An age-old problem

PFM IOL 4thq 2012 retirement age Colin Daniel What can you do to survive financially in retirement in the face of increasing longevity?

This article was first published in the fourth-quarter 2012 edition of Personal Finance magazine.

The popular retirement age of 65 dates from 1889, and many people still think about retiring at 65, 63 or even 60, Megan Butler, research actuary at Alexander Forbes, says. Back in 1889, workers could, on average, expect to spend two years in retirement before they passed on to the big retirement home in the sky.

Today, Butler says, employees aged 65 can expect, on average, to live for a further 16 years if they are men and 20 years if they are women.

Some employers have earlier retirement ages than 65, such as 60 or 63, with the result that retirees will spend even more years in retirement. And then there are employees, who may or may not belong to occupational retirement funds, who want to retire at 55.

Although a longer retirement means you may have more time to play golf or go fishing or spoil not only your grandchildren but your great-grandchildren, the big question is whether you will be able to afford to keep living and golfing or fishing.

Global economic problems have seen the slide in interest rates and company profits exacerbate the affordability challenge posed by longevity.

With future investment returns expected to be lower, and with retirees living for longer, people who are staring retirement in the face need to:

* Increase their retirement savings;

* Accept a lower standard of living in retirement;

* Try to increase their returns – which also has the risk of earning lower returns;

* Postpone their retirement; or

* Implement a combination of the above.

The easiest way – and one of the surest – to increase your retirement savings is to work and save for longer. This has a double advantage: you will save more and you will have fewer years in retirement in which to spend your money.

The table “Benefit of delaying retirement relative to projected pension” (see link at the end of this article) shows how postponing your retirement by two or three years can benefit you if you have saved diligently throughout your working life and have not plundered your retirement savings along the way. However, people who have not saved enough will probably not be able to maintain their current lifestyle in retirement even if they delay their retirement by a few years.

The Alexander Forbes Pensions Index suggests that lower-than-expected investment returns relative to salary increases, the higher cost of guaranteed annuities (pensions) and expected lower real (after-inflation) returns into the future have eroded projected pension benefits substantially.

For example, a person born in 1952 who at the age of 50 in January 2002 was on track to receive a pension equivalent to 75 percent of his or her final salary when retiring at age 65 in 2017, could expect to replace only 58.4 percent of his or her final pay cheque by June this year.

Butler says that by retiring at age 67 instead of 65 you could add almost 10 percent of your pre-retirement salary to your retirement income.

However, she warns that although postponing your retirement will certainly help to soften the blow, it probably will not overcome the looming crisis posed by the current economic conditions.

In addition, most people cannot put off their date of retirement willy-nilly. If you are employed and belong to a retirement fund, your age of retirement is set down in the rules of the fund.

And then there is the problem of whether retirement fund members will accept a later retirement age. In Greece and Spain, there has been turmoil on the streets because of protests against raising the retirement age, which is intended to prevent the total

collapse of those countries’ pension schemes.

But where governments fund pay-as-you-go retirement schemes, there is little incentive to raise the retirement age. Pay-as-you-go means that this generation of workers pays, through tax, the income of those who are on pension.

In South Africa, most people in full-time employment belong to defined contribution schemes – in other words, they have to fund their pensions from their own savings, albeit in most cases with a bit of help from their employers. So you are responsible for making up any shortfall caused by falling investment returns and living longer than average.

If you have a skill that your employer does not want to lose once you retire, you could be brought back on contract and, hey presto, your problem is solved. But this solution is not an option for many employees and their employers, Butler says.

“Extending the retirement age is sometimes an unpopular issue for both employees and their employers. Employees may resent having to work longer than they had planned, particularly if the change is introduced quickly and without proper communication, while employers may fear the productivity implications of an ageing workforce.

“In some jobs, it may be unsafe to continue working after you reach a certain point in the ageing process. In some other job categories, productivity may be a concern.

“Certain jobs have characteristics that lend themselves to earlier retirement, while others lend themselves to later retirement. This generally accepted principle suggests that different retirement ages are required for different jobs,” Butler says.

Researchers agree that, as employees age, the variability in ability between workers of the same age grows, she says. In other words, older workers are a diverse group, and it is difficult to make definitive statements about their productivity.

The evidence is very mixed about how age affects productivity, if at all. Some studies show that productivity declines with age, whereas other studies show that older workers tend to perform better when it comes to accuracy and consistent output. Some studies have found that there is almost no relationship between age and productivity once other factors have been taken into account.

Other studies have concluded that “job fit” has a much stronger influence on productivity than age. In other words, if an older worker is in a job to which he or she is well suited, the worker’s productivity is unlikely to be affected by his or her advancing years. There is also evidence that small adjustments to the workplace, such as brighter lighting to counteract weakening eyesight, negate some of the physical consequences of ageing and improve the productivity of older workers, Butler says.

Much of the opposition in Europe to upping the retirement age has come from unemployed youth, who have argued that postponing the age of retirement will mean fewer opportunities for them.

But Butler says that research shows there is not necessarily any correlation between later retirement and youth unemployment.

