Is equity essential for retirement investment portfolios?

Jo-Anne Bailey, Sales Director & Country Manager for Africa at Franklin Templeton Investments.

The answer to this apparently simple question is twofold. Before one can delve into the issue of the importance of equities in investment portfolios aimed at retirement, it’s necessary to investigate the concept of retirement investment as a whole. In this regard, it’s necessary to consider the fact that the advancement of medical science now means that most people are likely to spend virtually the same amount in retirement as they did working and building up their retirement nest egg.

This longevity places a massive amount of pressure on the retirement capital we have available when we stop working and significantly increases the importance of starting to save for retirement as early as possible. By way of illustration, an average annual inflation rate of 6% means that if your monthly expenses are R50 000 today and you are 40 years of age, your expense will increase to over R160 000 per month by the time you reach age 60. Even during retirement, the impact of inflation will mean that your expenses keep growing every year and will touch over R280 000 at 70 years and, by the time you are 80 years old, will amount to more than R510 000 per month.

At face value, these figures may appear astronomical but they will be a reality if inflation continues at 6% p.a. Of course, during your working years, your income should increase proportionately. However, to meet these expenses for 30 years after you retire, you will need to have an amount of at least R10million to invest when you reach a retirement age of 65 years. And that’s assuming that this at-retirement investment still earns above-inflation annual interest throughout your retirement.

What does all this mean? Well, for one, it means that our money must work harder than ever for us to meet our expenses. You could make a similar calculation for any life goal – be it education, marriage, taking a vacation or buying that dream home.

It’s also important to differentiate between saving and investing. While South Africans are notoriously bad at saving, there are some households that have savings accounts. However, this saved capital should not really be factored into long-term investment goals - especially retirement - because while a savings account is excellent for minor financial emergencies, the money is not usually being invested optimally as interest from fixed deposits or other pure savings facilities are simply too low over time to grow your money enough to meet your retirement needs. Add to this the fact that people’s propensity to save has declined in the face of rising consumption and living expenses and it becomes clear that ‘saving’ for retirement is a very risky approach. What is needed is proper investment, linked to a clearly defined investment plan.

Importantly, such an investment plan has to focus on much more than merely whether to buy equities, debt or some other form of investment. Rather, it needs to be a goal-based approach to investing, where investments are segregated for each goal and monitored until that goal is achieved. Just as we use specialists like wedding planners, interior designers, nutritionists, physical trainers, etc., to meet our lifestyle objectives, goal-based financial planning requires special skillsets typically offered by the relevant financial professionals such as Certified Financial Planners (CFPs) and Financial Advisors.

While following a planned and methodical approach is particularly relevant to retirement investment, it applies equally to any form of investment, with any long-term desired outcome. Starting to invest early for your goals is critical, as any delay in investing can negatively impact your ability to achieve your objectives. By way of illustration let’s go back to the required R10 million required as a retirement investment to secure an inflation-equivalent pension of R50 000 at age 65. Assuming annual returns of 10%, if you start investing towards this lump sum* at age 25, you will need to start by putting away R480 per month. If you wait 10 years and only start investing at age 35, your starting monthly investment jumps to R1700! Delay your start date by another 10 years until you’re 45, and you can expect to start out investing R6500 per month.

Of course, putting your money into a savings account is unlikely to earn you 10% per year growth, which brings us to the original question of whether equities need to be part of your plan to build the desired investment sum. A critical aspect of ‘asset allocation’ is deciding the amount of money allocated to different asset classes such as equities, bonds, property, etc., in a portfolio. One way to decide asset allocation is by age and time horizon available to reach that goal. For example, a young person in his first job may be willing to take higher risk as he may have limited liabilities and responsibilities. On the other hand, a 50-year-old could have higher liabilities and responsibilities and may choose a portfolio with a slightly lower return, but with relatively less risky investments. So, deciding the right asset allocation based on our goals and risk appetite is very important in constructing a well-planned portfolio. Please do remember, financial planning is not just about investments, it should also include contingency planning like insurance and succession planning.

Given that we have established that our money needs to work harder than ever to keep up with the rising cost of living and our longer lifespans, rather than asking whether equities are essential, we should be asking ourselves why equities are essential. The answer is relatively simple. Equities have the proven potential to provide higher returns than most other investments over a period of time. However, due to the higher risks involved in getting these higher returns, equity investments should be chosen for longer-term goals, which are ideally more than five years away. As such, investment funds with a strong equity bias are one of the best ways to invest for the long term and, as such, should be considered an essential part of any well-planned and diversified investment portfolio.