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Research shows consistent investment returns key to comfortable retirement

23 February 2010 Alexander Forbes

Most people understand that they should save for retirement but what is less well known is just how large a portion of retirement income comes from investment returns - not just how much you’ve saved.

John Anderson, Head of National Consulting Strategy at Alexander Forbes, said: “More than 75% of retirement spending comes from returns on investment.

“Investment performance is therefore paramount in meeting net replacement ratio objectives or simply put, the percentage of your salary that retirement savings will replace when you retire.”

Anderson notes that according to research carried out by Alexander Forbes, an important contributor to a comfortable retirement is consistent investment returns that are above inflation and over the long term.

“Our research shows research shows that for every Rand spent in retirement:

• 23 cents on average is from pre-retirement contributions
• 41 cents on average is from pre-retirement investment returns
• 36 cents on average is from post-retirement investment returns

“What the research illustrates is that three quarters of retiree spend comes from returns on their savings.

“It highlights that while putting money away for retirement is of course fundamental, more focus needs to be on returns on that investment because each 1% per annum really counts.”

Compound interest is one of the most important allies for savers.

The positive impact of interest increases exponentially over the long term as one starts to earn interest on interest. A further result is that an increase in the interest rate has an exponential impact over the long term.

This can be illustrated as follows:


 (Click on image to enlarge)

The following conclusions can be drawn from the above graph:

• At a rate of 4% per annum, R 100 will grow to R 148 over ten years, i.e. R 48 interest. If the interest rate increased to 6% per annum, one ends up with R 171 i.e. R 31 more interest (around 65% more interest!).

• Over a working lifetime of 35 years, the difference is an end value of R 769 vs. R 395, i.e. R 374 more interest (i.e. around 127% more interest!).

• Of the R 669 interest earned over 35 years (at 6% per annum), R 339 (i.e. more than half) is earned over the last 10 years. It is therefore important to continue to earn a good investment return by investing appropriately right up to and into retirement.

Said Anderson: “Clearly it is important to achieve as high an interest rate on retirement savings as possible and every bit extra counts.”

“Unfortunately inflation works against the positive investment returns achieved. The real interest rate, being the difference between the actual investment return earned and inflation, is therefore the key driver behind achieving a comfortable net replacement ratio.”

Examples:

• Joe works for 35 years and saves all his retirement contributions over this period. Assuming he contributed at 15% of his salary and earned 4% above inflation (and his salary increased in line with inflation); he can expect a net replacement ratio of about 69% at his retirement age of 60. In order to earn this return, Joe invested in a portfolio with a high weighting to equities.

• Joe’s twin brother Jack also worked for 35 years, contributed 15% of his salary over this period and retired at age 60, but Jack invested in a cash only portfolio. Over the long term, cash returns are lower than the returns on a balanced fund, but Jack was lucky: the cash returns kept up with inflation…but only just! He earned a real return of 0% and as a result, his net replacement ratio came to 33%, less than half that of Joe’s net replacement ratio.

This result can be further illustrated below:

Real return

Expected NRR

0%

33%

1%

39%

2%

47%

3%

57%

4%

69%

5%

85%

6%

106%











• NRR : Net Replacement Ratio

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