Author: zombie

There are three types of people in the world: Those that make things happen; those that let things happen; and those who look back and ask, “What happened?”

I am not entirely sure of the source of that quote but it is rather apt when it comes to the various ways in which we plan for retirement.

We are coming to the end of yet another year. If you are anything like me, you will once again be dismayed at how quickly the last 11 months have passed. That in turn usually lends itself to a timely, albeit unwelcome, reminder that life is literally flying by.

As we evaluate the success’ and failures of 2012, and even contemplate our annual New Year’s resolutions, I thought it would be useful to stick some numbers on a hypothetical retirement plan in the hope that many will be encouraged to shift their financial planning needs a little higher up the priority list going into 2013.  

6.00%           
The proportion of South African retirement fund members who retire financially secure. (1)

The top of the range for South Africa’s Monetary Policy Committee’s inflation target.

The average annual nominal return from South African cash and equivalent investments since 1900 (2)

12.50%          
The average annual nominal return from South African equity investments since 1900 (2)

R1 225 000.00   
The equivalent annual income that  a 22 year old, earning R100 000 today, who wishes to retire at 65, will need to earn from a retirement annuity at retirement. (3)

1125%             
The amount by which the cost of living will have risen over the working life of that individual if  inflation averages six percent a year. (3)

R245.00        
The cost of two litres of milk in 43 years time assuming a 6% inflation rate and current price of R20. Just to put the overwhelming 1125% increase in price levels into a bit of perspective.

516                
The number of pay checks a 22 year old will receive over her lifetime if she works until 65. Think of this as the number of opportunities she has to contribute to her savings plan over her working life. Not many is it?!

4.68%               
The annuity rate available today if she buys an escalating joint life and survivorship annuity. (4)

R26 180 000.00
The amount of retirement savings she will need to target, in order to purchase an annuity that will provide her with the annual equivalent income of R1 225 000 mentioned above using today’s annuity rate. (4)

R1 750.00        
The amount a 22 year old must put away each month, from the start of her career,  to achieve this savings target if she invests solely in equity markets. (5)

R 11 650.00      
The amount a 22 year old must put away each month, from the start of her career, to achieve this savings target  if she invests solely in cash and equivalents.(6)

R5 750.00            
The amount a 22 year old must put away each month to achieve this savings target  if she delays her retirement savings plan until she is 32 years old and invests solely in equity markets. (7)

R19 400.00         
The amount a 22 year old must put away each month to achieve this savings target  if she delays her retirement savings plan until she is 42 years old and invests solely in equity markets (8)

Now before we all get too despondent about what these numbers suggest, we need to put them in context. You are likely to earn more and therefore be able to save more as your career progresses. Your spending habits are under your control and you can make significant progress towards a successful retirement by controlling how and where you choose to spend, or more accurately, choose to save.

All forecasts are subject to some rather large assumptions. The actual rate of inflation, your actual return on investments, your saving contributions and the eventual annuity rate you receive are all going to have a significant impact on the final outcome.

 
Key messages to take away from the numbers:

Most of us do not have sufficient savings by the time we retire.

The majority of this shortfall stems from the fact that we do not plan as well as we should during our working lives.

Don’t delay saving for retirement any longer. The younger we start planning and saving for retirement the easier it is to achieve our goals.

Be conservative in your assumptions when planning for retirement. Don’t overestimate returns and don’t underestimate inflation.

Have a target and monitor the changing variables over the life of your retirement plan so as to minimise any nasty surprises long before you reach retirement.

 If you have not started saving for retirement DO NOT despair – take control from this point onwards and ensure that  you save what you can so that at least a proportion of your retirement income is secured. 

Please note that the content of this article does not constitute investment advice. Contact White Investments if you have any queries regarding the content of this article or require assistance in compiling a retirement plan.

NOTES:

1) Source is the Old Mutual Savings & Investment Monitor July 2012

2) Credit Suisse Investment Returns Handbook February 2012. Data is up to the end of 2011.

3) White Investments retirement planning calculator. Assumes a rate of inflation of 6% over the 43 years to retirement. Note the actual level of inflation in SA since 1981 is 9.7%. (http://www.tradingeconomics.com/south-africa/inflation-cpi)

4)The source is Metropolitan’s rates from the Personal Finance Magazine as at 01 October 2012. The annuity rate used assumes an escalating annuity guaranteed for 10 years and then for life. The 4.67% calculated here is based on being paid R389.94 a month increasing by inflation.

