- Taking control of planning for one’s retirement is especially important as shifting demographics, changing rules and benefits for government pension systems, and escalating health care costs are redefining the retirement picture across many Asian societies.
- Achieving a successful retirement requires a focus on both saving and investing. We believe there are five keys to a financially secure retirement: Define a goal; make a plan; set up and maintain an emergency reserve fund; save smart and early; invest wisely and for the long term.
- A retirement goal will be based on three assumptions: the age at which one expects to retire; the lifestyle one hopes to support; and a longer lifespan than previous generations, given the increased longevity of today’s retirees.
- Balancing personal risk tolerance with the risk capacity associated with the longer investment horizon of retirement is essential when making informed asset allocation decisions for a retirement goal. At any risk level, diversification is key, as it can help to maximize returns for a given level of volatility.
FOR MANY PEOPLE , PLANNING FOR RETIREMENT CAN SEEM OVERWHELMING. FOR OTHERS, IT SIMPLY FEELS LESS URGENT THAN OTHER FINANCIAL GOALS, SUCH AS BUYING A HOME OR SAVING FOR A CHILD’S EDUCATION.
But today, a trio of powerful forces—shifting demographics, changing rules and benefits for government pension systems, and escalating health care costs—is redefining the retirement picture across many Asian societies. As a result, it has become ever more critical for individuals to take control of their financial future. This will demand a focus on both saving and investing for retirement, and the sooner the better. Preparing for this life chapter is important, but it needn’t be intimidating—as we will demonstrate in the following pages.
We believe there are five keys to a successful retirement outcome:
- Define a goal
- Make a plan—“A goal without a plan is just a wish” —Antoine de Saint Exupery
- Establish and maintain an emergency reserve fund
- Maximize savings—and dedicate those funds to a retirement investment strategy
- Invest wisely—and for the long term
DEFINING A RETIREMENT GOAL
In setting a retirement goal, the first step is foundational: Clearly define what retirement success is, on both an individual and a household basis. Only then is it possible to know if one is on the right financial path to achieve the targeted results. Naturally, goals can and will evolve over time, and it is important to periodically review both the objective and the plan to make sure that the necessary steps are being taken to achieve retirement success.
A retirement goal will be based on three assumptions: the age at which one expects to retire; the lifestyle one hopes to support; and a longer lifespan than previous generations, given the increased longevity of today’s retirees (EXHIBIT 1). If these assumptions are difficult to make on a personal basis, established rules of thumb can apply: a national retirement age, an income replacement estimate of one’s current lifestyle, and a life expectancy of at least 95 years old (given longevity in Asian societies).
Advances in medicine and healthier lifestyles mean that people are living longer
EXHIBIT 1: THE PROBABILITY OF LIVING TO A SPECIFIC AGE IF YOU ARE 65 TODAY
DETERMINING RETIREMENT SPENDING NEEDS OR “LIFESTYLE”
Determining how much wealth will be needed to cover retirement spending needs is never a simple exercise. Ideally households would know not only what they spend today, but also have a good estimate of how spending will change once they retire, and then after they have lived in retirement for many years. The reality is that few people know their current spending level, much less what it will be in the future. The easiest way to quickly estimate current spending, or “lifestyle,” is as a percentage of current income. This is known as an “income replacement ratio.” Someone who is still working can make this calculation as follows: Take total monthly income (for example, $30,000) and subtract any savings ($6,000) and transfers to the government such as income tax payments ($3,000). That will represent monthly spending ($21,000) or 70%. In this situation, the lifestyle is equal to 70% of current income (EXHIBIT 2).
Targeting an income replacement rate of 70% conservatively estimates the amount a person will need in retirement
EXHIBIT 2: FACTORS TO CONSIDER WHEN DETERMINING RETIREMENT SPENDING
This is a good first estimate, based on the average national saving rates in Asia, tax policy and an Asian tradition of familial support to retired parents. That tradition has weakened some in recent years, but it remains a powerful force in Asian societies. Individuals approaching retirement may find that when they increase savings, they become accustomed to a lower spending level; alternately, other sources of retirement income, such as familial support, may offset some spending, so that investments alone need not cover as much of their pre-retirement lifestyle.
Although personal situations will vary, targeting an income replacement rate of 70% conservatively estimates the amount a person will need in retirement. People often anticipate that in retirement they will spend considerably less than they did when they were working full time. This is not always the case. It is important to plan for current lifestyle needs at a minimum. Then, as retirement nears, the plan can be refined as an individual has a better understanding of lifestyle costs and how they will change over time.
