The consequences of an additional 1%

We have seen numerous articles and studies that illustrate the negative effects that investing too conservatively or drawing too much income can have on your overall retirement benefit.

In this article we will explore the effect that an additional 1% return or income withdrawal can have on your pre- and post retirement benefit at varying stages of your life.

The assumptions used are:

• Investment starts with a lump sum amount of R20 000 at age 26;
• Contributions until retirement at age 65: R4000 per month;
• Contribution growth rate: 7% per annum;
• Inflation: 7% per annum;
• Total fee: 0.75% per annum (excluding fund specific fees)

Pre-retirement investing:

Using the above assumptions let’s take a look at the effect an additional percentage point return will have on your portfolio during the early, middle and later stages of your pre-retirement saving. Another way of looking at this is to see what the impact of a 1% fee per annum can have on your investment.

Assuming a real return of 5% and 6% the absolute difference in your pre-retirement benefit can be substantial – especially over the longer term. See the last column in the table below:

From the table above you can see that if your investment achieved a 6% real return and you had been invested from age 26 to age 57 your investment would have grown to a value of R3 791 912.20. This amount represents an additional return of R637 330.39 when compared to the value achieved by an investment that only managed to generate a real return of 5%.

The reason for this is the effect of compounding, which was called “the greatest mathematical discovery of all time” by Albert Einstein.

Having illustrated this – many investors in general still choose to invest more conservatively when approaching retirement, despite the fact that this is exactly the time when a higher return has an exponentially larger impact on your retirement benefit.

Post-retirement income withdrawal:

Let’s now consider the effects of an additional percentage point income withdrawal after retirement on your retirement benefit. Using the same assumptions we will now compare an income withdrawal rate of 5% and 6% respectively. In this example we assumed a real return of 6% over all investment horizons.

From the two tables below one can clearly see the dramatic effects that an additional percentage point withdrawal has on both the income amount per annum and the capital value of the investment over all life stages.

Effect of a 5% income withdrawal rate:

Effect of a 6% income withdrawal rate:

*The income amounts stated above are all after tax annual income amounts.

If you chose an income withdrawal rate of 5% you would not only have been able to grow your respective annual income but also the capital value of your investment over all the respective life stages. However, if you selected an income withdrawal rate of 6% - a mere 1% more - you would have reduced your annual income amount from year one as the capital value of your investment would have declined from the very first year. This can be seen in the graph below.

What is also interesting to note from the graph below is how the income gap (between a 5% and a 6% withdrawal rate) narrows up until age 83 - after which a 5% withdrawal rate produces a higher annual income amount. This can mainly be attributed to the fact that the higher withdrawal rate of 6% is being calculated on a smaller capital value when compared to the capital value of the investment where a 5% withdrawal rate was selected.
 (Click on image to enlarge)

In summary, the effects of compounding can have both a profound positive or negative effect on your investment, especially when you are in a life stage where your investment has a relatively large capital value, for example, when you are close to retirement or in the early stages of retirement.

As a result it is important that you – together with your financial intermediary – not only look at ways to enhance returns during periods when your investment has a relatively high capital value and limit your withdrawal rate especially during the early stages of your retirement but to always make sure that your portfolios aren’t invested too conservatively - while at the same time taking your personal risk tolerance into account.

*Glacier ICE provided the figures used in this article.