A key question in any financial planning exercise is “How much do I need to save so that I can comfortably maintain my standard of living in retirement?”
Addressing this correctly and timeously is critical as pensioners have different needs (a regular income that ideally increases with inflation over time) and different risks (running out of money, i.e. living too long) to other types of investors.
There are also important psychological aspects that must be considered.
Many retirees will find it difficult to survive on a state pension, go back to work or be supported by their family.
Investec Asset Management recently completed an in-depth study into how investors should approach their retirement income provision.
One conclusion highlights that choosing the right level of starting income is key to investors managing their risk of running out of money.
In short, a retiree should elect a starting income level of no more than 5% of their retirement capital.
Remember these numbers
With this starting income level of 5% of retirement capital as your standard, we can calculate that you require a capital lump sum equal to 20 times your final salary to invest in an income-producing annuity on retirement.
This is the amount required to generate an income equal to 100% of your final salary, post-retirement (i.e. a replacement ratio equivalent of 100%).
Drawing no more than 5% is considered likely to provide you with an inflation-adjusted income for 30 years, ensuring a comfortable retirement.
Any capital lump sum of less than 20 times will result in a lower starting income (a lower replacement ratio) than your final salary and therefore you would need to reduce your monthly expenditure accordingly.
Start early – but remember it is never too late
While knowing how much you require is critical, so too is knowing where you are on the path to this lump sum.
Arriving at a sufficient retirement pot is a journey that takes a full working lifetime, as the following formulas illustrate.
The impact of delay is considerable:
Starting at 20:
15% of pre-tax salary X 40 years of employment = 20 times income required at age 60In this example, someone starts working at age 20 and saves 15% of their pre-tax salary every month for their entire working career.
And, in the event they change jobs, they preserve their existing retirement savings.
This proverbial unicorn is one of the minority who can retire comfortably at age 60.
Starting 10 years later:
30% of pre-tax salary X 30 years of employment = 20 times income required at age 60A more realistic example is where someone does not start providing for retirement from age 20 or does not preserve their retirement benefits when they change jobs in the first 10 years.
They are then required to save twice as much of their pre-tax salary for the shorter 30-year period to achieve the same outcome (or retire at 70).
Starting 20 years later:
60% of pre-tax salary X 20 years of employment = 20 times income required at age 60The more extreme outcome requires an improbable savings rate of 60% of pre-tax salary (or retirement at 80!).
Clearly, there are no quick fixes to a lack of retirement provision and, for many, very little likelihood of being able to comfortably retire at 60 unless you act wisely at the right time.
However, it is never too late to start.
How can you assess your progress along the way?
The chart above shows what multiple of your current annual salary you need to have saved at any age between 20 and 60 to ensure a replacement ratio equal to 100%.
We have also shown the multiples required for a 75% replacement ratio by way of comparison.
A 75% replacement ratio may suffice for many retirees, depending on lifestyle choices and financial obligations.
Once retired, retirees do not typically contribute to a retirement fund anymore.
Transport and clothing costs could come down, and they may be debt free, with financially independent children.
So, by age 40, you should have accumulated retirement savings of approximately five times your annual salary if you are targeting a replacement ratio of 100%.
Another interesting observation of this chart is the acceleration of capital values in later years, a clear illustration of compounding benefits.
Note, while it took 20 years to accumulate savings of five times your salary, it takes only a further 10 years for your accumulated savings to double to 10 times, and then only another 10 years for your accumulated savings to double yet again and reach the magical 20 times!
The value of active management should not be overlooked.
A key assumption in our calculations is a portfolio return of 7% above inflation, which joins forces with compound interest and your contributions to deliver your lump sum available at retirement.
With this return, 40 years of saving 15% of your pre-tax income should see you retire comfortably, drawing 5% per annum from your savings.
However, if returns are 2% higher, at CPI + 9%, you’ll have saved 35 times your final salary.
Paul Hutchinson is sales manager at Investec Asset Management.