HOUSING COSTS AND CHOICES
Housing considerations impact retirement planning in several different ways. First, housing costs affect how much people are able to save for their old age: saving for a down payment, paying off a mortgage and making maintenance payments necessarily reduces spending on non-housing expenses. After home mortgages have been paid off, money that had been earmarked for those monthly payments may be redirected either to increased savings or spending. Therefore, if someone anticipates that those earmarked funds will be saved, he/she may have a lower income replacement ratio. For example, if a mortgage payment had represented 20% of pre-retirement income, the replacement need may go from 70% to 50%. Exhibit 2 illustrates the potential impact of a paid-off mortgage on a post-retirement lifestyle.
First, data shows that very often people do not actually downsize, even when they intend to do so. Sometimes that is because by the time a person retires, housing that seemed inexpensive at the time a plan was initially created may become more and more expensive as the plan is updated closer to retirement. What’s more, even when a preretirement home is sold, it is unlikely to dramatically alter one’s overall retirement spending needs. In short, many retirees find it difficult to maintain their quality of housing. Of course, if a retiree moves in with family members who will cover all housing expenses, that decision will obviously have a substantial effect on spending needs.
Second, housing costs remain a significant item in a retiree’s monthly budget. Often retirement plans contemplate that a retiree will “downsize,” that is, sell a pre-retirement residence and/or move someplace smaller and less expensive. In this way some portion of home equity is freed up for other lifestyle needs. In theory, this is a sensible approach, but in practice it can be problematic. We recommend that people do not count on using home equity as a source of additional funding within their retirement plan.
MAKE A PLAN
Once a retirement goal has been identified, individuals can quickly assess whether they are on track based on their current age; a “checkpoint” approach can be very useful here, as illustrated in EXHIBIT 3.
Are you on track to reach your retirement goals?
EXHIBIT 3: HONG KONG RETIREMENT SAVINGS CHECKPOINTS (IN MILLIONS, HKD) USING YOUR CURRENT MONTHLY SALARY AS REFERENCE
Continue to make 20% contributions to investment accounts, either into the Mandatory Provident Scheme or a personal account. If these accounts earn 7.0% annually before retirement at age 65 and 5.0% annually post age 65, the portfolio will be able to support 30 years of withdrawals at an amount equal to 70% of the age 65 salary inflated annually. This is estimated to provide a lifestyle equal to the lifestyle before retirement. Salary replacement rates are derived by beginning with 100% of preretirement gross income, subtracting the amount of the Old Age Allowance flat government pension ($1,235), subtracting the pre-retirement savings level (20%) and subtracting an additional 10% due to post-retirement expenditure changes, taxes or familial support.
What might a retirement plan look like? Especially if a goal seems elusive, a specific, well-crafted plan will clarify what it will take to successfully retire. A financial advisor can examine an existing retirement strategy and make an educated estimate of an individual’s likelihood of success. More importantly, a financial advisor can recommend actions that can be taken to boost the odds of achieving successful retirement outcomes. Those may include:
- Saving smart: as much and as early as possible
- Establishing an emergency reserve fund
- Adopting a goals-based approach
- Investing effectively, given time horizon and risk tolerance
Saving smart-and early
Because Asia has a strong savings culture, most individuals already save a good percentage of their earned income. But they may be less effective than they could be in putting that savings to work over a long period of time to maximize the amount available in retirement (EXHIBIT 4).
An early start to saving means that investments can work over a long period of time to maximize the amount available in retirement
EXHIBIT 4: GROWTH OF SAVINGS ACCOUNTS
When Asian families are asked why they are saving, most people say they are doing so for “precautionary” reasons, seeking protection against the unknown. They view their savings as a bulwark against both unexpected setbacks, such as losing a job, and inevitable life events, such as retirement.
Compartmentalizing those savings in a way that aligns to a household’s various needs and goals can be a more effective approach. We advise people to set aside some savings for emergencies in a dedicated “emergency reserve fund” and invest it in short-term investments that will be available at a moment’s notice (for example, cash or other highly liquid investments). This will reassure even risk-averse individuals that unforeseen events should not prove to be a financial calamity. Generally, households should establish and maintain an emergency reserve fund of at least three- to sixmonths’ worth of total household expenses.
An individual whose profession is more volatile, and income more variable, will want to have more money set aside. So too would someone in a field where the job market is more precarious. These individuals should consider setting aside perhaps enough to cover one year’s worth of expenses.
Establishing an emergency fund offers one added benefit: It will boost an individual’s confidence that long-term investments—for goals such as a successful retirement—won’t have to be sold at an inopportune time.
Other financial goals, such as educating children, funding a wedding and buying a home, will have time horizons somewhere between an emergency reserve fund and retirement. Therefore, we encourage a “goals-based investing” approach (EXHIBIT 5).
