Two new analyses recently showed that South African retirees invested in living annuities risk running out of money, with many already living on half the income they enjoyed just six years ago. This heartbreaking situation will be exacerbated by the fact that local markets are likely to produce low returns over the next ten years.
How did we get here? The confluence of various forces in the 1980s and 1990s led employers to largely abandon traditional defined benefit (DB) pension schemes in favour of defined contribution (DC) pension schemes.
“Along with DC schemes was a new freedom of choice as to how members’ contributions would be invested while saving for retirement. Again, this was welcomed with open arms.”
At the time, a long bull market was producing high real returns relative to the pension values assumed by actuaries. DC schemes were welcomed with open arms as they gave the benefit of these returns to the members rather than the employer. Along with DC schemes was a new freedom of choice as to how members’ contributions would be invested while saving for retirement. Again, this was welcomed with open arms.
Choice was also introduced into the post-retirement space in the form of living annuities. This allowed pensioners to choose where their accumulated ‘pot’ of money would be invested to provide them with an income for life.
But, too much choice is not always a good thing.
A study by Columbia University demonstrated that when faced with a substantial selection of jams to sample, subjects became overwhelmed and were unlikely to buy any. When faced with a modest selection, subjects were almost seven times more likely to buy. Even though we think offering choice will be appealing to buyers the reality is that buyers find too much choice debilitating.
This has certainly played out in the retirement arena. As advisors to retirement fund trustees, we are constantly saddened by how many boards of trustees’ report that their members show little or no interest in exercising their right to choose how their retirement savings are invested. This is not simply apathy; it is paralysis.
“Once members retire from their fund, whether it is a compulsory employer fund or a retirement annuity, they are thrown into the even more baffling world of post-retirement options.”
A recent UK survey, conducted by Price Bailey found that 40% of respondents did not even know which type of scheme (DC or DB) they belong to. Respondents, even in a country where consumers are viewed as relatively educated and financially sophisticated, cite lack of knowledge and understanding as barriers to active retirement planning. The same is true in South Africa, where a vast majority of pension fund members are hamstrung by the daily financial grind and inadequate financial education. It is therefore not surprising that nearly 42% of pension fund members end up in their scheme’s default option. This is not necessarily a bad thing provided trustees have applied their minds to their members’ best interests.
Once members retire from their fund, whether it is a compulsory employer fund or a retirement annuity, they are thrown into the even more baffling world of post-retirement options.
Not only is there a wide range of types of products, there is also a long list of product providers. There are also trends to worry about. Guaranteed annuities were thought of as the right choice several years ago, followed by living annuities and more recently the trend is towards a combination of both.
If a living annuity is chosen, structuring the underlying investment portfolio on an ongoing basis is the next problem for investors and their advisors. Then there is the issue of how much to take as an income without running the risk of depleting your capital, especially as people are now living longer, healthier lives than ever before.
“The move to DC retirement funds engendered a new focus on the total return a member would have at retirement when he ‘cashed out’ of his scheme. In other words, how large a ‘pot’ of money would be available with which to buy an income annuity.”
Every year the Association for Savings and Investments publishes the average rate at which pensioners are drawing down and this year the average was 6.62%. One of the analyses publicised this month came from Marriott. They modelled a series of draw down rates from 4% to 7%, increased by inflation every year, to see whether the retirees’ money would last 30 years. The difference between drawing down 4%, which is generally agreed by the industry to be a ‘safe’ draw down rate, and 6% is enormous in terms of failing to provide for 30 years of income. At 4% they calculated the failure rate to be 6%, while a draw down rate of 6% resulted in a massive failure rate of 47%.**
The move to DC retirement funds engendered a new focus on the total return a member would have at retirement when he ‘cashed out’ of his scheme. In other words, how large a ‘pot’ of money would be available with which to buy an income annuity.
This was a complete sea change in how pension funds had traditionally been managed. In the old DB era, the focus was squarely on what liabilities the fund would have in the form of pensions to be paid out and investment portfolios were structured with the objective of meeting these liabilities. From the members’ point of view there was the certainty of knowing they could ‘bank’ on receiving an income of approximately 70% of their final salary for the rest of their lives, providing they had continually contributed to their fund and preserved their savings for at least 35 years.
The advent of DC funds also resulted in a chasm opening up in the retirement journey between the pre-retirement and post-retirement phases, with different products and providers for each. Trustees of DC funds turned their attention to maximising a member’s ‘pot’ as much as possible. Once the member retired, trustees had no further responsibility as the relationship between the company and the employee was severed.
We need to return to the ‘cradle to grave’ approach of the DB environment. Fortunately, government has realised this, and in August this year, amendments to the Pension Fund Act regulations were gazetted.
Known as the Retirement Funds Default Regulations, the amendments require trustee boards to assist members during both the accumulation and the retirement phases of their life. Trustees will have to formally implement a default arrangement – i.e. for drawing a pension income – for current fund members, for those leaving the fund and for retiring fund members. This means that, once again, members will be able to enjoy an integrated solution that allows for a seamless transition from pre- to post-retirement.
– Petri Greef
*This article originally appeared on Business Day online on 7 December 2017
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