Decent therefore is a relative standard: essentially it describes the ability to maintain your accustomed standard of living in retirement. To do so, you should secure an annual income that replaces at least 60% of your final salary, guaranteed to grow with inflation through-out retirement. To achieve this goal, you should strive to invest 15% of your income over your entire working life (around 40 years) in a way that will likely deliver a long term real (after inflation) return of at least 3.5% per annum, net of fees.
That’s not easy, but it’s not impossible. Yet few South Africans reach this savings goal, largely through a combination of ignorance, neglect and poor discipline. How does this show up in your savings strategy?
To kick-off Part 1 of this two-part series, we visit the first 5 of your top 10 retirement saving mistakes.
1. Saving too little
No rocket science here – you can’t save like a pauper and then expect to live like a prince in retirement.
So yes, the number one reason most people miss their retirement goal is because they don’t save enough. Empirically, the amount you contribute to your savings plan is the largest single factor that determines your savings outcome.
Strive to save at least 15% (net of admin fees and risk premiums!) of the income you wish to replace in retirement. Per the latest Sanlam BENCHMARK Survey (2012), total gross contribution across all funds averaged 16.2%. But net of risk premiums and administration fees, it drops to only 12.4%. So you’re off to a bad start. Compare this to the mandated contributions to the Government Employee Pension Fund: 7.5% from the employee and another 13% from the employer. The reality is that the majority of private sector employees underfund their retirement.
2. Starting too late
Few people in their twenties worry about retirement. It is one reason they get to worry about it for the rest of their lives.
Understand that contributions are only one source of your future retirement income; the other is the net investment return you earn on your contributions. The sooner you contribute to your retirement fund, the longer your money works for you and the more the net investment return contributes to your pension.
Initially, returns add only a little to your total investment. But then compounding (earning a return on your return) kicks in. Compounding acts like a snow ball rolling down a mountain: it keeps growing and picking up momentum. Ultimately, the compounded investment return totally overwhelms your contributions. In numbers, say you earn a total real (after-inflation) annual return of 4% pa (net of fees of 1% pa) on your constant annual contribution. After 10 years, returns equal roughly 32% of your total contributions, after 20 years 74%, after 30 years 132% and after 40 years 217%.
As you can see, the big kicker to your pension comes in the last ten years of this 40-year example. But it if you only save for thirty years, then the only big kick you should expect is the one you give yourself.
3. Not preserving
Not preserving is very popular in South Africa – between 70% and 80% of fund members have at some point played “not preserving” on changing jobs. This game is so popular in fact that some change jobs just for the opportunity to not preserve their savings, and to “invest” in the latest 4×4 instead.
Not preserving has the same effect as starting late. When you change jobs and cash in your pension, you not only lose your accumulated saving, but also the return you would have earned on those savings for the rest of your working life. Over twenty or thirty years, that makes for a very expensive car.
It becomes very difficult to make up this shortfall in later life. In retirement, these fund members will come to appreciate that the term “preservation” referred not just to their savings, but also to their living standard, especially if “4×4” now refers to the size of their flat.
4. Paying high fees
Do you know how much you are paying away in investment fees every year? And how much this adds up to over thirty or forty years, after you include the additional return you could have earned on those savings? The number is so obscene that the industry would prefer a “18-65” age restriction on this information.
The ugly truth is that paying total fees above 1% pa greatly diminishes the likelihood you will achieve your retirement goal. In our example above, we used a net real investment return of 4% pa. This may appear punitively low, but for many investors that number will eventually border on wishful thinking. Remember, we are talking about the real return, after inflation. It is the return that actually grows your wealth. The long-term real return on a balanced portfolio has historically averaged around 5% pa.
But 5% is the return before investment fees. There is always a cost to investing, but you need to keep it as low as possible. Why? Because the impact is highly geared – every 1 percentage point in fees pa reduces your real investment return by 20%. Alternatively, every 1% in fees you save improves your long-term savings outcome by 30%!
Most South African retirement investors have no idea (and no curiosity) as to what fees they pay on their retirement savings, and how this may affect them. This apathy plays into the hands of the retirement fund industry, which, on average charges fees of 2% pa on umbrella funds, and 3% pa on retirement annuities. “Average” implies that many of you pay more.
The bottom line: paying a fee of 3% pa over 40 years will almost halve the real value (purchasing power) of your pension. And it will ruin your retirement. So keep your fees low by shopping around for a low cost provider, and avoiding high active fund management charges.
5. Over-conservative asset mix
Investing too conservatively is one of the riskiest things you can do with your retirement savings. Why? Because it massively increases the probability that you won’t make ends meet in retirement.
On any given Sunday, would you rather play chess or sky-dive? How much of a market decline can you stomach before you throw up? These and other “scientific” questions probe your attitude towards risk and, by extension, the investment risk ideal for you. And as most of us would rather play chess than exit planes in mid-air, we end up in a medium risk portfolio and ultimately moderate (ie too low) investment returns.
Investment risk refers to the probability that the actual investment outcome differs from the expected outcome. As the investment return from shares is volatile, this probability is high – in the short term. Share markets have been known to double or halve within a 12-month period. But should that really matter if you have a 40-year time horizon? Historically, as the investment term has lengthened, so share returns have become less volatile and more predictable. And they have been well above those of bonds and cash.
So let your time horizon guide your investment risk. If you are young, you can afford to ride out short-term volatility and invest in a high risk (high equity) portfolio, with the reasonable expectation that this asset class will deliver the highest return over the long term. As you come to the end of this term, increase your allocation to lower return assets such as bonds and cash, to preserve what you have saved.
So invest according to your age, not your hobbies; your money is so not interested in what you get up to on the week end.
