Set a re­tire­ment tar­get you can achieve

Ex­pect­ing that your fund will pro­vide an in­come in re­tire­ment of 75 per­cent of your pre-re­tire­ment pay is un­re­al­is­tic, new re­search says. In­stead, funds should aim to pro­vide you with a re­tire­ment in­come that is based on your per­sonal cir­cum­stances. Laura

Weekend Argus (Saturday Edition) - - GOODPOSTER -

It is “un­re­al­is­tic” for mem­bers of many em­ployer- spon­sored re­tire­ment funds to ex­pect to re­tire on 70 to 75 per­cent of their pre-re­tire­ment in­come, ac­cord­ing to a Har­vard pro­fes­sor and a lo­cal ac­tu­ary.

Pro­fes­sor Robert Mer­ton, a fi­nance pro­fes­sor at the MIT Sloan School of Man­age­ment and emer­i­tus pro­fes­sor at Har­vard Univer­sity, and Shaun Levitan, the chief op­er­at­ing of­fi­cer and co-founder of in­vest­ment man­ager Colour­field Li­a­bil­ity So­lu­tions, say many South Africans who be­long to de­fined-con­tri­bu­tion funds be­lieve they will re­ceive this level of in­come in re­tire­ment, be­cause it is re­ferred to so of­ten.

(At re­tire­ment, de­fined-con­tri­bu­tion funds pro­vide mem­bers with their con­tri­bu­tions, those of their em­ployer and the in­vest­ment growth on th­ese con­tri­bu­tions.)

How­ever, just as many peo­ple be­lieve the Great Wall of China can be seen from space, al­though it can­not, the re­al­ity is that most fund mem­bers will not re­tire on 70 to 75 per­cent of their pre-re­tire­ment in­come, Levitan says.

The per­cent­age is known as the re­place­ment ra­tio, be­cause it tells you what per­cent­age of the in­come you earn be­fore re­tire­ment will be re­placed with a pen­sion in re­tire­ment. Levitan and Mer­ton say that achiev­ing a re­place­ment ra­tio of 65 per­cent will be “chal­leng­ing” for most mem­bers of de­fined-con­tri­bu­tion funds.

You may not be on track to re­tire on 70 to 75 per­cent of your pre­re­tire­ment in­come, but there are things the trus­tees of your fund can do to en­sure you have a greater chance of achiev­ing an ap­pro­pri­ate in­come tar­get, and they can en­able you to make mean­ing­ful de­ci­sions about the in­come you want.

Levitan and Mer­ton will present a pa­per to the Ac­tu­ar­ial So­ci­ety of South Africa’s an­nual con­ven­tion later this month in which they will:

◆ Ar­gue the case for mem­bers of de­fined-con­tri­bu­tion funds to fo­cus on the in­come that their re­tire­ment sav­ings will pro­vide, rather than the cap­i­tal they will have ac­cu­mu­lated by the time they re­tire.

Mer­ton wrote an ar­ti­cle, “The cri­sis in re­tire­ment plan­ning”, for the Har­vard Busi­ness Re­view, in which he out­lined the prob­lem that has arisen as a re­sult of the global move from de­fined- ben­e­fit funds (that guar­an­tee a pen­sion based on pre-re­tire­ment in­come) to de­fined­con­tri­bu­tion funds.

◆ Out­line how trus­tees should set a de­fault in­vest­ment strat­egy that takes into ac­count your age, ac­cu­mu­lated sav­ings, con­tri­bu­tion rate, salary and years to re­tire­ment, and that will pro­vide all mem­bers of the fund with an ap­pro­pri­ate in­come in re­tire­ment.

◆ Rec­om­mend that you be given the in­for­ma­tion you need to make de­ci­sions about your re­quired in­come in re­tire­ment.

Levitan and Mer­ton’s pa­per points out that four things de­ter­mine your in­come in re­tire­ment:

◆ How much you and your em­ployer con­trib­ute to your fund;

◆ The in­vest­ment re­turns your sav­ings earn; ◆ How long you save for; and ◆ The cost of buy­ing a pen­sion (an­nu­ity) at re­tire­ment.

DO­ING THE MATHS

They say the Alexan­der Forbes Ben­e­fits Barom­e­ter shows that the av­er­age an­nual con­tri­bu­tions (ex­clud­ing group life pre­mi­ums) by both employees and em­ploy­ers to most pri­vate sec­tor em­ployer-spon­sored funds is be­tween 12.1 and 15.7 per­cent of pen­sion­able in­come.

Levitan and Mer­ton say you can earn a real (af­ter-in­fla­tion) av­er­age an­nual re­turn of two per­cent on gov­ern­ment in­fla­tion-linked bonds and 5.5 per­cent on lo­cal eq­ui­ties (as­sum­ing in­vest­ment costs are met by any mar­ket out-per­for­mance).

