Client Situation
Last week we met Susan, a 50-year-old senior manager, who earns $50,000 per month before taxes. She changed jobs twice in the last 15 years and, in both cases, she contributed to company pension plans. Based on the analysis in the last article, we recommended that Susan should exercise her option from her first company's pension plan to take a lump sum of $67,500 and a reduced taxable annual pension of $13,500.
With respect to her current employer's pension plan, we made some projections based on the following variables:
�2 Employee contributions of five per cent of basic salary, equally matched by employer
�2 Voluntary contributions up to the maximum tax-deductible limit for retirement plans
�2 An annual increase of 10 per cent of her base salary
�2 An average fund growth of seven per cent annually over a 15-year period
�2 A projected retirement rate of return on matured funds of six per cent annually
If Susan were to continue her current savings strategy up to age 60, she would accumulate a fund value of: $1,500,047, which would provide her with a tax-free lump sum of $375,012 ($1,500,047 x 25 per cent = $375,012) and a reduced annual taxable pension of $67,502 ($1,500,047 - $375,012 = $1,125,035 x 6 per cent).
Susan's desire is to maintain at least half of her current lifestyle whilst factoring an assumed annual inflation rate of eight per cent.
Nick's Assessment & Advice
In our last article, we got as far as figuring out what Susan's total retirement benefits would be.
Table 1 shows our estimates of Susan's monthly after-tax retirement income (inclusive of an NIS pension) to be $9,563 ($114,752 /12 months), which will remain fixed for the rest of her life. This figure is significantly off the targeted 50 per cent of current salary. If we were to advance Susan's current salary of $50,000 by 10 years using the 10 per cent annual increment stated before we would get a monthly income of $129,687 before taxes and approximately $99,566 after tax, an even more glaring shortfall.
Filling the after-tax gap
Susan needs–or rather wants–to have an after tax income of $49,783 ($99,566 x 50 per cent) per month, in the first year of retirement, but will be collecting only $9,563; a shortfall of $40,220. Seeing that her final salary was calculated using an increment rate of 10 per cent per annum, which is higher than the assumed inflation rate of eight per cent, we are fairly confident that her standard of living will remain relatively unchanged over the next 10 years.
What does Susan need to do to fill this gaping hole in her retirement income?
The first thing to consider is how much money or rather what value of assets she needs to accumulate by age 60 to generate the $40,220 extra in monthly income.
Assuming that at retirement Susan can find an asset that generates the same rate of return as her second pension plan (six per cent per annum), she will need to amass the sum of $8,044,000 in 10 year's time ($40,220 x 12 = $482,640 / 6 per cent = $8,044,000). This figure is quite intimidating even for someone earning $50, 000 per month. Susan needs to set aside $67,000 monthly (assuming zero interest) for the next 10 years to hit that target; impossible and unrealistic, in light of her current situation.
Something has to give in order for this goal to make any sense.
Adjusting the variables
When trying to accomplish any financial goal there are five key variables that must be considered. These will dictate how much Susan should set aside monthly and the investment instruments she chooses to match her risk tolerance.
1. Time: Susan has 10 years until retirement. However, if her goal is out of reach, she may consider extending her time horizon to allow for additional savings. This is one the reasons many retired people return to work beyond age 60. Of course, inflation does not stop at retirement and unfortunately the figure she is aiming for at age 60 may be quite different if she defers to age 65 or 70.
2. Target or future value: If with Susan's best efforts she still cannot accomplish her goal, she may also need to revise her projected retirement income figure to fall in line with her ability to save from current earnings.
3. Periodic savings: Whether it is monthly, quarterly, semi, or annually; there is limit as to how much Susan can realistically set aside from current earnings after making all the necessary adjustments to her expenditure.
4. Present assets: In the case given, we were not told if she has any other assets. If she does have other resources, her portfolio should be (re)allocated in such a way so as to accomplish her retirement goal. For example, if she has all of her present savings in a regular deposit account that yields less than one per cent per annum, she may be forced to increase her level of savings to make up for the low returns on this instrument.
To counter this, she might consider rebalancing her portfolio so that the weighted average portfolio return improves. For instance, if Susan had all her money in a deposit account that yielded one per cent, then her overall portfolio return would be one per cent (1 per cent x 100 per cent).
However, if half of her portfolio was held in the same 1 per cent instrument and the other held in a six per cent instrument, the overall portfolio return would be 3.5 per cent (1 per cent x 50 per cent = 0.5 per cent) + (6 per cent x 50 per cent = 3 per cent).
5. Rates of return and risk: Higher returns are often accompanied by higher risks and if Susan is desirous of fetching better returns to make up for what she cannot save on her own, she must consider taking on more risk. However, as she approaches retirement, her appetite for risk would diminish because her ability to recover from an investment loss would be greatly reduced.
If Susan focuses on higher risk/return instruments such as stocks some 10 years prior to retirement she may need to scale down this component in the final three to five years before retirement. Because no one can predict what any investment will do in the future, Susan must review her portfolio performance periodically to ensure that she is on track and if not, make the necessary adjustments.
Type of investment & strategy
Susan will want to save and invest in such a way that she gets the best possible returns for the least amount of risk. One way to do this is to employ various investment strategies to close the gap.
One such strategy is diversification. She can select an asset class such as stocks, which offer higher returns but with more risk. She can reduce her exposure to loss by spreading her investment across several stocks.
Secondly she can employ a systematic approach to investing in a relatively volatile instrument. By setting aside a regular amount each period she may be able to take advantage of changes in unit or share prices. Lower prices mean she will fetch more units thus increasing her base for growth. When prices increase she will have a greater potential for gain.
One such asset may be a stock-based mutual fund. These offer diversification across several shares and tap into better returns when the companies invested in do well on the stock market.
Table 2 shows how adjusting the investment variables could impact her monthly savings figures and aid her in closing the retirement gap.
Caveat: The above analysis is for illustration purposes only. If you need to make an investment decision you should consult a qualified financial advisor with a proven track record for improving clients' financial positions.
If you have any questions or need advice on today's subject please e-mail