In our previous newsletter (October 2013), we quantified the guaranteed annuity income you can expect to receive for a given lump sum at the time you plan to retire.
In summary, your annuity income will depend on your estimated life expectancy when you retire, the type of annuity you choose and the prevailing interest rate.
However, you most likely don’t know WHEN you will retire, how much you will have saved by that time, and whether that will secure your retirement standard of living.
Your retirement income (and final income replacement ratio) can be modelled, based on:
- Your present salary
- Current contribution rate
- Current annuity prices
- The projected long-term real (after inflation) returns on a balanced life-stage portfolio
In Figure 1, we first quantify the cost of R1 of annuity income (based on the Sanlam Investment Management annuity rates at 7 March 2014). The later you retire the cheaper every rand of annuity income becomes. So a man of 55 will pay R18.10 whereas a man of 65 only R13.90. This is for an inflation- linked annuity, for a single person.
We can use this information to quantify how much you need to have saved, to buy an inflation-linked annuity that replaces 60% of your final salary. By multiplying the annuity cost by 60%, we can derive the multiple of final salary required to achieve this income. A single male aged 65 would thus require savings of 8.3x final salary, a male aged 55 savings of 10.9x final salary.
ARE YOU SAVING ENOUGH?
Our previous comment assumed that you had saved the same amount irrespective of whether you retire at 55 or 65. That is not a reasonable assumption; when you retire early, you not only receive a lower annuity for your lump sum, but your lump sum will also be smaller because you have made fewer contributions and earned investment income for a shorter period.
Our example assumes that you (a male) start saving at age 25. You earn R20,000 pm, growing annually at 1% after inflation. Your contribute 15% to your retirement fund, and you earn a real (after-inflation) return in your retirement fund of 5% pa, before fees.
The projected savings outcome is calculated with the 10X Retirement Calculator. We use the Sanlam Investment Management annuity rates as at 7 March 2014, to calculate what annuity these savings would buy, and how much of final income this would replace.
Fig 3 graphs the projected replacement ratio you would achieve based on our example, and the current cost of an inflation-linked annuity. The target replacement ratio is 60%. At age 55, the replacement ratio is only just 40% but at age 62, it would 60%, a full 50% higher!
Retiring a few years early comes at a heavy cost, just as retiring a little bit later, say at age 67, translates into a significantly higher retirement income.
YOUR ANNUITY INCOME
Fig 4 shows the impact on your final income replacement ratio if you paid an annual fee of 3% rather than 1%. Based on our example, a single male planning to buy an inflation- linked annuity with a 60% IRR could retire at 61 with the 1% fee, but only at age 68 with the 3% fee.
Paying a fee of 3% rather than 1%, he would have to work an additional seven years, to meet his retirement goal.