Young adults who are unable to contribute large amounts to their retirement savings can still retire financially secure provided they gradually increase their contributions as they get older.
However, in order to implement this strategy, your retirement fund will have to allow you to adjust your contributions as your circumstances change. Many funds do not allow this.
Many younger members of retirement funds struggle to contribute as much as they should to their funds, because they have pressing financial commitments, such as a home loan and raising children. This is one of the findings of the latest annual Sanlam Benchmark survey, which was released this week.
But Willem le Roux, the head of investment consulting at retirement consultants Simeka Consultants, says this need not be a train smash if you have a well-structured retirement plan.
He says the new tax incentives for retirement fund contributions, which were introduced on March 1, enable you to save more for retirement. You can now deduct contributions made by you and your employer up to 27.5 percent of your annual taxable income. This allows you to structure your contributions so that you allocate more of your income to meeting expenses when you have a young, growing family and, as you get older, allocate more of your income to retirement savings, particularly if your income grows above the inflation rate in the later stages of your career.
For example, you could save five percent of your income for the first 15 years of employment. This is less than the average total member and employer contributions of 14 percent for members of stand-alone retirement funds and 13.5 percent for members of umbrella funds (funds for the employees of more than one employer).
To make up for the low contributions earlier in life, at age 35 you will have to start increasing your retirement fund contributions until they reach 27.5 percent of your total income at age 50, and maintain that contribution level until 65, when you retire. This should provide you with an initial income in retirement equal to 72 percent of your final salary. This replacement ratio is one percentage point higher than the ratio you would have achieved if you and your employer had contributed 12.5 percent for 45 years, or 15 percent for 40 years.
Le Roux warns that, when structuring their contributions in this way, high-income earners will have to take account of the R350 000 annual cap on tax deductions for retirement fund contributions.
He says that, in order to allow members to adjust their contributions during their working lives, funds will have to provide tailor-made investment strategies for each member. This introduces complexity for members and fund administrators. Portability (the ability of members of defined-contribution funds to transfer their savings from fund to fund when they change jobs) also adds to the complexity.
He suggests that the solution for most members is to link contribution levels and investment choices to their age.
The complexity associated with flexible contribution rates “cannot be left to members with no support”, and this is why it is important for funds to have default contribution rates, investment strategies and annuities (pensions). Members require advice and support when selecting an annuity at retirement, he says.
The challenge to adjusting contributions as members grow older is that, according to the Benchmark Survey, 75 percent of funds do not allow flexible employer and member contributions.
Viresh Maharaj, the chief marketing actuary at Sanlam Employee Benefits, says funds that do not allow flexible contributions need to set contributions at levels that will be sufficient to enable members to create retirement wealth, or “members are being set up for failure”.
Maharaj says default contribution levels, which are intended to provide you with a minimum targeted income in retirement are better than leaving the choice entirely to you. The reasons for this are:
* Where funds allow members to decide their contribution levels, members are often not aware that they have the option to contribute more, or procrastinate in taking advantage of this opportunity.
The difference between average total contributions and the maximum tax-deducible contribution of 27.5 percent is 9.87 percentage points for stand-alone funds and 10.89 percentage points for umbrella funds.
Increasing the contributions to the maximum of 27.5 percent could increase your fund value over 20 years by an average of 56 percent if you belong to a stand-alone fund and 66 percent if you belong to an umbrella fund, assuming an average annual return of 10 percent.
* Members can sabotage their ability to build up sufficient retirement capital. On average, members’ contributions are typically based on 80 percent of their total cost-to-company package. But if members are allowed to select the proportion of their retirement contributions when structuring their cost-to-company package, contributions as a percentage of pensionable earnings drop to 73 percent for members of stand-alone funds and 67 percent for umbrella fund members, the survey shows.
Maharaj says this suggests that members reduce their pensionable earnings in order to maximise their take-home pay, because this will reduce their retirement fund contributions. So, although you may be contributing, say, 15 percent towards retirement, this may be 15 percent of 63 percent of your cost-to-company package, which will negatively affect your ability to save enough for retirement.
* Reducing your pensionable pay usually results in a reduction in your group life assurance benefits, the impact of which you will fully realise only if you need to claim.
Le Roux says the biggest problem with leaving it up to members to decide how much to contribute to their funds is that most members do not save enough for retirement or do not preserve their retirement savings. As a result, they:
* Have to lower their standard of living in retirement.
* Invest their retirement savings in a living annuity, so that they can draw down a higher pension than they would be able to do with a guaranteed annuity. But this results in them quickly depleting their capital, leaving them dependent on their family and friends and the state.
* Have to delay retirement and work longer, which allows them to remain invested in higher-risk growth assets, such as equities, for longer.
CALCULATE YOUR LIKELY INCOME IN RETIREMENT
Do you want to know what percentage of your income you are likely to receive as a pension in retirement? Try Sanlam’s Day One Member Tool (go the link at the end of this article).
To use the calculators (one for existing fund members and one for new members), you will need to know your:
* Total guaranteed package for the year. This is the total amount, including any allowances and bonuses, before tax that your employer pays you.
* Pensionable remuneration. This is the annual income on which your retirement fund contributions are based. This is typically your salary less any allowances and bonuses, and is typically 70 to 80 percent of your total guaranteed package.
* What percentage of your pensionable remuneration you and your employer jointly pay as contributions to your retirement fund.
If a portion of the contributions paid by your employer is used to fund group life benefits for you or to pay costs, you also need to enter this information.
The calculators will work out what percentage of your total income you will receive as a pension in retirement if you continue to contribute at your current rate – in other words, your replacement ratio. It will suggest the percentage of your salary you need to make as a contribution to your retirement fund in order to achieve a pension equal to 75 percent of your income at retirement. You can adjust this targeted replacement ratio, as well as your retirement age, to see how this will affect your income in retirement.