This week I would like to focus on the term capital income, which is usually used to describe the taxable portion of a capital gain realised. However, the term capital income is also applicable in retirement planning. Let me explain further.
The best theoretically source of retirement income is rental and / or dividends. The reason for this is that both rental and dividends are expected to increase annually. The retiree is thus assured of an income escalating with inflation without touching the capital base, which continues to grow uninterrupted leaving a legacy for the children.
The key word here is “theoretical”. On paper the strategy seems perfect. The retiree is living off the “fruit of the tree” without affecting the “tree”. But as often happens outside the classroom, life throws a curveball, which we have just witnessed with Covid, where all but a few companies suspended or delayed dividends. The hardest hit has been the property sector with significant falls in rental income as tenants have been unable to pay their rent.
Retirees’ dependant on rental and dividend income have seen their incomes dry up entirely and those without contingency funds have been forced to sell assets at depressed prices to provide for their income, thus turning temporary paper losses into permanent loss of capital. The perfect retirement income strategy has been found wanting, which brings me back to the term capital income and a total return strategy for retirement planning.
Capital income is used to describe a drawdown from an investment portfolio, this is most often associated with Living Annuities, where the retiree elects to draw a percentage of the portfolio value of between 2.5% – 17.5% per annum. The general rule of thumb to ensure a sustainable income for life is less than <5% in the 1st decade of retirement and less than <6% in the 2nd decade.
The major difference between the income strategy and a total return strategy is the underlying composition of the portfolio. A total return strategy would typically include exposure to more defensive assets iro cash / bonds and offshore assets. The addition of fixed interest and offshore assets reduces the expected return of the portfolio, which then requires the retiree to draw on both capital and income in meeting their pension requirements.
The result is capital erosion in retirement, which talks to the recommended drawdown limits in ensuring that the capital will last over the life expectancy of the retiree. Contrast to the pure income strategy where you are only living off the income produced from the capital, which remains intact and growing, but………………
The income strategy comes with the higher risk/return budget, which is probably not suitable for most retirees and is certainly questionable after the Covid experience when income disappeared overnight.
Mcomm, CFP®, HdipTax
T. 021-205 1133