A popular approach to saving for retirement is to divide your working life into stages and adjust the risk profile of your investments accordingly. But this strategy is under question in some quarters as being too risk-averse in the final stages. We take a closer look at life staging and its alternatives.
The closer you get to retirement, the more meaningful is the effect of compound interest (or market returns). In the five years before retirement your contributions will be a mere fraction of your investment returns. In some cases, your investment returns, particularly in times of buoyant markets, could even outstrip your annual income.
But the potential volatility of investment markets as you reach retirement scares many people into moving into lower-risk, mainly cash investments. This approach falls under the fairly broad church of retirement planning called life staging, in which your investment risk profile is determined by how close you are to retirement.
The argument is that equity markets are high risk and could crash shortly before you retire, leaving you seriously out of pocket. A prime example is when the FTSE/JSE All Share index crashed from a dizzy height of 33 000 in May last year to a low of 17 814 in November. That represented a 46-percent fall in listed equity values.
Imagine if you retired on that awful November day. But equally, your retirement day could have been on the sunny autumn day in May.
Earlier this year, in the newspaper version of Personal Finance, which is published in all the Saturday newspapers in the Independent News & Media group, Richard Carter of Allan Gray said that to blindly move your entire portfolio out of equities into cash in the years before retirement is madness.
Carter says: "It is the last few years before retirement that will provide you with the benefits of compound interest."
He pointed out that the mean after-inflation returns for South African asset classes from 1905 to 2005 were: equities 7.3 percent a year, on average, and bonds 1.8 percent a year. This sort of return disparity is going to have an impact on your end result.
Carter assumed that on an initial salary of R100 000 a year, growing at a real (after-inflation) one percent a year, and with real (after-inflation) investment growth of five percent a year, at retirement 40 years later you would have R13 125 265. But if, five years before retirement, you switched to a cash portfolio that provided a zero after-inflation return, you would end up with R10 988 003. That is a difference of more than R2 million, or almost 20 percent.
At the point five years before retirement, the amount saved was R7 369 860, which shows the power of compound interest. Most of the growth came from investment performance, not retirement fund contributions.
But a 20-percent difference in retirement capital means that if you purchase a guaranteed annuity (pension), the pension will also be about 20 percent less, and that is for the rest of your life. This is a significant impact.
The problem is that very few people can determine whether their retirement date will be on a glorious day in May 2008 or on a jump-out-of-the-window day in November 2008.
Most occupational retirement funds have pre-set retirement dates. Many will allow you to retire early but the pre-determined final date is fixed.
No single solution
in simple terms, if markets crash shortly before your official retirement date you could be in serious trouble if your retirement savings are in equities to the maximum permissible. But if you had transferred to a cash portfolio five to 10 years before retirement, you would have also done yourself a serious disservice if markets did not crash.
However, the argument of how you manage your retirement savings shortly before retirement cannot be based on the returns of different asset classes alone. Serious product providers and advisers are aware of the problem, but there is quite significant disagreement about how to address it.
On three things all agree:
- All the asset classes - equities, bonds, property and cash - must be used to get the best (targeted) returns for the most acceptable level of risk.
(Note: Regulation 28 of the Pension Funds Act requires that retirement savings be invested in an investment portfolio diversified by asset type. For example, the portfolio in which your retirement savings are invested may not hold more than 75percent in equities. But the risk profile - in terms of volatility or the propensity of the investment to swing widely in value - of the portfolio can still be dramatically altered by reducing the equity proportion to, say, 40 percent and increasing the interest-earning investments by the equivalent amount. The lower the percentage of equities in the portfolio, the greater the risk that you may not receive inflation-beating returns, at least not at the level required to give you a financially secure retirement. The reason is that, historically, listed equities have out-performed other asset classes over the longer term.)
- A single, balanced portfolio, with the same underlying percentage in the four asset classes, from the first day of work through to the day of retirement, may not be the answer.
- You cannot take the simplistic approach of "the more money I have on the day I retire the better my retirement years will be".
Independent actuary Rob Rusconi, who blew the whistle on the high cost of life assurance retirement savings products, says one of the problems in dealing with this issue is the way risk is considered. Risk, he says, is not merely the propensity for an asset to swing in value. There are other risks, such as not having saved enough money for retirement.
