Making Cents: Take notice of your returns
Financial column
I ANSWERED a question a couple of weeks ago from a reader who was told by his bank that he needed to increase his monthly pension contributions by €467 which was money he didn’t have.
And my advice to him was to review how his fund was set up because an extra 2% return every year was the equivalent to making those extra €467 monthly lodgements.
This advice resonated with a lot of readers judging by the number of emails I received shortly after the article was posted. The people who made contact all remarked how up until reading the piece they (a) never really took notice of how their pension fund was performing each year and (b) they largely ignored how their fund was set up and (c) they were all surprised at how much a small percentage could add so much to a funds end value.
And just to remind you that, that 2% differential added €229,557 to the fund of the gentleman who made contact, when he reached retirement age.
Aside from the extra money this small percentage would generate, it also had the ability to fast forward retirement for him because with a higher return he’d accumulate a larger fund in a shorter period of time.
The extra 2% would mean he could retire six years earlier because his fund size would be the same at age 59 as it would be at 65 if his return was 2% lower.
And we could go much lower than 2% by the way, and the impact would still be significant. If he managed to get an extra 0.5%, it would add €48,002 to his fund when he’s 65.
Anyway, taking notice of annual returns is something that’s often overlooked by people, and perhaps the reason why is because they don’t know what’s a good return or what’s a bad one.
But if they had a particular number they could measure their returns against, that would help enormously. If they knew that if they hit say 4% per year based on their current contributions, they’d accumulate a fund, that would be enough for them to live off when they are 59 or 60 or 62 or whatever age they were targeting.
The majority of people don’t have that annual target number and are winging it really, hoping they’ll have enough when they retire, but if they don’t know what that enough is, how can they know how much their returns need to be?
And not knowing will mean they’ll never be able to figure it out, and their annual returns will have very little meaning for them. And that’s why people ask me all the time whether their annual return is any good or not?
They ask because they don’t know what impact a particular return will have on their fund value and they don’t know what their end fund value needs to be either.
One person who contacted me after reading the article had a look at his pension fund and unfortunately was horrified to find that after a year’s contributions from himself and his employer which amounted to €25,000, when added to the €92,000 he had already accumulated, the value of his fund was now worth about €94,000.
He was looking to see if he could make 1% more on his fund and was assuming that his fund was going to be positive, only to find out it had reduced in value by c. 20%. And it had reduced by that much because it was only invested in government bonds.
When I asked him why he was only invested in bonds and only in just one asset class he didn’t really know why but vaguely remembers listening to a colleague in work who said the stock market was going to crash and he should go into bonds because they were safe and they would protect his money.
He couldn’t have received any worse advice if he tried to.
During those 12 months of contributions, the bonds in his fund, as I said, reduced in value by about 20% and funds that had a relatively small exposure to equities had increased by about 4%.
And that increase was on a medium risk fund, higher risk funds increased by a larger amount.
Anyway, long story short he’s young enough to have caught this early and has moved out of the fund he was in and into a new much more appropriate one and he won’t continue to ignore how his fund is performing anymore or assume everything is going fine either.
Another person made contact with me and she looked at how her fund was performing and it was good news because it was averaging about 7% per year for the past three years and that return was excellent.
I thought there wasn’t much more room for growth based on the fund she was invested in, so trying to get an extra 1% or 2% would mean taking on more risk which was something she didn’t need to.
And sometimes looking for that extra return might not be possible and it will depend on the fund you’re invested in, your appetite for risk and your years to retirement.
I don’t want to labour the point but taking notice of how your pension fund is performing is more than important.
And maybe people would take more notice if they were told what percentage return they need each year.
I think if they were told that if they wanted a monthly income of say €3,000 at age 65, based on the amount they have accumulated and the amount they are contributing each year, they’d need annual returns of 3%. Knowing this, now they have something to target and measure how their fund is performing against.
And if they were told that anything lower, say 2% would give them an income of €2,500 at 65 and anything higher say, 4% would give them €3,500.
They could also be told that a 3% return means retiring at 65 and a 4% return means retiring is possible at 62 and a 5% return means retiring is possible at 60.
Having this type of information to hand, someone could see that a 2% return would leave them €500 short of what they need each month in retirement, but a 5% return would mean they’d have enough at age 60 so there wouldn’t be a need to work an extra five years if they didn’t want to.
I think showing people what impact different annual returns would have on their fund value, good and bad by the way, and giving that difference some meaning would help people, and they would take much more notice of how their fund was performing and not just wait and see what the annual statement says.
The numbers I’ve just referred to are obviously just examples, but it’s not difficult to create something like this, and I think it would help everyone enormously for all the reasons I’ve already referred to. And your financial adviser, if you have one, should be able to figure this out for you very easily, so I’d say put that on the agenda when you’re having that yearly check up with them.
And I appreciate that it’s not all about returns either.
The three key components to how much you’ll end up with at retirement are (1) annual contributions (2) annual returns and (3) years to retirement.
But focusing on improving returns could save you having to contribute more money - remember the gentleman I was telling you about at the beginning of this article where if he managed an extra 2% return each year, it had the same impact as increasing his contributions by €467 per month.
So, there are a couple of ways you can get to your end number and one might mean having to contribute a whole lot more and one might be just taking more notice of those annual returns.
Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at [email protected] or www.harmonics.ie