About 46% of people approaching retirement believe they have saved enough for their retirement. However, only 26% of retirees actually do retire with enough savings to allow them to retain a standard of living comparable to what they enjoyed while working[1]. Is it that retirees do not know how much they should have saved to retire comfortably or is it because retirees simply do not start early enough to save for retirement?
This article will shed some light on some of the issues mentioned above. The needs of the investor in retirement determine how much he should save for retirement. Categorising the needs into essential and non-essential varies from one investor to another. Your income in retirement should cover both essential and non-essential needs.
Due to the fact that retirees’ needs differ and that retirement planning is over a long time horizon, it is difficult to quantify the needs of a retiree in advance. The solution is to compare your income after retirement to your income before retirement. This is called the replacement ratio.
The rule of thumb is that in order to retire comfortably you have to aim for a replacement ratio of 70% to 80%. The fact that this ratio is less than 100% is based on the assumption that the retiree’s expenses will be lower in retirement. Although certain expenses such as medical care may increase, other expenses such as the costs of raising children (food, clothing, education, etc), bond repayments and other such expenses will ordinarily fall away. Of course if the retiree will still have some of these expenses, the required replacement ratio will be higher.
The question remains - how much do you have to save on a monthly basis in order to replace 70%, 75% or 80% of your pre-retirement income. The result will be greatly influenced by the time you start saving for retirement, the return you earn on your savings and the interest rate at the time of retirement.
For starters let’s assume that you start saving for retirement at age 30, will retire at age 60 and you save 21% of your gross pre-retirement income. Further assume that you are earning R340 000 gross pre-retirement income. Assume that the long term inflation assumption is 5% per annum and the long term investment return is 8% per annum (Inflation+3%).
Replacement Ratio |
Savings per month |
70% |
21% |
75% |
22.5% |
80% |
24% |
100% |
30% |
Calculation based on male lives. Female lives should expect to save more to meet the same replacement ratio as a male.
The difference between replacing 70% of your pre-retirement income and replacing 80% of your pre-retirement income is an extra 3% of savings per month. If you wanted to replace 100% of your pre-retirement income you would have to start saving an extra 9% compared to someone who is aiming to replace 70% of pre-retirement income.
What will be the fall in your replacement ratio if you delay saving? The table below gives an idea of the drop in your replacement ratio if you delay saving for retirement by 5, 10, 15 and 20 years. It is assumed that the individual will save 22.5% of his gross pre-retirement income per month until he reaches retirement age of 60.
Age at which you start saving |
Replacement ratio |
30 |
75% |
35 |
58% |
40 |
43% |
45 |
31% |
50 |
20% |
Calculation based on male lives. All things equal, female lives should expect a lower replacement ratio.
The average drop in the replacement ratio will be 3% for each year of delay. You have to save an extra 2% per year for each year you delay saving for retirement. If you start saving for retirement at age 40 you will have to save 42.5% of gross income in order to replace 75% of you pre-retirement income. This is almost half your income. Most retirees will find this impossible to achieve. A rand in your retirement savings today is better than a rand in your retirement savings tomorrow. The earlier you start saving for retirement the earlier you will earn interest on your savings. In this way you can target obtaining a higher replacement ratio.
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1. Retirement survey statistic from Old Mutual
References:
Samkelo Zwane and Danelle Van Heerde. Optimising a client’s post retirement portfolio using the Four Box Strategy. Glacier Retirement Matters Newsletter
R. E. Dorrington and S Tootla. South African Annuitant Standard Mortality Tables 1996-2000 (SAIML98 and SAIFL98). South African Actuarial Journal