We have all read that the current global environment of low and stable inflation rates implies an era of low returns from financial assets, with bonds yielding 5-6 per cent a year and shares struggling to beat 7 per cent.
But exactly what does this new paradigm mean for someone saving for retirement? Is your objective of "$200,000 by the time I'm 50" realistic? Is $200,000 enough anyway?
Don't expect too much in the way of intelligent comment on the subject from the savings industry as many participants have vested interests and thus desperately cling to the fantasy of double-digit returns; hedge funds being just the latest manifestation of this sort of wishful thinking.
While research in the US and Britain (Morningstar and the FSA) shows that funds with high management fees generally achieve lower returns after fees, the reality in New Zealand is that the higher the fee structure of your financial adviser, the higher their "forecast" returns are likely to be, so as to project a worthwhile after-fees result.
To acknowledge the reality of low returns is usually to admit that one's fees are set far too high. For this reason, and because the marketing department says "that if the savings task looks too hopeless many individuals will ignore the issue", fund managers and financial planners are loath to embrace the new era of "low inflation, low return" investing.
The sole voice of reason in the debate about forecast returns seems to belong to disinterested parties such as the Financial Times, the Economist, John Bogle, Warren Buffet and Robert D. Arnott of First Quadrant in Los Angeles.
It's no surprise then that many of the retirement calculators available from financial planners and fund manager websites use assumed growth rates well ahead of commercial reality.
Indeed many appear to be based upon the euphoric and unsustainable 1981-2000 period rather than the more austere conditions likely to prevail in the next 20 years.
The new fair dividend rate (FDR) of tax on international shares, pitched at an assumed dividend of 5 per cent when the real world is closer to 3 per cent, will be another drag on performance.
So what do "low inflation, low returns" and "FDR" mean for someone saving for retirement in 2007?
How much do we need to save and what level of cashflow will our portfolios support once we are retired? Below we put some numbers for various savings scenarios based on realistic return assumptions and real-world management/monitoring fees with tax at 33 per cent.
First let's define low returns: a balanced portfolio like those run by pension funds and balanced unit trusts is typically made up of 40 per cent bonds, 10 per cent property and 50 per cent shares, with half the bonds and two-thirds of the shares invested abroad.
Our return assumptions, given current market metrics, are thus as follows:
* NZ bonds: Average yield is around 7 per cent.
* Offshore bonds: Average hedged yield is around 6.5 per cent.
* Property: Assume same return as for NZ equities.
* NZ shares: Dividend yield plus long-term growth rate of dividends = 6 per cent + 4 per cent = 10 per cent.
* Offshore equities: Dividend yield plus long-term growth rate of dividends = 3 per cent + 4.5 per cent = 7.5 per cent.
This gives a weighted average pre-tax, pre-fee, nominal return of about 7.9 per cent a year for your typical balanced fund. It is pretty easy to re-do the sums for your own portfolio once you know your asset allocation.
The next step is deducting fees. If you save via a portfolio of unit trusts in a mastertrust structure which a financial planner monitors for you, total fees will be likely to average about 3 per cent a year. So our post-fee, pre-tax, nominal return is 7.9 per cent, less fees of 3 per cent, to net a 4.9 per cent return. We ignore implementation fees for simplicity.
Thanks to the recent changes in taxation of managed funds, tax is levied on income only - except for international shares which, despite the fact that they yield only 3 per cent, will be taxed as if they earn 5 per cent.
Tax on income from the portfolio will be about 1.1 per cent a year so our post-tax, post-fee return is 3.8 per cent.
Finally we must adjust our post-tax, post-fee nominal return for inflation, which allows us to compare future terminal sums in constant 2007 dollars. It is not much use being a millionaire in 2027 if Saturday's Herald costs $100,000. We assume inflation averages 3 per cent so our post-tax, post-fee, real return is only 0.8 per cent. Not all that flash is it?
That's the return assumptions. Now let's get saving: Scenario A is for a couple aged 50, retiring at age 65, with investment assets - excluding their house - of $150,000 and saving $500 a month via a portfolio of managed funds which are monitored by a financial planner and are subject to income tax including the 5 per cent fair dividend tax on international shares. The model calculates a terminal sum of $263,000 in 2007-dollar terms. Incidentally, total annual fees on this option add up to around $100,000.
Scenario B is as above but with total annual fees of 1 per cent tax to yield a post-tax, post-fee, real return of 2.1 per cent a year. Terminal sum is $311,000.
Scenario C is for an individual aged 25 saving $100 a week with no lump sum via a company superfund with total annual fees of 1 per cent a year and no initial fees. Total real return after tax and fees is 2.1 per cent a year. Terminal sum in 40 years in current dollar terms is $327,000. Note the sensitivity of the terminal sums to changes in the rate of return.
Einstein is supposed to have said that the greatest force in the universe was compound interest. Perhaps not quite so true in a low inflation world with high fees and tax: in this environment what you retire with is increasingly a function of what you have saved.