This article was first published in the third-quarter 2012 edition of Personal Finance magazine.
So you expect to retire from your defined contribution (DC) occupational retirement fund with a pension of 75 percent of your final pensionable pay cheque? The reason is this is what your fund’s trustees have, in your fund’s investment policy statement (IPS), told you they are aiming to give you.
At retirement, you decide you want to purchase a guaranteed pension that will escalate every year in line with inflation so that the buying power of your pension will remain constant. Then, at or shortly before retirement, you find out that your accumulated retirement funds will buy you a pension equal to only 60 percent of your final pay cheque.
So what went wrong and who is to blame?
The first thing you may do is to check regulation 28 of the Pension Funds Act. In your fund’s IPS, repeated mention is made of regulation 28, which sets down how, and the rules according to which, your fund’s trustees should invest your retirement savings in a prudential manner.
For “prudential”, you understand that your trustees should not take undue risks with your retirement savings. In other words, your trustees should not be investing in some hare-brained scheme dreamt up by a lunatic employer.
You discover that regulation 28 has:
* Rules about how much may be invested in any particular asset class, such as a maximum of 75 percent in equities (shares of companies); and then there are limits on how much can be invested in the shares of any one company. And to keep a lunatic employer at bay, no more than five percent of your fund’s assets may be invested in your employer’s company.
* A set of principles (since 2011), which, in effect, are a set of instructions to your trustees on how they should invest and protect your savings.
Among other things, the rules state that your trustees must “ensure that the fund’s assets are appropriate for its liabilities”.
The assets are what you have saved, and the fund’s liability is the pension you want to achieve. So, in your case, the fund’s targeted liability is sufficient money after 40 years of membership to purchase a pension equal to 75 percent of your final pensionable salary that will increase in line with inflation.
John Anderson, Alexander Forbes’s managing director: research and product development, says reasonable member expectations and trustee responsibilities in meeting those expectations are highlighted in other legislation and in Financial Services Board (FSB) notes. As with the principles in regulation 28, he says, many of these are broadly worded. For example, one FSB guidance note (PF130) states that boards of trustees are expected to identify the varying expectations and interests of current fund members and pensioners, and to ensure that those expectations are met and/or managed, if appropriate.
Anderson says the “expectations and interests of current members and pensioners” can vary widely. In most funds, this objective will relate to saving appropriately for retirement.
Despite their shortcomings, Anderson says, the replacement ratio (RR) objectives in an IPS are a useful way of capturing trustee responsibilities and member expectations, “although, in reality, they will be changing over time as conditions, member demographics and needs change”. The RR is the percentage of your final pay cheque that you can expect to receive as a monthly pension.
He also points out that the preamble to regulation 28 states that trustees have a duty to use a “responsible investment approach to deploying capital into markets that will earn adequate risk-adjusted returns suitable for the fund’s specific member profile”.
Anderson says on the basis of all these admonitions to trustees, he believes that trustees have a duty to ensure that their fund’s investment strategy is expected to earn adequate returns to meet your realistic expectations. It is not enough to base a fund’s investment strategy simply on historic investment market returns and interest rates.
You speak to your fund’s trustees to find out what has gone so badly wrong with your RR.
Anderson says your trustees will probably have a list of justifiable reasons why you did not achieve an RR of 75 percent. These reasons could include:
* You have not been a member of your retirement fund for 40 years. The RR calculation in your fund’s IPS is based on your belonging to the fund for 40 or 45 years, whereas you may have been a member for only 30 years.
* You received salary increases way above inflation over the 10 years before retirement. The consequence is that the returns on your retirement savings have not kept pace with the increase in your pay. The result is that your RR has reduced. To have kept your RR in line with your pay increases, you would have had to have increased your contribution levels.
