With the stock markets being so volatile in the past six months or so, people who have their retirement savings in equities must be going through an anxious period.
The most common piece of advice financial advisers have for individuals is to start saving when they are young, and to let the savings compound with time.
With interest rates being so low, putting one's money in fixed deposits is a very inefficient way of achieving the compounding effect. Consider this: It takes 72 years to double your savings from say, $100,000 to $200,000 at an interest rate of 1 per cent a year.
However, if you can find a way to grow your money at 10 per cent a year, your $100,000 would grow to $200,000 in less than eight years. In 24 years, your $100,000 would have grown to some $1 million. That's the magic of compounding.
One way of letting the money compound at a faster rate is via the stock market. However, this route entails significant volatility, as we have witnessed in the last six months and in various episodes in the past, for example, during the global financial crisis, the Sars epidemic and the Asian financial crisis, to name just three.
Now, let's take a look at how market volatility impacts one's retirement savings. Let's assume that the analysis is done using the Straits Times Index (STI), with dividends reinvested. No transaction costs are taken into consideration.
Let's say the retirement savings plan entails putting $10,000 each quarter into the STI for 20 years, with dividends reinvested.
That's $40,000 a year over 20 years. So the principal amounts to $800,000.
The good news is, over a 20-year period, every single person who has consistently put money into the stock market quarterly would have managed to have a pot which is bigger than the capital put in. Most people would end up with a retirement sum of $1.95 million - double the principal they put in.
Over a 20-year period, every single person who had consistently put money into the stock market quarterly would have managed to have a pot which is bigger than the capital put in. Most people ended up with a retirement sum of $1.95 million - double the principal they put in.
The not-so-good news is, depending on when one starts investing in the market and when one retires, the outcome at the end of 20 years can vary significantly. It can mean a difference as large as $1.6 million.
The lucky person, let's call her Jane, who started investing, say in the third quarter of 1987, would have had a pot of $2.7 million after her retirement as at the third quarter of 2007. That was the peak of the market just before the global financial crisis.
However, the person who joined the workforce just four years earlier and started investing in the first quarter of 1983, let's call her Mary, would end up with a retirement pot of just $1.1 million as at the first quarter of 2003. That was when the Singapore market was depressed from fears of the Sars epidemic.
SEQUENCE RISK IN RETIREMENT SAVINGS
This is called sequence risk. A saver may earn a different sequence of returns during the accumulation phase and that made a world of difference to the final outcome. In Mary's case, even though she got good returns early in her savings plan, she suffered bad returns near her retirement, when her account balance was higher. Jane, however, was lucky to have caught the bull run from 2004 till 2007.
Here is how the two retirement savings plans grew over time.
Mary would have got very miserable returns for her 20 years of diligent saving had she withdrawn all her money as soon as she retired.
However, if she left the bulk of the money in the market, and took out just 5 per cent, or $55,000, to fund her living expenses that year, and continued to take out just 5 per cent of the portfolio value every year since, her portfolio as of today would be worth much more.
Between 2003 and 2015, Mary would have taken out $1.5 million to spend, and as at Feb 29 this year, her portfolio would be worth $2.1 million. Mind you, this is valued based on rather depressed pricing for the STI currently.
As for Jane, she would have done better had she taken out her entire retirement pot at the peak of the market. But she had to have the courage to reinvest the entire pool back when the market corrected. Had she not, she would most likely be worse off in a few years' time.
Let's assume she had taken out her total pool of $2.7 million and put all the money in a fixed deposit that yielded her 1 per cent a year from 2007 until now, and that she took out 5 per cent from her pool every year. By now, she would have taken out $1.07 million and her pool would be $1.77 million.
The amount she is withdrawing reduces by the year as her pool shrinks since her interest is not compounding as fast as her 5 per cent withdrawal every year.
In comparison, had Jane left the money in the market as Mary had done, she would have taken out a slightly smaller sum of $969,000 between 2007 and now, and her portfolio is worth $1.69 million as at Feb 29 this year.
Again, market valuations as of now are pretty depressed and there is a very high chance that they will recover.
Notice also that Mary's retirement pot today is larger than Jane's. Starting early does pay.
To recap, for retirement savings, end-of-period market valuation makes a difference if one decides to withdraw the entire sum at that point. It is less decisive if it is a piecemeal redemption.
And for a plan of constant investment over a 20-year period, the starting market valuation doesn't really make a big difference either.
The takeaway is: Stretching out the investment period and making piecemeal redemptions take the stress out of managing one's retirement fund and one will not be held ransom emotionally and psychologically to market gyrations.
That is from the comfort of knowing that one will never run out of money with 5 per cent redemptions a year from a pool invested in a basket of productive and decently priced companies. So one can tune out the market noise.
•The writer is a partner in Aggregate Asset Management, manager of a no-management-fee Asia value fund, and author of Show Me The Money - Fighting Paralysis In A Market Meltdown.