5)Source: White Investments retirement planning calculator. Assumes a rate of inflation of 6% over the 43 years to retirement. Assumes we earn nominal investment returns of 12.5% a year on a 100% allocation to South African equities over that full period.

6)Source: White Investments retirement planning calculator. Assumes a rate of inflation of 6% over the 43 years to retirement. Assumes we earn nominal investment returns of 6% a year on a 100% allocation to South African cash and equivalent investments over that full period.

7)Source: White Investments retirement planning calculator. Assumes a rate of inflation of 6% over the 33 years to retirement. Assumes we earn nominal investment returns of 12.5% a year on a 100% allocation to South African equities over that full period.

 8) Source: White Investments retirement planning calculator. Assumes a rate of inflation of 6% over the 23 years to retirement. Assumes we earn nominal investment returns of 12.5% a year on a 100% allocation to South African equities over that full period.

R-I-S-K

Understanding risk, and what is meant by risk, is essential in determining an appropriate investment strategy and in managing your own expectations when it comes to investing.

The concept of risk is difficult to define as it encompasses a broad range of notions and can mean different things to different people depending on individual experience and circumstance.

The only thing we can say with absolute certainty when it comes to risk, is that we would all prefer less of it while not having to sacrifice any long-term return potential.

It may be helpful to consider risk in three ways:

(i)                 Your tolerance for risk – this represents the emotional extent to which you experience a change in the value of your investments. It is essentially the level of risk you would prefer to take or your willingness to accept risk.

(ii)               Your capacity for risk – This refers to the ability to take on a specified level of market risk. It is the capacity to soak up short-term price movements that deviate from expectations without causing a significant reassessment of your long term financial plan.

(iii)             The risk you are required to take – This represents the amount of risk you will have to take in order to meet your objectives. Even though you may have a low tolerance for risk, you will probably not meet your objectives by investing in cash and bonds delivering 6.4% a year on average.

Your investment strategy should encompass a balance between all three of these concepts but it should, in the first instance, ensure that you can generate the required investment returns to meet your objectives rather than to meet your tolerance for risk.

Types of risk to be aware of:

(i)                 Volatility – This is the most common expression of risk and is typically measured by a standard deviation. It is essentially a measure of market risk or the risk of an asset falling in value. In short, if an asset class or market has delivered an average return of 10% over the last 10 years and has a volatility or standard deviation of 5% over that period, then the range of expected returns from the asset class should fall between 5% and 15% a little over two-thirds of the time. It is important to note that this represents an average expected return and range but over shorter time periods you can experience much greater gains and losses to reach this average.  

 (ii)               Shortfall risk – the risk of an asset not growing quickly enough to meet your objectives. It is the risk that you do not gain enough exposure to assets that will deliver a high enough return to achieve your financial goals. If you are investing for retirement in 20 years time, and you require a return of 12% a year based on your initial capital plus additional contributions, then you run the risk of not achieving this objective if you invest solely in cash and bonds which historically only provide an average return of 6.4% a year.

 (iii)             Inflation risk – All financial plans imply a rate of inflation when assessing what your income requirements will be by the time you retire. In most cases this inflation rate will be based on a broad basket of goods such as the Consumer Price Index and is usually a reflection of historic levels of inflation.

 Of course forecasting inflation 20 years or more in advance is not a particularly accurate past time but you should be aware that if you use a 6% inflation rate to project your annual cost of living when you retire in 20 years time and the realised inflation rate is actually 9%, then you are likely to experience a significant shortfall in retirement savings relative to your original plan.

 By monitoring inflation and having a focus on REAL RETURNS (after inflation) from your investments you can mitigate this risk to a large extent over the long term.

Factors that impact on risk appetite:

(i)                 Time horizon – Essentially the longer your investment time horizon the better placed you are to sustain any short term fluctuations in market prices. Even some of history’s greatest market “crashes” can appear a mere blip on a long-term chart.

Basically, you can invest in the supposedly riskier assets such as equities and ignore the short-term market moves while you capture the long term benefits of greater average or expected returns. (Of course this is all very simple in theory but it takes discipline and patience to implement in practise when you actually experience significant paper losses).

