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Targeting benefits at retirement
Members of a defined contribution scheme seldom consider targeting benefits at retirement. People no longer think of their retirement benefits in relation to their salary at retirement as they did in defined benefit schemes.
In a defined benefit scheme, your annual pension was specified in relation to your salary as you approached retirement. Hence your benefit was defined - you knew when you joined the fund what you were going to get when you retired1.
With defined contribution schemes, your benefits at retirement are simply the assets you have accumulated at retirement: the accumulated value of your contributions up to retirement - no benefit is targeted and no benefit is defined. The risk falls into the member's hands as to whether or not he/she has enough when he retires.
To reduce the risk of not having enough when you retire comes down to two key decisions:
* When to start setting aside for your retirement.
* What to do with the money you set aside every month.
When to start setting aside for your retirement
Let's say that the average person contributes 10% of his monthly income towards retirement. That represents a small portion of an individual's monthly income. That small portion needs to accumulate over the individual's working life to provide the person with sufficient income for probably 20 years, from the time he retires (say, at 65) to the end of his life.
The rand amount you contribute every year grows because, hopefully, your salary grows with at least inflation.
Assuming inflation of 6% over your working life, let's say that your annual salary grows by 1% more than inflation on average over your working life.
The average pension fund has achieved a real return in excess of 5%/year (above inflation) on your pension assets over time2. We think a typical balanced portfolio (one that invests in a prudential mix of equities, bonds and cash) should deliver this over long periods of time.
Your pension assets are typically long-term investments, so let's assume that your pension assets deliver a return of 11%/year, on average, over your working life (assuming 6% inflation).
Using these assumptions, an individual's pension assets were calculated in relation to his final salary at retirement. In other words, how many years of your final salary at retirement will your pension assets comprise.
If you start contributing 10%/month of your salary from the age of 25 and these contributions earn a return of 5%/year above inflation at retirement, at 65 you'll have 9,4 years' worth of your final salary in pension assets. It doesn't sound like much - especially after contributing to your pension assets for 40 years.
The second column in the table outlines the number of years' final salary at retirement one would have accumulated as pension assets based on different starting ages. Let's compare someone starting to contribute towards his pension assets at 25 and someone who delays starting to 35.
For the person starting at 25, those 10 years of additional contributions make up 3,7 years' worth of final salary out of 9,4 years at retirement. So someone who only starts at 35 has effectively "lost" 3,7 years' worth of final salary under the same assumptions.
It's considered acceptable for some reduction between your salary at retirement and your retirement income. If you assume that the average person will live to 85 and that his pension keeps pace with inflation, if his pension assets earn a conservative real return of 3%/year, the person who started contributing at 25 will experience a 37% drop in income between his salary at retirement and his retirement income. That's shown in the last column in the table above. In comparison, the person starting at 35 will experience a massive 62% drop in income.
So assuming you were earning R10 000/month prior to retirement, if you started at 25 your retirement income will fall to R6 300 versus R3 800 if you only started at 35. For the person starting at age 35, those initial 10 years will "cost" 40% in income.
Table 2 shows the longer you prolong contributing to your pension assets, the lower your pension assets at retirement and the less money you're going to be able to retire with.
Starting early makes a significant difference as to how comfortably you can r e t i r e .
That's the power of compounding.
Those 10 "lost years" for the 35-yearold would have compounded for at least 30 years for the 25-yearold.
Einstein is rumoured to have said the power of compounding is one of the strongest forces. You can see why. So one way to reduce the risk of not having enough money to retire comfortably is to start contributing to your pension assets as early as possible.
What to do with the money you set aside each month
The average pension fund has been able to deliver at least 5% above inflation over the long term from a typical balanced portfolio. People often say that they'd prefer to reduce the risk of loss on their pension assets by targeting a lower return. The problem is that it's probably more risky to invest in a lower return portfolio if you have time on your hands. A 25-yearold investing in his pension assets has a 40-year time horizon to retirement and then probably another 20 years to live off the benefits. However, people are often so concerned with the volatile short-term returns that they're prepared to give up some of their longterm returns to reduce the volatility.
A 25-year-old saying that he doesn't want any negative returns on a one-year basis is effectively targeting a lower return. That's because to deliver a nonnegative return on a one-year basis, typically stable, lower expected return asset classes are preferred to volatile, higher expected return assets classes.
If you started contributing towards your pension assets at 25 and, using the same assumptions but instead achieved a 3% real return as opposed to a 5% real return, instead of 9,4 years of your annual salary at retirement you'd only have 6,1 years of your annual salary at retirement (a 35% reduction in your pension assets). The pension assets at retirement with a 3% real return is only slightly more than you would have had if you started 10 years' later but achieved a real return of 5%/year on your pension assets.
It must be understood that shortterm volatility in returns is often necessary to deliver superior long-term real returns. Targeting a lower return when you've time on your hands is just as risky as starting too late. Time allows you to recover any short-term losses while targeting a higher long-term return.
In terms of the Consulting Actuaries Survey, over long periods the top quartile pension funds have been able to outperform CPI in excess of 10%/year.
For a 25-year-old achieving this return over his working life equates to a considerable 30,9 years of final salary at retirement in relation to the 9,5 years final salary achieved with a real 5% return.
That shows while the average manager has been able to achieve in excess of 5%/year real, managers who've been able to deliver superior performance over long periods have been able to add significant value for members through appreciably higher benefits at retirement.
Summary
In order to reduce the risk of retiring with too little money (ie, maximising your pension assets and benefits at retirement) start contributing as early as you possibly can. If you're young and have time on your hands accept some short-term volatility in returns. It makes a difference in terms of what you'll have when you retire.
1. An example of a defined benefit would be pension from the fund of 2% of the final salary at retirement for each year of service. So a member with 30 years' service would receive a pension from the fund of 60% of his salary at retirement.
2. As per the Consulting Actuaries Survey, 2003.
Mahesh Cooper
Mahesh Cooper, business analyst, BBus Sc, FIA, FAS (SA). Cooper completed his Bachelor of Business Science at UCT and is currently reading his Masters. At university he received several prestigious awards, including Class Medal, Marks & Spencer/Woolworth Scholarship, Dean's Merit List and Jan Smuts Academic Award.
He started his career in product maintenance at Momentum Life in Pretoria and then moved to Alexander Forbes Asset Consulting as associate director. Before joining Allan Gray, he worked for Medscheme, where he was an actuarial consultant.
He joined Allan Gray in April 2003 as a business analyst providing support to the institutional client servicing team.
