How to protect your retirement plan from inflation

We feel the effects of inflation in almost every aspect of our daily lives. From the rising cost of groceries to the escalating price of petrol, and especially the big increases in medical aid premiums, we often find ourselves wondering when this continual increase will finally subside. The truth is it won’t. As with every year up to now, these expenses are only going to carry on increasing throughout your retirement years. The only unknown factor is how much prices will increase each year.

The two biggest financial risks in retirement are running out of money and not maintaining the buying power of your Rands. These two risks cannot be ignored, and a balance needs to be found in the creation of your retirement plan. Although we need to ensure that you can pay the bills now, we also need to ensure that you’re still able to do so twenty or thirty years into retirement. It’s tempting to maximise your income from the onset, but failure to consider and cater to the rising costs of goods and services could put you in a position where you struggle to afford even the bare necessities in years to come. Unfortunately, by the time you realise this, it is often too late to fix the situation.

When it is time to retire from your retirement funds (Pension, Provident, Retirement Annuity, and Preservation funds) there are essentially two main options available to provide you with an income (pension), a guaranteed life annuity, or a living annuity. Depending on your annuity choice, how you incorporate inflationary protection into your retirement plan will differ.

Guaranteed Life Annuity

When purchasing a guaranteed life annuity, you’ll need to decide on your annual increase at the inception of the annuity. An inflation-linked annuity will provide the best inflationary protection, as your annual increases are aligned to and guaranteed to match the actual inflation rate each year. However, it’s important to note that this is also the most “expensive” type of guaranteed life annuity, meaning that your initial income will be lower than that of alternatives. You pay for this complete inflationary protection in terms of a lower starting income.

Another option available to you would be to set a fixed annual increase in your income. For example, a fixed 5% annuity would guarantee a 5% increase each year. You can choose what increase you would like to implement. Naturally, the higher the increase, the lower the starting pension, and vice versa. Finding the right balance between an adequate starting income and inflationary protection is key. The major risk associated with this type of annuity is the potential for inflation to exceed the increase you have chosen, resulting in your income increasing failing to keep pace with the inflation rate and eroding the purchasing power of your income over time.

A level annuity provides a higher starting pension but with no annual increases. This might feel good for the first few years into retirement, but the diminishing purchasing power of your income that you will likely experience in the long term is a heavy cost to pay. Remember, once a guaranteed life annuity is implemented, it cannot be changed, an important consideration in this case.  

With-profit annuities provide for an annual increase that’s linked to the performance of a specific underlying investment portfolio. In this case, you’d normally choose a with-profit annuity that targets a certain level of inflation protection. However, this annual increase is not guaranteed, and if markets do not perform as anticipated, your purchasing power could diminish.

Living Annuity

When investing in a living annuity, I would argue that catering for inflationary protection within your income strategy is the most crucial consideration. While a living annuity offers the flexibility to change your income annually on the anniversary date, it is essential to have a cash flow plan in place that accounts for potential future inflationary increases.

Clients often ask me why they cannot draw the full growth on their portfolio each year. Based on the living annuity product rules, which allow for an annual income draw of between 2.5% and 17.5%, you may certainly do this. However, it is essential to understand how your current annual income draw affects your ability to increase your income with inflation each year.

Let’s use a simple example: Client X invested R1 000 000 into a living annuity. Based on his financial adviser’s growth assumptions for the investment, he could expect a return of 10% per year. Client X decides to draw the full 10% growth as income (R8 333 per month), as this matches his income requirements. This would leave his R1 000 000 capital untouched in year one.

However, in year two, client X’s expenses have increased due to inflation, and he now requires R8 800 per month to meet his monthly expenses. Client X will now have to set his income draw rate in year two at 10.56% of the capital. As this exceeds the estimated growth, from year two, client X will begin depleting his capital. As he attempts to increase his income on a diminishing capital value each year, the ability to match his expenses will become more unachievable. Additionally, once your income draw reaches 17.5%, you cannot implement further increases. Although you still have capital in your living annuity, your income reduces drastically after this point.

Instead, client X should look to set an initial draw rate less than the assumed portfolio growth in his early retirement years. This would enable the portfolio to achieve capital growth to fund future inflationary increases. It’s likely that client X will eventually need to draw on his capital, but ideally, this should occur in the later years of his retirement. A financial adviser will be able to create an income plan that aligns with your goals and objectives.

In conclusion, inflation poses a significant threat to retirement plans by eroding purchasing power over time. To mitigate this risk, it's important to incorporate inflation protection into your retirement strategy. One option is to use an inflation-linked annuity, which provides guaranteed annual increases aligned with inflation but comes with a lower starting income. While an annuity with a fixed annual increase or a with-profit annuity will give you a better-starting income, there is a risk of failing to keep up with the actual inflation rate over time. Alternatively, a living annuity with a well-planned cash flow strategy can help maintain purchasing power in the long term. Balancing starting income with inflation protection is key to ensuring your financial stability throughout retirement.

* Wendover is a financial consultant at Alexforbes.

PERSONAL FINANCE