Focus on income stream
While tried and tested retirement savings approaches have worked effectively for many decades, the retirement funding environment has changed significantly and many conventions are now being questioned.
One issue is the approach taken by many savers and the pension fund trustees that manage the funds in their pension funds on their behalf, is to focus on developing a large cash pool for pension fund members. However, RisCura director Prasheen Singh says the time has come to concentrate on funding an income stream.
“Within pension funding the ultimate objective is to ensure that the member retires with a pension that is suitable for their needs and requirements on retirement and until death,” says Singh. “The most important reason for taking the income funding stream approach is that the cost of funding an income stream (pension) changes overtime.
“It evolves as interest rates evolve, inflation and other factors change, as these variables are used to price the cost of the income you can buy at retirement.
“Therefore, pension fund trustees’ responsibilities need to move beyond simply ensuring a lump sum. It is not just about a lump sum that people get but rather about how much that lump sum can buy for the retiree in terms of income,” Singh says.
She says the larger the capital pool, the larger the income it will buy. However, conventional thinking is that capital must be safeguarded at all costs, including significant wealth creation. A cost that will almost certainly lead to less capital at the time of retirement.
Singh points out that capital can be put at risk because the cost of funding a pension changes. For example, if interest rates go down, the cost of purchasing an income goes up.
In simple terms, in a capital protection environment, R100 might be available to buy an income of R10. If the R100 is invested in a bank’s fixed deposit, the R100 capital would theoretically be safe and over a year — assuming an interest rate of 10% — the cash pool would grow to R110.
However, if interest rates fall from 10% to 5%, the R100 capital would generate only R5 for a total of R105 at the end of a year. To achieve the R10 annual income, the saver would need to invest twice as much, namely R200.