With our life expectancy increasing, you’ll have more time to enjoy a comfortable retirement – provided you’ve built up sufficient funds thanks to meticulous planning! It’s essential to take a proactive approach to your finances by adopting the right management strategy as early as possible.
The fact that most of us can expect to live a longer life is good news, but at the same time it can be a financial headache for a lot of people. To enjoy a carefree retirement – given the likely prospect of a substantial drop in your income and therefore your standard of living – you’ll need to take action to compensate for the shortfall. The issue is compounded by fears that our social systems will be unable to fully fund our extended retirement in the future. Therefore,, the challenge is to build up sufficient savings that can be used when the time comes.
While avoiding excessive risk, what’s the best way to transform your pension savings into a source of long-term income? One that’s capable of making up for the loss of purchasing power due to a sudden drop in income, not to mention inflation? And how can you make sure you’re able to leave something to your children? The answer is simple: by using your assets to generate income for retirement. Your assets need to generate an income. That’s easier said than done, however, as it’s difficult to keep a cool head when you’re faced with financial markets in turmoil.
One thing is clear: you need to start preparing now! Don’t rely solely on the income from your statutory pension and build up enough capital to generate an income when the time comes. myLIFE sets out the main considerations to bear in mind for achieving your objectives.
Investing over the long term (…), more importantly, allows you to benefit from compound interest.
Compound interest – the Holy Grail of investing
In the first place, you can never overstress the importance of preparing for retirement at an early stage. It’s clear that the longer you have to prepare for retirement, the easier it will be to generate the substantial assets you’ll need when the time comes. Investing over the long term allows you not only to smooth out the vagaries of the market and reduce risk, but also – more importantly – to benefit from the compound interest. This consists of reinvesting the interest you earn, in other words not spending it but retaining it within your investments, with the aim of earning interest on that interest in the following year and so on, thus creating an exponential growth curve. Legend has it that Einstein described this “compound” interest as the Eighth Wonder of the World and the greatest force in the universe, adding that “he who understands it, earns it; he who doesn’t, pays it.” Along with tax considerations, repaying your debts as soon as possible is also one of the keys to the same equation.
The effect of compound interest on capital gains is gradual; in the event of capital losses, however, it is immediately detrimental in that the exponential growth rate starts to turn downward. That’s why it’s crucial to understand that yesterday’s 50% loss won’t be made good by today’s 50% gain. For example, a 50% loss on €1,000 gives us a total of €500. A 50% increase on €500 gives us a total of €750 – i.e. 25% less than the €1,000 we had at the start. Another way of illustrating it is to point out that a market that’s down by 90% equates to a market that’s down 80% and then fallen again by another 50%. A market that’s up 90% is a market that gained 80% and then increased again by 5.56%.
The power of compound interest lies in its exponential strength.
The power of compound interest (and compound returns more generally) lies in its exponential strength. Used to your advantage, this strength is particularly useful in preparing for your retirement – provided you combine it with regular payments.
Prioritise regular payments
When you’re young, your biggest asset is probably not money but time and a bit of discipline in terms of saving on a regular basis. The way you save will have a much more significant impact than the return on your investments. Making sure you save and increasing your savings capacity on a regular basis will be the most important factors in generating sufficient retirement capital. The well-known adage “time is money” couldn’t be more true in this case.
Setting up a regular, scheduled investment plan will enable you to achieve more steady improvements while benefiting from a smoothing effect when faced with market turbulence. Here too, it’s all about maths. With scheduled payments, you buy less when markets are rising and more when they’re falling. The key thing is to avoid panicking when you hit a bout of turbulence.
Returns and inflation
Compounding and regular investment are timeless strategies when it comes to pensions or any other form of investment. However, it’s also important not to forget that saving and investment merely reflect a personal choice to postpone immediate consumption to a later date. So, the implicit objective of any decision to postpone consumption is to at least maintain your purchasing power – and ideally to grow it. That’s where the concept of money illusion comes in – where the return on your investment is lower than inflation and your real situation has therefore worsened. In other words, your purchasing power only really increases if the return achieved is greater than the rate of inflation.
Risk and return
Any potentially high return on an investment goes hand in hand with substantial risk, and any secure investment is accompanied by poor returns – commonly referred to as the risk/return ratio. All investors have their own understanding of the best balance between risk and return. Their risk behaviour is determined by multiple parameters (including financial situation, savings capacity, investment horizon, investment experience and risk tolerance). In short, each investor is unique. That’s why it’s essential to determine your investor profile before you start investing.
The risk/return ratio has traditionally enabled us to define the optimum breakdown between different types of financial assets for an investment portfolio, based on the simple principle that equities are risky and investing in them therefore requires a greater return in order to compensate for bearing the risk. Over the long term, shares generally deliver a positive return. The prerequisite, therefore, is to have a reasonably optimistic temperament, but also to have sufficient time as well as to diversify your investments.
The younger you are, the more time you’ll have until you retire, meaning you’re in a position to take on a higher degree of risk. Although you’ll inevitably be subjected to market turbulence, you can let time to do its work in terms of making good any losses. If you’re approaching retirement and planning to live off your investments in the not-too-distant future, you’ll have less time ahead of you to make good any losses – that’s why a more cautious approach is called for. As retirement approaches, the priority generally switches from creating wealth to protecting it.
Diversification is a must
One of the most important decisions for any investor is what share of their money to allocate to high-risk, high-return investments such as equities, and what share to invest in low-risk, low-return assets such as bonds. Diversification has a vital role to play, not only in terms of limiting risk but also with regard to increasing the potential opportunities. A basket of equities may well benefit from “creative destruction”, but that’s next to impossible for an individual share.
To successfully manage your diversification and correctly calibrate the risk based on your circumstances, having the support of a banker is a must in our view.
As the famous saying goes, “the best time to plant a tree is 20 years ago; the second best time is now.” We all aspire to have the financial freedom that will enable us to no longer worry about working and paying the bills. When we retire, this freedom is about being able to enjoy retirement without reducing your standard of living. The challenge is thus to transform your nest-egg – which is often the culmination of a lifetime of working – into a source of stable income that avoids excessive risk, neutralises the effects of inflation, and supplements the income from your statutory pension in line with your expectations. It’s a delicate task that requires regular adjustments.
Clearly, it’s better to not go it alone in creating your investment strategy for retirement unless you have solid experience and a good deal of self-control. Your banker can help. They are on hand to advise you on your investments and apply a strategy that suits you. Investing for your pension requires planning and discipline. You’ll need a plan that will help you quantify the level of risk you’re willing to accept in order to achieve your objectives. This will allow you to define your guiding principles, chart a course, and then stick to it when the going gets rough. It’s up to the individual to decide what suits them, not forgetting that other retirement planning solutions are also available, such as retirement savings and life insurance. Careful management of your budget, for example in accordance with the 50-30-20 rule, will help in terms of correctly implementing your investment strategy for a comfortable retirement.