Very few members of defined-contribution retirement funds achieve the pension their funds aim to provide, even when they have been members for 35 years, because the funds’ investment targets fail to take an individual’s circumstances into account.
If you save for about 30 years, most retirement funds aim to provide you with a pension equal to 75 percent of your final pay cheque – excluding any allowances. This percentage is known as the replacement ratio.
But research by Alexander Forbes shows that only 15 percent of members with 35 years’ membership and only eight percent of current active members over the age of 55 will achieve a replacement ratio of 75 percent or higher. The research also shows that only two percent of active members over the age of 55 will have more than 35 years’ membership at retirement.
In a best-case scenario, if members have belonged to a retirement fund for 35 years, nine out of 10 of them can expect to achieve a replacement ratio of at least 60 percent. But as soon as other factors, such as low contribution rates, fewer years of membership and the non-preservation of retirement savings come into the equation, the situation becomes far worse.
Alexander Forbes researchers John Anderson and Dwayne Kloppers say another very important contributory factor to the failure of retirement fund members to retire financially secure is that retirement funds do not treat members as individuals and fail to take the personal factors of each member into account.
These factors, which should determine how your retirement savings are invested and which will affect how much you have at retirement, include:
u Age. The older you are when you become a member and the closer you are to retirement, the more you need to save and/or the more aggressively you need to invest, by choosing high-growth assets such as equities.
u Gender. Women can expect to live longer than men, so they need to save more (see “What women can do to become financially secure” on page 3).
u Retirement date. The normal retirement date in South Africa is considered to be 65, but most people retire two or three years earlier, which means they need more money to retire on.
u Dependants. The more dependants you have, both before and in retirement, affects the amount of capital you will be able to save before retirement, or will need in retirement.
u Savings. The more you have saved outside of your retirement fund, the less you need to have in your fund or the more conservative you can be with your retirement fund investment choices.
u Contributions. The more you contribute, the more likely you are to reach the 75-percent replacement ratio target.
u Desired retirement income. Anderson says very few people will obtain their desired level of income in retirement, but the desired level needs to be taken into account when your retirement plan is individualised to meet your aspirations.
u Required minimum income. For an income in retirement, South Africans predominantly rely on their retirement fund savings. If your retirement fund savings are your only source of retirement income, they must provide a minimum safety net, because the only other option is the very low state old-age grant, which you will receive only if you have no savings or assets.
You therefore need two goals in saving for retirement: a high likelihood of achieving the minimum amount you require to retire and survive financially, and a higher desired income level, at which you will have choices about your lifestyle.
new ways to increase odds
Anderson, who is the managing director of research and product development at Alexander Forbes, told an Actuarial Society of South Africa retirement seminar this week that a new way had to be found to increase the odds that a greater proportion of retirement fund members will retire with greater income security.
Echoing comments made recently in South Africa by Harvard professor Robert Merton, Anderson says it has become essential that you be treated by your retirement fund as an individual and that your retirement plan be customised to meet your unique needs and circumstances.
However, Anderson and Kloppers warn that there is no magic solution for people who have simply left saving for retirement too late, or have saved too little. However, by setting individual goals and checking regularly whether or not you are on track, the chances of retiring reasonably financially secure increases significantly.
They say that one of the main reasons for the parlous state of affairs when it comes to the income on which pensioners retire is that retirement funds have made assumptions about the “average member” and acted accordingly, particularly in the way the fund’s assets are managed. The focus has been on providing pensions for all members based on the returns achieved in the fund instead of on the income each member will require in retirement.
One of the results of this is that investment strategies have been based on performance relative to other investment managers as measured by the best returns, and these have not necessarily had the highest likelihood of achieving a sustainable income for members in retirement.
Anderson and Kloppers say the solution lies in goal-based investing, where various factors peculiar to you are taken into account to enhance your chances of achieving a sustainable income.
