“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.”
– Warren Buffett
Do the math, there are no shortcuts
Your plan will always begin with a cash flow analysis. The goal of a cash flow analysis is to provide you with a realistic overview of your portfolio’s ability to meet your future income requirements. Your budget serves as the foundation for your cash flow analysis, which considers all anticipated cash flows. Income from retirement products, rental income, the sale of a property or a business, and so on are examples of this. It also incorporates your fixed expenses, tax, and ad hoc expenses such as replacing your vehicle or traveling abroad. You must also consider the changes in your lifestyle that come with getting older, such as spending on medical care.
To make planning as realistic as possible, assumptions for inflation, growth, and longevity must be made. The tax implications of each source of retirement income are also considered. For example, gradually selling shares will only result in capital gains tax, whereas annuities purchased when retiring from retirement annuities will be taxed at your marginal rate. Withdrawal rates must always be considered in the light of your income sources, your financial needs, inflation, and investment performance.
Do you have clearly defined goals?
Have you ever noticed how the same people jog or cycle every day? Most people want to get in shape, but that doesn’t mean they’re willing to put in the effort. Similarly, if you want to become and stay financially fit, you must exert the same level of effort and discipline. You must establish clear financial goals, budget, and manage your expenses. Prioritising goals, including those related to essential needs, contingency funds, discretionary spending, and legacy matters, is essential.
Income efficient portfolio
In the pre-retirement stage, your focus should be on accumulation, where you benefit from rand cost averaging, which means you buy more assets when prices fall. As you get closer to retirement, you start planning the transition from work to retirement, and your focus should shift to capital preservation and income distribution while still targeting some growth.
Returns during this period will have a significant impact on the duration of your retirement income. If you have poor early returns in retirement, your income may be depleted faster than if you have strong early returns, and vice versa. This is known as sequence risk. This can have a significant impact on you if you rely on the income and can no longer contribute new capital to offset losses. Sequence risk should be carefully managed.
Wealth allocation framework
It makes sense to divide a retirement portfolio into buckets based on investment time horizon. Allocate the first two years’ worth of income to a strategy focused on capital preservation and income generation (money market and bonds). Set aside three to five years’ worth of income for a preservation strategy that includes diversified assets and aims for real returns with a high degree of capital stability. The remainder of the portfolio should be allocated to a wealth creation strategy that includes exposure to growth assets, which will allow the portfolio to grow faster than inflation over time.
Segmenting a retirement portfolio by time horizon provides you with a predictable stream of income while also assisting you in weathering volatility in the more aggressive growth assets. Your risk profile and expected returns, liquidity needs (cash flow), and time horizon will all influence your asset allocation. Health warning: This strategy will not work if your withdrawal rate is too high or if you use inferior building blocks to populate your portfolio.
The next article will go over diversification, balancing risk and return, costs and taxes, balancing reason and emotion, life expectancy, and ignoring noise.
Created by Jeanne-Marie Lombard CFP®, FPSA®, TEP