Your golden years’ fund

DEFINED BENEFIT VS DEFINED CONTRIBUTION

Apension fund is designed to provide meaningful payments to members in their retirement: they’re set up as a saving vehicle for post-working years. A defined benefit (DB) fund has a sponsor, usually the employer.

The pension is paid via a promise from the fund, often based on final salary and years of service, independent of the fund’s performance. While morally obliged to pass on any surplus to pensioners through increases in their pension payments, the sponsor bears the risk of the deficit and is responsible for covering it over a reasonable period.

Thus, most have given way to or been converted to defined contribution (DC) funds.

Under the DC system, contributing members’ assets equal liabilities.

There’s a further distinction: DC funds allowing payment of their own pensions, and those not. A DC fund can only get surpluses/ deficits by paying annuitants. If a deficit arises, it wouldn’t be fair to ask contributing members to reduce their share of the fund to cover this or to reduce pensions being paid.

However, pension increases could be halted, or the employer could be asked to make a special payment.

To counter mixing pensioners’ investments with those of contributing members in one fund, the rules of most retirement funds – and a condition in SA – require any new retiree to take their share of the fund and purchase an annuity from an approved third party.

Thus there’s a constant outflow from the fund as each retiree takes their share. Note fund performance in the case of a DC fund is a myth. Yes, considered as an entity, trustees need to see that assets and new contributions are well managed, but each member gets their own performance, depending on how large/small current contributions are relative to accrued assets.

Actuaries estimate the value of the liabilities based on assumptions. These are often for long periods, especially for DB funds, with pensions often for 40 years plus.

But some assumptions haven’t been met in practice: mortality has been much lower than expected.

Also, investment returns haven’t met expectations.

For DC funds that don’t pay their own pensions, there’s almost no need for estimates, as the investment returns are credited to each member monthly (and could be negative). Another DC fund myth is the need to provide net replacement ratio.

This is based on each member’s current assets and assumptions about expected future salary increases, to which expected invest returns are applied to get the expected fund value per member at the expected retirement date.

Making further assumptions about the pension that could be expected on that fund value, the ratio is that monthly amount relative to the expected monthly salary at retirement date.

Liston Meintjes is a wealth portfolio manager at NVest Securities