The dilemma of how much risk you prefer to take versus how much risk you are prepared to take to meet your retirement goals

In a previous newsletter we spoke about the relevance of the salary replacement ratio and provided table 1 below. Most of us save for retirement in some form or another. All of us, however, hope that when we retire, enough investments have accumulated for a dignified retirement. Instead of just hoping for the best, one should plan for retirement and one of the tools that can be utilized is the salary replacement ratio. This ratio expresses the pension that will be received on retirement as a percentage of the pensionable salary in the last month before retirement. The table below reflects this ratio, based on certain assumptions.

You will realize that we place a lot of emphasis on ‘real investment returns’ and on ‘income replacement ratios’ and you may ask, are the figures used in the table good, bad or indifferent? The table uses 5% as the maximum assumed ‘real investment return’. You will notice that the table does not produce an income replacement ratio of anywhere close to 100% for any of the scenarios. Internationally pension fund structures aim to achieve an income replacement ratio of 2% per year of service, i.e., if you worked and saved continuously for retirement for 40 years, a well structured fund should be able to offer you a pension equal to around 80% of your last salary before retirement. An income replacement ratio of 100% is therefore essentially unachievable.

So how do we get to the assumption on the expected future ‘real investment return’ and what is the implication for how you should invest? Table 2 breaks down the real investment return into the typical components of a retirement fund portfolio. It shows that if you employ a maximum equity exposure of 75% (65% domestic and 10% global), 15% in bonds (10% domestic and 5% global) and 10% in the money market you can expect a ‘real investment return’ of 5.6%. Prudential balanced portfolios would typically employ such an asset allocation.

You can manipulate the figures in table 2 to determine what ‘real investment return’ you may expect based on different asset allocation scenarios. The historic real returns should be taken as a given but the allocation between the different asset classes can be varied.

A more conservative investor who is averse to fluctuations in values would reduce equity and bond exposure in favour of cash. Take into account the ‘prudential maximum’ you may invest in the various asset classes in terms of regulation 28. The extremely conservative investor who cannot live with any value fluctuations might want to invest 100% in the money market. Per table 2 this should produce a ‘real investment return’ of roughly 1.7% (100% exposure to a return of 1.7%). Whilst table 1 does not provide for such a scenario it should be evident that this investment strategy would require a total contribution towards retirement of way in excess of 16% of total remuneration.

When you plan for retirement, the contributions to your employer’s retirement fund are usually a given and cannot be manipulated to suit your needs. You have the choice though to make additional voluntary savings outside the fund, sometimes within the fund as well.

Table 1 will tell you how much you need to set aside in total to achieve a desired income replacement ratio after retirement, based on the ‘real investment return’ your investment is likely to generate and based on a service period of 30 years. It shows that if you require an income of N$ 600 after retirement while you earned an income of N$ 1,000 before retirement (i.e. a replacement ratio of 60%) and you want to invest in a conservative investment generating a ‘real investment return’ of 3% per year, you need to set aside for retirement only, 16% of your total remuneration over a 30 year service period.

Conclusion
From these examples it is fair to conclude that your risk appetite is really irrelevant with regard to retirement planning. It is rather a matter of how much you are setting aside and how much income you need after retirement that will determine how much risk you need to take to achieve your ultimate goal with regard to your income replacement ratio after retirement.

Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of Retirement Fund Solutions.