Defining the pros and cons of ways to save for your old age
• Decisions to be made with regard to retirement can be complex and mind-boggling
In the electrical world, it might be all about AC/DC but in pensions, it’s more like DB/DC (defined benefit/defined contribution). Anybody under 40 probably hasn’t experienced a definedbenefit fund, with the big exception of the Government Employees Pension Fund (GEPF).
In the GEPF, pensions are still paid out on the classic formula of final salary multiplied by length of service.
And there is a rock-solid guarantee from the government, although that seems a lot less solid than it did 10 years ago.
Defined benefit is valued in much of Europe, but it became deeply unpopular in SA: people who entered the workforce in the 1980s and ’90s will remember being given, on their resignations, their contributions plus something derisory such as a 5% return (inflation peaked at 20% in those days).
Millennials would not have tolerated defined benefit: it is a way for the young and mobile to subsidise the corporate lifers. In most countries, defined benefit was abandoned because companies were sick of the obligation to fund deficits.
But in SA, it was driven from the bottom as there was huge demand from staff for a more flexible arrangement. Definedbenefit fund deficits were very rare except in cases of fraud and incompetence. In fact, the issue was too much money, which was disposed through the surplus apportionment exercise.
DB’s successor, defined contribution, is a lot simpler than DB, which is the preserve of actuaries. DC is much like investing in a unit trust and at the end of the term, leaving the fund with the accumulated capital.
It is just 20 years since, for example, the Times Media Pension Fund converted to DC, Members could stay in the DB section of the fund, but less than 5% chose to. The disadvantage of DC is that members are exposed to market fluctuations. Some argue that people surrendered their DB rights too easily: they were given enhancements of up to 40% to their fund values, enough in most cases to lead to a quick decision. But in the process, it has allowed the whole concept of the guaranteed pension to become obsolete.
And it is easy to get cynical as quite a few people got wealthy in the conversion process, notably the management and shareholders of Alexander Forbes.
As it happens, the performance of the JSE over the past 20 years has been so strong that DC returns would have overshadowed anything DB members could have expected. DB returns, after all, grow at the same pace as salary increases, which would have been far slower than the growth in the JSE, or even of a basket of shares, bonds, cash, property and offshore assets. Offshore was only introduced into local pension funds in 1995.
According to Pew Research, there is most anxiety about retiring with an acceptable pension pot from generation X, those between 35 and 44.
Those of us in the older baby boomer cohort have had the chance to build up the beginnings of a nest egg, but it doesn’t look so great yet for gen X. And the millennials still believe they are indestructible, so they don’t worry about fuddy-duddy issues such as retirement.
The biggest drawback of DC funds is that on retirement, members are forced to leave the fund and fend for themselves. Financial advice is still the preserve of the rich. The Treasury is trying to change this with the introduction of defaults for investment, preservation and annuities. It is a problem many other countries have faced as they struggle to find a replacement to the regular pension from the company fund.
So, I was interested to meet Lesley-Anne Morgan, the global head of DC Schroders. Apparently, she hadn’t realised that Schroders has an exclusive arrangement with Absa in SA as she was speaking at a Sanlam function. She says some defaults are chosen as they present the lowest chance of the fiduciary (such as the fund trustee) being sued, it has the lowest fee or it has the simplest governance, none of which will probably improve the outcome.
She also says that too much choice can lead to confused members and often inappropriate switching: defaults are important. Many do not have the financial education — or, quite honestly, the time or the interest — to make a choice.
The main worry about postretirement income, and it is a cliche, is longevity. The first person to reach 142 has already been born. But Morgan says the three other issues are:
● Inflation — What will things cost in the future and will this be gradual or in spikes?;
● Investment — Will my assets return enough and could a market crash wipe them out?; and
● Consumption — What goods and services will I need?
Australian research shows that spending decreases as individuals age — much of this is in leisure spending.
But Australia has a wellfunctioning, socialised healthcare system. In SA, additional healthcare spending is likely to offset most savings retirees achieve in other areas.
Morgan weighs up the main retirement options. In SA, the cash lump sum is only available to members of provident funds, at least for now. It is common in the UK since compulsory annuitisation was abolished two years ago, though the values have averaged quite a modest £30,000. Morgan says that this only applied to DC funds: unlike in SA, most money in the UK is still tied into DB plans. A cash payout provides no longevity protection or growth prospects or any form of inflation protection. But it provides flexibility of income, the option to pass funds onto beneficiaries and simplicity, a concept still alien to actuaries such as Morgan.
Guaranteed annuities pass the simplicity test. People know that R4m will buy, say, R20,000 a month of income. They are also guaranteed for life but provide no growth or flexibility.
The living annuity, often called a draw-down product overseas, does best, although it is not suitable for everyone. It is highly flexible and can provide a growth net of fees. But perhaps their greatest attraction is that they are not binary. There is no turning back after investing in a guaranteed annuity. But all or part of a living annuity can be converted into a guaranteed annuity at any time.
Morgan says that a hybrid annuity is very often an optimal solution, although she points out that as inflation in SA is much higher than in the UK or Australia, inflation-linked annuities should be considered to provide 30% of income, especially at around 75 or 80.
TOO MUCH CHOICE CAN LEAD TO CONFUSED MEMBERS, AND OFTEN INAPPROPRIATE SWITCHING