Most investors would have noticed a decline in their investment returns over the last two calendar years due to volatile market conditions, especially in 2016. When times are tough, retired and semi-retired clients feel the pinch and may consider other sources to supplement their income. Sometimes this leads to them venturing into new businesses, hoping that the capital withdrawal from their investment savings will ‘make up’ for the diminishing income.
Sometimes clients make these decisions without consulting their advisers in advance about the potential consequences should the venture be unsuccessful. Having a business plan, industry experience, a positive attitude, faith and encouragement from family and friends could simply not be enough.
“Statistics vary, but on average, about 50% of all start-up businesses in South Africa fail within 24 months due to the inability and inexperience of their owners” according to Ravi Govender, Head of Small Enterprises at Standard Bank. According to Ravi a major contributing factor is because these small businesses are started as survivalist ventures.
A new business may face many pitfalls and challenges. I mention only three below:
- No capital limits set at the planning phase. “We’ll see how it goes and adapt” attitude is risky.
- Cash flow problems that lead to more capital withdrawals, exceeding the initial capital at the planning stage.
- Not knowing when to say “No”. Customer service, quality, follow-ups etc. are all important. Sometimes you have to say “No” to business projects in order to stay focused on quality and not quantity. Buying new stock to satisfy one or two customer requests might not be profitable.
Unsuccessful business ventures may relate to the psychology of the business owner. Did you seek professional help? Did you follow the advice or did you believe the cycle would turn if you continued a bit longer?
Let us have a look at a practical example and how the decision can affect a retired couple’s capital and income if the venture fails:
Brian and Sue retired at age 55, live in a retirement village where they have purchased a life right unit, have no debt and no dependent children. Both of them worked and now earn a pension in their retirement years. Due to increasing living costs, they anticipate monthly income shortages within 24 months. Brian and Sue are both aged 60, fairly fit and healthy, with combined retirement capital of R4 million. Their current monthly income from the R4 million is R20,000.
Brian and Sue are encouraged by their son to buy a small business. The purchase price of R500,000 is redeemed from Brian’s investment capital, leaving Brian and Sue with R3.5 million capital. The business turnover is satisfactory for a new venture, but after 12 months Brian withdraws another R200,000 when the business experiences cash flow problems. The business eventually fails and they decide to close the doors after two years. They were renting premises, so there was no capital from the sale of a property, and there was no interest from anybody to buy their failed business. They were able to sell unsold stock to the value of R100,000. In total a loss of R500,000 (initial) + R200,000 (addition) – R100,000 (stock sold) = R600,000. Is this the real loss?
Brian and Sue did not approach their financial adviser prior to making the decision, but are now concerned about their financial future at the age of 62. Let us try to analyse their situation, without focusing on the reasons why the business failed:
Firstly, assume the following:
- Brian and Sue made no other capital withdrawals over the two years.
- They lived modestly off their retirement capital of R20,000 per month in year 1 of the business and R22,000 per month in year 2 of the business.
- The average return on their remaining retirement capital was 9% after year 1 of the business and 5% after year 2 due to volatile market conditions.
- Ignore taxes for this exercise.
Brian and Sue meet their financial adviser at the beginning of year 3 when their remaining retirement capital is worth R3,280,870. The first question Brian and Sue ask is: “What would our retirement capital have been at the beginning of year 3 if we had not withdrawn funds for the business?”
Assuming the four assumptions above held true, their adviser calculated retirement capital of R4,065,988 at the beginning of year 3:
- R4,065,988 – R3,280,870 = R785,118 was the loss over two years. So, the loss exceeded the original R500,000 business investment and the monetary loss of R600,000.
- The opportunity cost was R785,118. It could have been monthly income of R22,000 for three years. This represents a loss of 20% of their original R4 million capital in just two years.
It is not just the capital and future income losses we should be concerned about, but the future values and benefits in later retirement years that are lost due to the failed business venture.
Three years ago Brian and Sue had retirement capital of R4 million and were withdrawing 6% per annum for living expenses. At the start of year 3 they have R3,280,870 retirement capital and budget an extra R1,500 per month needed. Their withdrawal rate jumps to 8.6% per annum.
The potential financial situation Brian & Sue now face at age 62 can be summarised below:
- Their retirement capital has diminished but their living expenses may increase over time as they get older.
- An increasing withdrawal rate beyond the investment return will deteriorate their financial situation.
- The capital value of their unit in the retirement village (remember it is a life right) is not accessible at this stage, and can’t be taken into account for living expenses.
- Should Brian or Sue require capital withdrawals for medical expenses not covered by their medical aid, or one – or both − need frail care in future, the pressure on their retirement capital and monthly expenses may lead to difficult times.
- Financial assistance from family may be necessary, but adult children may have their own financial commitments and strain, or worse, borrow money from their parents in retirement who can’t afford to lose the capital.
Starting a business, even as a silent business partner (providing capital only) in retirement should be thoroughly investigated and the impact on your retirement savings be discussed upfront with your financial adviser.
Failing to plan is planning to fail. Passion is no substitute for experience.
Loren Godet is a Trust Officer at Personal Trust. She joined the company in 2011 and has over 15 years’ experience in the financial services sector.