Kristin van den Berg, Director and Trust Officer, considers how much one needs to save for a comfortable retirement.
When we plan for retirement we are, quite simply, building a nest egg that will one day be used to replace the income that ceases once retired. It is important that the income generated from your capital is enough to maintain your current lifestyle (or close to it) and will, at a minimum, last your lifetime.
‘If you aim at nothing, you will hit it every time’
In planning for retirement, it is important to know what you are aiming for. Many people are responsible and save consistently and assume that this will ensure a comfortable retirement. This is often not the case. Ongoing assessment of your ‘roadmap’ to retirement is critical in ensuring you are doing everything necessary to reach the required capital sum.
But what is the magic number? How much capital is enough to maintain one’s lifestyle and ensure capital longevity?
This is not an easy question to answer and differs widely from one person to the next. It is however a concept that should be discussed and monitored within your financial plan and in conjunction with your advisor on an ongoing basis.
Studies have shown* 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 (in this low return environment, 5% withdrawal rate has been squeezed to 4%, in the hope of a normalised environment we will make use of 5% for this article).
So, with a starting income level of 5% of capital, we calculate that you will require a capital lumpsum of 20 times your final salary. This is the amount required to generate an income equal to 100% of your final salary and should provide you with an inflation-adjusted income for 30 years plus. Anything less than 20 times and you will need to adjust your income expectations down.
The above numbers assume 100% income replacement value. It is worth noting that a 75% replacement ratio will often suffice for many retirees. Costs tend to come down in retirement, i.e. retirees do not typically contribute to a retirement fund, transport and other costs reduce and you are in all likelihood debt free, with financially independent children. In this scenario, 75% of the above capital number would, likely, be adequate.
While reaching the magic number on retirement is important to ensure adequate income replacement, ongoing capital management during retirement is just as important.
Inflation beating returns
Inflation erodes the purchasing power of your capital and is one of the biggest risks to a retiree. With modern medicine, it is not unusual for retirement years to be in excess of 30 years. It is for this reason that retirement portfolios should not be invested too conservatively which can be tempting. Sufficient exposure to ‘growth’ assets (shares and property) is an important long-term consideration in preserving capital and negating the eroding effects of inflation.
Volatility
Although exposure to ‘growth’ and hence riskier assets is important, too much can create a volatile portfolio which will have a detrimental impact on your long-term capital longevity. It is important that the appropriate asset allocation is put in place to limit volatility but also that the selected fund managers manage risk and hence volatility of their portfolios. Research has shown that drawing from a volatile portfolio has a detrimental effect on long term capital.
Discipline
One of the biggest destroyers of value is investor behaviour. Investors should avoid inappropriate short-term decisions based on emotions, i.e. switching to chase past performance, switching due to panic or being overly conservative.
Conclusion
Reaching the ‘magic number’ requires a clear strategy and takes patience and discipline. Saving is not a get rich quick scheme, it is not about chance and it will not suddenly happen. It is about starting early, planning and having clear goals.
Understanding and then reaching your required capital goals at retirement is vital and the first step to a comfortable retirement. Ongoing management of that capital throughout retirement is, however, as important.
*Source: Are you investing enough for your future? By Paul Hutchinson, Ninety One