Saving towards retirement is a matter of discipline and proper planning. The sooner one realises that retirement is not light years away but rather a fast approaching reality and starts planning accordingly, the likelier they are to reach their pension goals. How much pension savings will be required depends on lifestyle and spending habits. According to studies, most people fail to plan for their pension needs either because of sheer neglect or perceived lack of knowledge.
Planning and implementation
As a general rule of thumb, in order to maintain the accustomed lifestyle in retirement, pension income ought to be around 80% of the income prior to retirement. The latter can be achieved through the three-pillar retirement framework:
Pillar 1 – Public pension
The first pillar caters for social insurance and covers basic subsistence needs in old age. It aims to provide the elderly with a minimal level of income and is guaranteed by the government.
Pillar 2 – Occupational pension
A pension system in which both employers and employees pay into. In the private sector in Cyprus these are usually in the form of a defined contribution scheme which means that employees will receive a lump sum at retirement which will depend on the money contributed plus any positive or negative performance accumulated throughout their career. In the government and semi-government organization sectors a defined benefit system usually guarantee a salary throughout retirement.
Pillar 2 is the core of the three pillars and is the foundation for the continuation of the accustomed standard of living. The bad news is that around 40% of employers in Cyprus do not offer a pension scheme to their employees. This segment of the working population ought to turn to Pillar 3 and consider the various investment plans that exist in the market and at the same time encourage own employers to consider setting up a pension scheme.
Pillar 3 – Private retirement savings
These are voluntary private savings to cover additional retirement needs. They might include savings in bank deposits or fixed income products or investments in financial instruments. Whereas in many countries such savings can be set up in tax deductible schemes, in Cyprus such schemes are not yet tax deductible.
Management of assets
With the retirement needs calculated and pension plan implemented via the three-pillar approach, the final and equally important step is how contributions made to Pillar 2 and 3 will be invested. The majority of pension savings in Cyprus, both in the public/private sectors and the social insurance funds are sitting in bank deposits earning close to zero interest. While they are seemingly safe, in actuality their value is deteriorating due to the rise in the cost of living. Inflation rate in Cyprus averaged 3.68% from 1951 until 2018. What this translates to is a loss of approximately 50% of the buying power of money within 20 years if the funds earn no interest. In 20 years, the buying power of €20,000 in today’s money will be around €10,000.
Compound interest
According to Einstein, compound interest is the eighth wonder of the world. He who understands it earns it, he who doesn’t, pays it. Saving and investing, especially at a young age, will potentially maximise the benefits of compounding (compound interest means that you begin to earn interest on your interest, resulting in money growing at an ever-accelerating rate thus creating a snowball effect). However, for this effect to materialise, investments must earn a return. Saving and investing in bank deposits that earn little to zero interest will not take advantage of the compounding effect.
The following example illustrates why it is vital for pensions to be invested in financial instruments that have the potential of earning returns. Investor A contributes €200 per month for 35 years with a yearly return of 0.5%. Their contributions will be €84,000 and the estimated total after 35 years is €94,000. Investor B contributes €200 per month in financial instruments but instead earns a yearly return of 4% due to the higher risk undertaken. Their estimated total return will be €182,746, almost double the amount compared to investor A.
Thanks to the miracle of compound returns, the earlier you invest the more it will be worth when you retire, given of course that a well-thought investment strategy is followed with global diversification. Pursuing one’s retirement goals is not a complicated affair. It involves three steps: planning, implementing and finally ensuring a prudent investment methodology is adopted.
Christis Michaelides, BA, MSBA, MCIM
Ancoria Insurance Public Ltd