Actuary Karen de Kock, the head of annuities at Sanlam, says that far too much attention is given to the build-up of savings relative to what happens at and in retirement.
Yet another actuary, Rowan Burger, at asset manager Stanlib, underscores this by pointing out that, depending on various assumptions, only 32 cents of every R1 of your pension will come from what you (and your employer) contributed to your retirement savings; 38 cents will come from investment returns before retirement; and the balance of 30 cents will come from investment returns after retirement. The reason for this is that at retirement your wealth is at its maximum and, under normal circumstances, your retirement savings will be receiving maximum returns. If you buy an annuity, the assurance company earns the interest and passes this on in pension payments.
Defined contribution funds
Until the major advent of defined contribution funds in the late 1980s and '90s, the matching of retirement savings to pensions did not really matter because, in most cases, you moved seamlessly from being a contributing member to being a pensioner, all as a member of the same fund.
Defined contribution funds changed all this. You became responsible for choosing your own pension, with a wide range of choices on offer (see "Annuities available to you on retirement" below).
It soon became evident, however, that it was not simply a case of reaching retirement, taking your money and buying a pension.
The financial services industry has been playing catch-up over the past few years, trying to solve this perplexing problem by finding the most efficient and cost-effective way to manage the transition from saving for retirement to being in retirement. (See "New ways to structure the path to a pension".)
In recent years, what is called life staging has become a popular choice. But life staging can mean many things. In its most simplistic form it deals primarily with volatility risk, switching you from volatile assets (equities) to mainly cash in the years shortly before retirement. This causes the problem detailed by Carter.
But there is not even agreement on whether life staging is the answer (see "Life stage vs lifestyle").
It is worth considering that most retirement fund investment strategies, in which members are not given any choice about underlying investments, aim to provide a percentage of final income, known as the income replacement ratio (IRR), of between 70 and 80 percent after 35 to 40 years of membership.
In the case of a defined benefit fund, the IRR is guaranteed. With a defined contribution fund it is simply a target, not a guarantee.
In defined benefit funds, such as the giant Government Employees Pension Fund, the target is easier to achieve because the move from being a contributing member to a pensioner is seamless and any downturn in the market on retirement day is unnoticeable for the retiree.
On the defined contribution side, where you have to take the money and buy a pension, the length of the investment period, combined with the required diversity of asset classes, should even out some of the market volatility. In other words, the average 20-percent-a-year increase in equity values leading to May 2008 (and other above-average periods) will, on average, more than cancel out the bad years.
Burger says: "We need to move away from defining investment risk as being market volatility. Your main risk is the risk of not being able to meet your liabilities, namely your required pension."
In other words, the issue is not about measuring investment returns but matching your liabilities to your assets at retirement. Your liabilities are what you need as a pension and these need to be matched to your retirement savings at retirement.
Making the switch
Rusconi argues that it is the type of annuity you purchase that is the most important consideration in what your investments should look like at retirement, not an expectation of whether markets will crash or not.
He says the best way to protect the capital value of your retirement savings is to switch to cash.
"Obviously, the switching process itself is not risk-free, so this needs to be done with care, usually over a period of time, but this is a separate issue. If you are in cash, your capital is guaranteed not to fall and will rise a little as well.
"But this is a good strategy only if you plan to spend the money at retirement. For any other purpose that involves investment, cash is not good," Rusconi says.
The reason is that for your money to provide you with inflation-beating returns you have to be invested in asset classes other than cash. So if you move into cash before retirement you would run another risk when you switch back into those investments.
So cash is good for cash, and similar arguments are true for any other pension structure you may use at retirement.
For example, in a traditional life assurance guaranteed annuity, in which your pension is guaranteed at least until your death, the switch before retirement should be into bonds, since the asset class used by the insurers to back your pension (annuity) is bonds.
"The best way to protect against movements in bond market rates is to invest in bonds ahead of the time. Your bond portfolio does not provide capital protection, of course, because its value rises if interest rates (technically, bond yields) fall but falls if interest rates (yields again) rise.
"But annuity prices also vary with bond yields. When interest rates are high, the income provided by a guaranteed annuity is high and the cost of a certain income stream is low. And the reverse applies when rates are low.
