Perhaps the most crucial factor that will determine whether you will have sufficient income in retirement is how your money is allocated among the various asset classes over the course of your working life. Equities provide the inflation-beating returns you need to grow your nest-egg, but market volatility, especially as you're about to enter retirement, can be disastrous. We look at different approaches to structuring your investments for growth and security.
Does your retirement fund or retirement annuity (RA) fund offer you a range of investment options? If so, how much choice are you given? Do you use it? And do you use it wisely?
Sanlam's annual survey of retirement funds found that in 2007 some 43 percent of funds offered their members a choice of investments - down by one percentage point on the previous year.
Of the members of these funds, 64 percent chose the default investment portfolio that had been pre-selected by the funds' trustees. In other words, most fund members do not exercise their right to choose, even when they have it.
And to make matters worse, the survey found that most principal officers believe that while 93 percent of senior managers who belong to retirement funds understand more than half the financial advice they receive, only 50 percent of other fund members comprehend what they are told. This would include the advice they receive on investment choice.
The providers of financial products are adamant that the investment choices you make or fail to make about your retirement savings will affect how much money you will have in retirement. However, they disagree over what choices you should be given and how to make the right choices.
The risks and returns of the options you choose - in particular how the assets are combined - will determine how much money you will have in retirement.
Many retirement funds may drastically limit your choices to, for example:
- A market-linked balanced, or managed, port-folio, where the value of your savings rises and falls in line with the values of the underlying investments. The underlying investments are mainly in shares, property and bonds (chiefly those issued by the government), as well as interest-earning investments.
- A capital-guaranteed product. This is likely to be a cash-only, interest-earning portfolio or a life assurance product that guarantees all or part of your capital and is invested in an underlying portfolio of shares, property, bonds and cash. Your returns are declared annually as bonuses. The bonuses often come in two forms: guaranteed and vesting, and/or non-vesting. If the markets are performing particularly badly, the non-vesting bonus can be taken away.
At the other extreme, an increasing number of occupational retirement funds, and particularly RAs sold by the financial services sector, offer you an extremely wide and intimidating level of choice, from risk-adjusted portfolios to allowing you to construct your own portfolio by selecting from, in the main, a range of unit trust funds.
The hit-and-miss approach to investment choice is being phased out on the back of the requirement of the Financial Advisory and Intermediary Services Act that you receive appropriate advice, the increasing emphasis, in terms of the Pension Funds Act, on keeping you informed about how your savings are being managed and threats of tighter legislation.
Discussion papers emanating from the government's retirement reform process indicate that the National Treasury wants to limit investment choice because of the consequences of fund members' bad choices in the past and the costs of giving members a wide range of choice.
The problem lies with the history of retirement-funding. For many years, all that was on offer were employer-sponsored, defined benefit pension funds, which were both savings vehicles and payers of pensions. All the assets were, in the vast majority of cases, handled in a single portfolio. In other words, a pensioner member was de facto invested in the same number of shares as a 20-year-old who had just joined the fund, with 45 years to go until retirement.
When defined contribution funds made their appearance in the 1980s, their assets were managed in much the same way as those of defined benefit funds - using managed funds, with or without guarantees.
This meant that everyone's retirement savings - those of both pensioners and members - were all in the same pot of assets and were managed according to exactly the same asset allocation.
This became increasingly unwise, because, with the move to defined contribution funds, pensioners - either by choice or because they were forced to do so by their retirement funds - took their pensions outside their funds. Many pensioners opted to purchase investment-linked living annuities (Illas), while funds also outsourced their pensioners to life assurance companies.
These developments have reduced funds' risk pools, leaving members who are nearing retirement exposed to the volatility of equity investments. But these trends have also left younger members exposed to investment portfolios that do not have sufficient equities to provide these members with the superior investment returns they require.
The answer has been to provide members with a greater choice of investments in the build-up to retirement. But, even when the choices are limited, many fund members do not understand the consequences of their decisions. Too many members opt for low-risk, low-return products, which result in them having insufficient money in retirement.
The Sanlam research reveals that, of the retirement funds surveyed, 85 percent of members prefer stable investment returns and 63 percent consider guarantees on benefit payments to be important.
Dawie de Villiers, the chief executive of Sanlam Structured Solutions, says that generally speaking fund members need to maintain almost the maximum allowable exposure to equities for the bulk of their working lives to ensure they derive the highest long-term, real (that is, inflation-beating) returns.
Will you have enough?
Andrew Davison, the head of institutional asset consulting at financial services company acsis, says four major factors determine how much money you will accumulate by the time you reach retirement. They are:
- The percentage of your salary you save towards retirement every month;
- The period over which you save, which is affected by when you start contributing, your expected retirement date and whether you preserve your accumulated savings when you change jobs;
- The investment returns you earn; and
- The fees that are deducted.
These four elements must be properly balanced to ensure you have a comfortable retirement. The investment return required by each person, and hence the structure of his or her investments, is dependent on the other three factors, Davison says.