Given that reg­u­la­tion 28 un­der the Pen­sion Funds Act pre­vents re­tire­ment funds from in­vest­ing more than 75 per­cent in eq­ui­ties, Levitan and Mer­ton say you can rea­son­ably ex­pect your re­tire­ment sav­ings to earn a real re­turn of 4.6 per­cent a year over your work­ing life.

Most re­tire­ment funds cal­cu­late their re­place­ment ra­tios by as­sum­ing that mem­bers will con­trib­ute to the fund for 40 years – that is, start at age 25 and stop at 65 with­out with­draw­ing any of their sav­ings if they change jobs.

Mer­ton and Levitan be­lieve it is more likely that a mem­ber will con­trib­ute for 35 years, mainly be­cause most mem­bers start saving when they are about 30, but also be­cause some mem­bers re­tire be­fore 65.

They say you also need to take into ac­count what it will cost to pro­vide an in­come in re­tire­ment. They ar­gue that an in­fla­tion-linked guar­an­teed an­nu­ity is the most ap­pro­pri­ate pen­sion, be­cause this prod­uct:

◆ Pro­vides an in­come that in­creases in line with in­fla­tion each year, which pro­tects the buy­ing power of your in­come; and

◆ Pays a pen­sion for life, which means there is no risk of you out­liv­ing your sav­ings, as there is with an in­vest­ment-linked liv­ing an­nu­ity.

Us­ing th­ese as­sump­tions, Levitan and Mer­ton have cal­cu­lated that, at a con­tri­bu­tion rate of 12.5 per­cent for 35 years and as­sum­ing a real re­turn of five per­cent a year, you will achieve a re­place­ment ra­tio of only 54 per­cent.

If you and your em­ployer con­trib­ute 15 per­cent, your re­place­ment ra­tio will be 65 per­cent.

If your re­turns are closer to four per­cent, your re­place­ment ra­tio will be lower.

PER­SON­ALISED IN­COME GOAL

Levitan and Mer­ton say the re­place­ment ra­tio is a good mea­sure of how on track you are to reach­ing your tar­geted re­tire­ment in­come.

How­ever, in­stead of set­ting an in­come tar­get for the hy­po­thet­i­cal mem­ber, trus­tees should tai­lor a re­place­ment ra­tio for each mem­ber, based on the likely num­ber of years of fund mem­ber­ship and pos­si­bly his or her gen­der. (Women tend to live longer than men in re­tire­ment and will there­fore pay more than men of the same age for a guar­an­teed an­nu­ity.)

They say your per­son­alised in­come goal should take into ac­count how much you have al­ready saved for re­tire­ment, how much you are con­tribut­ing and the cost of buy­ing an in­come at re­tire­ment.

If you join a fund at, for ex­am­ple, the age of 40, the trus­tees should re­duce your in­come goal, be­cause you have saved in an­other fund for the pre­vi­ous 10 years. How­ever, if you did not save for those 10 years, or you didn’t pre­serve all your sav­ings, you could in­crease your con­tri­bu­tions within the per­mit­ted tax de­duc­tions, which will in­crease next year for most mem­bers if tax amend­ments are im­ple­mented.

Al­ter­na­tively, you could, within the lim­its set by reg­u­la­tion 28, ex­pose your sav­ings to more in­vest­ment risk with a view to earn­ing a higher re­turn.

As you ap­proach the level of in­come you re­quire, your as­sets should be moved out of a port­fo­lio aimed at achiev­ing in­vest­ment growth and into one that pro­tects your re­quired in­come.

Levitan and Mer­ton ar­gue that your fund trus­tees should as­sume that you need an in­fla­tion-linked in­come in re­tire­ment, which only an in­fla­tion-linked an­nu­ity can guar­an­tee. The cost of this an­nu­ity, how­ever, changes over time.

They say the way to pro­tect your­self from a mis­match be­tween the in­come you thought your re­tire­ment sav­ings would pro­vide and the an­nu­ity you will, in fact, be able to buy at re­tire­ment is to move your in­vest­ments into in­fla­tion-linked bonds as you ap­proach re­tire­ment. This ap­proach is con­trary to the one used by many re­tire­ment funds, which is to move your sav­ings into cash or nom­i­nal bonds as you ap­proach re­tire­ment – a strat­egy known as life-stag­ing.

In their pa­per, Mer­ton and Levitan show that, al­though mov­ing your re­tire­ment sav­ings into cash will pro­tect your lump sum as you ap­proach re­tire­ment, it will not pro­tect your abil­ity to buy a par­tic­u­lar level of pen­sion.

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