Financial industry commentators constantly remind us of statistics that indicate the growing challenge South Africans face in saving sufficiently for retirement. The easiest way to explain this challenge is to call it the retirement funding gap. This is the difference in the amount of retirement savings you need to sustain your desired lifestyle during retirement and the amount of capital you have saved the day you decide to retire or are forced to retire.

How much is enough?

The formal target in the retirement industry for measuring if you saved sufficiently for retirement is known as the net replacement ratio. This ratio expresses the monthly income you will receive at the start of retirement as a percentage of the amount you received as a final monthly income the day before you retired. During financial planning, various inputs and assumptions are used to calculate your net replacement ratio, such as your salary level, savings rate, investment growth, retirement age, and longevity. The industry standard for a net replacement ratio target is 75%, or 75 cents for every rand received as a final monthly income. This means you should only need R750 for every R1 000 you receive as a final monthly income to maintain your standard of living in retirement. The reason is that you should have less or no debt, fewer dependents, a lower tax rate, and a simpler lifestyle during retirement.

The four ingredients

The critical question is how you give yourself the best chance to achieve a net replacement ratio of 75%. The answer lies in ensuring that you have a sound retirement savings and investment strategy in place and that you measure your progress continuously by having your financial adviser calculate your net replacement ratio every year during your annual financial planning review discussion.

A sound retirement savings and investment strategy requires that you mix four critical ingredients. These are: starting to save for retirement as early as possible, saving as much as possible, taking sufficient investment risk, and not touching your retirement savings until retirement. In combination, these four ingredients will unleash the full potential of compound growth, putting you well on your way to achieving your 75% net replacement ratio goal.

Retirement outcomes

Let us consider the different outcomes at retirement for four individuals, depending on the extent to which they made compound growth work for them. Let us assume all four members earn a monthly income of R40 000. Savers A and B save 15% of their monthly income from age 30, while Saver C only saves 10% of his monthly income from age 30 through a retirement annuity. Saver D only starts saving 15% of his monthly income at age 40. The salary of all four members increases by an average CPI inflation rate of 5% per annum, and at age 65, they would all be earning R220,641 as a final monthly income. This means that at a 75% replacement ratio, they would need to start drawing a monthly income of R 165 753 at retirement. This amount needs to increase by 5% annually to maintain their living standard during retirement. We also assume that their investments earn a return of CPI + 5%, or 10% per annum, after investment fees up to age 65. The only exception is Saver B, who earns an investment return of only CPI+3%, or 8% per annum, because the individual invests the savings more conservatively.

During retirement, it is assumed that the individuals are invested in a Living Annuity and that their retirement savings earn a more conservative return of CPI+3% per annum. All returns are tax-free as they are funded through registered retirement vehicles.

The following table contains the retirement savings results of the four individuals should they all retire at age 65.

Note: CPI assumed at 5% per annum and returns during retirement at CPI+3% per annum

Based on the results from the table above, it can be said that:

1. Saver A alone can retire with sufficient retirement savings at a replacement ratio of 75% which will last 38.5 years after retirement at 65 (i.e. until age 103). This is due to a 35-year period over which the savings were allowed to grow, the 15% savings rate, which was increased by CPI inflation every year and the annual real investment return of 5% above inflation achieved over the period.
2. Saver B only achieved a 50% replacement ratio, even though the member saved for over 35 years and achieved an annual real investment return of 5% above inflation. This is because saving only 10% of your income is insufficient, and this member’s savings will last 18.2 years after retirement at 65 (i.e., until age 83).
3. Saver C achieved a slightly better replacement ratio than Saver B of 51%, with retirement savings lasting 18.7 years after retirement (i.e., until age 83). This is despite the fact that Saver C’s annual investment returns were only 3%, not 5%, above inflation. This speaks to how important it is to start saving as early and as much as possible.
4. Finally, Saver D ended up in the worst scenario during retirement as the replacement ratio is only 40%, and the retirement savings only last 13.6 years after retirement at 65 (i.e., age 78). This result comes despite the 15% savings rate and the annual investment return achieved of 5% above inflation. This clearly illustrates that you can never really make up for lost time when starting to save for retirement too late.

Saver A’s retirement savings will last more than twice as a long as a result of utilising the four key ingredients that allows for capturing the magic of compound growth. Regarding retirement planning, one needs to apply an outcomes-based approach to achieve the best possible replacement ratio at retirement. A higher replacement ratio means more savings for individuals to retire on, enjoying the lifestyle they desire and experiencing the comfort that their retirement savings will last during retirement.