Towards a sustainable retirement plan

By Daniel R Wessels

The conventional approach to retirement planning & advice • Retirement capital required to sustain an annuitant’s real income (annuity) over the long term (25-30 years after retirement) • Retirement capital ratio (factor of final salary) •

The minimum savings rate required to meet the required retirement capital

•

The maximum withdrawal rate allowed at retirement to sustain annuity income over the long term

The conventional approach to retirement planning & advice

Relationship between replacement rate, initial withdrawal rate and retirement capital ratio

14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 100% Replacement 70% Replacement 50% Replacement 8 9 10 11 12 13 14 15 16 17 18

Retirement capital ratio (factor of final salary)

19 20

The basic premise of this approach is that we assume that future returns will be similar than what we experienced in the past… But is this a realistic assumption?

For example, consider three different investment portfolios and their long term historical returns…

•

Low-equity portfolio

(25% equities, 75% bonds and cash): •

Medium-equity portfolio

(50% equities, 50% bonds and cash): •

High-equity portfolio

(75% equities, 25% bonds and cash):

Annualised portfolio returns (1900-2010)

Portfolio Low-equity Nominal 9% Real 4% Medium-equity High-equity 11% 13% 6% 8% Volatility 9% 14% 18%

Low-equity portfolio

Real Portfolio Return Annual Returns

50% 40% 30% 20% 10% 0% -10% -20% -30% -40% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

Real Portfolio Return Rolling 30-year return

6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

Medium-equity portfolio

Real Portfolio Return Annual Returns

80% 60% 40% 20% 0% -20% -40% -60% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

Real Portfolio Return Rolling 30-year return

9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

High-equity portfolio

Real Portfolio Return Annual Returns

100% 80% 60% 40% 20% 0% -20% -40% -60% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

Real Portfolio Return Rolling 30-year return

12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

In all instances we note secular periods of high and low real portfolio returns, i.e. a period of high real returns is followed by a period of lower real returns…

Real Portfolio Return Rolling 30-year return

9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1930 1940 1950 1960 1970 1980 1990 2000 2010 Real Portfolio Return

Therefore, determining a savings rate to acquire a certain retirement capital ratio and/or a withdrawal rate that will sustain the retirement plan over time may be futile because long-term real returns are not consistent

For example, the savings rate required to meet a certain retirement capital amount at retirement would have varied considerably over time…

Minimum Savings Rate to meet Target Retirement Capital

30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 19 00 19 04 19 08 19 12 19 16 19 20 19 24 19 28 19 32 19 36 19 40 19 44 19 48 19 52 19 56 19 60 19 64 19 68 19 72 19 76

Year at which saving for retirement started

Minimum Savings Rate

Likewise, the maximum initial withdrawal rate that would have been allowed to ensure a retirement plan sustaining a real income over time varied from as low as 4% to high as 12% in the past…

Maximum Withdrawal Rate

14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980

Year at which retirement period started

Maximum Withdrawal Rate

And the retirement capital (retirement capital as a factor of final salary) required would have varied considerably … Minimum retirement capital required to sustain retirement plan over thirty years Replacement rate = 70% 24.00

22.00

20.00

18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

2.00

-

The Targeted Retirement Capital approach

: The higher the long-term real returns, the lower the required savings rate or higher the safe withdrawal rate…but you won’t know this beforehand!

Minimum Savings Rate to meet Target Retirement Capital

30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 19 00 19 04 19 08 19 12 19 16 19 20 19 24 19 28 19 32 19 36 19 40 19 44 19 48 19 52 19 56 19 60 19 64 19 68 19 72 19 76

Year at which saving for retirement started

10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Minimum Savings Rate (lhs) Rolling 30-year real return (rhs) 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0%

Maximum Withdrawal Rate Year at which retirement period started

Maximum Withdrawal Rate (lhs) Rolling 30-year real return (rhs) 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0%

Alternative Solution

:

Focus on the full cycle of the retirement plan, i.e. contribution period (30-40 years) and withdrawal phase (25-30 years) Then the question would be how much of my salary should I save each year to ensure that I will have sufficient retirement capital to sustain my retirement income over the long term?

Minimum Savings Rate required over time…

35-year contribution period, 30-year withdrawal period, 70% replacement rate, constant real income (annuity) 18.0%

Minimum Savings Rate required to sustain retirement plan over full cycle

35-year savings, 30-year retirement 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 19 00 19 03 19 06 19 09 19 12 19 15 19 18 19 21 19 24 19 27 19 30 19 33 19 36 19 39 19 42 19 45

Start of 65-year cycle

Minimum Savings Rate

Safe Savings Rate based on historical evidence…

35-year contribution period, 30-year withdrawal period, 70% replacement rate, constant real income (annuity) The percentage of retirement plans sustainable over a 65-year lifecycle

Savings Rate

After 10 years retirement After 15 years retirement After 20 years retirement After 25 years retirement After 30 years retirement

10%

100% 81% 34% 11% 0%

11%

100% 100% 57% 32% 13%

12%

100% 100% 85% 47% 32%

13%

100% 100% 100% 66% 47%

14%

100% 100% 100% 91% 64%

15%

100% 100% 100% 100% 91%

16%

100% 100% 100% 100% 100%

Safe Savings Rate based on historical evidence…

The contribution period, replacement rate at retirement and portfolio selection all play a key role… But the contribution period is probably the most important determinant…

Sustainable retirement plan based on historical evidence… Retirement plan sustainable for 25 years

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Sustainability of retirement plan Replacement = 50%

10% Savings rate 12.5% Savings rate 15% Savings rate 25 30 35

Contribution period

40

Sustainable retirement plan based on historical evidence… Retirement plan sustainable for 25 years

100% 80% 60% 40% 20% 0%

Sustainability of retirement plan Replacement = 75%

25 30 35

Contribution period

40 10% Savings rate 12.5% Savings rate 15% Savings rate

Practical considerations for investors

• Start early – from your first pay cheque • Keep the discipline of saving regularly, despite good or bad periods that you’ll experience over time • At retirement: Do not go over the top! Stick to your budget and plan (do not withdraw more than you initially planned for and think twice about buying that car!) • Retirement is not where you stop applying your mind and skills. Empower yourself to earn additional income from your specialised skills, hobbies or interest during the retirement years.

Practical considerations for financial planners  Most likely the planner will be approached by investors at or near retirement, not at the start of their working careers! Thus, the financial planner must advise on what is available, not what could or should have been.

 Err on the conservative side in planning and projections  Identify low-cost administrative investment platforms and investment portfolios, which benefits are obvious in a lower real return scenario, but are easily hidden or forgotten in buoyant years.

Practical considerations

Relationship between replacement rate, initial withdrawal rate and retirement capital ratio

14.00% 12.00% 10.00% 100% Replacement 8.00% 6.00% 70% Replacement 4.00% 2.00% 0.00% 8 50% Replacement 9 10 11 12 13 14 Possible "Safe Zone" 15 16 17 18

Retirement capital ratio (factor of final salary)

19 20

Thank you The full research report can be requested at: [email protected]

Daniel R Wessels Martin Eksteen Jordaan Wessels cc Financial advisors FSP 12406 2nd floor 5 St Georges St Georges Mall Cape Town 8001 021-4193134 (t) 021-4193390 (f)

DRW INVESTMENT RESEARCH Disclaimer:

Please note that all the material, opinions and views herein do not constitute investment advice, but are published primarily for information purposes. The author accepts no responsibility for investors using the information as investment advice. Please consult an authorised investment advisor.

Unless otherwise stated, the author is the sole proprietor of this publication and its content. No quotations from or references to this publication are allowed without prior approval.