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Phase 3: 40-60

In Phase 3 income continues to rise, but it does so at a lower rate. Expenditure reduces mainly because in this phase:

- The children leave the nest.

- The mortgage debt is repaid.

Consequently, the savings gap (I > E = S) widens sharply, allowing for a substantially higher level of own (non-retirement fund) investment. At the end of Phase 3, the approximate portfolio of the family could be as indicated in Table 4.

Asset class

Indirectly via retirement fund (% allocation)

/ debt

Notes on own investment / debt

FINANCIAL ASSETS

Shares

75%

40%

Indirect: ETFs and / or SUTs

Bonds

10%

5%

Indirect: bond SUTs

Money market

8%

5%

Direct: funds in bank account Indirect: money market SUTs

REAL ASSETS

Property

5%

40%

Direct: own dwelling

Commodities

2%

5%

Direct: gold coins

Other real assets

0%

5%

Direct: antique furniture, art, rare books & stamps

DEBT

Zero

Zero

Zero

NET ASSETS

Positive

Positive

Table 4: Example of portfolios: end of phase 3

Note the following:

- The asset allocation of the retirement fund is unchanged.

- The family has diversified its own investments between asset classes to a degree, but the majority of financial assets are in shares. This is because the family continues to have a long investment horizon.

- The proportion of property in the own portfolio, although still high, has fallen sharply, a result of the allocation of savings to the other asset classes.

- The family's investment in financial assets (exception = bank account): as in Phase 2, they do not have the time to analyze shares and rely on the expertise of the fund managers of the SUTs and ETFs.

Phase 4: 60-80+

We assume that the two breadwinners decide to cease their active occupations at the start of Phase 4 and to pursue other interests, without income from these interests. They base this on having achieved their FSG. This in turn is based on an analysis of their total portfolio, as indicated in Table 5. Here we assume that the value their participation interest (PI) in the retirement fund is LCC 5 million and that the value of their own portfolio is also LCC 5 million. Given these numbers, their total portfolio's asset allocation is as shown in the last column (ignore the bracketed figures).

Indirectly via retirement fund (% allocation)

Own investments

FINANCIAL ASSETS

Shares

75%

40% (60%)

57.5% (67.5%)

Bonds

10%

5%

7.5%

Money market

8%

5%

6.5%

REAL ASSETS

Property

5%

40% (20%)

22.5% (12.5%)

Commodities

2%

5%

3.5%

Other real assets

0%

5%

2.5%

TOTAL

100%

100%

100%

Table 5: Example of total portfolio: start of phase 4

According to the retirement fund statute, they are obliged to purchase an annuity from a life assurer. There are two main types: the traditional guaranteed annuity (which guarantees an income for life, but has zero value at death) and the living annuity (which is subject to the vagaries of the markets, but has a value at death which can be passed on to the children). As they have substantial assets, and wish the children to inherit assets, they choose the living annuity. The statute obliges the annuitant to accept a minimum annual income rate of 2.5% and a maximum rate of 17.5%. They choose 5%, because at this rate, assuming a return on the portfolio of 10% pa, the income will only start reducing after 33 years. They expect to live for another 25 years (to age 85), so they have a margin of safety. The living annuity provides a taxable annual income of LCC 350 000 (assume LCC 245 000 after tax).

Annual annuity dividend

Implied yield (annuity / LCC 5 million x 100)

60

LCC 479 940

9.60%

70

LCC 553 440

11.07%

80

LCC 634 140

12.68%

85

LCC 675 080

13.5%

Table 6: Annual guaranteed annuity dividends and implied yield at various ages

They also find comfort from being able to switch to a guaranteed annuity, which generates a higher income as one gets older (because life-expectancy falls, as indicated in the numbers provided by the life assurer (see Table 656).

What decisions do they need to make in respect of their own private portfolio? Firstly, as their dwelling, valued at LCC 2 million, is now too large for them, they sell it and purchase a smaller dwelling for LCC 1 million. Secondly, the saving of LCC 1 million is allocated to the share market, bringing about a change in the asset allocation as indicated in brackets in Table 5.

The question arises: why did they allocate the LCC 1 million to the share market when they already had almost 58% in this market. The answer is straightforward: 25 years is the investment horizon, and it is a long period over which to be denied the higher return on shares.

If the average return on their own portfolio is a conservative 7% pa (assuming no dividend or capital gains tax and a low tax rate on interest), the income is approximately LCC 320 000 pa. This amount together with the annuity income gives a total annual income of about LCC 565 000. Given annual expenditure of approximately LCC 480 000 (LCC 40 000 per month), the financial situation is comfortable, without impairing capital (depending on inflation). If inflation is high or rises, there is comfort in the availability of the capital.

However, the closer one gets to exodus, asset allocation shifting and timing become important. For example, if one has 5-10 years to exodus, and the share market has had a good run for a few years, it may be wise to shift the portfolio in the direction of low risk assets (bonds and money market assets). Alternatively, if the share market has been low for an extended period (and one did not make a portfolio shift before this period), it may be wise to keep the portfolio as is. It is a personal choice, and it makes pertinent the study of macroeconomics, especially the interest rate cycle. The money market interest rate is the denominator in security valuation calculations.

 
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