* Interest rates have fallen since your trustees calculated the RR of 75 percent. Guaranteed pensions are based on long-term interest rates. In simple terms, a life assurance company takes the money with which you buy a guaranteed pension and uses it mainly to purchase long-term bonds at a fixed rate of interest. In effect, your money is lent to quality borrowers, such as governments, at fixed rates of interest over periods that may be as long as 20 years. So, if you retire when interest rates are low, the prevailing long-term interest rates will affect the level of your pension.
* The returns on your savings in your retirement fund were lower than anticipated because of the crash in investment markets in 2008.
Let’s say you have been a fund member for the required period of time, and the RR of 60 percent is a consequence of salary increases and changes in interest rates. You can then argue that your fund’s trustees should have:
* Taken action to counter the effects of those changes; and/or
* Warned you that your expectations of an RR of 75 percent would not be met because of the changes.
Your trustees, in turn, may argue that:
* You are a member of a DC fund, where your pension is not guaranteed as it would be with a defined benefit (DB) fund. All that was guaranteed was that your employer would contribute a percentage of your pay to your retirement savings. The trustees stated in your fund’s IPS that the RR of 75 percent was a target – not a guarantee – and warned that you may have to save more. In other words, you should have taken greater responsibility for your future.
* It would be impossible for your trustees at fund level and/or at individual member level to keep making adjustments to things such as investment mandates and the contribution rate to ensure an RR of 75 percent.
Your trustees would have taken various factors into account in structuring the IPS and the targeted RR. The main ones would have been:
* The contribution rates of both yourself and your employer;
* The expected and the required investment returns at acceptable levels of risk; and
* The required period of fund membership.
Anderson argues that your trustees do have access to tools that allow them to have “engineered a more accurate RR”. Referred to as asset/liability modelling (ALM), these computer-based tools enable the calculation of the impact, on an ongoing basis, of variables (things that change) such as current investment returns; future interest rates and therefore annuity (pension) rates; and pay increases and therefore contribution rates.
However, Anderson concedes that although they are useful, RR targeting and ALM exercises cannot solve many of the limitations of DC funds.
“The primary purpose of these tools is to assist trustees in identifying potential problems within funds so that corrective measures can be taken where possible, or member communication can be designed if required. These tools also offer a way to assess whether the fund’s objectives are still realistic,” Anderson says.
He suggests that a number of actions are available to trustees (some which would have to be agreed to by both employers and employees). Consideration could be given to:
* Altering the targeted return
In setting investment return benchmarks (minimum targets), which are normally expressed as a percentage above inflation, your trustees have to be realistic, taking account of risk. If, for example, the trustees’ mandate to the fund’s asset managers states the required return is four percent above inflation, the problem of an inadequate RR cannot be solved by simply increasing the required return to six percent above inflation. The reason is that the greater the return required, the greater the investment risks that may have to be taken to achieve it and the greater the chance that the investment performance will be below the original required return.
And this is with a fund with very limited investment choice. With a fund that offers its members a wide range of investment choices, the task of the trustees in setting required investment returns is virtually impossible. It would be possible only with a default option that the trustees offer to members who do not want to make investment choices.
If the default option is based on the life-stage approach to investing, it could, in fact, exacerbate the problem, because the life-stage structure lowers investment risk, and therefore potential returns, as a fund member approaches retirement. This reduction in risk would have to be reversed if a higher return had to be achieved, exposing a member who is approaching retirement to the very risks that the life-stage structure seeks to avoid.
Anderson says a life-cycle approach, rather than a life-stage approach – which is based on a fixed, one-size-fits-all framework – would allow trustees to set appropriate investment returns. The life-cycle approach recognises that different fund members have different needs at different times.
“With this kind of approach, one can put in place an appropriate default considered to be suitable for most members, with some other limited options where members can tailor the benefits to their needs. Within the life-cycle approach, affordability constraints would be taken into account, especially for younger members (who generally face more strain on their finances), as well as the needs of lower-income individuals,” Anderson says.
* Increasing the contribution rates
This is a question of affordability, both for your employer and the fund members. Affordability would have been the biggest single factor in setting the contribution rates in the first place.
