The three risks underlying retirement planning is longevity, inflation and investment risk. As a retiree you have no control over your longevity and the inflation risk. If only we knew when our time was up planning would be easy. Just as impossible is forecasting inflation over the next 30 years. The only lever we have in planning for both longevity and inflation risks is the investment strategy, which talks directly to the underlying investment risk.
Defining investment risk is a minefield and very misunderstood by both investors and funny enough also the regulator who defines risk as volatility of return, which is an over simplification dealing only with client behaviour.
The fact that an investment can fall by 40% overnight classifies this as a high-risk investment, but this risk is only how the investor behaves. i.e. if the investor panics and sells the investment the temporary “volatility” driven loss is then crystalized, and the money is gone. If the investor has the emotional ability to weather the temporary “volatility” loss the investment will recover without loss. Nothing to do with investment risk, but the behaviour of the client. Risk should rather be defined as permanent loss of capital, which happens with crooked investment schemes and / or when a company goes bust.
An appropriate investment strategy with sufficient exposure to growth assets (equities) will cover the longevity risk, which could be anything up 30 years post retirement by generating an inflation plus return and thus addressing the inflation risk or does it???
My concern is that although retirement plans quite correctly plan to grow annual income at inflation to maintain the real buying power, that the published inflation rate is significantly lower than the actual personal inflation experience of retirees.
The current consumer price index (CPI) is 3.8%, however many of our retired clients indicate a personal inflation rate of closer to 8% – 10%. Of course, everyone has their own rate of inflation depending on their personal basket of good & services, but a higher personal inflation rate experience appears to be a common theme for both retirees and those still working.
It is frightening how quickly retirement capital is eroded if you assume an annual escalation rate higher than the official inflation rate. Unfortunately, current annual inflation increases appear to be eroding real (after inflation) income, which will then require a lifestyle adjustment and / or a capital injection at some stage if retirements plans are to hold.
Given the inequality in SA it is highly unlikely that the current basket of goods representing the official inflation rate will be amended to better represent the actual inflation experience of the minority. Plan accordingly.
Mcomm, CFP®, HdipTax
T. 021-851 3746