In our last post we showed you how to find the amount you need as a lump sum at retirement. Finding that goal is half the battle, the next step is figuring out the rate of return you need from your KiwiSaver fund to achieve that lump sum. That will allow you to choose the right type of KiwiSaver fund you need to be in.
What is rate of return?
Rate of return is what you earn for investing your money. Think about term deposits and their fixed interest rates. You put your money in an account with your bank for a specified period of time. The interest you earn is the rate of return on your Term Deposit.
Once you have calculated your rate of return, you can select a strategy that matches your required rate of return.
Being in a KiwiSaver fund that is not setup to match the rate of return you need can cost you thousands of dollars. This adds up over a lifetime of investing to a significant amount that could be the difference between achieving or failing your retirement goals.
Why do I get a different return from different KiwiSaver funds?
There are over 200+ KiwiSaver funds so choosing the best one can be tricky. These funds have a range of expected yearly return from 2% for cash funds to 6% for growth funds. The difference is because they are invested in different types of assets. Funds that prioritise high returns invest in more growth assets as compared to more conservative funds. Conservative funds aim for greater stability by investing in less volatile assets which produce lower returns.
Watch our short video which explains what investment assets are and the differences between the main types of KiwiSaver funds.
When making an investment decision, it is important to balance the fund’s volatility and expected return with your personal situation. To choose the right fund, we first need to figure out the rate of return you need from your KiwiSaver account. This will be the key to determining which fund you invest in.
Calculating the rate of return.
When determining the required rate of return for your KiwiSaver it can get a bit complicated as we need to work backwards to calculate it. To do this we need to take a few factors into consideration:
- Your current KiwiSaver balance
- Your contribution rate
- Your employer contribution rate
- The years remaining for your retirement
When we do these calculations at National Capital we also take into consideration that your salary and the contributions you and your employer make will keep increasing. We assume that you will get a salary increase which approximately matches inflation. (Currently, we use 2% - May 2020)
So what's the calculation? We use something called a Goal Seek, where we apply different rates of returns to find what your final return will look like. The logic for that looks something like this:
|-- Logic --|
|Boundary Conditions Check|
|If y>a when x=0% then x=0%. Stop processing|
|If y<a when x=20% then x=FLAG. Stop processing|
|Goal Seek Logic|
|Run Calculations till y=a|
|if y>a then Upper Bound=TestStart|
|else if y<a then Lower Bound=TestStart|
|TestStart = (Upper + Lower)/2|
In the above table (a) is the KiwiSaver lump sum you need, we calculated that here; and (y) is the actual lump sum you will get to depending on the different rates of return we use.
Once we find an answer (y=a), we also need to ensure that we don’t end up with a result that doesn’t withstand the common sense test. It would make no sense to suggest that you invest in a more conservative fund before retirement and a more aggressive fund after. To safeguard against that, we use a smoothing process to ensure that the value we get for your return rate is either higher or the same as our assumption for your retirement return rate.
Ok, I have a value, what now?
Once we have calculated the return rate you need, we then use that to figure out the strategy that matches your goal. This could mean investing in one fund or taking a two-pronged approach to ensure you are making the most gains while securing your existing savings.
We don’t want you in a fund which will not earn enough for you to be able to achieve your retirement goals, but we also don’t want you in a fund which has more volatility than you need or are able to bear.
So that's it right?
Well, no. We need to take a few more factors into consideration before we can make a recommendation to you on which fund you need to be in. Just knowing what returns you need is not enough. We also need to take into consideration your volatility capacity and tolerance. More on that in this post - 3 factors in choosing a KiwiSaver Fund.