Employers are hardly likely to increase their contribution levels according to market factors. Among other things, it would make budgeting very difficult, and it would be akin to re-introducing the principles of a DB fund, where an employer is obliged to make up any shortfall to provide a defined pension.
Members, particularly lower-income members with families, may have more important short-term priorities, such as paying off housing loans and educating and feeding their children, than increasing their retirement fund contributions.
And there is a tax limitation in the case of fund members who are prepared to increase their contributions. It is pointless, in most cases, to increase your contributions above the 7.5 percent of pensionable salary you are allowed to deduct from your taxable income.
Anderson says that proposed changes, scheduled to be introduced next year, to the tax-deductibility of retirement fund contributions will give fund members better contribution options and will allow trustees to adopt a more life-cycle-orientated approach.
Trustees (depending on how remuneration packages are structured) will be able to introduce compulsory or voluntary contribution rates up to 22.5 percent (total from members and their employers) for members younger than 45, and 27.5 percent for members who are 45 or older.
Fund members who can afford to top up their contributions will benefit from the changed structure, because they will be able to use their occupational funds, which, in general, have far lower costs than private sector retirement annuity funds.
* Assessing costs
Trustees should be aiming to achieve maximum cost-efficiencies all the time. However, Anderson says, this should not be a cost-slashing exercise, because some costs could positively affect RRs. For example, a successful communication or education campaign may cost something, but it may improve RRs, because the campaign could result in members preserving their savings, saving more for retirement or making better annuity choices.
He suggests that trustees need to consider costs relative to their benefits and their effect on RRs.
* Assessing assurance premiums
Currently, along with membership of a retirement fund, most risk life assurance structures, which provide benefits if you die or are disabled before retirement, are a condition of employment.
Most risk assurance benefits are based on a multiple of salary, no matter what your age. But some members, mainly older members, may wish to have a higher savings contribution rate and less risk assurance; whereas others, mainly younger members, will want as much risk cover as possible.
The level of cover is not simply a matter for the trustees to decide but is also a condition of employment. It is not something that can be altered at will.
However, Alexander Forbes advocates a more life-cycle approach to benefits, in which you tailor the benefits to meet your needs.
* Altering the retirement age
Delaying retirement will improve your RR, but this is also more of an employer-employee issue, because employers aim at the most optimal, cost-effective use of labour rather than considering whether or not you have saved enough for retirement.
However, Anderson says, employers should start considering the retirement ages of their employees in more detail.
He says the Alexander Forbes Pensions Index highlights that different generations of fund members have different expected retirement outcomes. Demographics are changing and are expected to do so more rapidly in future – employers should be looking at what this means in terms of members’ retirement ages.
If your trustees have tried all the above strategies to improve your RR so that it is more in line with the one projected in the fund’s IPS but without success, Anderson says they should use RR projections to warn you of the potential shortfalls.
Anderson says the earlier you are warned, the more chance you have of correcting the problem. You can then attempt to make adjustments to your financial plans. At a minimum, a warning will give you an opportunity to prepare yourself for a poor RR and a tight financial situation in retirement.
It is important your trustees do not create the expectation – or that you have the expectation – that the projected RR in an IPS is what the fund will achieve, he says.
You need to understand that the RR is a target, with your ultimate expectation limited to whatever your DC account (contributions plus investment returns) provides and whatever pension you decide to buy. Your trustees need to set out clearly in the IPS that your fund is not promising a particular RR, but instead that the RR is a target to see whether you are on track for a financially secure retirement.
BETTER INSIGHT INTO THE PENSION YOU CAN EXPECT
Pension fund services provider Alexander Forbes has structured a pensions index so that retirement fund members can see, as a general guide, how various factors are likely to affect their pension payments.
John Anderson, Alexander Forbes’s managing director: research and product development, says the Alexander Forbes Pensions Index aims to help members of defined contribution (DC) retirement funds track how their projected income in retirement may be affected by market forces. However, Anderson warns that the index is not a substitute for personal assessments of a fund member’s financial circumstances or for obtaining advice from a professional financial adviser.
