When we consciously save for retirement, we tend do so with one objective: to secure our life style in retirement.
At 10X, we have a simple retirement formula to achieve this goal: save 15% for 40 years, earning a real return (after fees and inflation) of at least 3.5%. This should secure a guaranteed inflation-protected pension replacing at least 60% of your final salary, which we believe is a sound minimum target.
15% may sound like a big cut, but remember the contribution is not taxed, so the effect on your take-home pay is less. You should save at this rate through-out your working life (approximately 40 years), to reap the benefit of compounding. We illustrate the concept of compounding in the figure below.
An investment of R100 earning a 5%pa real return will grow to R430 after 30 years and to R700 after 40 years. Over the last ten years, the investment value increases by 63% even though the investment term only increases by 33%.
Time is your strongest ally when it comes to retirement saving. The only way to offset lost time is to save more in later years but the longer you delay, the more unaffordable this becomes.
How to save more without hurting your current life style
We see long faces when we explain our savings formula; many employees have skimped on their saving. In fact, the average contribution rate in South African pension funds (after administration costs and risk premiums) is only just above 10%.
Unfortunately, most set their contribution rate when they first sign up, and do not revisit it again for many years. It then becomes more difficult to save more, as you then have fixed financial commitments. Can you then make up the shortfall without cutting back on your life style?
There are two ways.
The first is to allocate a part of your real (after-inflation) salary increase to your pension fund.
This means your living standard does not drop even though you are now saving more of your salary. Assuming your salary increases by 1% in real terms per annum, you can, over five years, increase your savings rate from10% to 15%.
How effective is this? Provided you do not leave it too late, it can significantly raise your final income replacement ratio, as we show in figure below. Note that these outcomes are projections only, as future returns are not guaranteed.
The above figure shows the final income replacement ratio if you increase your savings (under different real return assumptions). The base case outcome (bottom row) assumes a constant contribution rate of10% for 40 years.
Assuming a real return of 3% pa, the base case projects a final IRR of 43%, for a single male at age 65 buying a guaranteed inflation-linked annuity at retirement. This is well short our minimum goal of 60%
But by raising his contribution from 10% to 15% over five years (applying the 1% real salary increases from years 11 to 16), he has a good chance to improve his IRR to 56%, 30% higher and near the target of 60%.
Increasing the savings rate from years 21 (19% higher IRR) and 31 (7% higher IRR) also improves the savings outcome, but not sufficiently so.
Note that investors who earn a higher return are more likely to reach the target IRR, even if they save less than 15% of income. But future returns are not certain, so you should allow for this by saving more.
The second way is to target a higher investment return.
Your long-term investment return ultimately depends on just two factors: your investment mix (how much you are invested in shares, bonds and cash respectively) and how much that return is reduced by fees.
Historically, a high equity portfolio (75% invested in shares) has delivered almost 6% pa over the long-term, compared to a medium equity portfolio (50% in shares) of only around 4% pa. Investors who hold less equity because they fear markets going down usually end up with a much lower IRR.
To illustrate, in the base case, the projected IRR on a return of 4% pa is 54% compared to the 87% for a 6% pa return (not shown). The higher return translates into almost 60% more income in retirement.
The problem is that these returns are before fees. The average umbrella fund fee in SA is 2% pa, compared to lower cost options of less than1%pa.
In other words, the saver in an medium-cost, medium equity fund can expect a long-term real return of just2%pa, compared to 5% in a low cost, high equity fund. The second saver will receive almost double the pension, without saving more!
The figure above shows that if you raise your contributions AND improve your return, then you can significantly improve your projected IRR, even if you are only twenty years from retirement.
Assuming you are on the base case path (earning a net real return of 2%, saving at 10%), you can still get close to an IRR of 60% by increasing your contribution to 15% over five years and your expected return to4%pa.
So you can rescue your retirement in your forties, but only if you take the right actions.