People are living to an ever-riper old age and spending more time in retirement. This increases the risk that your retirement savings will not last the distance. We report on what you can do before and after you retire to secure your financial future.
Mortality tables show that if you and your partner are aged 65, at least one of you has a 99-percent likelihood of living to age 70, a 96-percent likelihood of living to 75, an 88-percent likelihood of reaching 80 and a 52-percent likelihood of reaching 90. Or to put it another way, if you are 65, your "expected" age of death if you are a man is 82 and 86 if you are a woman. And you have a 50-percent chance of living longer.
The first person who will live to 150 is alive today and is probably in his or her fifties.
Another statistic reveals the trend: the United States Census Bureau says that there were 4 447 people over the age of 100 living in the US in 1950. By 2001, the number had grown to 50 454. By 2050, the number is expected to be 834 000.
This increase in lifespan is having a dramatic impact on the retirement planning of millions of people around the world.
Anil Thakersee, the managing director of Old Mutual Unit Trusts, says the ratio of years spent saving for retirement to those spent drawing a pension has changed from four years in employment to one year in retirement, to two to one and, in some cases, to one to one.
Protests have erupted in Europe in recent years as governments want to increase the retirement age because they can no longer afford their pension payment commitments. The civil pension schemes in many European countries are based on the current working population paying for the pensions of those people who have retired.
Longer lifespans mean there are more and more people drawing pensions in relation to actively employed people paying for those pensions.
According to research by Discovery Health, Japan is planning to increase the official retirement age from 65 to 67. And 78 percent of Japanese aged between 55 and 59 say they will work past the official retirement age. The qualifying age for a state pension in the United Kingdom is to rise to 68 in 2044; and in the US one-third of retired people go on to pursue a second career.
Longevity is not only posing a dilemma for governments in Europe. It is a growing problem in South Africa. The issue is complicated by the fact that most people do not accumulate enough money on which to retire, and they then compound the problem by retiring early.
Research by financial services company Alexander Forbes indicates that you have a 50-percent likelihood of going into retirement with a pension equal to less than 28 percent of your pensionable salary at retirement. The reasons for this include retiring early, not starting to save soon enough, not saving enough and cashing in retirement benefits before retirement.
When you retire with too little retirement capital, it will be used up within a few years, leaving you to live out your retirement on the social old-age grant (which is now R870 a month).
And the problem with assuming that your savings will be adequate to see you through until the average expected date of death is that 50 percent of people will outlive the average. This is where things can go very wrong, because many financial advisers base their calculations on the average life expectancy and not the exceptional life expectancy. So if you are not Mr or Ms Average, prepare to starve if you have not planned to live longer than the average.
This lack of adequate retirement savings is one of the main reasons the government is intent on reforming the retirement industry. It wants to ensure that you will save enough money to provide for a pension that will last you until you die.
To achieve this the government intends to make you save for retirement a portion of every bit of income you receive. The government will allow you to make withdrawals from your retirement savings before retirement only under very stringent conditions, and it will force you to use at least two-thirds of the money you save to provide for a monthly pension until the day you die.
The government aims to ensure that your monthly pension will be, at an absolute minimum, 40 percent of your final salary cheque, but many people could, after a full working life, achieve close to or full income replacement at retirement.
However, you are going to have to save a lot more to ensure that you will be able to maintain your standard of living until the day you die - whenever that might be.
The issue of longevity is compounded by people in South Africa retiring at an ever-younger age. So the equation is simple: early retirement equals less money potentially saved, and a longer life equals more money needed. Combine the two and that equals potential poverty late in retirement.
There are other factors you need to consider, such as the fact that medical inflation increases at a greater rate than overall inflation, and 60 percent of your lifetime's medical expenses will, on average, be incurred after the age of 60.
An unsubstantiated claim has been doing the rounds for many years that only six out of every 100 employed people will retire with sufficient assets to ensure financial security until death.
The only way to avoid becoming one of the "destitution" statistics is to plan well ahead and to understand the consequences of your decisions.
