This article was first published in the second-quarter 2012 edition of Personal Finance magazine.
Many occupational retirement funds and financial advisers base their investment strategies on providing you with a pension equivalent to 75 percent of your final salary at retirement after saving for 40 years.
But new research shows that this target could be hopelessly too low to maintain your lifestyle into retirement.
Megan Butler, a research actuary at financial services company Alexander Forbes and a lecturer at the University of the Witwatersrand, recently completed research towards an MSc into the income and expenditure profiles of almost 3 000 South African households.
She found that, contrary to popular belief, most households do not reduce consumption voluntarily on retirement. In fact, for certain households, consumption increased in retirement due to higher health expenditure.
So, the lower expenditure of retired households that is seen in practice may well be a result of pensioners having lower incomes than what they had while working.
She says: “These pensioners are forced to reduce spending. If not limited by their lower incomes, these households would spend at similar levels to what they did while working.”
Butler’s research considered the lump sum that would be sufficient at retirement to avoid reduced consumption and quality of living at retirement. The results suggested that households need more than previously thought and that retirement needs differed dramatically among different types of households.
Whether you have sufficient money in retirement is normally measured by your replacement rate, which is based on your income in the year after retirement as a percentage of your income in the year before you retire.
Butler says most retirement calculations use pre-tax incomes and target between 70 and 79 percent of final pensionable income.
Butler found, however, that a gross tax replacement rate target of 79 percent was inadequate for at least 82 percent of single females and at least 88.7 percent of single males.
The calculations for couples were better, particularly if the younger partner continued working after the older partner retired. However, only about half the couples found a target of 79 percent to be enough to avoid a consumption drop at retirement.
So if you do not want to drop your living standards in retirement, you will have to consider:
* Retiring later;
* Increasing your savings rate;
* Increasing the return on your investments, subject to an acceptable degree of risk; and/or
* Having the younger partner continuing to work after the older partner reaches retirement age.
Butler says her research suggests that higher replacement rate targets are achievable if you are willing to save about 10 to 15 percent of your total household income (where a lifecycle approach can be adopted, you can afford to save more as your career progresses); do not dip into your savings before retirement, particularly when changing jobs; and work until 67.
She warns that there is no single replacement rate target that is appropriate for all households.
You need to have accumulated in the region of 14 to 18 times your annual salary for retirement at age 60; reduced to between 12.5 and 16.5 times for retirement at age 65; and between 10.5 and 14.5 times for retirement at age 70.
Also, single women need to accumulate more than single men because they live longer than men, on average.
Butler found that for couples, the gender of the household head made a difference when considering what the household needed to retire comfortably.
She says the reasons one replacement rate does not fit all are because of different life expectancies of the households and the fact that households spend differently. This, she says, highlights the importance of personal financial planning.
John Anderson, the managing director of research and product development at Alexander Forbes, says Butler’s research supports the holistic lifecycle approach to retirement and financial planning.
“Because each household is different, individuals need to take control of setting financial goals and then use financial advice and planning tools to ensure they remain on track to meet these goals.”
Anderson says the research also indicates that retirement fund trustees of occupational retirement funds need to move away from the one-size-fits-all approach towards a more lifecycle orientated one, where the benefit design is better able to cater for individual needs as required.
He says the lifecycle-type default benefit structure, where the risk/return of your fund is adjusted to your age and needs, is more suitable for you.
FACTORING IN THE VARIABLES
There are significant dangers in assuming a pension based on replacing your final salary by a pre-determined percentage and then simply investing in a portfolio that will provide the required return on your investments to achieve the selected replacement rate.
This warning comes from John Anderson, the managing director of research and product development at Alexander Forbes, who says some financial advisers typically recommend using portfolios with benchmarks based on the consumer price index (CPI) plus a specified percentage.
He says this investment structure seems to offer a simple solution. It appears to offer a link to the amount you require as a pension.
But he says your retirement income will be dependent on far more than the investment return you receive before retirement or even your returns during retirement.
A major reason is that annuity rates for guaranteed pensions fluctuate because of variable interest rates – so if you retire when interest rates are low, you will receive a far lower pension than someone with the same amount of capital who retires when interest rates are high.
These factors are ignored if a CPI+ investment mandate is used and the choice of asset allocation to meet this target is left to an asset manager.
“This is similar to planning a journey by car. A map will certainly tell us the shortest route for us to take. Maps can tell you about the quality of the road you have to travel, distances and sometimes even the speed limits permitted. For an asset manager who is told to get from point A to point B (that is, CPI plus five percent), a simple map is all that is required.
“But what if we told you that the true destination B is constantly changing? Then the tool the driver requires to get to his or her destination is a full satellite navigation system. The GPS component of the system allows us to keep track of where our target B is at any point in time.
“The ‘real-time’ traffic and road monitoring capabilities allow us to identify other dynamic factors that might influence our ability to travel from point A to point B. These are factors such as traffic, road works, weather conditions, breakdowns or obstacles on the road.
“With an effective satellite navigation system at your disposal you can avoid the greatest potential pitfalls for the journey.”
Anderson says that, likewise, planning for retirement requires a system that takes account of the constantly changing dynamics of a retirement fund or member’s liabilities. This means constantly adjusting the asset allocation and risk to ensure you are always on track.
He says while this approach may sound complex, practical implementation is surprisingly easy, and there are computer software packages that allow financial advisers to consider all the variables jointly.
Factors such as interest rates, annuity rates and inflation are also considered for each outcome. Your probable replacement rate, rather than your achieved real investment return, is then calculated.
Your financial adviser can then determine which asset allocation would be best suited to meeting your needs and your required replacement rate on an on-going basis. This is called an asset/liability modelling exercise.
He says targeting an adequate replacement ratio is significantly better than ignoring liabilities completely, as happens in your typical “best investment view” balanced funds.