In effect, this means structuring an investment portfolio specific to you, which will maximise the likelihood of your desired income goals being met by dynamically allocating your retirement savings among portfolios.
Anderson says this is now possible as a result of technological developments, innovations in investment markets and the use of what is called liability-driven investment (LDI).
In simple terms, LDI calculates your required capital at retirement based on actual market conditions. This figure is the “liability”, and it varies over time as market conditions change. The key is that it reflects the market price of matching your income requirements in retirement. Investments are then structured to best achieve the amount in savings to cancel out the liability. It is important to realise that this goal will change and develop over time due to market forces affecting the cost of retirement.
Anderson says the LDI industry is developing in South Africa. It uses the broad range of financial instruments, including long-dated inflation-linked bonds and derivatives, to reduce risk, as well as maximise returns, in relation to the liabilities. For example, derivative instruments can be used to protect against potential investment losses.
One of the aims of LDI is to achieve the desired outcome at the lowest level of risk.
Anderson says that goal-based investing matches and takes further the aims of National Treasury, which has recommended in draft regulations that retirement funds be required to have default investment options and annuities in place for their members.
The default options require retirement fund trustees to take into account the needs of their members, including their preference for balancing risk and return, their likely future membership in the retirement system, their level of financial sophistication and their ability to access financial advice.
Anderson and Kloppers say goal-based investing is also far more dynamic than the old approach of simply trying to achieve the best returns. For example, a riskier underlying investment can be “derisked” once a certain target (or income goal) has been achieved as a result of a change in any of the factors that affect the individual member, such as increased contributions or reduction in dependants.
Equally, greater risk can be taken on if factors increase the member’s liability (the amount of capital required at retirement).
A dynamic approach to investing can also provide choices to members as to how much risk they want to take at the different stages of their lives relative to their retirement income goals – for example, by taking more investment risk when they are younger and reducing that risk as they approach retirement.
Kloppers says that there are also new ways to measure whether you are on track to have sufficient money in retirement. In effect they measure your “financial wellness”.
The problem, however, is that many of these measures are difficult to explain, even to fairly sophisticated retirement fund members. Members can be shown the outcomes of their choices and what choices they need to make.
FUNDS MUST DO MORE FOR YOU
About 75 percent, or R1.2 trillion of the savings of most private-sector retirement fund members are in defined-contribution funds. The balance is in defined-benefit funds, which, until the 1990s, were the predominant funds in South Africa.
John Anderson, the managing director of research and product development at Alexander Forbes, says the growth in defined-contribution funds continues, which means that far more effort has to be put into ensuring positive outcomes for members. Because the risk of having enough money for a financially secure retirement lies with defined-contribution fund members, more has to be done by funds and employers to ensure better outcomes, he says.
INVESTING TOWARDS A GOAL
Goal-based investing is significantly different from traditional investing, John Anderson, the managing director of research and product development at Alexander Forbes, says. These differences include:
* Investment targets
- Traditional methods seek the highest possible return and the lowest possible risk.
- Goal-based investing |seeks to achieve the highest probability of meeting an individual’s financial goals.
* Risk definition
- Traditional methods test risk on the volatility of an investment, namely the propensity of an asset to move up and down in value or relative to a benchmark.
- Goal-based investing tests the risk of falling short of a desired income target.
* Investment strategies
- Traditional methods seek an asset mix that will provide the highest risk-adjusted return measured against other asset managers and relative to capital.
- Goal-based investing seeks to mix both assets and investment strategies to increase the probability of meeting an income goal.
* Performance measurement
- Traditional methods measure performance of the past one, three and five years against a benchmark or other asset managers.
- Goal-based investing measures both past and possible future success in achieving investment goals over a targeted time frame.
* Sustainable investment
- Traditional methods simply adopt a policy of how underlying investments will impact on the environment, socially and good governance with no specific measures.
- Goal-based investing incorporates sustainability into the strategy to increase the probability of meeting a goal in the future.