Building The Foundation Of Your Retirement Savings

This is going to be a simple post because the idea is pretty straight forward.

We may all retire some day. Some aspire to do it as soon as possible (such as those in the the FIRE movement), while others choose to delay it as long as possible since there’s pretty much nothing else productive to do at home right?

If you wish to live a comfortable retired life then you will need a suitably sized nest egg that generates sufficient returns so that it runs out, ideally and bluntly, when your life does.

The good news is that starting your retirement savings is almost automatic if you are an employee. This is because your company will help you deduct a portion of your salary and deposit it in a retirement savings fund.

Malaysia’s Employee’s Provident Fund (EPF)

In Malaysia, such a fund would commonly be the EPF. By statutory law, the employer will match and exceed your contribution. For every 11 ringgit that you contribute to this fund the employer will fork out 12 or 13 ringgit. Starting 2019, up to RM4,000 of annual contribution to your EPF account will be eligible for tax relief.

The EPF then takes the money and invests it in bonds, stocks, real estates and infrastructure projects. The returns in the last decade has been very stable at around 6%. Even during the terrible 2008 global financial crisis, the EPF still gave a dividend of 4.5%. Comparatively, the KL Composite Index lost 40% that year. What’s also astounding is that it operates at a low cost of around 26 sen for every RM100 that it manages.

Malaysia’s Private Retirement Scheme (PRS)

The alternative to the EPF is the Private Retirement Scheme (PRS). These are essentially mutual funds managed by banks so they come with much higher management expenses (between RM1.00 and RM1.80 for every RM100 managed, gulp!!) and most funds also charge a sales fee of up to 3%. The only saving grace is that you get a tax relief of up to RM3,000 contributed to the fund. I’ll write a separate post to compare the returns of PRS funds to the EPF in the future but the main point here is that sales fees and management fees take a toll on the long term returns of the fund.

US 401(k)

In the US, an equivalent of the EPF/PRS is the 401(k). Your contributions to the 401(k) comes from your pre-taxed income. In other words, you will reduce your taxable income by the amount that goes to the 401(k) (which is similar to a tax relief). However the IRS sets a limit on how much you can contribute to the 401(k) each year so you cannot put all your salary into the 401(k) to avoid paying income tax. Comparatively, there is no limit how much you can contribute to the EPF – contributions below the tax relief cap is like ‘pre-tax’ while contributions above the tax relief cap is like ‘after-tax’.

Similar to the EPF, the employer will add to the employee’s contribution to the 401(k) except that the amount is only partially matched by the employer.

The 401(k) is similar to the PRS in the sense that you get to choose how to invest your 401(k) fund. There are numerous retirement funds to choose from and they automatically adjust the proportion of stocks to bonds from year to year to gradually reduce the risk to your retirement fund as you approach your formal retirement age. Their expense rates are around 70 cents for every $100 managed (2.5x higher than the EPF). Its long term returns are around 6%-9%.

When you eventually retire and withdraw from your 401(k), your withdrawal will then be taxed like a regular income. Nothing escapes the US tax man. Comparatively EPF withdrawals are not taxed so you get to keep all of it, including the dividends.

US Roth IRA

The alternative to the 401(k) is the Roth IRA. The Roth IRA is a bit similar to the PRS in Malaysia. You contribute after-tax dollars instead of pre-tax dollars. In other words, contributions to the Roth IRA are taxed as part of the income tax. And just like the PRS, the employer is not legally required to top up or match the employee’s contribution.

When you eventually retire and withdraw from the Roth IRA, the withdrawal will not be taxed.

The EPF and PRS in Malaysia as well as the 401(k) and Roth IRA form the foundation of your long term retirement savings. Build it up over your working career and let compounding interest do its magic. As much as possible, protect this nest egg and resist the urge to withdraw from it until you retire.