The risks of early retirement and poor financial choices

Feel free to reach out to PSG Wealth adviser Bernice Barnard  directly.

The Dangers of High Withdrawal Rates

All retirees face the reality of living longer, especially with ongoing advances in healthcare. This means that you may need to rely on your retirement savings for longer, which increases the risk of depleting your funds early, particularly if your withdrawal rate is too high.

The critical question is: how much can you safely withdraw without depleting your funds too quickly? Retirees often turn to living annuities, where they can choose a withdrawal rate of between 2.5% and 17.5% per year. The goal is to withdraw at a sustainable rate, typically around 4%-5% annually, for retirees of normal retirement age (60-65 years of age). However, if you retire early, this percentage may need to be even lower to ensure that you don't outlast your savings.

The more excessive your drawdown rate, the less likely the chances of the investment growth earned keeping up with your drawdown rate, even if markets perform very well. Over time, you may find yourself with insufficient funds to cover your expenses, especially with longer life expectancies and increasing healthcare costs.

Before you retire, it's important to understand that it is doubtful that you'll be able to receive the exact value of performance-based salary increases or bonuses during retirement unless you have made proper provision for it. Therefore, it's essential to try to establish additional sources of income, such as rental income or investment proceeds, to supplement your primary income for as long as possible.

Property purchases in retirement: Be cautious

Buying property during retirement can be risky. If you purchase a home to live in, your money will be tied up in an asset that doesn't generate income unless you rent out at least part of it. The property's value won't cover ongoing expenses like maintenance, food, medical costs, or utilities, which could make you financially vulnerable if your retirement funds start to decrease.

However, investing in property for rental purposes can provide an additional source of income. Nevertheless, there are potential downsides, such as long periods of unoccupancy and potentially significant maintenance costs, so it's essential to anticipate and prepare for such costs.

In short, a property can be an asset in retirement if it generates income, but if it's solely for personal use, it offers no liquidity to cover other essential expenses.

Other Financial Challenges Faced by Early Retirees

Inflation and Rising Costs: Over time, inflation erodes purchasing power, and even conservative estimates of 4-6% inflation can significantly impact long-term savings. Early retirees may find it challenging to maintain their standard of living, especially with fixed income streams.

Healthcare: Medical expenses tend to rise significantly as you age, and early retirees may face the financial burden of covering private healthcare for a longer period. Annual premium increases often exceed inflation, making healthcare a significant financial concern.

Supporting Dependants: Early retirees may feel the need to support both children and ageing parents financially. With high unemployment rates, many retirees may also feel the need to provide financial assistance to adult children, placing additional strain on their retirement savings.

Loss of Employment Benefits: Early retirees lose access to employer-sponsored benefits such as group life insurance and pension fund contributions. Without these, retirees must cover such premiums themselves, adding more pressure to their finances.

Taxation on Retirement Income: Income from post-retirement funds is subject to income tax, and large withdrawals may push retirees into higher tax brackets, reducing the overall value of their retirement savings.

Debt Repayment: Many retirees still have outstanding debt, such as home loans or personal loans. Managing debt repayments on a reduced income can strain finances, especially when combined with interest payments. It is essential to prioritise debt repayment before you retire to reduce ongoing financial obligations.

Lack of Structured Planning: It is crucial for retirees to have a diversified portfolio to manage risks associated with market volatility and inflation. Diversification spreads risk across different asset classes, sectors, and geographic regions, which minimises the impact of any one investment that performs poorly.

Lifestyle Inflation: Many early retirees tend to increase their spending on luxury items or travel. While enjoying life is part of retirement, overspending can quickly deplete retirement savings, leaving retirees vulnerable in later years.

Paying for Children's Education: Early retirees often face the question of whether to use their retirement lump sum to cover their children's tertiary education or take out a study loan. If you did not make sufficient provision for your children's tertiary education, ask yourself what you would have done had you still been a salary-earning employee with a fixed monthly income. While you may think that covering these expenses from your lump sum withdrawal will eliminate the debt aspect, it is essential to note that you will be reducing your retirement savings pool considerably and that once that capital is gone, so too is the growth you could have earned on it. Study loans typically offer lower interest rates than personal loans, allowing you to spread the cost over time and plan your budget while preserving your retirement funds. Obtain quotations from different institutions, weigh your options and see how this can fit into your monthly budget as an alternative to using your lump sum and losing out on the potential growth.

Possible solutions to financial challenges in early retirement

Despite these challenges, early retirees can still enjoy a secure and fulfilling retirement by adopting a strategic approach to financial management. Key strategies include:

1. Set a sustainable withdrawal rate: To make your retirement savings last, stick to the recommended drawdown rate, which will help you strike a balance between covering expenses and allowing investments to grow.
2. Diversify income streams: Consider generating income from rental properties, dividends, or part-time work to supplement your retirement income for as long as possible.
3. Maintain an emergency fund to handle unexpected expenses without dipping into long-term investments or spreading out payments. This approach allows retirement savings to continue growing.
4. Delay large expenses: Postpone significant costs, such as purchasing property or luxury travel, until you have a clearer understanding of your financial situation.
5. Seek professional advice: Consulting a financial advisor can help you create a personalised retirement plan that addresses your unique financial needs, ensuring your savings last for the long term.

Conclusion

Early retirement can be financially rewarding with careful planning and disciplined financial management. By maintaining a sustainable withdrawal rate, diversifying income streams, and resisting the temptation to overspend, retirees can protect their financial security. With a well-structured plan, early retirees can enjoy the benefits of retirement without the fear of running out of money.