Unknowns make retirement planning difficult

Published Oct 10, 2015

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It is extremely difficult to calculate accurately how much you will receive as a pension if you are a member of a defined-contribution retirement fund or a retirement annuity fund.

If you are a full-time employee in the private sector, you probably belong to an occupational defined-contribution fund. In this case, all you can be certain of is how much your employer will contribute and how much you may contribute. There is no guarantee of how much money you will accumulate by the time you retire, and there is no guarantee of how much you will receive as a pension. There are too many variables at play.

Your fund, using mainly historical data on the performance of investment markets, will aim to provide you with capital that will give you a replacement ratio (your pension as a percentage of your final salary) of between 60 and 80 percent after 40 to 45 years of membership. But this percentage is not guaranteed – it is a best estimate.

The amount you receive, even if you belong to the fund for 40 or 45 years, will depend mainly on the investment returns earned by your retirement portfolio in the build-up to retirement.

On the day you retire, interest rates will affect the size of the pension you can buy with your accumulated savings.

When, in the 1980s and 1990s, trade unions demanded a move from defined-benefit retirement funds and employers saw the benefit of divorcing themselves from the risks attached to these funds, little thought was given to whether members would be able to access appropriate pensions.

Normally, you can buy a pension guaranteed by a life company only when you retire as a member of a defined-contribution fund, but the guarantees are very different from those on a defined-benefit fund.

The most important factors that influence a life assurance guaranteed pension are:

* The life company calculates the guaranteed pension only on the day you retire, because the capital you will have accumulated will be known only then.

* The life company will use most of your retirement savings to buy interest-bearing debt instruments. The reason is that the returns are far more predictable than the volatile returns provided by equity markets, although shares have historically provided better returns.

If interest rates are low when you retire, this will result in a lower guaranteed pension. For example, a 65-year-old man with R3 million who bought a pension guaranteed by life assurance company Liberty in 1999 would have received a monthly pension of R37 284. A woman would have received R36 982, because women, on average, live three years longer than men, which means that the life company will on average pay out the same amount over the course of a woman’s life.

Today, when interest rates are much lower, a man with R3 million will be able to buy a guaranteed pension of R17 403 a month.

And the pension you are quoted when you buy it will not change for the rest of your life, with the exception that you can choose to buy a pension that will increase every year by a preselected amount. But in this case you will initially receive a lower pension than you would receive if you bought a pension that did not increase – a level annuity.

A level annuity is dangerous, because if you live longer in retirement (and life expectancies are increasing) inflation will soon reduce the buying power of your pension.

HOW INTEREST RATES, MARKETS AFFECT YOUR RETIREMENT

“What a difference a day made / Twenty-four little hours / Brought the sun and the flowers ...” are the opening lines of the 1950s hit song by Dinah Washington.

“What a difference a day made” is an apt way to describe how the volatile nature of financial markets can affect your retirement.

The following scenarios illustrate how the 2008/9 global financial crisis could affect South African retirees:

Scenario 1: Retire in May 2008. On May 1, 2008, Mr A and Mr B retired at the age of 65. They had retirement savings of R3 million each. On that date, the FTSE/JSE All Share Index (Alsi) topped 33 000. Mr A’s and Mr B’s savings were in an investment portfolio of which 60 percent tracked the Alsi and 40 percent was invested in the FTSE/JSE All Bond Index.

Interest rates were about double what they are today. The repo rate, which is a base rate set by the South African Reserve Bank, was 12 percent.

Mr A chose a guaranteed annuity (a pension guaranteed by a life assurance company) that would escalate at six percent a year. He received an initial pension of R21 309 a month.

Mr B chose an investment-linked living annuity, which does not guarantee a pension, and which requires him to select the underlying investments and choose how much to draw down as a pension. By law, the drawdown must be between 2.5 and 17.5 percent of the annual capital value. Mr B chose a drawdown rate of five percent, which gave him an initial pension of R12 500 a month.

Mr A’s pension was 70.5 percent higher than Mr B’s, and Mr A removed the risk to his income by having a life company guarantee his pension.

If Mr B wanted a pension equal to Mr A’s, his initial drawdown would have to be 8.5 percent, but research has shown that this rate is unsustainable. High drawdowns can quickly deplete your capital.

Now, seven years later, Mr A’s monthly pension is R32 041, while Mr B’s monthly pension is R17 677. Not only does a day make a difference, but so do much longer periods of time.

Scenario 2: Retire in December 2008. Both Mr A and Mr B retired six months later, on December 1, 2008, when the Alsi had lost about 45 percent of its value, dropping below 18 000.

Using the Alsi as a proxy for the value of the 60 percent of Mr A’s and Mr B’s retirement savings invested in shares, the value of their accumulated savings has fallen from R3 million to R2.2 million. Between May and December 2008, interest rates dropped by 50 basis points (0.5 percent).

Mr A’s initial pension from his guaranteed annuity, which escalates at six percent a year, is R14 024 a month. Mr B, who draws down five percent from his living annuity, receives a pension of R9 167 a month. Mr A’s pension is now 53 percent higher than Mr B’s.

Scenario 3: Retire in 2015. Mr Mr A and Mr B retired on October 1 this year with R3 million each. Mr A receives an initial pension of R17 403 a month, escalating at six percent a year. Mr B’s pension, at a drawdown rate of five percent, is R12 500 a month.

The big difference is that Mr A receives R3 906 less when he retired this month than he did when he retired in May 2008. This is because interest rates are much lower.

Scenario 2 revisited. Mr B kept the equity exposure of the underlying investments of his living annuity at 60 percent. The Alsi has, on average, recovered by 15.7 percent a year to reach more than 50 000.

Mr B continued to draw an annual pension equal to five percent of his growing capital. This means that Mr B’s capital is now worth R2.7 million and his monthly pension is R11 431.

Mr A’s pension has grown to R19 893 a month after seven years.

But the future of Mr B’s pension is unpredictable; it depends on what the markets return. If returns are good in the early years of his retirement, he has a far better chance of a financially secure retirement than if returns are level or negative.

Remember, Mr B will have to increase his pension every year to keep up with inflation. If the returns are zero or negative over any period, he will have to increase the percentage of his annual draw-down, digging deeper and deeper into his capital.

The final result of poor market returns, particularly if Mr B lives for a long time, is that he will reach the maximum drawdown of 17.5 percent. Then he will suffer a double whammy:

* His pension will decrease in rand terms; and

* Inflation will constantly reduce the buying power of those rands.

A good tip: When market returns are good, allowing for generous above-inflation rand increases in an income from a living annuity, you should keep the increase in line with inflation and reduce the percentage drawdown so that you can build up capital for the lean years that will come.

* The information on guaranteed annuities was provided by Liberty.

Next week: How you can reduce the impact of market volatility on your retirement savings.

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