"So, if before retirement you are invested in bonds and if yields fall, the value of your portfolio rises. This is almost precisely offset, however, by the worsening terms available on guaranteed annuities (caused by the fall in bond yields) and you are in the same position as you would have been had yields not fallen.
"If, on the other hand, yields rise, the value of your portfolio falls. That's not a disaster, though, because the portfolio is used to purchase nominal annuities, which now offer better value thanks to the yield increase. You are in the same position as you would have been had yields not fallen," Rusconi says.
But if you want a guaranteed annuity that will increase in line with inflation, then the best match is inflation-linked bonds.
If you want a pension that is based on the ongoing value of your assets, such as an investment-linked living annuity (Illa) or a with-profit annuity, then you should aim at having the same assets before and at retirement.
In simple terms, you need to match your assets (your retirement savings) with your liabilities (the reasonable pension you require). This clearly can be a moving target. Most people aim at an IRR at retirement, but different people have different income requirements in retirement. For example, one pensioner may want to travel abroad every year to visit children and grandchildren while another is content with tending a garden in a small Karoo town.
Prevailing view
So the dominant view is that you need to establish what you want to do in retirement and establish your retirement liability accordingly. An IRR is likely to be totally misleading for most people. It has problems apart from the percentage of final income targeted by an occupational retirement fund. Burger says these problems include:
- An excessive salary increase shortly before retirement. This is likely to depress your IRR below the targeted level.
- Periods of unemployment (particularly if accumulated retirement savings are not preserved). This will also take your IRR below the targeted level.
- Urgent short-term needs that reduce the amount you may allocate to savings, such as illness, a family bereavement or the education of children.
- Unforeseen "environmental" changes such as tax changes, any prescription on how assets must be invested and expected long-term average returns.
Burger says the best protection against all these problems is to save as much as you can as early as you can. Realistically, the vast majority of people simply will not achieve this because they cannot afford to.
He agrees with Rusconi that you need to manage the transition of your retirement savings to match the type of annuity at retirement. And you need to transfer your savings over a period into the matching structures to iron out market fluctuations. But this also presents a problem, namely getting advice. Most people do not understand the advantages and disadvantages of the various pre-retirement investment products and pension options. They need advice.
Burger says very few people have the savings that will excite a financial adviser. As a consequence it is probably best for occupational retirement funds to adopt the lowest-risk option that targets adequate pensions for the majority of fund members while allowing the sophisticated, who can afford advice, the flexibility to manage their own strategy. This, in turn, exposes yet another problem. The recent Sanlam Employee Benefits Benchmark Retirement Survey ( www.sanlambenchmark.co.za) revealed that the vast majority of occupational retirement funds that allow a fruit salad of investment choices push up costs for all fund members.
The result is that the lower-income, less financially sophisticated members who use vanilla options often have their pension benefits reduced by the costs of high-income members using more complex and expensive options.
If, as a member of an occupational retirement fund, you suspect that you have fallen behind in your retirement savings, it is hardly likely that you will be able to make up the shortfall with additional contributions. The reason is that you are limited to claiming a maximum of 7.5 percent in contributions of your pensionable income against tax and very few employers offer to make flexible contributions to your fund.
The only alternative is to additionally contribute to a retirement annuity where you are allowed to claim 15 percent of your taxable income that is not regarded as pensionable income against tax. Self-employed people are also allowed to claim 15 percent of their income.
In using a flexible-contribution retirement annuity, such as those offered by the unit trust industry, you will be better placed to make adjustments.
Most financial planners will set about defining how much money you need for retirement by establishing what lifestyle you reasonably want in retirement and then working back from there.
But even when you have these targets, there are, as Burger points out, factors that are beyond your control. These include projected real rates of return and the introduction of new taxes such as the now scrapped retirement fund tax, which reduced your savings by taxing interest, foreign dividends and net rental income before retirement. This means that there has to be active planning around your retirement savings, particularly as you approach retirement, to keep yourself on target. This will include such things as narrowing down your annuity choice, fine tuning how much you will need in retirement, topping up your retirement savings and, in a poor-case scenario, deciding whether you can, in fact, afford to retire and, if you have to retire, how you can generate an income in retirement without placing what retirement savings you have at additional risk.
- For Part II of this story see here.
This article was first published in Personal Finance magazine, 4th Quarter 2009. See what's in our latest issue