Low rates a threat to your retirement


PF 10Nov cost cartoon

Colin Daniel

Persistently low interest rates are playing havoc with the financial security of pensioners.

Ongoing low interest rates are playing havoc with retirement savings and, more particularly, the financial security of pensioners.

The latest research by the country’s biggest retirement fund administrator, Alexander Forbes, shows that people who in 2001 were on track to receive a pension (replacement ratio) equal to 75 percent of their final pay cheque can now expect to receive a pension that is as low as 41 percent of their final pay cheque, mainly because of low interest rates, but also because other asset classes are expected to provide lower investment returns.

If interest rates remain low, you will have to save a lot more – probably more than 20 percent of your income – if you want to receive a pension equal to 75 percent of your final pay cheque (see “Act now to boost your savings”, below).

Most retirees are facing the stark reality of an income of less than 32 percent of their final pensionable income – although this shocking figure is largely a consequence of retirement fund members withdrawing their retirement savings before retirement.

John Anderson, Alexander Forbes’s general manager in charge of research, says low interest rates are affecting people who think they have saved enough for retirement, while making it worse for people who have not saved enough.

He says low interest rates affect how much you save for retirement and, more importantly, your income in retirement. The most important interest rates are those paid on long bonds. This is the interest paid by government, parastatals and large corporates on long-term loans.

Currently, less than 13 percent of fund members included in Alexander Forbes’s research can, based on their current retirement fund savings, expect a replacement ratio of more than 60 percent. About 4.1 percent of members can expect a replacement ratio of 75 percent or more. (These figures exclude savings outside a retirement fund.)

Anderson says that 10 years ago, real (after-inflation) bond yields (the combination of the capital value variations and the interest paid) were in the region of 4.5 percent to five percent a year.

“But the financial world has changed significantly over the last few years, and current real bond yields are now around the 1.8-percent mark. As a result, the expected investment returns up to retirement are also approximately two percent a year lower than 10 years ago,” Anderson says.

The situation becomes worse at retirement. The cost of a guaranteed pension at retirement will depend on interest rates at that time.

Life assurance companies generally invest a large portion of their annuity book investments in bonds in order to meet their liability to pensioners. Bond yields provide an indication of the post-retirement interest rate used to calculate guaranteed pensions at retirement.

Anderson says when real bond yields were 4.5 percent to five percent a year, a typical with-profit annuity could be expected to provide pension increases to keep pace with inflation over the long term.

However, with current bond yields at about 1.8 percent a year, a with-profit annuity cannot be expected to achieve that.

ACT NOW TO BOOST YOUR SAVINGS

Here are some of things you can do to ensure you have a better standard of living in retirement:

* Save more. Research by Alexander Forbes shows that the average retirement fund contribution (fund member and employer) is 13.5 percent of pensionable salary.

Before the most recent reduction in real (after-inflation) yields, a 25-year-old who wanted to receive a pension equal to 75 percent of his or her final pensionable salary at age 65 would have to have contributed at a rate of 19.8 percent for 40 years (see the table, link at the end of this article). However, less than nine percent of retirement funds allow members to save 19.8 percent of their pensionable salary.

The allocation of salaries towards retirement benefits varies significantly between industries: the energy sector has the lowest allocation (9.2 percent) and the government sector (local to national) has the highest (17.7 percent).

* Preserve your retirement savings. Alexander Forbes estimates that only 7.7 percent of fund members preserve their savings if they withdraw from a fund before retirement. It warns that if members continue to withdraw their savings in cash at the current rate, the expected replacement ratio, on average, will be significantly reduced to between 15 percent and 20 percent for members who are now aged 25 to 45. Alexander Forbes says early withdrawals are a big reason for replacement ratios being lower than the ideal of 75 percent.

* Retire later. In 2011, the average age of retirement was 60.9 years, which is slightly higher than the 60.4 years in 2008.

Assuming a total contribution rate of 13.5 percent of pensionable pay and the same investment returns, if you start working at age 25 and retire at 55, your replacement ratio will be a little under 30 percent. If you retire at 60, your replacement ratio will be almost 40 percent, while delaying your retirement to 65 will increase your ratio to more than 60 percent.

* Make appropriate investment decisions. Alexander Forbes’s research shows that about 10 percent of retirement fund members select investment portfolios that have no exposure to equity markets, which provide the highest returns over the long term, albeit at the highest risk.

The company says the expected out-performance of equities over bonds and cash is a crucial contributor to members’ retirement benefits. The compounding effect of just a few percentage points over 40 years’ employment can result in a benefit that is as much as 50 percent higher at retirement.

WHAT AFFECTS YOUR PENSION?

Increasingly, retirement funds are basing their investment policies on what is called a replacement ratio.

Your replacement ratio at retirement is your initial retirement fund income (your pension) as a percentage of your final pensionable pay – that is, your basic pay, excluding any allowances, such as a car allowance.

Your replacement ratio is primarily affected by:

* Investment market conditions, both while you are building up your savings and when you go on pension. Most retirement funds base their expectations of what you will receive on historic returns, taking account of current conditions, such as low interest rates.

* How much you save. This is the total of the contributions made by you and your employer.

* How long you save. The shorter the period, the lower your replacement ratio will be.

* Your retirement age. The older you are when you retire, the fewer years you will live in retirement, on average. So if you retire at age 65 instead of age 60, you will be able to save for an extra five years and you will live for five fewer years in retirement. The average age of retirement in 2011 was 60.9 years.

* Pay increases up to your date of retirement. If your pay increases shortly before you retire, your replacement ratio will fall, because you will not have enough time to make up for the lower contributions you made in previous years.

* The cost of a guaranteed pension at retirement, which in turn will depend on the type of pension you buy and prevailing interest rates.

RESTRUCTURING GROUP LIFE BENEFITS COULD GIVE YOU A BETTER DEAL

Members of retirement funds could be better off at retirement if funds restructured their group life assurance benefits, which mainly cover death and disability.

Research by Alexander Forbes shows that assurance benefits for most members, other than older members with long service, are inadequate relative to their needs.

Most group life assurance is paid as a multiple of salary (3.4 times on average) no matter what the age of the member or his or her actual life assurance requirements.

The shortfall for younger members is greater than that for their older counterparts, because younger members have lower accumulated retirement savings and usually have more, and younger, dependants. This means many older members are over-insured for death benefits, whereas younger members are significantly under-insured. By reducing the amount of life assurance for older members, who require less cover, the amount they save for retirement can be increased.

Funds and employers may consider a lifestage (age-based) approach to death benefits or a core/flexible structure, where members can purchase additional life cover based on their specific circumstances and needs.

Table: what you must save to get a replacement ratio of 75%

Graph: Annuities cost more as bond yields fall


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