Your best-laid plans for saving for retirement could be upset by factors that cannot be built into typical retirement savings calculations.
And targeting a particular lump sum with the view to it sustaining your desired income in retirement may be a bad idea, especially if you assume that you will continue to enjoy high real (after-inflation) market returns indefinitely.
Local asset manager Grindrod Asset Management highlighted the problems with typical retirement calculations in a recent presentation to financial advisers.
Meanwhile, research by Daniel Wessels, an adviser at Martin Eksteen Jordaan Wessels, shows the flaws in targeting a capital lump sum at retirement.
Wessels’s research shows that the conventional wisdom that a capital target of 15 times your annual income will be sufficient to sustain a retirement income of 75 percent of your final salary is not necessarily true. He found that the appropriate target for people retiring between 1940 and 1984 after saving for 35 years, to sustain an income in retirement for 30 years, varied greatly; it was between eight and 20 times their annual salary.
If you have a plan about how much to save for retirement, it probably targets a particular lump sum to provide you with your chosen level of income in retirement, and the lump sum has probably been calculated using various assumptions. Nobody knows how long you will live in retirement, but for planning purposes it is assumed you could live for 30 years.
Your retirement-saving calculation, done by a financial adviser or using an online calculator, typically takes into account your monthly retirement fund contributions and the number of years you have until retirement. It assumes a certain return on your savings before calculating an estimate of how much you need to save.
While your initial planning takes into account the income you will need in retirement, Marc Thomas, the business development manager at Grindrod Asset Management, says that, thereafter, you often receive updates only about the lump sum and not about the income it will generate.
He says the value of measuring retirement savings in terms of the income they can generate is starting to be recognised internationally, but most local asset managers have yet to start thinking in these terms.
Typically, calculations are based on the annuity rate – the rate of income you receive for every R1 000 of savings you have at retirement to buy an annuity. This rate determines the pension you receive for the rest of your life.
But Thomas points out that there are a number of problems with these calculations:
Most calculations are based on annuity rates (guaranteed, with-profit or even recommended living annuity withdrawal rates) at the time you perform the calculation. Unfortunately, annuity rates, including recommended withdrawals from living annuities, change over time as markets change, Thomas says.
He says the problem is outlined in a recent article in the International Express, a newspaper aimed at Britain’s expatriate population around the world: “Pension disaster for millions – shock after annuity rates hit record low”.
The article says that guaranteed level annuity rates, which were 11.3 percent in 1995 (that is, you would receive a pension of 11.3 percent of the amount you used to buy an annuity), had dropped to seven percent in 2008 and to 4.7 percent this year. And for escalating annuities, the rate is only 2.7 percent.
Thomas says the average South African rates for a level annuity have come down from about 14 percent in 2000, to 8.6 percent in 2006, to 7.2 percent today. The rate for an annuity escalating at five percent a year is about 4.2 percent, he says.
Guaranteed annuity rates are based on bond yields (the interest you earn on a bond relative to the bond investment).
John Anderson, the head of research and product development at Alexander Forbes, says South Africa’s guaranteed annuity rates have declined in line with declining bond yields, and the recommended drawdown rate for a living annuity has also declined over the past decade. Recent research by Allan Gray suggests that the safe drawdown rate for a balanced portfolio is just four percent.
And when it comes to with-profit annuities (see “Definitions”, below), although the rates have been stable, the increases have been declining, Anderson says.
Alexander Forbes publishes a Pension Index that reflects both the increasing cost of buying an annuity at retirement as well as the effect of lower returns on your ability to generate an income during retirement. The index shows changes in pensions expressed as a rate of income replacement for retirement fund members of different ages and how these have changed over time.
The low guaranteed annuity rates have driven most South Africans to opt for investment-linked living annuities.
Wessels says that not only does the capital amount you require at retirement vary depending on when you retire, but the returns you earn on your savings can vary over the period during which you save.
He says a retirement savings rate of 15 percent of your income (that is, if your retirement fundcontributions and those of your employer amount to 15 percent of your salary) for 35 years would, in some cases over the different periods he studied, be insufficient to achieve a final capital amount of 15 times your annual salary at retirement (see graphs, link below).
SEQUENCE OF RETURNS
Most retirement-funding calculations assume a particular average return over your investment period. This includes good returns in some years and bad ones in others.
The problem, however, is that close to retirement, a market downturn can have a big impact, from which you may have too little time for your capital to recover sufficiently to reach your targeted capital amount, Thomas says.
To protect you from this risk, it is recommended – and most retirement funds have this as a default option – that, when you are close to retirement, you move your savings into less risky assets that offer greater protection from market falls.
Sanlam’s Benchmark survey of retirement funds, which was released last week, shows that more than 60 percent of retirement fund trustees choose for their members what are known as “lifestage” portfolios. These reduce your exposure to higher-risk capital-growth investments as you approach retirement. The survey shows that 54 percent of funds using a lifestage strategy convert all of their members’ savings to cash in the final year before retirement.
The survey identified this as a problem, because when your fund values are at their highest, this is when you could be benefiting most from inflation-beating returns.
Members have to give up a significant amount of growth on their investment for this protection. The portion of your portfolio that is invested in cash and bonds may well produce a return that is, after costs, below inflation, Thomas says.
In addition, you are likely to need exposure to higher-risk assets in retirement in order to ensure sufficient growth on your investments to sustain your withdrawals.
