We have all read the scary statistics of how few people will be able to retire comfortably in South Africa. If you haven’t, just know that only five out of every 100 people get this right. There are many valid reasons for this, but a large part of the problem is our own behaviour. People don’t like to sacrifice current benefits for the future. Sadly, this trait costs most people their financial freedom.
If I told you to sacrifice one cappuccino per week for the next 15 years, so that you could enjoy one cappuccino a week for the next 35 years, you would probably agree that this sounds like a real bargain. However, when we discuss investments and people are offered the opportunity to sacrifice R1 000 per month now for 15 years so that they can have the equivalent of R2 400 per month after the 15 years of saving, most people decide to do other things with their money.
It is all about compounding
Compound interest has often been referred to as the ‘eighth wonder of the world’. However, it is not a wonder if you are in debt and it is working against you. Compound interest results when interest is added to your original contribution, known as the principal. From that moment on, the interest that has been added also earns interest. That is great for you if you are saving, not so great if that is added to your existing debt.
To show the effect of compounding, we look at a 50-year-old person who wants to start saving more for retirement. We worked on the basis that the person retires at the age of 65 and thus contributes to retirement savings for 15 years. At age 65, the person needs an income until age 100, if the person passes away earlier, the heirs will inherit the remaining capital.
We assume that the person decides to invest R2 500 per month and increases this amount with inflation annually (we have used 6% per annum in calculations) until 65 years old. In terms of investment, we assumed that R2 500 is invested in a relatively low-cost, well-balanced portfolio, which means that the investor has approximately 50% exposure to foreign assets (25% directly and a further at least 25% indirectly through companies listed overseas or earning a sizable portion of their income overseas) and at least a 60% exposure to growth assets (shares and listed property) so that the portfolio will adjust to among other things, long-term inflation rates. We used long-term average growth of 10% per year after all costs over the 15-year period. This is in line with the long-term goal of such a balanced portfolio.
After 15 years, the total contributions (R2 500 per month raised annually with inflation) will be around R700 000, but due to compound growth, the value of the investment is just over R1.5 million at age 65. The purchasing power of the R1.5 million is equivalent to about R625 000 today (with 6% inflation per year over 15 years). If you withdraw R6 400 each month after 15 years, and increase the amount with inflation each year to maintain purchasing power, your capital should last until you are 100 years old. The question is of course what you can buy with the R6 400 a month to make it relevant. That money is worth R2 600 in today’s purchasing power. So, you invest today’s equivalent of R2 500 per month for 15 years, and get R2 600’s purchasing power for 35 years after retirement.
Start saving as soon as you can, and you will quickly see the huge benefits of compounding.