How to use the rule of thumb to make your clients’ retirement savings last

A rule of thumb is a general principle or guideline based on practical experience rather than a strict law or scientific proof. It’s used to make quick, approximate decisions when exact information isn’t available or necessary.

In finance, a common rule of thumb for budgeting and saving is to “save at least 20% of your income”. There is such a rule of thumb for people with a living annuity, yet like the savings rule, it is sometimes difficult to achieve. The rule is, “if you want your living annuity income to last 25–30 years while keeping up with inflation, your withdrawal rate should be no more than 4% to 5% of the capital amount when you retire”.

What’s not immediately obvious is that this rule essentially includes an underlying assumption about returns. When using a simplistic inflation assumption of 5% on the income amount, you can calculate that for an initial 5% withdrawal rate, you would need an 8.2% net of fee return to maintain your income for 25 years.* This does seem like a realistic long-term rate of return. The same calculation can be done for each level of drawdown (as shown in the table below).

This tells us why the rule is at 4% or 5%. Moving to an income drawdown of slightly over 6%, you would, for more than two decades, need double-digit returns after fees to make this equation work. These levels may not always be achievable, but in reality, it may not always be avoidable.

Drawing an income of only 5% (and that will still be taxable) from your living annuity means you would need a R2 million living annuity to get a starting income of R100 000 per year, or R8 333 per month.

It is clear that the amount of money needed can become astronomical very quickly and many people will have to break the rule of thumb. They will have to draw more than the guideline of 4% or 5%, implying that they may need a 10% or much higher return from their market-linked funds to maintain the intended income stream.

At Momentum Wealth, we believe we have a way to make it easier to achieve the rule of thumb. Our new Guaranteed Annuity Portfolio (GAP) pays a guaranteed income for as long as your client lives, thereby protecting a portion of their retirement income. Unlike the traditional market-linked components that are used in living annuities, the GAP “return” is not linked to the market, as its income payments are guaranteed for life.

The levels of income that you can lock into in the GAP are generally high, and it enables clients to draw a higher level of income from their living annuities without increasing the underlying required return needed on their market-linked assets to maintain the income as above.

As an example, a 65-year-old male, drawing a 5% starting income from a traditional living annuity, would be able to maintain his income (increasing by 5% per year) to the age of 90, should his market-linked assets provide a return, net of fees, of 8.2% per year.

When allocating 50% of his portfolio to the GAP, that same man invested in the same market-linked assets performing at the same 8.2% per year, would be able to maintain a 7% starting income (increasing by 5% per year) from his “hybrid” living annuity.** In this instance, it is a 40% higher level of income.

This happens because with a R1 million GAP, the starting income of R7 468*** per month (that escalates at 5% every year), is just under R90 000 per year. If we think of this as a starting income of 9% (R89 616/R1 000 000), and we only needed 7%, it’s easy to understand that we would only need to draw about 5% from the market-linked assets. This is in line with the rule of thumb and implies that an 8.2% net return on these market-linked assets would be sufficient.

Clients no longer have to choose between the certainty of a life annuity and the flexibility of a living annuity. To see how we’ve reimagined retirement income planning into a blended product solution supported by a state-of-the-art income illustrator, visit our website momentum.co.za.

*Potential changes to inflation and inheritance needs have been ignored for simplicity.

**These are calculations done on a specific example and will not hold for clients drawing excessive income from their living annuities.

***The guaranteed rates of income that were available at the time of the research on a R1 million GAP. 

Momentum Wealth is part of Momentum Investments and Momentum Group Limited. Momentum Wealth (Pty) Ltd is an authorised financial services provider (registration number 1995/008800/07, FSP number 657). Momentum Metropolitan Life Limited is an authorised financial services and credit provider (registration number 1904/002186/06, FSP number 6406). The Retirement Income Option and the Guaranteed Annuity Portfolio are life insurance products, underwritten by Momentum Metropolitan Life Limited, a licensed life insurer under the Insurance Act and administered by Momentum Wealth (Pty) Ltd. The information in this article is for general information purposes and not intended to be an invitation to invest, professional advice or financial services under the Financial Advisory and Intermediary Services Act, 2002. Momentum Investments does not make any express or implied warranty about the accuracy of the information herein.