We’ve seen why solving for multiple savings strategies is near impossible for a middle- to lower- income earner if we use a traditional approach to these funding problems. This chapter shows how a concept that borrows heavily from lifecycle investing can go a remarkable distance in achieving those goals.
Rather than applying a time-varying approach to allocating capital for each individual goal, we use a concept borrowed from lifecycle investing: we approach the problem by using a constant savings percentage towards all goals simultaneously which, provided the contribution is sufficient, dynamically allocates to the different financial goals. The solution adopts a combination of goals-based investing, lifecycle investing and liabilitydriven investing strategies.
Estimated cashflow profile (from age 23 to age 63)
Based on the assumptions, the model solves to a 46.2% lifetime contribution from age 23 to retirement at age 63 to approximately meet all objectives:
A 46.2% constant contribution, although meeting the investment objectives, would not provide the required means to support day-to-day living for an individual earning R72 000 a year, especially during the early years. At this contribution rate, despite the expected benefit, the savings programme would not be feasible against more immediate consumption needs. At R60 000 a year this rate jumps to almost 55%.
Absorbing housing costs, which include rental costs and interest rate funding early in the lifecycle, would force contribution rates to above 55%.
Another significant factor to the high contribution required is the requirement of capital from the time a person is employed to the time a child needs to start school. Research presented earlier in the book outlines the need for effective primary education to maximise the chances of the future human capital trajectory. Accessing good early education for the child is clearly imperative. This is one of the areas where investments can’t be stretched to create healthy outcomes. Good, cost-effective schooling is a social imperative that can only be met with significant sacrifice by most employees, if these are the true costs they face.
A further insightful observation is that a constant allocation towards each savings goal is ineffective. Despite a constant overall savings rate, the allocation to retirement savings remains negligible until the costs for a home and education costs are paid. Retirement savings as measured by the replacement ratio is almost zero at age 48. This variable allocation would be consistent with the principles in lifecycle investing.
For the savings programme to succeed for low-income earners, we need to explore other levers where investments can lower the overall contribution:
A further insightful observation is that a constant allocation towards each savings goal is ineffective. Despite a constant overall savings rate, the allocation to retirement savings remains negligible until the costs for a home and education costs are paid.
We see the power of compounding quite dramatically if the individual started work two years earlier at age 21 and retired two years later at age 65:
Estimated cashflow profile (from age 21 to age 65)
Based on the assumptions, the model now solves to a 36.5% lifetime contribution to meet all objectives:
This is almost a 25% improvement, which can significantly improve the use of and commitment to the savings programme. While this demonstrates that additional time is meaningful and any savings programme of this nature should be implemented as early as possible, 36.5% still remains high.
To address this, we’d like to see schooling and employee programmes introduce behavioural and educational programmes that highlight the value of compounding.
The liability streams of these savings goals are onerous, particularly the education expense, which is also the most important element for ensuring social
mobility from one generation to the next. The inability to finance this cost not only impacts on a family but on the country as a whole, as it will fail to
improve the social fabric of its communities, creating a deeper reliance on the government.
If we remove the requirement to fund education, it’s possible to meet the remaining goals with only a 20% contribution, while funding the house
quicker, within 16 years.
Estimated cashflow profile (from age 23 to age 63)
This table demonstrates that unless the real income of a 23-year-old exceeds R144 000 a year, reflecting only a small percentage of highly qualified graduates, the savings programme will require lifetime contributions above 30%. We don’t see this readily being taken up as individuals will struggle to relate the use of this deferred consumption (although probable) to immediate consumption needs.
To improve this, we need to reduce the contribution rate. The only way we can envision this is by introducing some form of subsidisation against the costs.
Subsidisation includes any programme or process that will reduce the overall cost of the goal and thereby reduce the contribution rate. This can be across any of the expenses in the savings programme. However, given the impact of education, we take an explicit look at approaches to reduce these costs surrounding education:
Assuming that a 30% contribution rate is acceptable, let’s review its impact on the ability to meet the goals, measured by: the projected replacement ratio, which is the last of the financial goals to be met any shortfall in funding the savings goals at the required time.
For earnings less than R108 000 a year, a 30% contribution will result in:
The table also reflects the amount of subsidisation required on education costs to meet all goals. For someone earning R72 000 a year, the cost needs to be subsidised by 60%. As school fees are just a component of the education costs for primary and tertiary education, a 100% waiver on fees will only translate to about a 30% reduction (assuming R9 000 school fees), but more than 60% for tertiary education. This implies that over the early years an individual (translated into a household) will require greater assistance to access and support children at school. A higher-earning individual will also require assistance but a 33% reduction in school fees will have the required impact.
The traditional form of investing, which maximises expected return for a given level of risk, usually measured as volatility or the standard deviation of the expected returns, has proven woefully inadequate to meet the demands of an individual’s or household’s fi nancial needs.
A different approach is needed, one which recognises:
That being said, the future remains uncertain, and we can’t factor in all outcomes. But what is important is that a strategy takes cognisance of known factors and adapts to these risks. This is the basis of goals-based investing.
Goals-based investing is an application of an institutional technique called asset-liability management, which is a framework for ensuring that future expenses (liabilities) are funded as they are expected. An asset-liability model remains the critical approach for most defi ned benefi t pension plans. One of the key techniques applied is a stochastic estimate of the value of each liability for each date in the future. This, in turn, applies an asset-based investment strategy that focuses on meeting the ability to fund each and all liabilities as they become due. The goals-based investment framework adopts the same philosophy in a far more generalised form:
Goals-based frameworks differ from traditional performance-based frameworks in that success is not measured by beating a market benchmark, a peer fund or ensuring that the investment strategy is on the efficient frontier. It requires the investment strategy to consider the context of the liability, the horizon and the specific risks of failure.
Goals-based investing shifts the typical investment conversation from best performing products towards establishing the correct financial outcomes. It follows that determining the correct goals, managing to meet those goals, maximising the probability of success, and helping the individual understand the impact would lead to better financial behaviour and outcomes.
The average individual will probably face the same savings challenges over their lifetime. In trying to meet them, it’s likely that they would try to achieve these goals independently, resulting in severe cashflow pressures at multiple stages as well as debt. The objective here is to get people to understand that the high savings rate provides a better lifetime use of earnings than trying to achieve these goals on their own.
A lifetime savings programme is more efficient in achieving multiple goals in a structured way. However, given the low levels of income that many individuals have to survive on, accessing similar savings through retail channels can also be expensive. A public-, industry- or employer- driven solution can aggregate costs and administer such a programme more effectively. The issue is less about who does it, than it is about ensuring that someone fulfils that role.
Another challenge is that the cost of education and housing is high relative to earnings. As such, either contribution rates are higher or costs subsidised meaningfully for each earnings group. Raising salaries only creates inflation, which may drive these costs up even more.