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 pre-retirement 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.
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, link at the end of the article). 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 40-year 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 multi-asset 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, link at the end of the article).
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.