Different savings goals will have different time horizons
EXHIBIT 5A: SAMPLE PORTFOLIOS FOR DIFFERENT SAVINGS GOALS
EXHIBIT 5B: RANGE OF STOCKS, BONDS AND BLENDED TOTAL ANNUAL RETURNS, 1950–2015
Saving and investing by goal (and, usually, establishing discrete funds for each) enables an individual to align an investment strategy to the right time horizon. This generally means taking more risk when the goal is far off; then, when the goal is more imminent, it means getting more cautious, so that market swings have little effect. If a son or daughter is two years away from college, for example, college savings should be invested with far less risk than savings for a retirement decades ahead. This approach also helps investors take advantage of “mental accounting.” In this way, an individual gets a better read on where he/she stands relative to each goal. This is not an academic exercise: It inspires people to adjust their level of saving as needed and have greater confidence in the outcome of each goal.
Invest wisely for the long term
How does one invest for a retirement that is, say, 20 years in the future—a retirement that could last as long as 30 years? In industry parlance, individuals saving for retirement are in “accumulation mode” as they look to accumulate sufficient assets to fund a successful retirement. They thus have a significant risk capacity to weather volatile markets and benefit from the asset returns that accrue from investing for the long term.
When investing for any goal, diversification is critical. A look at asset class returns over the past decade (EXHIBIT 6) demonstrates the steady performance of a diversified portfolio through several market cycles.
A diversified portfolio delivers steady performance through several market cycles
EXHIBIT 6: ASSET CLASS RETURNS OVER THE PAST DECADE
Here we underscore the importance of staying invested through those market ups and downs. Market data from 1988 to 2015 (EXHIBIT 7) illustrates that intrayear stock market declines can be far more frequent, and severe, than negative calendar year returns.
Intra-year stock market declines can be far more frequent, and severe, than negative calendar year returns
EXHIBIT 7: MSCI AC ASIA PACIFIC EX-JAPAN INTRA-YEAR DECLINES VS. CALENDAR YEAR RETURNS
What is an appropriate asset allocation for a retirement strategy? There are various rules of thumb about how to allocate retirement account assets between equities and fixed income. One traditional guideline: Subtract one’s age from 100 to determine the percentage of equities that should be owned at any point in time (for example, a 55-year-old’s portfolio should hold 45% in equities). In our view, this simplistic approach does not take into account the more muted expectations for asset returns that have defined the investing environment in recent years. The 2016 edition of J.P. Morgan’s annual Long-Term Capital Market Assumptions estimates that a 60/40 portfolio (60% equities, 40% fixed income) will return an average annual 6.2% over the next 10-15 years. In contrast, from 2004 to 2014, the compound annual return of the 60/40 reference portfolio was 6.9%.
The traditional approach also does not take into consideration the benefits of a more diversified portfolio that looks for investment opportunity globally and is tactically managed and rebalanced as markets and economies change over time.
An investment strategy’s risk capacity should be balanced with an individual’s innate risk tolerance to ensure that the strategy is not only appropriate but maintained with discipline over the long term. If a portfolio is invested too aggressively, such that the strategy is abandoned at the first experience of volatility, poorer outcomes are likely. In creating a retirement plan, individuals should discuss with their financial advisor what level of risk or volatility they can manage. An advisor can then recommend what asset allocation would be most appropriate. At any risk level, investment portfolios should be well-diversified; this will help to maximize returns for a given level of risk.
OTHER SOURCES OF RETIREMENT FUNDING
Life insurance products that accumulate a cash value (such as whole or universal life insurance) can provide additional funding for retirement. But investors should bear in mind that when the cash value of an insurance policy is tapped, the value of life insurance consequently declines, potentially jeopardizing survivor or estate planning goals. Because these products can be complicated, one should make sure to fully understand how fees and surrender charges may reduce the amount of cash value available. One should also carefully consider how any guaranteed return compares to a similar non-insurance investment solution to understand the value of the insurance guarantee for the cost over a long period of time. A financial advisor can be helpful in evaluating these products, but, in general, they should be purchased primarily for the life insurance benefit provided for survivorship or estate planning purposes rather than as an efficient long-term retirement savings vehicle.
Although Asian families are usually very good savers, saving is only one part of what it takes to achieve a successful retirement. Many people postpone retirement planning, either because the activity feels overwhelming or because other goals appear more pressing. An experienced financial advisor can provide a useful perspective here, helping an individual establish goals, assess risk capacity and determine appropriate asset allocation and investment strategies. As we have discussed, five key steps can boost the chances of a successful retirement outcome: define a goal; make a plan; set up an emergency reserve fund; save smart and early; invest wisely and for the long term. Put another way, an effective retirement plan addresses saving and investing—the two go hand in hand.
For additional information, please contact your J.P. Morgan representative.