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
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