The South African retirement industry has been in trouble for a while. Most people cannot afford to retire.
On 1 March South Africa took a significant step towards addressing this issue. This was the day on which the default regulations to the Pension Funds Act came into effect.
The default regulations required that all retirement funds have the following in place:
- Default investment strategy
- Default preservation strategy
- Default annuity strategy
- Retirement Benefits Counselling strategy
To understand why we need them and how they can help, we need a quick lesson in pension funds.
Defined Benefit funds
Until the 1990s, most pension funds were of the defined benefit variety. These pension funds paid out a percentage of the employee’s final salary, based on their number years’ service. The norm was 2% per year so someone retiring after 35 years’ service would end up with a pension of 70% of their final salary.
This generally resulted in a comfortable retirement initially. Retirees would get a lump sum payment which they used to clear any debt (which was also quote low as access bonds were not around). They also typically had a company medical aid scheme they did not have to pay towards when they retired.
The employer carried the investment risk and needed to ensure that the fund had sufficient reserves to pay the pensions to the pensioners for the rest of their lives. The pension increases were low and many pensioners had to make lifestyle adjustments after being on pension for a while – especially in the days of high inflation
Another downside of this structure is that it was difficult to change jobs. Companies would often use the pension fund as “golden handcuffs” with the promise of a decent pension with punitive conditions if you left. It was not uncommon for funds to hold back the company contributions to the fund if a member left within 10 years of joining the fund. The payout was also given as a return of contributions at an interest rate of that was typically around 4%.
This clearly did not suit the needs of the 1980s workforce where the yuppies were entering the market and looking to change jobs regularly – all this in a world where equities were booming. A return of contributions at 4% would not cut it.
The world of work had computers – it was possible to run individual member accounts with unit pricing – enter the next phase of pension funds – defined contribution funds.
Defined Contribution funds
The defined contribution funds were hailed as the ideal structure for the workforce of the late 1980s. Members could select the portfolios in which their funds were invested, they could change jobs easily and they could select when to retire. There were no punitive conditions if you chose to retire a couple of years earlier. The size of your savings determined when you would be able to afford to retire.
All was good. The markets were booming. What could go wrong?
Employees did not appreciate the implications of the financial risk passing to them under these new structures. The booming equity markets masked the danger. Returns of 30% were not out of place in the late 80s and early 90s. Everyone seemed to be better off.
Defined contribution funds have a lot going for them but there are a couple of weaknesses that were not fully understood at the time. It is these issues that the default regulations are trying to address.
The weaknesses that caused many of the problems were:
- Members lacked investment knowledge to make the best decisions
Many members lacked the necessary knowledge of investment markets to choose the most appropriate portfolios to invest in.
We had situations of young people being in low growth conservative portfolios or paying for guarantees that they did not need. The impact here can be massive, especially when you have the compounding effect of the lost returns over the 30 year term of the investment.
We also had older members being in riskier high equity portfolios in the run up to retirement. A significant downturn in the market shortly before retirement can be devastating.
Attempts were made to address this and many funds introduced some sort of life-staging into their investments. While this is a step in the right direction, a lot must still be done. The Sanlam Benchmark survey indicated that last year, only 52% of retirement funds provided new members assistance in choosing their investment portfolios when joining a fund.
The new Regulation 37 seeks to address this issue by requiring that retirement funds have a default investment strategy in place that is appropriate for the particular category of membership.
This is a step in the right direction. It will eliminate many of the big mistakes members make by choosing inappropriate and expensive investments.
The nature of defaults is to do no harm rather than suggest the right solution that may not work in a minority of situations. The result here is that members could still be leaving money on the table by not being in the most appropriate portfolio for their particular needs. It is here that proper retirement benefits counselling is needed. Even a 0.5% improvement in return by being in the right portfolio can have a massive impact over a 30 year retirement saving term.
- Members cash in their withdrawal benefits
When you left a company, you had to withdraw or transfer your accumulated investment to the new fund or to a preservation fund. Many took this benefit to pay off short term debt and this would result in them losing the compounding effect of the early
Regulation 38 seeks to address this issue. The default is that the money must stay in the fund in what is called a paid up status (pup). Funds need to allow a member to keep their money in it and not prejudice them in terms of costs or service.
Members need to specifically request to remove the funds and they need to be counselled as to the implications.
If the lessons from behavioral economics can be applied here, this should have a big impact on the retirement savings of South Africans. In the USA when the default for 401(k) savings moved to automatic enrolment with individuals having to ask not to be enrolled, the enrolment levels moved from 34% to 90%
- Retiring members choose the wrong pension
Choosing the right type of annuity is not a simple matter. There are a multitude of different options available. These would include:
- Traditional annuities
- Life annuities
- Life annuities with a particular annual increase rate
- Life annuities with guarantees of varying lengths
- Joint Life annuities (pays out a lower pension to a surviving partner)
Long guarantees and high annual increases will result in lower initial annuities.
- Living annuities with varying drawdown rates
High drawdown rates for living annuities will reduce the capital. You also need to strike a balance between growth assets and immunizing the investment against volatile market movements.
- Hybrid annuities
These are a combination of living and life annuities
Each of these annuity structures comes with its own risks and costs and it takes quite a bit of insight to choose the annuity the most appropriate one for a member.
We have come across many examples where pensioners have taken out living annuities with high drawdown rates without understanding what this will do to the investment in a couple of years. Many are also in risky portfolios and do not appreciate the impact that a significant market correction can have on the annuity.
Living annuities are also a lot more expensive than the traditional ones and pensioners do not have the insight into the structures to make a call as to whether the investment is worthwhile.
Regulation 39 seeks to address this. All funds must have a default annuity structure in place that is appropriate for the members and with all costs being disclosed.
Again, this is a very good step in the right direction but again, as it is a default, the choice of annuity will probably be the one that will not expose the fund and its trustees for making a bad recommendation.
Retirement Benefits Counselling
Included in these default regulations is the requirement that all funds have a retirement benefits counselling strategy in place.
This counselling must take place
- When a new member joins the fund
- When a member leaves the fund
- When a member retires from the fund
Retirement funds can tick the regulatory boxes and say that they have a retirement benefits counselling strategy in place by sending each member a brochure on the defaults and provide access to a call centre.
This is not sufficient.
Most fund members are not financially literate enough to properly understand the products and the implications of the choices.
They often don’t know what they need to know or what questions to ask.
Individual circumstances also differ so while defaults may give an acceptable solution it may be inappropriate in many circumstances. The dynamic input from a benefits counsellor can help members understand the defaults and make better choices.
Retirement funds should invest in getting a good quality retirement benefits counsellor to help their members make the right decisions in what is probably the biggest financial decision of their lives.
Kenny Meiring MBA CFP ®
Retirement Benefits Counsellor
082 856 0348