Early with­drawals and high costs make for a rough re­tire­ment

With the era of low re­turns upon us, you can­not af­ford to make with­drawals from your re­tire­ment sav­ings dur­ing your work­ing life. Laura du Preez re­ports

Weekend Argus (Saturday Edition) - - PERSONALFINANCE -

If you want a pen­sion that is at least three-quar­ters of your pre-re­tire­ment in­come, you should not with­draw any of your re­tire­ment sav­ings through­out your work­ing life, you must earn a re­turn of at least five per­cent above in­fla­tion, and you should con­tain the to­tal an­nual costs to be­tween two and 2.5 per­cent.

This is the ad­vice of Daniel Wes­sels, an in­de­pen­dent fi­nan­cial plan­ner and part­ner at Cape Town-based fi­nan­cial ad­vice com­pany Martin Ek­steen Jor­daan Wes­sels, who has con­ducted re­search into how early with­drawals and high costs can af­fect your re­tire­ment sav­ings.

Wes­sels’s re­search shows that if you earn a re­turn of only four per­cent­age points above in­fla­tion (in other words, with in­fla­tion cur­rently at six per­cent, as mea­sured by the con­sumer price in­dex, a gross re­turn of 10 per­cent), your re­tire­ment sav­ings will not be enough to pro­vide you with an in­come of 75 per­cent of what you earned be­fore you re­tired, even if the in­vest­ment costs are only one per­cent. This will still be true if you save for 40 years – based on a typ­i­cal work­ing life from age 25 to 65 – make no with­drawals and con­trib­ute 15 per­cent of your in­come to a re­tire­ment fund through­out that pe­riod.

If you earn a re­turn of five per­cent­age points above in­fla­tion – known as a real re­turn of five per­cent – you could in­cur costs of up to 1.5 per­cent a year (that is, your real re­turn af­ter costs will be 3.5 per­cent) and still achieve a post-re­tire­ment in­come of 75 per­cent of your pre­re­tire­ment in­come. How­ever, if your costs reach two per­cent a year, you will re­tire on less.

The re­tire­ment in­dus­try refers to the ra­tio be­tween your fi­nal salary be­fore re­tire­ment and your ini­tial pen­sion at re­tire­ment as your “re­place­ment ra­tio”.

To achieve a re­place­ment ra­tio of 75 per­cent, you need to con­trib­ute 15 per­cent of your gross in­come to your re­tire­ment sav­ings. This tar­get may sound high, but re­mem­ber that if you are an em­ployee, your em­ployer may also be con­tribut­ing to your re­tire­ment sav­ings.

You should find out what you and your em­ployer are con­tribut­ing in to­tal, and top up the con­tri­bu­tion with your own sav­ings if it is less than 15 per­cent.

EARLY AND LATER WITH­DRAWALS

Wes­sels’s re­search shows that if the real re­turn is higher than five per­cent and, in par­tic­u­lar, if the an­nual costs are less than two to 2.5 per­cent, you can achieve a re­place­ment ra­tio of 75 per­cent even if you with­draw all of your re­tire­ment sav­ings in the early years of your work­ing life – or if you start sav­ing a few years later than 40 years be­fore re­tire­ment.

But you are un­likely to achieve a re­place­ment ra­tio of 75 per­cent if you make with­drawals at a later stage of your work­ing life, un­less you in­crease your con­tri­bu­tions above 15 per­cent.

If you earn a real re­turn of five per­cent a year, you can af­ford to with­draw all of your re­tire­ment sav­ings only in the first two years of a 40-year work­ing life. Even in this case, the to­tal costs can­not be more than one per­cent a year; if they are, you will not achieve a re­place­ment ra­tio of 75 per­cent, Wes­sels’s re­search shows (re­fer to the ta­bles on the right). There­after, you must save con­tin­u­ously and hope that the in­vest­ment odds will be in your favour so that you achieve a good af­ter-in­fla­tion re­turn.

If you earn a real re­turn of six per­cent a year, you can af­ford to with­draw all of your sav­ings within the first four years of your work­ing life, but your an­nual in­vest­ment costs must not ex­ceed 1.5 per­cent if you want to achieve a re­place­ment ra­tio of 75 per­cent.

Wes­sels warns, how­ever, that the fu­ture is un­cer­tain and ide­ally you should not make any with­drawals from your re­tire­ment sav­ings.

If you have made with­drawals and you can­not con­trib­ute 15 per­cent of your in­come through­out your work­ing life or you do not achieve the re­quired re­turns above in­fla­tion, you are likely to re­tire with a pen­sion of less than 75 per­cent of your pre-re­tire­ment in­come.

If you do not make any with­drawals from your re­tire­ment sav­ings, Wes­sels’s re­search shows that you will achieve a re­place­ment ra­tio of 75 per­cent only if you save 15 per­cent of your in­come for 40 years, earn a real re­turn of six per­cent and con­tain the in­vest­ment costs to 2.6 per­cent a year – in other words, your av­er­age an­nual re­turn, af­ter costs and af­ter in­fla­tion, should be 3.4 per­cent.

You need a re­turn of eight per­cent above in­fla­tion on your re­tire­ment sav­ings through­out your 40year work­ing life in or­der to sus­tain higher costs of up to 4.6 per­cent and still achieve a re­place­ment ra­tio of 75 per­cent. And this is with­out any with­drawals from your sav­ings.

Wes­sels says that high costs have a more ad­verse ef­fect on the fi­nal val­ues of your re­tire­ment sav­ings than early with­drawals, but only if those with­drawals are in the first few years of your work­ing life. If you make a with­drawal 10 or more years af­ter you be­gan sav­ing, it is the with­drawal, rather than the costs, that will largely be re­spon­si­ble for de­stroy­ing your re­place­ment ra­tio, he says.

High re­turns al­low you the “lux­ury” of an early with­drawal, but in a low- re­turn en­vi­ron­ment you should avoid mak­ing any with­drawals, be­cause no one knows for cer­tain what your in­vest­ments will re­turn in fu­ture, Wes­sels says.

The rolling re­turns on mul­tias­set port­fo­lios ( based on the re­turns from their bench­mark in­dices and with­out costs) show that, in the two decades to 2012, a port­fo­lio with an eq­uity ex­po­sure of 75 per­cent earned av­er­age an­nual real re­turns of be­tween six and seven per­cent, while a port­fo­lio with an eq­uity ex­po­sure of 50 per­cent earned av­er­age an­nual real re­turns of be­tween four and six per­cent (re­fer to the graph, left).

How­ever, there have been times over the past 40 years when the re­turns were lower, and ex­pect­ing such high re­turns may be overly op­ti­mistic, Wes­sels says.

It makes more sense to ex­pect a real re­turn of four per­cent or less a year, af­ter costs, he says.

Wes­sels’s sen­ti­ments are echoed by many as­set man­agers, who have re­peat­edly warned that in­vestors should not ex­pect the high real re­turns of the past decade to con­tinue and that we have now en­tered an era of low real re­turns. There­fore, it is sen­si­ble not to make any with­drawals from your re­tire­ment sav­ings, par­tic­u­larly if you have less than 40 years to re­tire­ment, Wes­sels says.

In ad­di­tion, your over­all in­vest­ment costs – in­clud­ing fund man­age­ment, prod­uct ad­min­is­tra­tion and ad­vice fees – should not ex­ceed two to 2.5 per­cent a year, he says.

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