Ask anyone on the brink of retirement whether their pension savings will be sufficient to meet their expectations of a financially secure retirement and the answer is likely to be perilously uncertain. Pension planning is all about setting the right targets and getting the people who manage your retirement savings to do so as well. Setting targets is never easy, but set targets you must. And then you must keep them in sight. We show you how to set retirement targets and keep your investments on track.
There are many rules of thumb for working out your savings targets for a financially secure retirement. One of the most common is that to provide for a minimum secure level you must have retirement capital 10 times the value of your required annual income.
An even more ambitious savings plan is based on saving 15 percent of your income during a 40-year working career. That would result in retirement capital of 12 times your required annual income and a pension that would increase at a rate of 80 percent of inflation. But this doesn't sound all that secure.
Douw Kruger, the head of institutional business at Sanlam, says more and more people approaching retirement are developing uneasy feelings about their retirement savings. They see how pensioners are struggling to make ends meet and read about poor investment returns and unstable market conditions.
Kruger says investors in balanced portfolios (which invest across the three asset classes of cash, bonds and equities) have had a difficult time during the past few years. Equity markets have been volatile, long-term interest rates have fallen and diversification in overseas equity markets has failed to rescue the situation. Overseas markets have experienced their longest decline in value since the Second World War, while the rand has strengthened in value.
Pensioners with with-profit pensions (pensions that are adjusted upwards every year if the fund has had sound investment returns) have lately received low - or no - pension increases.
Pensioners with living annuities (where you make the underlying investment decisions, but have to draw down a pension of between five and 20 percent of the annual value of your assets) find themselves in a similar situation, because the value of their retirement capital has been reduced as a result of negative, or very low, investment returns.
Kruger says pensioners' problems are compounded by their own actions - especially the failure of most people to build up retirement capital over as long as 40 years. Regular changes in employment that release retirement money for spending instead of saving often result in a much shorter period of saving. And the shorter the period, the less time there is for compound interest to work in your favour.
According to Kruger, reducing the savings period by 25 percent, to 30 years, results in retirement capital being reduced by 40 percent to just seven times your final annual salary. And, he says, most people save for only 20 years, which results in retirement capital of only four times your final annual salary.
A second problem, Kruger says, is that 65 is no longer the typical retirement age. Many businesses want their staff to make way for younger people at ages closer to 55. The result, again, is too little time to save for retirement and a pension that needs to last much longer.
Not only are pensioners faced with lack of capital, Kruger says, but they have to deal with investment and economic conditions that work against them. These problems include the lower inflation rate and the increasing cost of investment guarantees.
- A lower inflation rate. "If everything moved along with inflation, there would be no problem," Kruger says. "However, if the inflation rate declines, so will interest rates and therefore also investment income - but not the cost of living, which will continue to increase, albeit at a slower pace."
He says that, traditionally, retirement funds assumed that, with inflation at 10 percent and long-term expected returns on the underlying assets of 15 percent, pension increases of at least eight percent a year (or 80 percent of the inflation rate) could reasonably be expected over time.
But, as expected returns have declined in line with the declining inflation rate, the formula has changed. Now, an average return of eight percent (or less) and an inflation rate of five percent are assumptions that are more realistic. This means that pensions purchased under the original assumptions will increase at only 50 percent of the inflation rate, on average, instead of 80 percent.
- Increasing cost of guarantees. Highly volatile financial markets and declining interest rates are making the investment guarantees offered by the popular with-profit pensions more expensive than in the past. This forces life assurance companies to either charge higher fees for capital guarantees, or to match their assets to their liabilities (what they have to pay out in capital or pension guarantees) by using more fixed-interest instruments (such as bonds or cash deposits) rather than equities, which have historically provided the best returns. Either option results in a lower potential for pensions to increase. The same applies to traditional guaranteed pensions, which are also offering lower pensions.
The factors that affect the potential for increases in with-profit pensions also apply to living annuities. Future investment returns are expected to be lower than before. This means that a given amount of retirement capital is going to produce a lower pension and/or lower pension increases than before.
Kruger says the bottom line is that you will need significantly more retirement capital than you would have thought you would 10 years ago.
This article was first published in Personal Finance magazine, 2nd Quarter 2004. See what's in our latest issue