Between the cup and the lip: fees and inflation

I remember buying my first retirement annuity, some 20 years ago. The broker projected that my investment would grow to over a R1m by the time I hit 55, based on historical markets return of 15%. I’ll be rich, I thought, and for only R102 per month, increasing at 15% pa. That has to be a good deal.

Our meeting lasted no more than half an hour. I never heard from him again, and although I’ve long since made the RA paid-up, I continue to pay for his “advice”.

The encounter irks me to this day, not just for my own ignorance at the time, but also for the things he said, and, more importantly, didn’t say. Let me put his arguments and omissions into a present day context.

The pitch

Assume you are a young 25 year-old graduate, working your first job, earning R300 000 pa. Your broker proposes a savings product that will make you rich beyond your wildest dreams. In fact, it will make you a multi-multi millionaire. And it’s so easy. All you do is invest 15% of your monthly pay check in a general equity fund for the next forty years.  You’ll start with a monthly contribution of R3 750; your salary and your contribution will grow with inflation.

The projection

Your broker has no idea what the stock market will do over the next forty years but he understands that long-terms equity returns have been amazingly consistent, and therefore assumes they will exactly match the past forty years (from 1 January 1971 to 31 December 2010). On that basis your investment would grow to an incredible R340m.

Too good to be true? Not if there is a repeat of the last 40 years’ equity returns – over this period, the FTSE/JSE All Share Index delivered a fantastic 16.5% pa compound return (including dividends). No catch.

The pay-out

Okay, there’s one little catch. The return quoted is the gross market return. You won’t get that because you have to pay fees. You are not the only one depending on your savings; there are also your broker, administrator, investment manager and adviser to consider. Fortunately, you’re all in for only 2.5% pa, not bad by South Africa standards. Your investment will still grow at a very handsome 14% pa. It won’t make much difference.

How little difference, you ask. Your broker may think it rude to talk net returns – it’s a bit like asking him how much he earns. On reflection, he admits it’s a lot like asking him how much he earns. But seeing you asked, he comes clean: you will still be worth a staggering R182m. Yes, it is R158m less, but that’s a “glass half empty” perspective. R182m is still like 600 times your current salary.

The value

But what can you actually buy with your investment in 40 years time, you ask. A lot! What can’t you buy with R182m?

Okay, inflation has been quite steep over the past forty years – headline CPI Inflation averaged almost exactly 10% between 1971 and 2011. There was a time when you could fill your tank with a R5 note.

Funny numbers come up when inflation grows at 10% for 40 years. Your R300 000 salary will inflate to R13m pa by the time your retire. That R500 000 luxury car will set you back R20m plus, and you’ll spend R27 000 filling it up. Clearly, R182m will not go as far as you imagined.

To determine exactly ‘how far’, it’s best to express the future value in terms of its present purchasing power. It’s not a pleasant prospect. You saw what 2.5% in costs did to your investment; imagine deflating it by a further 10% pa.

Adjusting for cost and inflation, your R340m retirement asset shrinks to 4.2m. Spot the difference?

The lesson

It is very easy to get carried away by long-term nominal benefit projections. Nominal projections include the inflationary contribution. Although we are all aware of inflation, compounded over long time periods, it is a much stronger force than we realize. And whereas financial advisers may use this to their advantage on the asset side (i.e by projecting enormous outcomes), it is typically ignored on the liability side (your living expenses in retirement). This creates an illusionary sense of future wealth.

Future asset values are meaningless if not placed within the context of their present purchasing power. This context is created by ignoring inflation and projecting only real returns.

Projecting nominal returns is, in any event, pointless as we have no idea what future inflation will do. Over the last forty years, inflation averaged 10%, but only 7.9% over the last twenty years and 6.1% over the last ten. Given that the Reserve Bank now targets an inflation band of 3% to 6%, we can be optimistic that future inflation will be lower than the historic mean, but we simply don’t know. And if we can’t predict future inflation, we cannot predict future nominal equity returns.

Real equity returns, on the other hand, have been very consistent over the long-term, averaging between 6% and 7% (including dividends). Future returns are always uncertain, but long-term real equity returns provide a more relevant trend line.

It just as easy to dismiss costs as irrelevant: few investors appreciate the ruinous impact of fees on the long-term investment outcome (and few advisers seem keen to broach the subject). Firstly, the impact of fees compounds as you not only lose the fees but also the return you would have earned on those fees. And secondly, fees are viewed in the context of nominal rather than real returns. Giving up 2.5% when your portfolio returns 16.5% pa does not seem onerous; in the context of a balanced portfolio, promising 5% real over the long-term, it halves your return!

The reality is that high costs can derail even a diligent 40-year savings plan. An element of fees is inevitable, but some fees are avoidable. If you paid only 1% pa in fees in the example above (for example, by using a low cost index tracker and going direct instead of through a broker), your investment would be worth R6.1m in 40 years or 45% more (in today’s money). That’s a real boost for your retirement.

So, the next time you are lead to believe your retirement cup “runneth” over, remember the slips.