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Strengthen your retirement plan: activate the right levers

11 June 2020 Old Mutual Corporate

A recent Forbes article states that “people who check their accounts frequently and trade more frequently tend to buy high and sell low compared to people who rebalance once a year”. Amid global concerns over the performance of retirement savings during these volatile economic times, it’s natural for people to be concerned about reductions in their savings. However, a successful retirement plan is about much more than investment returns.

According to Andrew Davison, Head of Advice at Old Mutual Corporate Consultants, there are six important factors that drive retirement outcomes. “We think of these crucial factors as levers, and it’s important to realise that they are dependent on each other. Often, people don’t appreciate the ways that the various levers interrelate — they adjust one of the levers without making compensatory adjustments to one or more of the other levers. Now more than ever, as the world continues to battle the economic fallout of the pandemic, investors should take into account the potential consequence of every move.”

Malusi Ndlovu, Old Mutual Corporate Consultants General Manager, says simply activating all six levers haphazardly will not produce the intended results. “There are combinations that make sense and many that don’t. Ultimately, as you examine the six levers, you’ll come to understand what makes sense for you,” he says.

Lever 1: Contributions
“Your contributions don’t do the heavy lifting,” says Davison, “but they are your ticket to the game. If you don’t contribute enough to your retirement pot, and do it early enough, there won’t be enough to grow.”

Lever 2: Investment strategy
Time is every investor’s friend, especially if you want to leverage the ‘secret sauce’ of compound interest. It is worth noting that the secret sauce only works when you have a long-term investment horizon.

“An example is Janet who left her previous employer and their pension fund in 2004. She preserved her retirement savings in a preservation fund. Since then she hasn’t touched it, but she also hasn’t added anything to it (as it’s not possible to add to a preservation fund),” says Davison. “Today, it’s worth more than five times the amount she initially transferred, thanks to the magic of compound interest.” This is despite the fact that the investment strategy for these savings has navigated a journey through the 2008 Global Financial Crisis and now the Covid-19 pandemic.

Lever 3: Preservation
The strategy of leaving savings untouched when changing jobs is probably one of the most difficult for retirement investors to heed, yet it is especially crucial if you want to meet the target of having nine or ten times your annual salary saved up at retirement date.

Lever 4: What to do with your capital at retirement
Your retirement date presents you with an array of important choices that will determine the quality of your retirement. For many people, it’s the point in time that they finally get their hands on all that loot that’s effectively been out of bounds until then. It’s a critical juncture and one that requires a cool head.

“The decisions you make when you retire really are momentous and will determine how you live from then on,” Ndlovu says. These decisions include how much to take as a lump sum, what type of annuity to use to convert capital into a monthly pension – which also includes the level of benefit you’d like to leave to beneficiaries, the level of future increases in pension you’d like to have and also how to plan for a spouse or other partner to receive income when you predecease them. There are also tax considerations and, potentially, decisions about where to live and hence about property.

“Savers ought to be aware that a bad decision can undo a lifetime of good savings behaviour. To avoid getting into a difficult situation, investors should make use of an adviser or a free retirement benefits counsellor”.

Lever 5: Retirement age
Ndlovu says the most important question concerning retirement date is not at what age you plan to retire but rather at what point you will be financially prepared to retire.

To this end, Ndlovu suggests that “the word ‘normal’ retirement age should probably be removed from the lexicon”, as this will vary from one individual to another based on their circumstances and the preparations they have initiated.

For some, retirement age may be 60 – for others it may be 55 (or even younger) or 65.

Lever 6: Pensionable salary vs cost to company
The final lever is probably the one that gets the least attention and yet it can have a big impact on your plans.

For mostly historical reasons, many pension and provident funds use a definition of salary called pensionable salary. In many cases the pensionable salary used is quite different to the actual cost to company. In fact, it is usually lower and this can be misleading because the contributions are calculated as a percentage of this lower salary and the projected benefits are also shown in relation to this lower salary. So a plan that seems reasonable might not deliver the desired benefits because it’s based on a lower salary, one that is not the whole salary that the member is dependent on to support their standard of living.

To provide the most accurate picture of your pension at retirement, all calculations should be based on cost to company salary.

Understanding the six levers is the starting point. The next step is to develop a retirement plan that considers each lever carefully and combines them to target a solid retirement outcome. The projected outcomes also need to be tracked on an ongoing basis and, if necessary, adjustments need to be made to ensure the plan remains on track.

An example of a sound retirement plan

As stated, there are many combinations of the six levers that will enable a person to enjoy a comfortable retirement. A company retirement fund will have a particular combination in place as the default. This will produce a particular outcome.

In some cases, funds will offer members choice in relation to one or more of the levers. It’s important not to assume that the default design will always produce an optimal outcome for everyone. Each member needs to consider their own circumstances and use any choice to ensure the fund delivers what they will need for their retirement.

Even if a fund does not offer choice, this does not mean that members cannot adjust any of the levers. It just means that they will need to make extra allowance outside of the fund, for example, by using a retirement annuity or even unit trusts or a tax-free savings account.

To illustrate one combination of a sound retirement plan, let’s consider the six levers:

Lever 1: Contributions

A good starting point is 15% of salary AFTER all costs and other deductions. Importantly, if there is a period of, say 2 years, when the contribution rate drops to 10%, then there will need to be 2 years when it’s at 20%. Beware of thinking that the first 20 years out of a 40-year working career can be at 10% followed by 20 years of 20%. Compound interest will be working on the lower level of contributions so your second half will need to be at a higher level of contribution. Compound interest isn’t able to do as much of the work.

Lever 2: Investment strategy

Inflation is the key hurdle when saving for retirement. Together with a contribution of 15%, you will need a return of 5% above inflation after costs each year and this will mean having about 65% of the portfolio in growth assets like shares and property.

Lever 3: Preservation

Full preservation every time you change jobs is the only way to avoid having to dramatically increase the contribution percentage.

Lever 4: What to do at retirement

This will depend on your circumstances, but a good strategy is to take only the tax-free amount as a lump sum. Identify basic living expenses and use a with-profit annuity to lock in a pension that you won’t outlive and invest any remaining capital in a living annuity to provide flexibility and satisfy any bequest motive.

Lever 5: Retirement age

65 (assuming work, and contributions, started at age 25)

Retiring any earlier will require a combination of more contributions and more investment return i.e. more investment risk.

Lever 6: Salary definition

Always use cost to company salary.

If pensionable salary is used then it’s important to target a pension that is higher than the 70 to 75% recommended target.

 

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