A Sense for Money
Last week, this column highlighted the fact that every one needs a substantial nest egg in order to achieve financial security in your golden years. Planning and nurturing this nest egg is not a one-off exercise, but rather a life long journey. It is a journey that will involve risks, uncertainties and storms. This week’s post provides you with some tips to help you stay on track and navigate around the biggest storms.
There are two quite distinct phases of this journey: The accumulation phase (when you are earning and saving) followed by the drawdown phase (when you are retired and cashing in your investments). The risks and uncertainties you face are really quite different in these two phases so we will deal with them separately.
In the accumulation phase, once you have started to set aside enough cash each month, the most important success factor is to get a good return on your money. The power of compound interest never ceases to amaze. For example, if you invest a million rupiah at age 20 and you get a two percent return, you will have just over 2 million when you get to age 60. Whereas if you get a ten percent return, you will have almost 45 million rupiah at age 60. Amazing!
One key risk is low investment performance, where your overall portfolio simply does not achieve the return you had hoped for. To give you a feel for the potential impact, saving 1 million rupiah a month from age 20 to age 60 would give you less than one billion rupiah at age 60 if you achieve a two percent return on your investment but almost 6 billion at ten percent. So, poor long term investment returns can cause major damage to your nest egg.
Another risk is that you may put too much money in one company, institution or asset type — and a catastrophic event affects that particular investment. This was what happened to people who entrusted all their money to Mr. Madoff or to Enron. Catastrophic under performance could also be experienced if you put all your money in the stock market only to find it crashes the month before you retire, or if you put all your money into cash in a year of hyper inflation (which makes cash worthless).
Diversification is the best way to avoid under performance. A good portfolio is when you spread your investments between:
- Real assets such as property, land, antiques or gems which provide a hedge against inflation.
- Secure assets such as deposits and savings with banks which give you liquid funds for an emergency and stability in the event of a stock market crash or property bubble.
- Funds with professional asset managers or insurers which will give you diversified exposure to equities and bonds.
With a diversified portfolio, even if one investment totally fails, you still have others to fall back on. Of course this is obvious and is the classic “don’t put all your eggs in one basket” story. But, at times, people tend to forget the obvious.
The drawdown phase, on the other hand, is the risk that concerns most of every one that you outlive your funds. For example, if you retire at age 60, live to 100 but run out of funds by age 75. It’s wonderful to think of living to 100 but being penniless is not a great prospect if you want to grow old with dignity. It would be so easy if you knew exactly how long you will live after retirement but you simply don’t know that, so you have to deal with the uncertainty.
One way to manage the uncertainty is to discipline yourself to cashing in a fixed percentage each year. Say you retire with Rp 1 billion and you decide to take 10 percent of your remaining funds each year. Then in Year 1 you can spend Rp 100 million. At the end of Year 1 you will have Rp 900 million plus investment income; say Rp 950 million in total.
If you cash in 10 percent of the remaining balance in Year 2 you will be able to spend Rp 95 million. Now this approach can lead to reducing income in retirement if your investment return is less than your drawdown percentage. It is not perfect, but it can work — the key point is that if you only spend 10 percent of whatever is left, you will never run out of funds.
Another approach to manage the uncertainty is to use insurance and buy a life annuity policy. For example, if you pay an insurer Rp 100 million at age 60, they may agree to pay you Rp 10 million a year for life, whether you live for one year or fifty years. Of course, the flip side of the coin is that it can seem like a pretty raw deal if the policyholder dies within the first year. But then again, insurers can build in guarantees – like payments for a minimum of five years. In fact, these annuity policies are not very common in Indonesia at present but we should expect to see more of them in years to come.