Save now, spend later
Retirement planning is simply a matter of understanding that you are deferring income you are earning now so that you can spend it at a later date. The key to successful retirement planning is to defer the correct amount of income, invest it responsibly and retire at the appropriate date, after taking into account how long you could live.
The good news is that Alexander Forbes has undertaken some important research on how to structure your finances when saving for retirement and, equally importantly, once you have retired.
Rowan Burger, the head of consulting strategy at Alexander Forbes Consultants & Actuaries, says the vast majority of South Africans in formal employment currently belong to defined contribution funds.
He says defined contribution retirement savings vehicles operate in ways similar to bank accounts.
"Each individual's contributions after expenses are saved in his or her unique account and accumulate investment returns. At retirement, the accumulated lump sum is available to purchase a pension to provide income for the balance of life.
"But the reality is that many South Africans are getting to retirement and are disappointed with the pension benefits due to them."
Burger says part of the problem is that retirement fund members do not receive sufficient information to enable them to understand how much money they are likely to have saved by the time they retire and then take pre-emptive steps as soon as possible to remedy any shortfall.
This lack of information is exacerbated by the fact that at present most retirement planning focuses on devising a strategy that will build assets in the run-up to retirement. Then a new strategy is formulated for the period after retirement.
Burger says retirement planning consists of two phases, which are:
- Disciplined saving during your working years. This can be described as deferred spending.
- How to spend in your retirement years what you have saved.
Burger says most of the focus in the past has been on the savings phase, and little attention was given to the type of pension you should purchase in retirement. Ideally, a financial planning strategy should be continuous, where the pre-retirement strategy is an accumulation (saving) phase and the post-retirement strategy is a decumulation (spending) phase. Investment strategies in the saving phase can afford to be more aggressive than investment strategies for decumulation, but by considering both the accumulation and decumulation (pre- and post-retirement) phases at the same time, you can integrate the strategies far more effectively.
"Currently, there are far too many cases where an individual moves into a more conservative portfolio near retirement, only to reinvest in a more aggressive portfolio after retirement. In this case, either the member should not have moved (or allowed himself to be moved) into a conservative portfolio close to retirement, or the member should not have gone into an aggressive portfolio after retirement."
Burger says ideally your pre-retirement investment strategy should take into account your likely post-retirement strategy. The problem, he says, is that few members understand their post-retirement options well enough.
He says that in the accumulation phase, you and your financial adviser need to assess whether you are on track to save sufficient money for retirement.
You cannot assume that because you belong to a retirement fund you will have enough money at retirement. The best way to establish whether you will have sufficient savings at retirement is to use what is called the replacement ratio.
Know your replacement ratio
A replacement ratio (also referred to as a net replacement ratio) is essentially the percentage of your pre-retirement income that will be paid to you after retirement. So, if your salary before retirement is R300 000 a year and your annual pension is R180 000, your replacement ratio is 60 percent (R180 000 divided by R300 000 and then multiplied by 100).
Burger says the key benefit of using the replacement ratio is that it gives you a sense in today's monetary terms of what sort of retirement benefit you can expect to receive.
Most people would like their standard of living in retirement to relate reasonably to their pre-retirement income. By using the replacement ratio you will be able to judge whether you will have sufficient money for this to happen. For example, you will have a fair idea of how a replacement ratio of 75 percent will affect your standard of living.
Most retirement funds base their contribution rates and investment strategies on you achieving a minimum replacement value of 75 percent of your pensionable salary at retirement after 40 years of contributing to the fund.
Seventy-five percent is generally used as a yardstick for an appropriate replacement ratio, because you will not require as much income in retirement as you did while you were employed. The reasons are:
- You will no longer need to save for retirement;
- There is greater tax relief for pensioners (at age 65 and older);
- You should have paid off all your debt; and
- Some expenses incurred while working should fall away (for example, the need to travel and buy clothing for work).