Retirement fund product and service providers agree that fund members must have a sizeable percentage of their retirement savings invested in equities at all times.
Most product providers say you, the fund member, should be offered products or investment options that give you the opportunity to put your savings into higher-risk, but historically better-performing, shares in your early working years and then allow you to switch into a more conservative capital guaranteed portfolio or cash portfolio as you near retirement.
They also agree that deciding on the appropriate investment portfolios for saving for retirement should not be a separate exercise from deciding how you will invest your money in retirement.
For example, Ant Lester, the chief executive of actuarial consulting company Fifth Quadrant, says the composition and risk profile of your retirement savings while you are saving depend on how you plan to use your capital in retirement. For example:
- If you plan to purchase an Illa, your asset allocation should be transitioned to a reasonable asset allocation for a living annuity at your retirement age.
- If you plan to buy a guaranteed escalation or level annuity, your assets should be transitioned into a long-dated bond (the matching assets off which the guaranteed/level annuity will be priced).
- If you intend to use a with-profit annuity, cash is best, because insurers don't vary their with-profit pensions in relation to equity market conditions.
Lester says this is an "inefficient solution", because you get out of equities before retirement, only for the life assurer to go back into equities once the with-profit pension is secured.
If life assurers varied their price according to the values of all the assets - including the equity values - in the with-profit portfolio, the strategy of matching the asset allocation in your retirement savings immediately before retirement with the asset allocation of the with-profit annuity would be correct.
- Cash is suitable for any part of the one-third of the tax-incentivised retirement savings you intend to commute to a cash lump sum.
The key point is to structure the assets to "match" the pension structure you intend to use in retirement and to transition the asset allocation gradually to this position, Lester says.
Lifestage approaches
Most financial advisers and product providers agree that some type of lifestage strategy (based mainly on the number of years you have until retirement) and the type of annuity that you will buy must be taken into account when saving for retirement. But they do not agree on how this should be done.
For example, Davison warns that you cannot adopt a simple low-risk/low-return strategy in the five years before you retire, because this is the period in which you will have accumulated most of your money, and low returns can dramatically undermine how much money you will have in retirement.
Craig Aitcheson, the head of Old Mutual Actuaries and Consultants (OMAC), warns that you need to be wary of a cash-based strategy as you near retirement. "You may forfeit additional returns by being in the most conservative asset class for the three to five years before retirement."
Lester says a low-risk strategy, using cash or even a conservative market-related portfolio, may be a high-risk strategy in terms of providing adequately for retirement (because of low returns).
Most of the differences of opinion over lifestage strategies concern what percentage of your investment portfolio you should have in equities as you near your retirement date.
Stuart Wenman, Liberty Life's managing director in charge of technical sales and distribution, says as a general rule the asset class structure of retirement savings should be changed over time to reflect both your intended "post-retirement" investment strategy, and the fact that as you get closer to retirement you probably want more certainty around the level of income you will receive after retirement. Hence you should reduce the level of expected volatility in your investment strategy over time.
"Younger members can afford to invest in more volatile assets (with the aim of maximising growth) as they have time on their side. The longer your investment horizon, the more volatility you can absorb. This means you can ride out the market downturns, which an investor closer to retirement is unlikely to be able to do. For these investors, greater certainty about the level of their income in retirement becomes more important, and hence there is a shift in focus from wealth creation to wealth preservation," Wenman says.
A lifestage portfolio approach provides the option of selecting upfront a predetermined investment strategy that has been developed over time to meet the "typical needs and objectives that drive investment thinking and attitudes to the volatility in the build-up to retirement", he says.
Aitcheson says Old Mutual supports the lifestage approach. He says, generally speaking, individuals with many years to retirement can tolerate more risk than those closer to retirement. This is because it is more likely that markets would have recovered from a strong downturn over a longer time period.
He says research by OMAC has shown that South African equity markets have historically taken 61 months or less to recover from a market crash. A balanced fund with a spread of asset classes would have recovered its losses much quicker depending on the asset allocation.
Aitcheson says fund members need protection in the six to 10 years before they retire, but don't need protection throughout their working lives, particularly if they preserve their retirement savings when they change funds.
Old Mutual believes the most efficient investment strategy involves investing in funds that offer protection for members who are close to retirement. This reduces the members' exposure to market risk near retirement but does not involve sacrificing returns at times when they do not need protection.
One size does not fit all
Retirement funds have historically protected their members' savings by either investing conservatively or by investing in products with explicit capital guarantees.
However, this is not good for members, because a conservative investment strategy will, on average, produce lower returns than a more moderate strategy and hence will, on average, produce lower retirement benefits, Aitcheson says.
Davison says this is where an age-banding approach is fundamentally flawed, because it equates age to perceived risk tolerance, where risk is taken to be volatility, and it ignores the needs and time horizons of individual members.
Although age-banding purports to address the needs of all members regardless of their age, it ignores the unique circumstances of each member and takes no account of their lifestyle needs and goals, and therefore their investment objectives.
