Brent Sheather

Never been harder to plan retirement

The significance of overstating returns is not just academic. It can lead to bad decisions and bad outcomes in the real world.

Low return forecasts for international shares and bonds are particularly significant for KiwiSavers, contributors to superannuation funds and investors generally because the average balanced portfolio has about 50 per cent in shares, two thirds of which are in international shares.

Typically 40 per cent of the average balanced portfolio is in bonds, split between NZ and international, with the remaining 10 per cent invested in property.

Using this asset allocation and assuming 4.5 per cent nominal returns on NZ bonds and a generous 7.5 per cent per annum for NZ and Australian shares we can calculate the weighted average forecast return for a typical balanced portfolio over the long term. A reasonable estimate of the long-term post-tax, post-fee return for a balanced KiwiSaver fund is thus 3.9 per cent per annum.

Remember, however, that forecasts of future returns are just that, forecasts, but paradoxically it is far easier to forecast 30-year returns than it is to forecast returns for the next 12 months.

Without going into too much detail, returns are a function of two variables — the normal long-term return and, as Vanguard group founder John Bogle calls it, the speculative return that arises from valuation changes.

In the short term, the speculative return can overwhelm the normal return but over the long run, valuation changes become less significant. The NZ sharemarket in particular has enjoyed a number of years of additional speculative returns and the jury is out as to whether valuations will return to average (lower) levels or stay elevated.

The biggest takeaway from the above is that if returns will be lower investors need to consider their investment options carefully.

Despite the extensive fake news on the subject of retirement, academics reckon that the three proven and reliable ways of improving outcomes are saving more (obviously), taking on more risk and reducing fees.

For many individuals (and institutional investors) saving more is not an option and reducing fees is the preferred strategy for increasing returns.

Choosing how you will save for retirement has probably never been more difficult. There are lots of alternatives — KiwiSaver, DIY investing, buying a house etc.

Then there is the matter of asset allocation — how much do you invest in bonds, property and shares?

All these variables will impact the terminal sum you save prior to stopping work for good.

Sounds complicated doesn’t it? But it just got worse because there is a new variable added to the mix and that is — what savings calculator you use to forecast your savings.

Pick the right one and you could be thousands of dollars better off come retirement day. Make the wrong choice and you may still be working when you are 70.

Too sarcastic maybe, however it is easy to be critical about fund managers’ choice of return forecasts. Formal intervention from the regulator looks inevitable especially given, as the FMA recently noted, the extent of the information asymmetry between product providers and consumers.

The significance of overstating returns is not just academic. It can lead to bad decisions and bad outcomes in the real world.

If you expect your investment to return 8 per cent per annum and it returns just 4 per cent you may not have saved enough for your retirement.

Analysis by investment group AQR made the point that future returns are likely to be lower than historic.

The Economist Magazine reviewed the AQR report and noted that one of the reasons why individuals saving for retirement may not save enough is that they “may have been deceived by the robustness of past returns”.

The major culprit in that deception is of course fund salespeople.

The AQR analysis suggests that a 1 per cent reduction in portfolio returns (from 5.5 per cent to 4.5 per cent real) requires 3 per cent in additional savings per year to achieve the same nest-egg value. That’s huge.

The additional significance of this figure is that if you are paying 1 per cent more in fees than you need to you may be required to contribute 3 per cent more in savings to achieve the same retirement outcome.

KiwiSaver calculators can predict widely different terminal sums for the same savings plan. Compare after-fee, after-tax returns used in KiwiSaver calculators for a long-term savings plan with a balanced portfolio of 40 per cent bonds and 60 per cent shares, a terminal sum calculated for someone aged 35, retiring at 65, earning $75,000 with employer and employee contributions of 3 per cent, wage growth of 2.5 per cent per annum and receiving a KiwiSaver Government subsidy of $521 per year.

The range of results include a $310,000 terminal sum assuming a 3.9 per cent per annum return and $399,000 assuming a 5.5 per cent.

However, just looking at the return forecast is not the full story — for example a 5.5 per cent per annum forecast return might look optimistic, however it becomes more realistic when the annual fee is about 1 per cent below that of the average KiwiSaver provider.

One KiwiSaver manager uses a 6.92 per cent return to give a terminal sum of $503,000, which looks most unrealistic given their fee structure is 40 per cent above the average used in this analysis.

So Kiwisavers be careful — it’s a jungle out there and remember the old rule that if it looks too good to be true it probably is.