 If you are only investing for a period of three years then you cannot afford to suffer years where you can lose up to 30% of your capital as you will possibly not be able to ride out the inevitable recovery.

 (ii)               Size of existing investment pot – If your existing investment ‘pot’ or portfolio is already large (let’s say 50% of what your 10 year goal is) then you can afford to take on much less risk as you will require a lower average annual return to achieve your goal.

 Of course in this case your capacity to take on more risk is also greater, if that’s the way you want to go, because you can suffer some of the more severe short-term fluctuations without ruining your chances of successfully reaching your objective.

(iii)             Emotions – One of the biggest single hurdles investors face is overcoming their emotions when it comes to investing. Emotion driven investing can have disastrous consequences – typically investors have a greater appetite for risk when things are going well. If equity markets have gained 30% in a year, most investors feel more comfortable adding risk and tend to buy at higher and higher price levels.

Conversely when markets go on sale and fall by 30% investors tend to stand back from the market or even consider selling some positions.

By having a better understanding of your own concept of risk, and by being aware of the potential types of risk you can be exposed to, you should be better equipped to combine your willingness and capacity for risk into a successful strategy that meets your required returns.  

Please contact White Investments if you have any queries regarding the content of this article or require further assistance in compiling an investment plan that suits your risk and return objectives.

The fees charged by the investment management industry are notoriously vague and often expensive despite the changes in legislation and regulation to combat this.

The debate between a basic flat fee service and a service based on commission structures features regularly in personal finance discussions.

There is a train of thought that suggests clients should pay a flat fee for the rendering of a financial service to them as this will reduce the opportunity for confusion over commissions and hidden costs. The theory being that commission structures are open to abuse and that unscrupulous advisers may not always provide unbiased advice in the best interests of their clients when faced with lucrative commission payments.

The other line of thought is that clients apparently do not like the idea of ‘paying’ fees. Somehow it is seen as more palatable if the cost of the service is incorporated into the products they buy and the advisers they use. This may be because they do not see the money actually leave their wallets as they would if paying a plumber or doctor for their professional service. Maybe it’s because the fee they pay comes off every month rather than in a potentially larger one off charge which may seem excessive when disclosed upfront.

It is impossible to cover all scenarios and all products in one go but by looking at the following real life example investors should get an idea of the type of fees charged within the industry and understand the impact of these fees on their investments.

EXAMPLE:

The client had a lump sum investment of R214, 400.00 that he wished to invest for the future education of his three children. He invested in a combination of three Collective Investment Funds or Unit Trusts offered by three well known asset management companies. He makes an additional monthly contribution of R4,626.00 which he wishes to escalate at 15% a year to outstrip the impact of inflation. The assumed rate of inflation for the purposes of the investment period was 6% and the investment time horizon was 10 years.

The client was invested in 3 separate funds which had the following return assumptions and fee structures:

The expected return on the portfolio based on the weighted return of the three funds is therefore 12.66% per annum before fees and inflation. (Calculation: (Weighting Fund A x Expected Return Fund A)+ (Weighting Fund B x Expected Return Fund B)+……)

The weighted Total Expense Ratio of investing in the three fund portfolio is 2.4% per annum. (Calculation: (Weighting Fund A x TER Fund A)+ (Weighting Fund B x TER Fund B)+……)

No initial fee has been charged in this case but investors need to be aware that often a fee up to 4% is levied on any initial lumpsum investment which could in this case have equated to an additional R8,576.00 charge (R214, 400.00 x 4% = R8,576.00).

The client’s previous financial adviser charged an additional annual advice fee of 0.5% of assets under management for providing ongoing advice throughout the year. He met with the client on an annual basis to discuss how the investment portfolio was performing.

A premium fee was levied by the financial adviser at a rate of 1% on the additional contributions that the client made each month.

There were no additional administrative charges but investors should be aware of other charges like the investment platform fee, monthly administrative fee, monthly debit order fee and something called a capital charge – All ways of attaching additional fees which reduce the amount actually invested as a proportion of the contribution the client makes.

At the end of the 10 year investment horizon assuming the returns of 12.66% were indeed achieved the portfolio value would look something like this:

*As fees are deducted during the course of the year it is not just the actual fee amount that must be adjusted for (R365,232.75) but the reinvestment income that is lost as a result of that money not being available for compounding in future years.

