement fund benefits.
The earlier you retire, the lower your retirement benefits will be, particularly if you belong to a defined benefit (DB) retirement scheme and are retiring before your scheduled retirement date.
In a DB scheme, your benefits are reduced by a fixed percentage for every year you retire before your scheduled retirement date. Although the percentage may appear small, it can compound into a significant loss of income.
If you belong to a defined contribution scheme, you will limit the potential final value of your benefit if you retire early. You should also take into account that if you die immediately after taking early retirement, the pension your spouse receives will be less than it would have been had you retired at the normal date.
- The retirement gap.
One of the major problems with retiring is that you may fall into the "retirement gap". The retirement gap is the difference between what you have saved by the time you retire and the amount you actually need to retire financially secure.
Very few retirement funds alone will provide you with the level of income that you received on your last day at work.
On average, if you have been a member of a retirement fund for 40 years, you can expect your income to drop by at least 25 percent when you retire. If you reduce the period during which you save for retirement to 30 years, your retirement capital will fall by about 40 percent.
On the other hand, the longer you remain employed and keep saving, the narrower the retirement gap becomes.
The generally accepted guideline to ensure you do not fall into the retirement gap is to accumulate capital equal to at least 15 times your required annual income. In doing this calculation, do not only factor in the capital in your retirement fund or retirement annuity, but include any capital that can be used to generate an income.
Remember, however, that the "15 times rule" is only a guideline - no two person's circumstances are the same. In fact, many financial advisers are now suggesting that you should aim to accumulate capital equal to at least 20 times your required annual income.
It is easier to calculate how much capital you need to retire financially secure if you belong to a DB scheme, because you know the actual amount of the pension you will receive. If you belong to a DB scheme, you should first deduct your pension when calculating how much capital you require. For example:
Annual income requiredR100 000
Less: annual pensionR60 000
Remaining income requiredR40 000
Capital required: R40 000 x 15 =R600 000
In the case of a defined contribution fund, particularly a provident fund, the assumptions you have to make increase the difficulty in assessing whether or not you will have sufficient money on which to retire. You need to factor in the rate at which you expect your investments to grow and the projected inflation rate.
- Loss of group life and disability benefits.
You will, in most cases, lose your group life and disability benefits on retirement. This can be a serious financial blow to your family, particularly if you still have dependent children and take early retirement on a lower pension. If you are in ill-health and it appears you may die before retirement age, you should stay employed as long as possible.
If you have the option to stay on a group life scheme after retirement, take it, because the premiums will be far lower than if you take out your own policy. If you need to buy extra life and disability assurance, take the higher premiums into account in your retirement calculations.
- Medical benefits.
Medical inflation is soaring at a faster rate than normal inflation. This poses two significant financial risks to people taking retirement.
The first is that some employers are no longer prepared to fund their retired employees' medical scheme contributions to the extent they have done in the past.
Secondly, unexpected healthcare expenses that exceed your medical scheme benefits can wreck your financial independence. The risk of ill-health increases dramatically with old age.
If you are planning to retire early, you should take the potential additional costs into account. When you turn 65, the South African Revenue Service gives you a break in that you can claim all medical expenses not covered by your medical scheme against your taxable income.
- Inflation.
All your calculations must take the effects of inflation into account. When you retire, you generally fall into what is called the "fixed income" category. In other words, your income is likely to remain the same. If it does remain the same or increases only slightly, you are in financial danger. The danger increases in direct relation to the number of years you are retired. By retiring before your scheduled date of retirement, you increase the risk of inflation eating into your savings.
- Your level of debt.
You must take into account your level of debt, particularly large debts, such as your home loan. You must deduct all debt from your income-generating assets in your calculations.
As a general rule, you should have paid off all your debt before you retire. You will significantly undermine your ability to retire financially secure if you use any lump-sum benefits from your retirement savings to pay off debt. If you still have a high level of debt, you should postpone your retirement.