The truth about inflation, fees and your investment return
20 November 2013 | Investments | General | Steven Nathan, 10X Investments
The retirement fund industry sold their clients the dream of becoming a multi-millionaire by simply investing 15% of their monthly income into a high equity fund for the next forty years, and with such a fund delivering a compound return of 16.5% per annum over the last 40 years, this actually seems possible. However, there is one little catch – the return is quoted on gross investment returns and fails to include the impact of fees and inflation.
Take a 25 year-old graduate earning approximately R300 000 per annum (pa) who will start with a monthly contribution of R3 750 and whose salary and contribution will grow with inflation. The graduate may receive an investment projection of an incredible R340 million by simply investing 15% of their monthly income into a high equity fund for the next forty years.
However, this is not the real value as the investor still has to pay fees charged by the advisor, administrator and investment manager.
The service providers will argue that fortunately, these fees only accumulate to 2.5% pa, resulting in the investment still growing at 14% pa. However, considering current market returns of 15.5%, these fees will equate to approximately R158m of the total investment return projection, leaving the investor with R182m.
While R182 million may seem like a lot, considering that headline Consumer Price Index (CPI) inflation averaged 10% pa between 1971 and 2011, this may not go very far. Funny numbers come up when inflation grows at 10% for 40 years. That R500 000 luxury car will set the investor back R20m plus, and they’ll spend R27 000 filling it up. Clearly, R182m will not go as far as they imagined. If 2.5% in costs reduced the investment to R182m, deflating this by a further 10% pa means the investor’s retirement asset shrinks to R4.2m after inflation.
Lessons about inflation and fees
It is very easy for investors to get carried away by long-term nominal benefit projections, which include the inflationary contribution. Although investors are all aware of inflation, compounded over long time periods, it is a much stronger force than most people realise. While the retirement fund industry may use this to their advantage on the asset side (i.e. by projecting enormous investment outcomes), it is typically ignored on the liability side (i.e. living expenses in retirement). This creates an illusionary sense of future wealth.
Future asset values are meaningless if not placed within the context of their present purchasing power. This context is created by ignoring inflation and projecting only real returns.
Projecting nominal returns is, in any event, pointless as we have no idea what future inflation will be. Over the last forty years, inflation averaged 10%, but only 7.9% over the last twenty years and 6.1% over the last ten. Given that the Reserve Bank now targets an inflation band of 3% to 6%, we can be optimistic that future inflation will be lower than the historic mean, but we simply don’t know. And if we can’t predict future inflation, we cannot predict future nominal equity returns.
Real investment returns, on the other hand, have been very consistent over the long-term, averaging approximately 6% pa for a high equity portfolio. Future returns are always uncertain, but long-term real equity returns provide a more relevant trend line.
It is just as easy to dismiss costs as irrelevant: few investors appreciate the ruinous impact of fees on the long-term investment outcome and the retirement fund industry seems keen to avoid the subject. Firstly, the impact of fees compounds as you not only lose the fees, but also the return you would have earned on those fees. And secondly, fees are viewed in the context of nominal rather than real returns. Giving up 2.5% when your portfolio returns 16.5% pa does not seem onerous, but in the context of a balanced portfolio, projecting a 5% real over the long-term, halves your return. Fees then compound to erode even more of the investor’s long-term investment.
The reality is that high costs can derail even a diligent 40-year savings plan. An element of fees is inevitable, but some fees are avoidable. If you paid only 1% pa in fees in the example above (for example, by using a low cost index tracker and going direct instead of through a broker), your investment would be worth R6.1m in 40 years or 45% more (in today’s money). That’s a real boost for your retirement.
So, the next time you are led to believe your retirement cup "runneth” over, remember the slips.
