DALL·E

Many of us know decision fatigue all too well, with countless events and choices that demand our attention daily. So just imagine the relief a one-size-fits-all retirement plan would bring.

Unfortunately, Nobel Laureate and MIT Sloan School of Management Professor Robert Merton nipped that fantasy in the bud when he compared retirement planning to a doctor prescribing the same medication to all his patients. He argued that patients have different symptoms and respond differently to medication – and similarly, our approach to retirement needs to be personalised to suit our needs.

Merton’s big thought regarding retirement planning, is that one needs to start by identifying what income you’ll need when you are retired – rather than focussing on the size of your savings pot.

But ‘income need’ is also a big concept to wrap your head around, because it’s impossible to predict the future. So, start with the very basics of what you do know: 

• You won’t have to pay school fees or commute to work anymore
• You won’t have to contribute to your company pension benefit or your retirement annuity
• If you’re a homeowner, you know more or less when your bond will be paid off

To further simplify financial planning for retirement,  Merton divided that income requirement into three distinct categories or buckets: Must-have income, flexible income, and nice-to-have income.

Category 1: Must-have, guaranteed income

What is the absolute minimum income needed for you and your household to cover essential expenses? This includes necessities such as housing, food, and healthcare.

Category 2: Flexible income

Falling not squarely in the guaranteed income bucket or the nice-to-have bucket, flexible income can support a nicer version of the necessities and perhaps sustain a hobby you’re planning to take up during retirement. These expenses are not strictly mandatory but are desired.

Category 3: Nice-to-have income

The third layer is allocated to income that you can do without, but which allow you to travel and enjoy your more expensive hobbies.

How does that guide your financial planning for retirement?

Category 1: Must-have, guaranteed income

You guessed it – an inflation-protected life annuity that offers guaranteed payments for life can set you up for a guaranteed income for the absolute necessities. We wrote about it here as well. A guaranteed annuity is essentially an insurance product – so your money will be safe, but it won’t grow. This is where the second layer comes in.

Category 2: Flexible income

The second layer caters to a secondary category of expenses. If you’re uncomfortable with relying entirely on annuities, a more balanced approach might work. Think about discretionary savings, a tax-free savings account, or additional income streams such as rental income.

Category 3: Nice-to-have income

This category can see you invested outside of a traditional retirement product and aligned with your risk tolerance.

In short 

Merton’s retirement income plan allocates savings according to spending needs. The key categories include covering essential expenses with guaranteed income, prudently investing for desired but non-essential spending, and allocating more risk for discretionary expenses.

Saving for retirement is the biggest investment most of us will ever make. Sadly, it can also be very complicated. In this monthly blog, Carina Jooste responds to common retirement questions, ranging from which products are best suited to different circumstances to efficient tax treatments.