Burger warns that you do, however, need to be aware that your medical expenses in retirement are likely to increase, and you need to plan appropriately for this.
The closer you get to retirement, the more important it is that you do a proper budgeting exercise to determine your unique replacement ratio.
Burger suggests that you determine two levels of retirement income. These are:
- A retirement income that will meet your desired needs in retirement (a "wants" income); and
- A level of income that will cover the basic essentials (a "needs" income). Your retirement planning should always aim to provide at least a "wants" income, but should never be such that there is a risk that you will drop below your "needs" income.
Key issues in saving for retirement
Your replacement ratio needs to take account of the following factors:
- Contributions.
Compulsory pension and provident fund contributions are based on what is called a pensionable salary. This normally excludes car allowances, medical scheme subsidies, commissions, bonuses and 13th cheques.
However, you use these additional sources of remuneration to maintain your lifestyle.
Burger says you need to make additional retirement savings contributions to avoid having to pay tax on this non-retirement-funding income. The South Africa Revenue Service (SARS) allows you to deduct up to 15 percent of your non-pension-funding income to retirement annuities (RAs) from taxable income annually.
That little bit extra you save can significantly improve your expected retirement benefit. Click here for a graph that depicts the relationship between savings rates and replacement ratio.
- Costs.
These include both the actual costs of administering your retirement fund and the costs of paying for risk benefits (for death, disability and funeral assurance). Keeping an eye on costs, particularly with an RA, can also increase the amount you will have in retirement.
- Salary progression (annual increases).
Burger says this factor is frequently forgotten when a replacement ratio is calculated. As the replacement ratio is a percentage of your salary, the rate of salary progression is very important.
It is also important to be aware that, in general, salaries increase at a faster rate than inflation. The rate of salary increases is on average one-percentage point a year higher than inflation.
Burger points out that an individual is targeting his or her own salary progression, which might be greater than the average increase. Effectively, the higher your salary increase, the harder it will be to achieve a certain replacement ratio.
For example, if you receive a 20-percent salary increase close to retirement, you will become accustomed to this higher salary and the associated way of life. You will want to maintain this higher standard of living in your retirement. Unfortunately, your accumulated retirement savings do not increase by 20 percent at the same time that your salary does. You therefore need to save extra to be able to retire on this new, higher level.
Your contributions to your retirement savings need to keep pace with your salary inflation and not just the inflation rate. The effect of not doing so can be very dramatic: your replacement ratio could over the long term be halved.
Click here for a graph depicting the relationship between salary- or inflation-linked savings increases and replacement ratio.
- Investment returns.
Burger warns that you must be realistic in projecting the investment return you use in calculating your replacement ratio. This also means taking account of your investment decisions.
Most retirement funds will give you some investment choice. This can be fairly wide or be restricted to just two choices: either a conservatively invested capital guarantee option or a higher risk/return market-linked option.
Burger says many young people are nervous of losing capital and so invest too conservatively. A conservative cash portfolio is unlikely to give you a return of much more than one percentage point over inflation. An aggressive portfolio may give five percentage points in excess of inflation. After a working lifetime of 40 years, the cash portfolio will have a value of only 40 percent of the aggressive portfolio. To retire with the same amount of money, the cash investor would need to contribute 28 percent of his or her salary, against 12 percent that a more aggressive portfolio would require.
He says you need to align the expected returns with the portfolios in which you will be invested. For example, you cannot estimate a return of 10 percentage points above inflation for a cash portfolio.
Most importantly, if you have a lifestage portfolio, where your investments become increasingly more conservative as you near retirement, these lifestage switches need to be taken into account when calculating how much you will have at retirement.
Similarly, if it is likely that you will move into a more conservative portfolio close to retirement, you cannot simply assume that your assets will continue to grow at the same rate.
Burger warns that while it is important to invest in an aggressive portfolio when you are younger to ensure your savings keep pace with your salary inflation, it is important that your retirement investment is aligned to the annuity (pension) options you may take at retirement. A risky, aggressive portfolio may reduce your expected retirement income significantly if the markets suddenly move against you.