He says this point can be illustrated by considering two members who belong to a fund that adopts an age-banding approach. Both members are aged 40, so they would be allocated to the same investment portfolio. However, one member joined the fund recently and has not preserved his accumulated retirement savings. The other member, who joined the fund after graduating from university, has accumulated a considerable amount and understands the need to preserve her savings when changing employers.
Davison says, alternatively, the two members' circumstances could be the same, except that one member will have a much higher level of future expenditure because, for example, his child has a chronic illness or he is living beyond his means.
Thus, these two members, although they are the same age, have substantially different requirements from their fund.
Davison says it would not be appropriate for either of them to have the same investment strategy simply because they are the same age.
He says the problems with an age-banding approach are exacerbated by the fact that many funds now offer flexible contribution rates. It is likely that two members of the same fund could have vastly different contribution rates and yet be placed in the same age-banded investment strategy.
He says a common flaw in the age-banding approach is to begin the migration from a growth to a conservative strategy too early.
"It is really only appropriate to begin switching to a more conservative strategy within five to seven years of retirement. Prior to this, the strategy should be to maximise growth within agreed risk parameters.
"The price of beginning to migrate too early is the lower returns earned over an unnecessarily long period and forfeiting the considerable benefits of compounding on these returns.
"Compounding is at its most powerful when applied to the large asset values near retirement, and reducing returns in the last few years before retirement - just when there is the opportunity to optimise growth - will have a significant impact on a member's retirement lifestyle.
"Also important is to ensure a gradual migration from the growth-orientated strategy to a conservative strategy. As a result of the fact that age-banding involves automatic switches, the timing of these switches may be disastrous for individuals.
"A switch into a more conservative portfolio on your 45th birthday may be fine, unless your birthday happens to be the day after the worst market crash in 30 years. For this reason, switches should be more frequent and more gradual, so that the effect of any major events is limited," Davison says.
The government, which will probably have the final say on investment choice for retirement savings, stated in its initial proposals in 2006 for retirement fund reform that it would like to see investment choice restricted to about five options.
The National Treasury is opposed to total open architecture in investment choice because it pushes up costs, appropriate advice is lacking and many members resort to the most conservative option. These factors result in fund members receiving a lower pension.
Class-conscious investing
Most retirement fund investment portfolios are constituted from a mix of four asset classes: equities, property, bonds and cash.
By law, any tax-incentivised investment portfolio is limited to how much of its funds it may invest in each of the different asset classes.
For example, in terms of Regulation 28 of the Pension Funds Act, no more than 75 percent of the portfolio may be in shares. The intention is to spread the risk of your investments by ensuring a proper diversification across asset classes.
Here is a brief description of the main asset classes:
- Equities.
Shares in companies have historically out-performed all other asset classes. However, shares suffer from short-term volatility - that is, their prices can rise and fall by fairly wide margins. The longer you stay invested, the more the volatility evens out.
Your returns come from dividends (your share of the profits of a company) and an increase in the price of your shares (capital growth).
Different sectors of equity markets have different risk-return profiles. For example, small companies tend to be more volatile than blue-chip companies.
Share portfolios can include shares listed on a stock exchange and shares in unlisted companies. Increasingly, retirement funds are investing in what are called private equity portfolios. These are portfolios of unlisted companies. A private portfolio manager helps to reduce the risks associated with unlisted companies by doing the due diligence work on behalf of investors before buying into the company.
When you near retirement, short-term volatility can be managed in various ways without having to convert to cash. For example:
* The portfolio manager can use hedging strategies to protect your investments against downside risk;
* A less volatile selection of shares can be used; and
* You can buy full or partial capital guarantees through products such as index-linked structured products, or you can convert to a guaranteed product.
- Property.
Historically, the returns from property investments have come second to those from equities, generally with less risk. There is a wide range of property products, from listed property companies, the life assurance property portfolios offered by Liberty Life, through to the very dubious property syndication schemes that are currently on offer.
The returns from property investments are derived from rental income and capital growth.
- Bonds.
These are lending instruments the prices of which are mainly based on the interest they earn. However, fluctuating interest rates mean you can lose capital when interest rates rise and make capital gains when interest rates fall. Although bonds have out-performed inflation historically, the returns are conservative. Bonds can also vary in risk. For example, government bonds are regarded as comparatively low risk in normal circumstances. (Zimbabwe would be an exception at the moment.) But so-called junk bonds issued by companies that are not financially sound have a much higher potential for default on repayment.
- Cash.
These are purely interest-earning investments. Although cash investments are normally as safe as houses, there is no quicker way of ensuring you will not have a financially secure retirement. The reason is that after-tax interest is unlikely to beat inflation, and even if it does, it will not be by much. In other words, you are losing money on every rand you invest.
- For the second part of this article, see here.
This article was first published in Personal Finance magazine, 2nd Quarter 2008. See what's in our latest issue