It is clear from the above example that the fees you are charged have a very significant impact on your investment returns.

A good service deserves to be remunerated and it is impossible to eliminate all fees associated with financial services rendered to you. However, investors can manage the impact of fees on their investments by deciding on the level of service they require on an ongoing basis (adviser) and also the type of products or product providers that they use (Investment Management Companies).

Please contact White Investments if you would like to learn more about the options available to you when structuring your retirement and savings plan so as to achieve an appropriate level of service in a potentially far more cost efficient manner.

We find ourselves in an environment of low interest rates as a result of the global financial crisis and the subsequent actions of global central banks to try and stimulate faltering economies. If you are borrowing money as a company and in some cases as an individual it may feel like a wonderful period as borrowing costs have rarely been cheaper.

However, if you have been diligently saving and doing what you are supposed to in order to provide for your income long after retirement, the current environment is likely to be devastating your investment returns and wreaking havoc with your savings plan.

Those that are in retirement and near retirement are very much on the receiving end of this set of circumstances as they already rely on their savings to provide an income.

What should we be seeking as investors?

Investors should be concerned with achieving real returns which means maintaining the purchasing power of their money. R100 today will not necessarily buy you the same amount of a good or service in a one year’s time. We only need to go past the petrol pump these days to see how inflation or a general increase in price levels eats away at the contents of your wallet. 

A real return is usually associated with a return in excess of inflation but the REAL real return should also consider taxes and investment management fees, as in truth all three of these factors influence what is leftover in the investment pot for future income generation purposes. *

Current inflation rates as measured by the Consumer Price Index (CPI) across various geographic regions are:

Source: www.tradingeconomics.com as at July 2012

What asset classes currently deliver real returns?

The options for earning real returns have dwindled in number post crisis. Not only are investment returns lower but in many countries inflation has crept higher largely as a result of higher food and energy prices. The current artificial monetary stimulus measures and easy money are likely to result in even higher inflation in the years ahead making the outlook for real returns even less certain.

Higher real returns are typically associated with exposing your capital to greater day-to-day swings in the market value of your investments. However we believe it is wrong to consider this as necessarily higher risk. The so called risk-free assets (cash and government bonds) that deliver negative real returns carry the risk of not maintaining your purchasing power over the long term which can have the same impact as a reduction in your capital value over time. 

Summary table of possible yields (Click on a Asset class name below for further detail):

Source: *tradingeconomics.com, ** ft.com+moonstone, ^ wsj.com, ^^ wsj.com + investorintelligence.com, ~ft.com,~~ Total return index from Morningstar LTM to end August (i.e. not comparable to all the others which show an income yield). As at 31 August 2012

The different asset classes do not typically respond to economic conditions in the same way. Each of these income options should be considered in the context of these factors:

Risk to capital – This means the likelihood that you will see fluctuations in the value of your original investment amount as a result of short term moves in market prices.

Real Returns – This means the return we are likely to receive in excess of inflation as defined above. These return expectations are usually inferred by recent past performance and existing yields but it must be noted that past performance is not an indication of future performance.

Investment time horizon – This relates to the amount of time you should consider holding the investment in order to realistically achieve the type of returns each asset class is supposed to deliver. Short term market moves can deviate significantly from expectations particularly in the current environment where macro concerns are dominating sentiment rather than any fundamental valuation measures.

Liquidity – This pertains to the ability to easily enter (buy) or exit (sell) your investments without incurring prohibitive transaction costs. The global crisis of 2007/2008 clearly illustrated how some asset classes can become very difficult to trade at time of severe distress. .

Investment options –This refers to the type of products available to investors looking to gain exposure to specific asset classes.

Tax – Income in the form of interest and or rental income are in most cases taxed at your marginal rate of tax. Capital gains tax is usually taxed at a lower rate and often subject to a capital gains tax allowance. Returns on assets held in a retirement plan (pension, provident or annuity) are tax free until you start to draw an income in retirement . You should consult a tax specialist for a full assessment specific to your personal circumstances.

Cash Deposits:

Interest rates are at all time lows. Any money sitting in the bank is likely to be earning less than this in most instances.

Conclusion: Not an attractive investment option but it is the only option if you are averse to any capital losses as a result of market price changes.