Click here for a graph depicting the relationship between different investment strategies and replacement ratio.
- Non-preservation.
Burger says that if you do not preserve your retirement benefits when you change jobs, you will dramatically reduce your likelihood of having an acceptable replacement ratio at retirement.
Alexander Forbes has analysed the data of the retirement fund members on its administration platform. The data show the average employee will have seven jobs over a 40-year working life. At no time in changing jobs is the average member likely to preserve more than 30 percent of his or her accumulated retirement savings.
The consequence is that the retirement benefit for a higher-paid employee will be about one-third of what it would have been had the member preserved throughout. This reduces to just over a fifth for the lowest-paid employees.
- Retirement date.
Simply, the earlier you retire, the less money you will have saved and the more money you will need in retirement. So if you retire too early, you could die in penury. This issue is becoming increasingly important against the background of people, particularly those who reach age 60, living ever longer. Other issues, such as your state of health, will also have an impact on your retirement date decision.
Burger says that South Africans are bucking the international trend. In Europe people are working longer as lifespans increase, but South Africans are retiring ever earlier, particularly those who are wealthier. However, South Africa has also experienced large-scale retrenchments, particularly of people at retirement age.
Research conducted by Alexander Forbes shows that 15 percent of men retire from their last fund with as little as between five and 10 years of pensionable service; 12 percent between 10 and 15; 14 percent between 15 and 20; and only seven percent with between 35 and 40 years. A mere three percent of men retire with between 40 and 45 years' service.
On average, pensionable service at retirement for men is 19.7 years and for woman 15.8 years.
Burger says this research does not mean that people may not have other savings or may have retained savings from other retirement funds.
But the reality is that in too many cases previous savings are spent on other living expenses.
Burger says someone who contributes to a pension fund for 40 years can reasonably expect a pensionable income that will be equal to about 80 percent of his or her final salary (depending on contribution rates and investment returns).
But halve that to 20 years and you will receive a pension that will be 28 percent of your final pensionable salary.
If you contribute to a pension scheme for a mere 10 years, you will receive a pension equal to only 11 percent of your final pensionable salary.
And the problem is that by saving for only 20 years you will not have maximised the effects of compound investment growth. If you save for 40 years, 60 percent of your final pension benefit will come from the first 20 years of saving.
Burger says that most of us would love to retire early, but you need to ask the question: "Can I really afford it, particularly if I live to 100?"
For example, if you have only 20 years' pensionable service and you retire at age 61, you can expect a pension that is equal to 28 percent of your final pensionable salary. Add another four years and retire at age 65, and you can expect 39 percent of your final pensionable salary.
So a delay of four years in retirement can add 40 percent to your retirement income.
When you retire
Having overcome various hurdles while building up your retirement savings, once you retire you have to ensure that what you have saved will provide you with an income for the rest of your life.
Burger says you must make the decisions about how you will manage your finances in retirement well before you actually retire.
"A wise investor will have ensured that the investment strategy in the accumulation stage is consistent with the decumulation (or retirement) stage, where you spend what you have saved."
He points out that you also need to take advantage of all the potential tax benefits when structuring your affairs appropriately before retirement.
The main challenge for people reaching retirement is the many different annuity (pension) choices and their associated risks and returns.
This conversion of your retirement savings to a pension needs to be realistic. For example, you should not think that an annuity can make up for a shortfall in retirement savings. No annuity (pension) option will make up for a shortfall in retirement capital.
You will also need to decide how much of your accumulated savings you should take in cash and how much you should use to provide a pension.
A lump sum is often required to settle outstanding debts, such as a mortgage bond.
Burger says once your debts are settled, you should expect your required level of income to reduce (since you no longer need to service this debt).
The important issue is how much income you can generate from your retirement savings.
Alexander Forbes's research shows that due to the tax consequences, people in higher tax brackets tend to take most of their benefit in the form of an annuity, whereas individuals in lower tax brackets tend to prefer cash.
