A new frame­work for the re­tire­ment fund in­dus­try De­fined con­tri­bu­tion fund in­vest­ment strate­gies have been based on max­imis­ing the re­turn on an in­vest­ment for a given level of risk. This works for early life stages, but what about the stage run­ning up and

Finweek English Edition - - COLLECTIVE INSIGHT -

over the last two decades, a sig­nif­i­cant shift has taken place in how re­tire­ment in­come is pro­vided to in­di­vid­u­als in South Africa. This shift has seen an in­crease in the use of de­fined con­tri­bu­tion funds to pro­vide an in­come in re­tire­ment.

New re­tire­ment think­ing sug­gests that while bas­ing in­vest­ment strate­gies on max­imis­ing the re­turn on an in­vest­ment for a given level of risk may be ap­pro­pri­ate in the early stages of life – when ac­cu­mu­lat­ing cap­i­tal – a dif­fer­ent ap­proach is nec­es­sary in the phase run­ning up to and into re­tire­ment when that cap­i­tal is con­verted into an in­come.

The cur­rent ap­proach gen­er­ally used in the in­dus­try is based on Mod­ern Port­fo­lio The­ory, which was pi­o­neered by award­win­ning econ­o­mist Harry Markowitz. Be­low is an il­lus­tra­tion of the “ef­fi­cient fron­tier”, which rep­re­sents the most ef­fi­cient port­fo­lios us­ing this ap­proach.

Port­fo­lio C is con­sid­ered more ef­fi­cient than port­fo­lio A, since it pro­vides a bet­ter re­turn for the given level of risk. Sim­i­larly, port­fo­lio B is more ef­fi­cient be­cause for the same level of re­turn it has a lower risk.

This ap­proach works for the ac­cu­mu­la­tion phase of re­tire­ment strate­gies, but in the pe­riod shortly be­fore and in re­tire­ment, this ap­proach is no longer suf­fi­cient on its own. As an in­di­vid­ual ap­proaches re­tire­ment, their ob­jec­tives change from ac­cu­mu­lat­ing as much cap­i­tal as pos­si­ble, to bal­anc­ing the abil­ity to pro­vide a sus­tain­able in­come in re­tire­ment with the need to pro­vide a legacy for heirs.

The most op­ti­mal in­vest­ment strat­egy af­ter re­tire­ment must there­fore look at how to bal­ance these two con­flict­ing ob­jec­tives, as well as tak­ing into ac­count an in­di­vid­ual’s tol­er­ance to volatil­ity dur­ing their re­tire­ment. In­ter­na­tion­ally, sig­nif­i­cant re­search has been done on this prob­lem by Moshe Milevsky, a pro­fes­sor of fi­nance at York Univer­sity, Canada, and Wade Pfau, a pro­fes­sor of re­tire­ment in­come at the Amer­i­can Col­lege for Fi­nan­cial Ser­vices in Bryn Mawr.

Their work has paved the way for what has been termed the Re­tire­ment In­come Fron­tier.

This ap­proach aims to mea­sure re­tire­ment strate­gies ac­cord­ing to how they pro­vide for a sus­tain­able in­come in re­tire­ment, and to what ex­tent they pro­vide a fi­nan­cial legacy. In sim­ple terms, the Re­tire­ment In­come Fron­tier is the set of in­vest­ment strate­gies with the high­est ex­pected legacy for any given level of sus­tain­able in­come pro­vided in re­tire­ment.

In­di­vid­u­als can then de­ter­mine what in­vest­ment strat­egy is most op­ti­mal based on their in­come needs, as well as bal­anc­ing this against their de­sire to pro­vide for a fi­nan­cial legacy and their tol­er­ance for volatil­ity in re­tire­ment. To il­lus­trate, we have con­structed a model to de­ter­mine the Re­tire­ment In­come Fron­tier for the fol­low­ing in­di­vid­ual (see page 27): per the lat­est sta­tis­tics by the As­so­ci­a­tion for Sav­ings and In­vest­ments South Africa. For sim­plic­ity, only strate­gies with vary­ing mixes of eq­ui­ties and bonds are shown. The as­sump­tions un­der­ly­ing the il­lus­tra­tive model are as fol­lows:

Ex­pected an­nual real re­turns: 6% on eq­ui­ties and 2.5% on bonds

Ex­pected volatil­ity: 20% on eq­ui­ties and 10% on bonds

Mor­tal­ity: PA (90) ta­bles ad­justed down­wards by three years

Fee dif­fer­ence be­tween re­tail and in­sti­tu­tional liv­ing an­nu­ities: 1.25% p.a.

Fee dif­fer­ence be­tween re­tail and in­sti­tu­tional life an­nu­ities: 1% p.a. The strate­gies tested, for il­lus­tra­tive pur­poses were:

Cur­rent re­tail liv­ing an­nu­ity (LA) strate­gies. These are the typ­i­cal LA strate­gies avail­able in the re­tail mar­ket. The asset al­lo­ca­tion was var­ied for il­lus­tra­tion from 0% to 100% eq­ui­ties.

100% in­come an­nui­tised, re­tail with prof­its an­nu­ity. This is a strat­egy where the full in­come of R5 500 is se­cured with a guar­an­teed an­nu­ity avail­able in the re­tail mar­ket which tar­gets pen­sion in­creases of

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