The pensions of DC fund members are mainly a result of how much they save and the investment returns on their savings. Therefore, market forces can have a significant effect on how much money you will have saved for retirement and how much you will need to purchase a sustainable pension.
The index tracks how the projected replacement ratio (the pension as a percentage of final salary) will change based on actual investment returns and future expected returns (before and after retirement), as well as the impact of changes in real (after-inflation) interest rates on the cost of annuities (pensions).
If real interest rates increase, the cost of annuities falls, and vice versa. Real interest rates also have an impact on expected returns up to retirement (through the pre-retirement investment return assumption), as well as on the cost of retiring.
Anderson says although members of DC funds may have access to projected retirement benefits, it is difficult for them to interpret what constantly changing investment markets, economic conditions and annuity prices mean for their retirement benefits.
The index provides values that indicate how the projected retirement income for typical fund members has changed, and will change, from January 2002, he says.
The index is calculated every quarter, based on three savers born on January 1 in 1972, 1962 and 1952. On January 1, 2002, they were 30, 40 and 50 years old respectively and all of them expected to be on track to have a pension that replaced 75 percent of their pre-tax salaries when they retired at age 65. So, for each saver, their index value was 75 on January 1, 2002.
On March 31 this year, the index values were 57 for the 50-year-old, 46.4 for the 40-year-old and 39.9 for the
30-year-old. In other words, the saver born in 1952, who is now 60 years old, is expected to be on track to receive a replacement ratio of 57 percent, and not 75 percent, because of changes in investment market conditions.
Anderson says the index values show just how much the projected retirement incomes have changed in recent years and how the projected retirement incomes are now very different for savers of different ages.
All three savers were invested the same way. However, the saver born in 1952 has a considerably better index value than the saver born in 1972.
Anderson says the index highlights the fact that the retirement savings landscape has changed. The investment outlook today is considerably gloomier than it was 10 years ago.
Anderson warns that “younger fund members are expected to be invested in these less favourable markets for longer. In addition, individual salary inflation (which includes general increases and increases as people progress in their careers) has been high relative to investment returns in recent years. This decreases the index, because past savings are proportionately lower relative to the current salary, and this effect is amplified over the time to retirement.”
He says although younger fund members have time on their side to rectify the problems, the index shows that they are, in fact, more sensitive to market conditions.
The younger generation of fund members faces two additional challenges:
* Improvements in longevity are difficult to predict and hence securing a pension might be considerably more costly for younger savers than for older savers, because they will be pensioners for longer; and
* High levels of consumption among younger members mean they will need more money in retirement to maintain their lifestyles, but they have less money to save.
Anderson says that retirement funds and employers may have to consider different approaches for different generations of members.
Retirement funds may already have different investment options and death benefits for older and younger members. Differentiated retirement ages, contribution rates and benefit targets may be the next logical step to help members of different generations.
HAVING TO BUY A PENSION PUTS YOUR SAVINGS AT RISK
One of the major ill-considered, unintended consequences of the tidal wave-like move in the 1990s from defined benefit (DB) funds to defined contribution (DC) retirement funds was the high cost of converting your savings to a pension provided by the financial services industry.
Under the old DB fund regime, you, as a contributing member, seamlessly and at no cost became a pensioner, with your pension paid by the fund. The reason was that your pension was defined and, to a large extent, guaranteed by your employer.
In those days, employers effectively controlled occupational retirement funds, and they were not going to allow you to make any mistakes that would see your buying the wrong annuity and then come knocking on their door if you ran into financial difficulties.
But following the great dash – spurred on by trade unions and employers – to DC funds, there was no need for employers to protect their back-pockets, essentially from any stupidity from fund members, so the door was opened for members to select and buy their own pensions from the financial services industry.
And the industry was quick to jump in with expensive and often complex products that can substantially reduce your pension – with the problem often compounded by bad commission-driven financial advice.