Nobel Prize-winning Indian economist Amartya Sen points out that we do not automatically assume that a country with a larger population will have higher unemployment. Similarly, a comparison of retirement ages and youth unemployment rates shows there is no real relationship between the two.

However, if every worker is allowed to work for five years longer from tomorrow and every worker used this opportunity, it could well have a negative impact on youth employment rates. But this is unlikely given that most retirement fund members already leave their jobs before their current retirement age.

KEEPING ON AGEING STAFF WILL REQUIRE CHANGES TO THE WORKPLACE

There is no official retirement age. If you have a retirement annuity, you can retire from the fund at any age from 55. If you want a state old-age grant, you can claim it from age 60 as long as you are virtually destitute.

If you are a member of an occupational retirement fund, your retirement age is normally stated in the rules of the fund, and in most cases it will be between 60 and 65.

With defined contribution funds, there is usually no penalty if you leave the fund before the retirement age, which is set in the fund’s rules.

Megan Butler, research actuary at Alexander Forbes, says that increasing the contribution rate in a defined contribution fund gives members more options.

The decision on your retirement age falls squarely with your employer and not with your retirement fund.

Extending the age of retirement can help fund members to achieve a more comfortable retirement without having to increase their contributions, she says.

Although there is strong evidence to suggest that a retirement age of 65 (and especially of 63 or 60) may have to be revised, some employees may not be able to retire later due to the physical demands of their job. These workers, and their employers and their retirement funds, will have to consider alternative ways of increasing their retirement benefits to ensure a comfortable retirement.

However, other categories of workers may benefit from later retirement, both financially and because they will not have to spend as many years in retirement.

“Employer profitability may not be adversely affected by this move, particularly if the employer’s approach includes phased retirement and workplace adaptations to accommodate an ageing workforce,” Butler says.

If employers are considering revising the retirement age of their employees, different ages could be considered for different categories of workers, she says.

Elements of the employee benefit package will have to be amended to ensure that each group of employees receives a fair deal, Butler says. For example, workers with earlier retirement ages will have to contribute more towards their retirement savings to achieve a reasonable benefit target. This in turn may require another part of the benefit package, such as group life assurance, to change to ensure that their take-home pay remains sufficient.

Once the job categories that will allow for later retirement ages have been identified, employers can consider the extent to which they can accommodate ageing employees.

“For certain jobs, small adjustments to the work environment could keep an employee productive for longer, but the employer would need to drive these changes,” Butler says.

Given that each worker and workplace is different, employers will have to use their judgment and experience when deciding how late to extend the retirement age, Butler says.

Most international experts believe that 75 is the maximum retirement age.

However, a more modest extension of the retirement age may be all that is required to enhance employees’ financial security in retirement. Extending the retirement age by just two years, from 65 to 67, can boost a pension in rand terms by 17 percent to 30 percent, depending on factors such as contribution rates, the size of the member’s fund credit and the member’s current age.

It may be important to introduce changes slowly to ensure employee support and to avoid economic shocks.

An alternative strategy may be to allow employees to retire gradually by reducing their working hours over a period of phased retirement. This strategy has the additional benefit of cushioning the potential psychological blow of retirement.

However, if phased retirement is granted at the employer’s discretion, it can be extremely difficult for fund members to plan for their retirement.

Properly structured phased retirement of employees should not adversely affect profitability of companies, Butler says.

BIGGER TAX INCENTIVES FOR SAVERS

From next year, you will be allowed to deduct from either your employment income or your taxable income, whichever is higher, 22.5 percent of your retirement fund contributions if you are under the age of 45 or 27.5 percent if you are 45 or older.

But when calculating how much you will be able to claim as a deduction, you must add your contributions to those of your employer, which include your employer’s contributions to pay for administration and provide group life assurance attached to your pension fund.

Super-earners who are under 45 and earn more than R1.1 million a year will be limited to R250 000 in what they can claim as a retirement-funding deduction from taxable income, while anyone aged 45 or older who earns more than R1.09 million a year will be limited to a deduction of R300 000.

Despite these restrictions, most people, even high earners, will be able to deduct more from their taxable income and save more than they can now. For example, a 45-year-old self-employed person with a taxable income of R1 million can currently claim a maximum deduction of R150 000 to a retirement annuity (RA) fund. This will almost double to R275 000.

Based on the results of the 2012 Sanlam Benchmark Survey, employers on average contribute 10.24 percent of their employees’ salary to retirement fund savings and members contribute 5.96 percent. This gives a total contribution of 16.2 percent, and it includes the cost of group risk benefits and administration.

Danie van Zyl, head of guaranteed investments at Sanlam Structured Solutions, says this means that Average Joe, contributing a total of 16.2 percent of his pensionable income, is quite a bit below the deduction threshold of 22.5 percent (and much lower than the 27.5-percent threshold for those over 45). Therefore, if Average Joe is under 45, he could save an extra 6.3 percent of his annual income for retirement. If he is over 45, he could save an extra 11.3 percent.

