Every year there is a crazy rush to make annual backdated contributions to pension funds and then it is forgotten for another year. There has to be a better way!
We have got to start looking at retirement planning as an essential part of living, as a high priority next to buying a home. The problem is that people are focussed on the contributions they make based on the tax relief and not the benefit they will receive when their income stops. Ideally they should be focused on what it is they will need when their working days are over.
The irony of not investing in an adequate pension plan is that people in retirement have much more time to do things like travelling abroad, spending money on their children and grandchildren and they may be faced with higher unforeseen medical expenses. Some may have outstanding loans and the mortgage is not fully paid off. So, two thirds of their final salary may not be sufficient in the immediate years after retirement.
In 1950 the life expectancy in Ireland was 65, in 2020 it is 82.35 and in 2050 it is projected to be at 86.35 (source: United Nations). To live that long with so much time on your hands and very little money, after retirement, would be a tragedy.
We must assume that most people will have to stop working between 60 and 65 for several reasons; they have to because their employment contract dictates, they want to as they have other pursuits they want to follow, they are not strong or well enough to continue. No matter what the reason you are pretty unique if you are still working after 65.
We have considered some of the key issues you should think about when planning for retirement and we are not going to use tax relief as an incentive!
What Is Your Time Horizon?
Your age now and your expected age at retirement are the key elements to creating an efficient retirement strategy. Your time horizon will determine the level of risk you can take in your investment portfolio. The longer the investment period the higher the level of risk. If you have 25 years or more, you should have most of your assets in riskier investments like stocks. These are more volatile but have historically outperformed other assets such as government or corporate bonds which have been less risky. When we talk about long term, we mean more than 10 years, medium term, less than 10 and more than 5 and short term, less than 5.
Furthermore, you need returns on investment that will outpace inflation. You will always need to maintain your purchasing power throughout retirement. Inflation erodes the value of your money over time. So, what might be perceived as a substantial sum looking forward into the future, can have little value when you arrive there and start to spend it. Over 25 years, an inflation rate of 3% can reduce the value of your investment in real terms by over 50%
Warren Buffet is a big believer in compound interest. He tells the story of the Court Jester and the King where the King has a huge Kingdom but no cash at hand, so the Jester asks him to put one grain of barley on the squares of his chess board each day he performs for him but with one small difference. He asks him to double the quantity each day as they go along. When the chess board squares are filled, the amount of barley is so vast that the King owes the Jester his kingdom. Again, this story demonstrates the power of investing over longer periods in assets which give high returns over time.
Portfolios for older people with less time to go to retirement should be more cautious when allocating funds to assets. A mixture of assets such as bonds and commercial property are more suitable investments for timeframes of less than 10 years. An even lower risk strategy, a mixture of cash and bonds is advisable for timeframes less than 5 years. Preservation of capital is the aim for this shorter time horizon.
Having an accurate estimate of what your expected expenses will be in retirement will determine what you need to have in assets when you retire. This is imperative, because it will affect the amount you withdraw each year and what your investment strategy will be post-retirement. You will outlive your portfolio if you underestimate your required expenses. Also, one can only invest small amounts in high-risk funds, such as stocks at this stage of their life as they would be susceptible to losing too much in the short term.
Calculating expenses is a tricky business and requires a complete understanding of a person’s income, expenditure, assets, and liabilities now and a projection of what these will look like in 10, 20 30+ years’ time. This is where your Broker or Financial Advisor comes in. They will have the tools and the skill to manage and implement this process.
To give an example of what it takes to build a fund let us look at a 30-year-old with an income of say €75,000 a year. To accumulate a fund of €1,000,000 by the time he/she is 60 will require a contribution to a pension fund of €1,000 per month for 30 years. (Assuming a growth rate of 3.75% and indexation of 2.5%). Remember the €1,000,000 has not been adjusted for inflation.
Even though we have not mentioned tax relief as an incentive to invest in your pension plan it is important to talk about taxation in retirement when you are drawing your pension. After taking a tax-free lump sum, potentially all the fund remaining is taxable. So once the spending requirements in retirement are determined we must ensure the feasibility of the portfolio of producing the needed income by calculating the income after tax. For example, a 66-year-old married with a single pension income of €50,000 per annum will take home €42,237. Therefore, the required income to cover the projected expenses is €42,237. If you are drawing from an Approved Retirement Fund (ARF), you ideally will need a fund which will sustain this income for as long as you require it. Possibly 20 years.
Investment Risk Tolerance
No one should ever be shocked when their pension fund has performed badly over a certain period. Upset, maybe, but not shocked. If they are, it is usually down to a misunderstanding or miscommunication between the Broker/Advisor and the client. As discussed earlier the riskier assets are for longer terms, low risk for short term, but we must also analyse where each client is regarding their risk tolerance. You need to be completely comfortable and fully understand the risks being taken in your portfolio. It is also advisable to look at how your investments are performing in relation to the overall time horizon and not to be examining every fluctuation in the markets. Expect it to be somewhat volatile. Markets will go through cycles. They will go up and down. If you are comfortable that they can achieve your ultimate goals, stick with it.
You, as a young person, should ensure that there is enough money to sustain the older you in the future. The older you, may be tired or sick or just want to follow dreams that will require sizeable funds. Your pension fund is a means to that end. This will be the platform to build on in retirement.
When you have a significant pension fund you can always cash-in other assets like property to pay for your retirement plan, even downsizing your home. But the pension plan will be the bedrock of your post-retirement future………………… and we still have not mentioned tax relief!!!!
Author: John Harkin HDipBusM, NDlaw, QFA. Executive Director, Harkin Insurance and Investments Ltd.