Because your pre-retirement savings are typically held in an occupational fund or retirement annuity (RA) separate from the annuity you use for an income after retirement, you may find that a significant portion of your savings is moved out of equities and property close to retirement only to be moved back into these higher-risk assets after retirement.
Thomas says other problems with retirement calculations are:
* Most exclude the impact of fees on your investment. This point is echoed by 10X, the RA provider that has launched low-cost index-tracking RAs and a living annuity.
* Most rely on assumptions, such as an average inflation rate, that can change over your working life during which you are saving for retirement. Anderson says that Alexander Forbes has seen some optimistic assumptions being used, and this can be dangerous, because they give you a false sense of security.
Retirement-savings assumptions need to be based on rigorous analysis and testing and signed off by senior investment and actuarial professionals, Anderson says.
He says that if you receive financial advice, you should ask about the source of the assumptions used. The Treating Customers Fairly regulatory environment requires that financial services providers do not create unrealistic expectations, Anderson says.
* They do not take into account the asset allocation of your portfolio, which, in turn, determines your returns.
SO WHAT CAN YOU DO?
Financial adviser Daniel Wessels says you simply do not know what your future returns will be, but you can give yourself a far better chance of a secure retirement if you focus on the things you can control: how long you save for and how much you save.
He suggests that you:
- Extend the period during which you save as far as possible;
- Save as much as you can; and
- If you use an investment-linked living annuity to provide a pension at retirement, limit the annual amount you draw down to between four and five percent of your capital.
Wessels says the actual capital amount at retirement should not be your major focus, since you don’t know for sure whether that amount will be sufficient to provide income for potentially the 30 years you will spend in retirement. He says you should be interested more in knowing what percentage of people’s salaries historically saved for retirement provided sufficient income for an extended retirement period, and for this you should consider the worst historical market return periods instead of only the most recent returns.
Wessels tested a variety of simulated returns to establish what savings rate would give you an 80 percent probability of accumulating enough savings to sustain an income in retirement for 30 years.
The table (click on link, below) summarises Wessels’s findings, giving the percentage of your gross annual salary you would need to save if you invested in a portfolio that held 60 percent in equities, 25 percent in bonds and 15 percent in cash.
Grindrod Asset Management has a different approach and has launched portfolios that are focused on producing a growing income. These portfolios invest in listed property and equities that pay growing dividends.
Grindrod’s business development manager, Marc Thomas, says that focusing on the income your savings will generate is more predictable and manageable than focusing on the capital value of your savings. The income is not reliant on annuity rates. It can be reinvested to earn compound interest that will enhance your capital and income both while you save and while you draw retirement income.
Thomas says you should be less concerned about the capital value of the shares in the portfolio than about the certainty of the income they produce, and that this income grows in line with inflation.
Thomas says the average dividend yield (dividends paid per share) of South African equities listed on the JSE has dropped significantly only once in the past 15 years and that was in 2008, while the capital values of shares have fluctuated wildly more frequently.
rules of thumb
John Anderson, the head of research and product development at Alexander Forbes, says that while “rules of thumb”, such as savings rates or targeted capital amounts at retirement, have their shortcomings, they can still be useful, as long as they are within a reasonable range, looking through different market cycles.
He says we use many mental models to make decisions and tend to use short-cuts to arrive at decisions, including those about how much we need to save and how much we need for retirement.
Rules of thumb take advantage of these short-cuts and prevent us from avoiding a difficult decision.
However, he says, once you have started to save for retirement, it is important to review your plan regularly, to see how it is coming along and whether adjustments are required as your circumstances change. This is where more sophisticated models and advice can improve your plan, taking into account how markets and other factors have changed since you started saving.
However, he agrees that retirement fund members should be shown the income that their savings will generate rather than the returns on a lump sum.
Anderson says that, as a retirement fund administrator, Alexander Forbes shows members who have seven years or less to retirement what income they can expect from their savings.
The income options for a living annuity, a with-profit annuity and a guaranteed annuity are shown because different people have different needs.
Anderson does not believe that members close to retirement should move all their savings into cash, but does believe they should reduce their risk to match that of the annuity they intend to use to generate an income in retirement.
He says this reduces the risk of a serious drop in the value of your savings if markets turn against you when you are close to retirement.
* Guaranteed annuity. You use your retirement savings to buy a regular monthly income. The income can be the same (level) for your life or escalating, to counter inflation. The income is guaranteed for your life, but stops on your death, unless you choose an annuity with a guaranteed payment period and you die before the period is up, or if you choose an annuity that pays until your spouse dies. When you and/or your spouse die, there is no residual capital, and the only further payments are those made until the end of any guaranteed period.
* Investment-linked living annuity. An investment made with retirement fund savings earmarked for a compulsory annuity, but instead of buying the annuity from a life company, you invest in your chosen investment portfolio, typically through a linked investment services provider. Your investments determine your returns and, together with the withdrawal level you decide on and your lifespan, the sustainability of your income. By law you must withdraw at least 2.5 percent of your capital annually and you may not withdraw more than 17.5 percent. Any residual capital can be left to your heirs.
* With-profit annuity. A hybrid of a guaranteed annuity and a living annuity. The life company chooses the investments and guarantees a particular income for life, but the increases on the annuity are determined by the investment returns. The better the returns, the better your pension increases. The annuity dies with you or your surviving spouse.