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Money Markets:

Money markets officially mean investments with a maturity of less than 1 year. Examples are certificates of deposit issued by companies who wish to access very short term funding.

Conclusion: Not an attractive investment option but it should provide a higher return than a cash deposit as your money will be lent at longer maturities and will have some credit risk associated with it.

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Government bonds:

Government bonds represent loans made to governments for which they pay you a pre-determined (usually fixed) income or coupon. The yields paid vary depending on the financial and political stability of the issuing country. The longer you loan money for the higher the yield you should expect to receive annually as it is riskier to lend for extended periods because in essence there is more time for things to go wrong.

Conclusion: Not attractive. While the yields are higher than cash and money markets even the longer term 10 year bonds for developed government bonds do not currently provide real returns. As interest rates come down so do government bond yields and fear over the global economy have seen ‘safe haven’ flows into UK Gilts, US Treasuries and German Bunds exacerbating the low yields.

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Corporate bonds:

Corporate bonds represent loans made to companies for which they pay you a pre-determined (usually fixed) income or coupon. The yields paid vary depending on the financial strength and stability of the issuing company.

Although not a fool-proof system of classifying risk within corporate bonds, the rating agencies ascribe a rating to corporate issuers that infer the credit risk associated with each company on the basis of probability of default and the loss given default. Investment Grade ratings refer to bond with a BBB minus or higher rating and are less risky than High Yield corporate bonds which have ratings of BB+ and lower.

Maturities of bonds also influence the yield you will receive – longer dated bonds should pay you a higher return than their shorter dated counterparts.

Conclusion: Corporate bonds are likely to offer you a real return even if you invest in the safer and higher quality sectors of the market.  You should be aware however that corporate bonds are priced off the underlying government bond market so are subject to the same significant risks of a rise in interest rates in the years ahead.

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Equities or Shares:

Unlike corporate bonds, which are merely loans to companies at the end of which you get your money back (maturity), when you buy shares you are buying an ownership interest in that company. You are therefore entitled to your portion of earnings and dividends if the companies you own see fit to pay out an income. Coupons on bonds are a contractual obligation in most cases whereas a dividend on a share is completely at the discretion of the company management and may be stopped, reduced or increased at will. This means your income is generally less certain when investing in equities.

Conclusion: Shares represent the asset class most likely to deliver a positive real return over the medium to long term given the current low yield environment we find ourselves in. Many investors are averse to investing in equities as the risk to the initial capital is deemed to be too high. This may be true in the short term but investors should be wary of taking too short-term an approach without regards for the relative value of equities versus other asset classes. You can mitigate the downside risk to capital by buying high quality companies at attractive valuations with good dividend yields and be willing to ride some of the shorter term fluctuations.

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Indirect Property:

Holding property investments need not involve your physical ownership of a residential or commercial property. There are ways to access this asset class through listed companies who specialise in managing a portfolio of properties and pay out a proportion of the rental income to the owners or shareholders.

Conclusion: Attractive from the perspective of delivering real returns but it may not be wise to throw all of your money into this asset class alone given the high correlation in times of distress and the potential for low liquidity to hamper the easy conversion to cash as and when needed.

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Definitions:

Credit risk – this is the risk that the counterparty you have loaned the money too is unable to repay you in full. This risk is typically lower the shorter your investment period and is lower the better quality the balance sheet of the entity you loan to.

Basis Point – This is a common term used when talking about fractions of a percentage point. There are 100 basis points (bps) in 1%. So 10bps = 0.1%

Default – In bond language this refers to the failure of a company or issuer to fulfil its obligations to pay you a coupon/income and to return to you all of capital when the bond matures.

Loss given default – In bond language this refers to the amount of money you are likely to lose if your bonds default. It is related to what is known as the recovery rate or the amount of money as a proportion of your initial investment you are likely to get once the company is liquidated or restructured.

*Trying to structure your investments as tax efficiently as possible is an important consideration and you should never underestimate the impact of fees on your overall returns as these can be very significant indeed. Since fees and taxes depend on various factors (the savings vehicle you use, the product you invest in, the source of returns and your tax bracket), it is simpler to use the definition that relates real returns to inflation alone.

Please note this write-up does not constitute advice. Please contact White Investments if you would like more information and insight into the various options discussed above.