A key retirement consideration: Replacement Ratio
We have all been told that the importance of joining a pension scheme is to secure a healthy retirement. But what is a healthy retirement? Replacement ratio is considered to be a reliable barometer of retirement health. This is a rule of thumb that estimates what percentage of a person’s pre-retirement income will be needed to maintain their lifestyle after retirement. Most studies suggest aiming for a target of between 60 and 80 percent of pre-retirement income. The more widely accepted target locally is 75 percent. This number is very critical in developing one’s retirement plan, because it is from it that one can estimate the corpus they need to build. But like all rules of thumb, this too needs to be used judiciously.
One may wonder why only a portion of your pre-retirement income is adequate in retirement. This is so because it is assumed post employment, some costs such as work related expenses and commuting costs will become irrelevant. In addition, many of the goals for which savings were made including retirement will no longer be a charge on the income anymore. Similarly, some of the debt one was servicing will hopefully now be closed. All this translates into lower income needed to meet expenses. Admittedly, there will be other costs in retirement that may not have formed a significant portion of pre-retirement years. The balloon cost is usually healthcare which tends to rise with age. Travel and leisure, which are significant factors in the western culture are not applicable for our market as our bagolo generally do not do it. Where one would think our locally nuanced replacement ratio should then be on the lower bound of the global range because of this, it is not so because of our culture of the elderly taking over their adult children’s livelihood costs. Which children sometimes never fly the nest. And then there is the pride that comes with spending ba nyadisa (footing wedding bills for their children). Even with that said, it has been shown that net net, the pre-retirement cost far exceed the retirement ones.
Thinking about income replacement ratio should be a starting point to plan for when you are young and retirement is decades away. What we often see happen though, is that members of a retirement fund start taking keen interest in their fund credits and replacement ratios the year they decide they want to retire, which at that point unfortunately it is too late as not much can be done about what they learn.
The aggregate average replacement ratio for pension funds in Botswana has hovered around just under 45 percent over the years. This is significantly lower than the requisite 75 percent, with the resultant reduction in the quality of life for not just the elderly but even children (going back to my earlier point of grandparents stepping in to be care givers).
Areas that need close monitoring to grow the replacement ratio are numerous but they key ones are ensuring that the overall investment strategy and implementation speak to member objectives and that contribution rates are aligned with the sought replacement level. Typically, pension fund advisers give indicative levels of replacement ratios both at a total fund level and more recently at an individualised level through projection statements. The onus then is on each member to track and ensure thorough comprehension of their individualised projections. I have come across many instances where a member nearing retirement gets excited from having only focused on their fund credits of say P800, 000.00 thinking it is a lot of money. Upon learning that once they encash their one third and then purchase an annuity with the balance, their monthly income could be as little (relative to expectations) as P3, 500.00 then despair hits.
Important to note is that there are some decisions members make that are to the detriment of their retirement savings. In Botswana, the law allows members to encash either P5, 000.00 or 25 percent of their retirement savings after tax, whichever is greater whenever they resign or are dismissed. If the loss of a job is as a result of retrenchment, the allowable encashment is a little higher at 33 percent or P5, 000.00 after tax, whichever is greater. Most members tend to always exercise the above options. And if one is a job- hopper, it goes without saying that not very much will accumulate in their retirement kitty. A lack of preservation is a big threat to a healthy retirement.
I cannot stress enough the importance of deferred compensation over instant gratification when it comes to retirement planning. This is because for most Batswana, their retirement savings are often the only asset base from which they can draw when they retire.
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Disclaimer: This does not constitute investment advice. For any bespoke investment counseling, do contact your financial adviser
Kgomotso Beleme is a capital markets professional with a focus on investment strategy development, implementation and monitoring.