Retirement Planning (2) An Employee Benefit Perspective
In the last issue we summarized that:
- Potential Earnings increase based on number of working years and average annual rate of salary increases.(Salary Progression) The longer the period of earnings is the greater the amount of potential earnings.
- Potential Savings increase based on number of years of saving and average annual rate of salary increases. The longer the period of savings is, the greater the potential savings.
- Investment is your money working for you. The longer the period of investing the savings is, the greater your potential Retirement Fund will be.
- A Retirement Plan maximizes these potentials and puts you on the road to financial security at Retirement.
In this issue we look at ‘The impact of inflation in Retirement Planning’.
Definition of Inflation
Simply defined, inflation is the increase in the cost of goods and services (the rising cost of living).
The effect of inflation is to reduce the spending power of your money so that the same amount of dollars buys less goods today than previously. The rate of inflation is calculated by the Central Statistical Office and is based on the value of the ‘average basket of goods and services’ which reflects patterns of consumption shown in the household. It is measured by the index of Retail Prices (RPI). The percentage increase or decrease between periods results in the rate of inflation. The RPI was rebased to 100 points in 2003. Since the rebase, the average annual inflation rate has been approximately 6%. However, in previous periods Trinidad and Tobago has experienced much higher inflation rates.
To successfully combat the destructive effects of inflation requires that your investments provide a return which equals or exceeds the rate of inflation. The difference between your investment return and the inflation rate is called the real rate of return. The following examples seek to illustrate the impact of inflation:-
Example 1 – Lump Sum Savings:
Assuming you deposit $1,000 in a non-interest bearing account for five years, subject to an average inflation rate of 7%. On withdrawal, our $1,000 will now have spending power of only $713.11. To maintain the spending power of $1,000 your investment must match or exceed the inflation rate of 7% and this will result in your having at least $1,403 in your account.
This example is based on a five year period so you can imagine if this is extended to one’s working career of thirty-five to forty years. Hence the reason for an effective Retirement Plan.
Example 2 – Periodic Savings:
Assuming you deposit $1,000 annually in a non-interest bearing account for
five (5) years, subject to an inflation rate of 7%. On withdrawal, your total
savings of $5,000 will now have a spending power of only $4100.00. To
maintain the spending power of your money, there are three options:
1. Increase your savings to $1,220 annually
2. Achieve interest earnings of at least 7% annually or
3. Attain a mix of 1) and 2).
In this regard salary progression plays an important part but the effect of inflation cannot be ignored.
TAXES – A Useful Friend
Individuals are subject to taxes at source e.g., PAYE, tax on interest income etc. PAYE is
charged at 25% of chargeable income in excess of $60,000. In order to maximize your
investment returns, it is imperative that you utilize the tax laws to your advantage.
The Board of Inland Revenue (BIR) encourages this by providing various concessions such as
tax-relief on amounts saved, tax-free accumulation of investment earnings and tax-free pay-
out of the investment or part thereof. The result is taxes which will normally be lost to the BIR
will now form a percentage of the moneys you are investing. For example:
- You invested $1,000 annually for five years at 7% interest compounded annually (without considering inflation) the result will be $5,751.00. Based on the current tax structure your taxes will be reduced by $250.00 to form part of your investment of $1,000.00. The balance of $750 would be your out of pocket contribution from your existing take home pay. In effect you are saving $1,000 annually by contributing $750.00 with the balance being paid by taxes. As such your investment returns will increase significantly from 7% to 21.5%. The intelligent use of the provisions of the Income Tax Act will result in significant increases in your investment returns, making taxes a friend rather than an enemy.
EMPLOYER CONTRIBUTIONS- A very important partner
Most persons are employed during their working career by an Employer or Employers. If these Employers can make a contribution to the Employee’s Retirement Fund/Plan, then this will give it an essential boost and make the load substantially lighter for the Employee. For example, if your Retirement savings were matched equally by your career employers your retirement fund would be doubled.
In today’s International Labour environment, Retirement Pensions are so highly valued and Employer contributions so significant that Pensions are considered as “Deferred Pay”.
In the next issue we will bring together all these aspects, contributors and partners as we look at various Retirement Plans from an Employee Benefit Perspective.