The big question most people ask shortly before or at retirement is: should I purchase a living annuity or a guaranteed annuity, and, if so, which one?
In our current environment of low interest rates, guaranteed annuities hardly seem to be an option for most people. But there have been many sorry stories of pensioners who have chosen a living annuity, only to find that incorrect investment choices and extravagant drawdowns have left them destitute.
Burger says that selecting the correct annuity is not an either/or choice that you make on the day you retire. You need to consider your options on an ongoing basis throughout your retirement.
Your decision is also more complex than selecting what is called a split annuity. For example, using a portion of your retirement savings to buy a guaranteed annuity that will provide you with a minimum level of income and then using the balance to purchase a living annuity.
Burger says people often set out inappropriate objectives when deciding on an annuity. For example, research by Alexander Forbes has shown that we are more concerned about protecting our assets should we die prematurely than about ensuring that our pensions will last until the day we die.
In other words, when deciding which annuity to buy, pensioners tend to give priority to what they can leave their heirs instead of their own need for a sustainable pension.
On top of this, when choosing between a living annuity and a guaranteed annuity, most advice given to pensioners is based on the expected lifespan of an average individual. The problem is that there is a 50-percent likelihood you will outlive the average.
Burger says a guaranteed annuity is "the only financial contract in existence that provides insurance against longevity - in other words, an income for life".
When deciding on your correct pension structure, you should take account of Sorri, an acronym devised by Alexander Forbes that stands for "short of required retirement income", and find ways to avoid being sorry in later years.
Burger says in reaching a decision you need to consider the following:
- Income for comfort (what you would like to have to live on); and
- Income for necessities (what you must have as a minimum). In other words, your wants as opposed to your basic needs.
Burger says the best retirement income solution for you is not necessarily going to be one that will give you what you want.
You need to understand what different retirement strategies will achieve in meeting your needs and wants. In considering your options, you need to take account of numerous factors, such as the cost of guaranteed annuities, inflation, life expectancy, your spending patterns, the requirements of your spouse (after you have died), the variability of investment returns and costs.
Burger says it is important to keep your options open when selecting an annuity. A guaranteed annuity will almost always form part of the best solution for you, but it is seldom a good idea to purchase a guaranteed annuity at retirement, particularly if you retire young. It is often better to opt for a living annuity first, particularly if you are retiring young. But in doing so, he warns, the assets must be allocated properly to reduce investment risk, and the maximum income you withdraw as a pension should be conservative to ensure that your capital lasts.
He says your initial annual drawdown should be no greater than about eight percent of your capital.
The reason it is best to avoid a guaranteed annuity when you are younger is because a life assurance company expects you to live for a longer period and therefore provides you with a lower monthly pension. But if you wait until you are in your seventies before you purchase a guaranteed annuity, your income will be substantially higher because the life company believes your life expectancy will be lower.
For example, Alexander Forbes has calculated the "implied yield" on a level annuity purchased with R1 million at different ages. (An implied yield is the annuity divided by R1 million expressed as a percentage.) So, a man aged 55 would receive an annual annuity of R93 288, or an implied yield of 9.33 percent. At age 60, he would receive R100 976, or an implied yield of 10.1 percent; at 70, R125 134, or an implied yield of 12.51 percent; at 80, R171 770, or an implied yield of 17.18 percent; and at 85, R210 280, or an implied yield of 21.03 percent.
You also need to take care when you select a guaranteed annuity provided by a life assurance company. Annuities quoted by life companies can vary by as much as 10 percent and there is no consistency in which company is the most competitive. One company can be the best when it comes to one type of annuity but the worst when it comes to another.
In the end, you must remember that you may be a lot more mortal than you expect and you need to plan accordingly.
- See the second half of this story 'How your finances are put at risk in retirement' as a 'related article' below.
This article was first published in Personal Finance magazine, 2nd Quarter 2007. See what's in our latest issue