For example, National Treasury, in highlighting the problem of costs, recently estimated that the total cost of the product provider and any advice for an investment-linked living annuity (illa) will reduce a pension by about 20 percent a year. This is apart from the risks of choosing the wrong annuity, making high-risk investment decisions or withdrawing too much from an illa.
The other advantage of a DB fund is that members were not subject to the effects of changing interest rates when purchasing their pensions. When you retired, you received the benefit you were promised based on the number of years of fund membership and your average final pensionable pay cheque.
Now, if you select a guaranteed annuity, the amount you receive at retirement will depend on the prevailing long-term interest rates, because life assurance companies that provide the guarantees use your money mainly to buy long-term bonds (they lend your money to governments, parastatals and companies). So if you retire when interest rates are low, you will receive a far lower pension than you would have received from a DB fund.
It is this “new” variable of buying a pension, with its potential for making the wrong choice, high costs and low interest rates, that is causing headaches for members at retirement and in retirement.
Asset/liability modelling while saving for retirement can counter some of the impact on your eventual pension. In other words, when interest rates are low, you have to take counter-measures, such as saving more.
Government, in its moves to reform the retirement industry, has opened discussions on the annuity (pension) issue. National Treasury has proposed a number of changes. These include:
* The use of low-cost annuities by retirement fund members as the default option in retirement. In other words, when you retire, if you do not make an active decision to choose another type of annuity – such as a high-cost, potentially high-risk illa – your fund will simply buy you a pension from the source chosen by your fund’s trustees. This will result in an immediate cost benefit, because no commissions will be involved and the fund will be able to negotiate a more favourable pension on your behalf than you, as an individual, would be able to do.
* The introduction of simple advice-free pension products that will compete on costs alone. It has been suggested that these products may not be made subject to the requirements of the Financial Advisory and Intermediary Services Act, so they can be used by retirement fund trustees as default choices.
* The introduction of a Treasury-sponsored illa based on RSA Retail Bonds, as well as opening the pensions market to other providers, such as collective investment schemes, which include unit trust funds and exchange traded funds.
* The introduction of guaranteed annuities that are individually risk-rated in a similar way in which life assurance company assess their risk when selling you life assurance. This includes assessing factors such as your age, gender, lifestyle, job and, in particular, your state of health.
Currently, with guaranteed annuities, the only differentiations made between pensioners are based on:
– Age. The older you are, the higher the pension, because your life expectancy is shorter – the life assurance company will have to pay a pension for less time.
– Gender. Women receive a lower pension, because they are expected to live for longer – they will receive a pension for more years than men.
However, the rich also live for longer than lower-income earners, because they can afford healthy lifestyles and top-end medical care, which promote longevity.
Lower-income people tend to die at a younger age, because they cannot afford to lead healthy lifestyles or access to good medical care. By dying earlier than wealthier pensioners, they in effect subsidise the rich, because the poor receive pensions for far shorter periods.
John Anderson, Alexander Forbes’s head of research and product development, says although the choice of retirement vehicle is outside the responsibility of fund trustees, they should at least consider the typical choices available to members and start to think about offering pre-retirement portfolios that attempt to make the transfer at retirement as seamless as possible.
In the 10 years before retirement, your trustees should be considering default options for you that will meet the objectives of your fund, such as providing a pension that is close to the targeted pension as a percentage of your final salary, Anderson says.
“Recent research shows that the ‘inertia’ people show in engaging with their retirement saving or making changes to this can be used by trustees to benefit members by placing them in well-thought-out defaults, which would also depend on member requirements and objectives.”
He says some retirement funds offer two or three default channels that target different types of annuities at retirement, such as with-profit annuities, illas and inflation-linked annuities.
Anderson says your trustees should also assist you by having a proper communication (education) policy. The policy should include educating members about:
* The importance of preserving your savings before retirement;
* The threats to achieving a targeted replacement ratio, such as investment market forces, salary increases, and interest or annuity rates;
* The need for additional savings (and the vehicles you can use); and
* The annuity choices at retirement.