How to prepare your investment portfolio for retirement income

Question: I will be retiring in three years. Should I be moving my money into a money market fund?

Answer: The decision to move your money into a money market fund depends largely on the type of pension you plan to use. Will you opt for a living annuity or a life annuity?

Living annuity

Your money remains invested, you choose the income level, and you bear the investment and longevity risks. A significant advantage is that you have a measure of flexibility in choosing your income, and the value of your annuity passes to your heirs upon your death.

Life annuity

Also known as a guaranteed life annuity, it provides a lifelong income, with the insurer bearing the investment and longevity risks. For a 65-year-old, the monthly income here is typically about a third higher than that provided by a living annuity. This does come at a cost, as the annual income and future increases are locked in when you start the annuity. Also, when you and your spouse die, there is usually nothing for your heirs to inherit.

If you are leaning towards a life annuity, then there is a stronger case for gradually reducing short-term market risk as you approach retirement. That is because you don’t want a sudden fall in the value of your retirement fund just before you lock in your retirement savings in a life annuity. A bad market at the wrong time can reduce the income available to you on day one.

If, on the other hand, you are likely to use a living annuity, you usually still need meaningful long-term growth in the portfolio. Your money may need to support you for 35 years. A portfolio that is too cautious too early can create a different danger: it may fail to grow fast enough to keep up with inflation, especially the kind of inflation retirees actually feel, such as medical costs. Living annuities do not guarantee income for life, so growth still matters.

How to work out what to choose

The first thing to work out, as realistically as possible, is how much income you will need in retirement.

Take your current monthly budget and strip out expenses that will fall away in retirement. These could include retirement fund contributions, work travel or children’s expenses that may no longer apply. Then add in costs that often rise later in life, particularly healthcare, domestic help and general lifestyle flexibility.

Once you have a monthly figure, multiply it by 12 to get an annual amount. Then do a rough capital check. As a very broad rule of thumb, if you divide the annual income you need by 5%, it gives you a rough idea of the capital required to support that income at a moderate drawdown. So, if you need R300,000 a year, you would want something in the region of R6-million. This is just a quick test, though, not a financial plan.

If your retirement capital is comfortably above that figure, a living annuity may be workable. If it is well below that figure, a life annuity, or a blend of life and living annuities may deserve serious attention, because it can convert capital into a more reliable pension stream.

In many cases, a life annuity can produce a meaningfully higher starting income than a very cautious living annuity, although the exact difference depends on age, interest rates, escalation choices and spouse’s benefits. If you are likely to use a living annuity, I would generally prefer a layered strategy to one big switch into a money market fund. In simple terms, think of your retirement capital in buckets.

• Keep roughly the first two years of expected income in cautious assets;
• Keep the next few years in a moderate portfolio; and
• Keep the rest invested for longer-term growth, ideally in a diversified portfolio that still has meaningful exposure to growth assets, but with some hedges to reduce downside risk.

If you are more likely to buy a life annuity, I would consider gradually de-risking as retirement approaches so that you are less exposed to a major market fall just before the annuity purchase.

Don’t make the decision too late

Many people ask this question only when retirement is a few months away, which is when choices become rushed and expensive. You are asking it with three years to go, which gives you time to do the work properly.

Retirement is an area where proper modelling matters enormously.

Before making any decisions, you should sit down with a qualified financial planner who can model your likely income needs, your annuity choices and the level of investment risk that you can actually afford to take. DM

Kenny Meiring is an independent financial adviser. Contact him on 082 856 0348 or at financialwellnesscoach.co.za. Send your questions to kenny.meiring@sfpwealth.co.za.

This story first appeared in our weekly DM168 newspaper, available countrywide for R35.