Recent volatility in investment markets has focused our clients’ attention on whether their current super balances will be sufficient to meet their retirement income goals. However, this presupposes that a particular retirement income target is reasonable for a particular client. The challenge is to determine the best estimate for a retirement savings target and then ensure that strategies are employed to continue progress towards it.
Retirement savings target
There are three equally important factors in setting a reasonable retirement savings target — the level of retirement income required, the number of years for which it is needed and real rates of return during retirement. An inadequate estimate of one factor can have a significant effect; getting all three factors wrong can render the results effectively meaningless, as shown in Table 1.
A client may be eligible for social security benefits, meaning that their retirement income target can be met with lower retirement savings. However, the higher the client’s required income, the more it must be provided by personal retirement savings.
So considerable care is needed to ensure that estimates for a particular client are the best fit possible given all known information. Life expectancy statistics and family history of longevity can be indicators of the expected length of retirement. Long-term estimates of asset class returns and inflation are indicators of performance. That then leaves the level of retirement income required. A client may assess their required retirement income more accurately the closer they are to retirement, but that assessment may still prove inaccurate over the longer term.
Consider again the client in Table 1. Perhaps their estimate is based on an assumption of a certain number of years of ‘active’ retirement, followed by a less active phase (less travel, fewer social activities), followed by a final phase of residential aged care at which time social security benefits should meet income requirements. It still pays to exercise some care in separately attributing income needs to each phase — especially the last two.
The second phase of a less active retirement may involve greater health care expenditure and a need for aged care services provided in the client’s home — ‘ageing in place’ services. These may be provided for privately or through a government-subsidised program. In either case, additional costs may be involved.
A residential aged care phase may also involve a significant cost, particularly when two salient points are noted:
- Choice of aged care facility, particularly one offering extra services, can involve high ongoing fees. It is possible today for an individual to spend $63,261.80 pa in ongoing fees for certain residential aged care services (based on maximum basic daily care fee of $36.94 per day, a maximum income-tested fee of $59.38 per day and an extra service fee of $77 per day).
- It is widely accepted that the consumer contribution to aged care costs will increase over the next 15-20 years (National Aged Care Alliance, September 2006, ‘A Summary of Options for Long Term Financing of Community and Residential Aged Care’).
Therefore, our client may actually need an income of, say, $55,000 pa for 15 years of active retirement, $35,000 pa for another 10 years and $70,000 pa for five years of residential aged care. Assuming a real return of 3 per cent pa over this period, the client would actually require retirement savings of a little over $1 million. Compare this to the client’s original estimate of $650,000 in Table 1, and the importance of making allowances for often significant health and aged care costs in later retirement should be apparent.
Retirement funding strategies
If the above analysis, or even a reduction in retirement savings due to investment market volatility, points to a potential funding shortfall for a client, additional or revised strategies are needed. While there is a range of possible strategies, arguably contribution strategies have the broadest appeal to clients. Increasing exposure to growth assets or transition to retirement strategies are relevant only to clients who have, respectively, inadequate asset allocations or have reached preservation age.
While making large contributions in the short term can be very beneficial to a client’s final retirement savings, actually doing so may be beyond their financial and/or psychological reach. An effective alternative is to make regular small increases to contributions, which could be achieved through a revised budget, reduced mortgage and other costs or future salary increases, as shown in Table 2.
Regardless of the cause of a retirement funding shortfall, taking immediate action to increase a client’s contributions in an affordable manner can help ensure that their retirement savings progress is on the desired track.
Deborah Wixted is senior technical manager at Colonial First State.
