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Broad principles of retirement savings

16 May 2013 Peter Atkinson, FIA
Peter Atkinson, National Technical Portfolio Manager at the FIA.

Peter Atkinson, National Technical Portfolio Manager at the FIA.

Most people view retirement savings as the ultimate goal of their wealth accumulation activities, with savings for expenses such as school fees, holidays and medical bills being necessary “sidelines” in the broader picture.

Although all forms of savings have their place, the importance of a proper retirement savings plan cannot be underestimated. South Africa offers little by way of a state-backed social retirement solution while employers are increasingly opting to leave retirement savings to individual employees rather than prescribing membership of approved schemes. The result: a ‘cafeteria’ approach to retirement funding with employees left to their own devices to spend their monthly ‘cost to company’ salary.

Increased worker mobility and the tendency for those who reach retirement age to live longer than previous generations are two additional challenges to retirement planning, as is the ever-increasing cost of medical services. It is well documented that the average person will incur approximately 80% of their lifetime medical expenses in retirement.

How should South Africans prepare for retirement? The planning process involves two stages – building of funds during one’s working life and then converting the funds into an appropriate income stream in retirement. For the more affluent, estate planning also becomes a consideration.

In each of these stages it is necessary to take into account the impact of taxation and available tax concessions, bearing in mind that there are those who earn so little that tax has no real effect. The major difficulty in planning for these stages is that one can never determine for how long the income stream is going to be required and the impact of inflation in retirement.

Financial and risk advisors traditionally tackle the retirement planning task from four angles:

Targeted savings contribution percentage

It has long been held that putting away 15% of your gross earnings over your full working career should result in a satisfactory level of savings. Recent thinking is that a contribution of 17.5% is more appropriate, particularly for savers who invest outside of formal approved schemes (foregoing the tax-incentives on offer) and when part of the retirement funding contribution is used to secure risk insurance benefits.

Whatever the contribution your success depends on channeling the funds to suitable investment vehicles and preserving your capital until you reach full retirement. The most important message is to begin saving for retirement as soon as you receive an income, because any delay means that the required contribution as a percentage of your salary escalates rapidly.

Targeted conversion ratio

This method is based on the widely accepted “benchmark” that the retiree should be able to secure an income in retirement of 75% to 80% of the level of income enjoyed immediately before retirement. Provision must also be made for subsequent escalations to combat post-retirement inflation, which would mean that the initial income in retirement could actually be somewhat lower than this target level.

The 75% to 80% replacement ratio is not set in stone and you can set a target based on your unique needs. Someone who is saving a high percentage of income just prior to retirement would be used to living off a lower percentage of the available income and could well be comfortable on a 60% conversion ratio, for example.

For this approach to succeed you must frequently reassess your retirement capital target as you approach retirement age.

Targeted capital sum

The targeted capital sum is based on the fact that the amount of accumulated capital (or retirement savings) needed varies according to the age at which you decide to retire. The target may be 18 times your annual income if you intend retiring at age 55, 16 times annual income if retiring at age 60 and 14 times if retiring at age 65. Upon retirement this capital must be applied suitably to provide an escalating income.

It is not easy to determine how much retirement capital you will need to achieve your retirement goals – nor how much your assets will contribute to this sum. Standard practice is to include all your long term assets and investments in the calculation but to exclude those that would continue to play a meaningful role in retirement – such as your primary residence.

Retirement income needs analysis

Under this approach a careful estimate is made of the actual expenses that will need to be met by the retiree. Allowance must be made for post-retirement inflation with careful consideration of the health of the retiree. This may provide an indication of the likely lifespan and hence the term of retirement as well as some indication of the likely medical costs that will be incurred in retirement. The main focus is on the expenses during the first year of retirement, with provision then being made for income escalations to cover the effect of inflation in subsequent years.

Each method has its advantages and disadvantages. The Targeted savings contribution percentage approach takes little account of the importance of the investment growth to be achieved. The Targeted conversion ratio and Targeted capital sum techniques typically ignore the reality that each retiree will have different personal circumstances and expectations – while both are based on an unknown variable, being the end salary. These methods become more accurate as retirement age is neared.

The Retirement income needs analysis, while probably the most precise, is difficult to calculate accurately until one approaches retirement age. And you still face the challenge of determining how much capital you will need to meet these needs.

Given the complexities involved it is wise to consult an experienced financial and risk advisor who can assist you with the various calculations, advise on the most appropriate retirement solution for your need and ensure that you implement the agreed solution.

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