The pensioners’ struggle: inflation, investment returns and longevity
“You would think that people would take their retirement savings ultra-seriously,” says Richard Carter, head of product development at Allan Gray Investor Services. He was addressing the audience at a financial planner forum hosted by the Association for Savings & Investments SA (ASISA) in Johannesburg recently. His “Investing for Retirement” presentation is particularly important in the South African retirement savings context. There are far too many South Africans who retire with insufficient funds or are forced to work years beyond their intended retirement age to compensate for poor savings discipline.
A simple retirement formula
The best way to kick off this debate is with a brief look at the concept of retirement provisioning. Your retirement pot – the funds available to you to ensure a comfortable income in retirement – is simply a function of how early you start saving, how much of your salary you decide to save, the real return you earn on these funds and your commitment to preservation. Although each of these variables is vital for the successful implementation of a retirement savings strategy, we must stress the benefits of getting an early start.
Carter demonstrates the importance of long-term savings with a simple model. Mr Jones begins saving for retirement at the age of 25. He contributes 10% of his gross salary to a retirement fund, receives an annual salary increase of 1% over inflation in each of the 40 years and achieves real returns after costs on his retirement savings of 5%. “At retirement Mr Jones will be able to buy an annuity that will provide him with 72% of his final salary as an income, and keep pace with inflation,” says Carter. Although this income is significantly less than his final income it should be sufficient to ensure a reasonable standard of living through retirement. The situation deteriorates rapidly if Mr Jones delays his savings plan.
If Mr Jones delays his retirement savings plan by 10 years he will have to save 16.5% of his gross salary, or continue saving 10% while boosting the real after cost return on his investments by 3%, to 8%. If he delays saving until he is 45 years of age, leaving only 20 years for his investments to compound, Mr Jones would have to save 31% of his gross pay or achieve a 15.5% real return! The message is clear. Delay your retirement savings plan at your peril.
Chasing real return
The big question is where to achieve the 5% real return mentioned in this model. Carter says the number of retirees who simply place their money in interest accounts illustrate a serious misconception of risk. “Volatility is not the risk – the risk is inflation – and not getting enough real growth!” he says. As an example – if Mr Jones had saved for 40 years in a money market account, matching inflation for the entire period, he would have retired on a 26% replacement ratio. The retirement savings process is entirely pointless in the absence of real returns. Carter sums this concept in a short punchy sentence: “Without real growth you’ve had it!”
The answer to the riddle lies in asset allocation and the correct weighting to individual asset classes. Going back 100 years [1900 to 2005] South African equities have delivered a compound annual real return of 7.3%, bonds 2% and cash 1%. These statistics prove that “we have to have a portfolio that’s oriented to equities to get the required real return,” says Carter. Without an appropriate weighting in assets with the potential to generate real growth your retirement plan is doomed. Carter also reminded the audience of the importance of preserving retirement savings. Alexander Forbes conducted a survey in 2006 that showed more than two thirds of these people removed money form their pension pot when changing jobs.
Challenges in retirement
There are three challenges for the person who reaches retirement age with acceptable levels of savings. The first is inflation. “Inflation really is the pensioner’s biggest risk, because they have to provide income for life,” says Carter. The purchasing power of your rand is constantly eroded by inflation. For example, in an environment with 6% inflation the buying power of R1 000 almost halves over 10 years.
The second challenge is longevity. “Across a big enough pool the insurer can get a very good idea of life expectancy.” But this means very little to the average client. If you’re not using a guaranteed annuity then longevity is a risk you’ll carry throughout your retirement. And finally, retirees need to pay close attention to investment return. Real return is the only weapon against inflation. Carter says “generating real returns is vital to provide real income growth in retirement.” To demonstrate this Carter provided a series of examples showing how quickly available funds are eroded when drawing income in excess of real return. “If you take more income than your real growth your funds will eventually go to the wall,” says Carter. A 1% decline in real return, all else staying the same, could speed up the draw down on invested funds by six years!
Perhaps the most frightening aspect of Carter’s presentation is that the information has long been in the public domain. Savers simply aren’t listening. To date the industry has tackled the issue by raising awareness around retirement planning and attempting to educate the country’s working class. Unfortunately many savers ignore this information under the misconception they’ll be able to ‘catch up’ their retirement savings at a later date! Carter uses a fantastic cartoon to capture this belief. A potential retiree takes a seat in front of his financial adviser and says: “I retire on Friday and I haven’t saved a dime – here’s your chance to become a legend!” Savers actually expect financial professionals to help in such situations. But there’s no such thing as a legend in the retirement funding space!
Editor’s thoughts:
It takes years to build up enough funds to retire comfortably. But changes in the work environment have made it increasingly difficult to achieve 40 years of uninterrupted retirement saving. How many of your clients will be able to boast 40 years of uninterrupted saving when they retire? Add your comments below, or send them to [email protected]
Comments