Currently, you are allowed to claim the following retirement-funding contributions as a tax deduction:

* 7.5 percent of your pensionable income (normally, your basic pay excluding allowances and bonuses) to an occupational retirement fund. Your employer can claim a maximum of 20 percent of your pensionable salary as a deduction from taxable income contributions to employee benefits.

* 15 percent of your total taxable income (excluding capital gains), less pensionable income, to an RA fund.

THE EARLIER YOU RETIRE, THE LOWER YOUR PENSION

The most important factors that will affect how much you will receive as a guaranteed pension for life are your age, your gender and interest rates. Your age and gender determine how long a life assurance company expects to have to pay you a pension. The shorter the period, the more you can expect to receive.

Graph 1 (see link at the end of the article) shows the effect of changing annuity (pension) rates between January 2002 and July 2012, mainly due to conditions in financial markets, particularly long-term interest rates, and increased longevity.

The graph is based on the change in the cost of a pension of R1 a year for a 65-year-old man since 2002 and the corresponding pension that R2 million can purchase.

Alexander Forbes, which did the calculations for the graphs on this page, assumed, among other things, that:

* The pension will increase in line with the inflation rate; it will provide your spouse with a pension equivalent to 50 percent of your pension when you die; and the pension has a five-year guarantee, which starts from when the pension is paid. The pension will be paid whether or not you are alive during the guarantee period. After five years, the pension will no longer be paid once you and your spouse have died.

* The fund member earns R60 000 a year every year (adjusted for inflation) and has R2 million accumulated by the age of 55.

* The pension is based on the annuity rates in June 2012 for a with-profit pension where the initial pension plus the annual increases are guaranteed while the pension is being paid.

Graph 2 (see link at the end of the article) dramatically illustrates the pension (adjusted for current values to give the same buying power for all the ages) that a man can expect at different retirement ages, from 55 to 75. The increase in the pension is the result of contributing for longer by deferring retirement, earning additional investment returns, also by deferring retirement, and the decreasing cost of a pension as the man ages.

Graph 3 (see link at the end of the article) illustrates what it will cost a man, at different retirement ages, to buy a pension of R1 a year paid for life, as well as a pension for life based on having R2 million.

When you buy a pension, you pay a sum of money for the chosen number of pension rands.

The left-hand axis shows that, at the age of 55, it will cost you about R22 to receive a pension of R1 a year for the rest of your life, but the cost will drop to about R13 once you reach 75.

According to the right-hand axis, R2 million (which, by age 75, will have grown because of additional contributions and investment growth) will buy you an annual pension of almost R90 000 at age 55. But if you retire at 75, you will receive more than R160 000 a year for the rest of your life, increasing in line with inflation.

The point of the graph is to show that the older you are, the higher the pension you can buy for the same amount. By retiring later, you will receive not only the higher annuity, but you will also have saved more and generated a lot more in investment returns. There is the third advantage that you will not spend as many years in retirement, reducing the amount of capital you would otherwise require.

Although this graph is based on an annuity bought by a man, the difference between a male and female pension is small, because the man’s pension is based on his spouse or partner receiving 50 percent of his pension after his death as well as a five-year period during which the pension will continue to be paid even if the pensioner has died.

SAVINGS TARGET NOW AT 20% OF YOUR INCOME

One option to ensure that you will have enough money to come anywhere close to maintaining your current lifestyle in retirement is to save more – and you should be saving about 20 percent of your pensionable income.

Some estimates are higher, such as that of Old Mutual economist Rian le Roux, who says the figure could be as high as 30 cents of every rand you earn, depending on financial market decisions and future increases in longevity.

The latest Sanlam Benchmark Survey shows that, on average, retirement fund members contribute 5.96 percent of their pensionable pay and employers a further 10.24 percent, making a total retirement fund contribution of 16.2 percent. But this total includes group life benefits and administration costs, which are paid mainly out of the employer’s contribution.

The Alexander Forbes Member Watch survey, which covers 788 retirement funds, says average fund contributions (from both members and employers) in 2011 were about 13.5 percent of pensionable salary.

Niel Gerryts, Alexander Forbes research and product development actuary, says if you are 25 today and contribute 13.5 percent of your income to your retirement savings, you can expect, under current financial market conditions and longevity scenarios, to receive a pension that will provide you with an income equivalent to only 51 percent of your final pensionable pay cheque.

Your income in retirement as a percentage of your final pensionable pay cheque is known as your replacement rate or replacement ratio.

The most recent rule of thumb used to determine how much you should save to ensure you can maintain your lifestyle in retirement was 15 percent of your pensionable income – it used to be 10 percent. A contribution rate of 15 percent aimed to provide a replacement rate of 75 percent after at least 40 years of fund membership.

Gerryts says the retirement environment has changed to such an extent that the estimated contribution rate for a 25-year-old retirement fund member who expects to retire at age 65 with a replacement rate of 75 percent is 19.7 percent.

He says your employer can help you to meet your savings target by reviewing contribution rates, particularly once the percentage of the contribution that you are allowed to claim as a tax deduction changes next year.

The review should also consider adopting a lifestage approach to contribution levels, based on member needs and affordability. For example, when you are younger and have a family to support, you probably need more group risk assurance, which will pay out if you die or become disabled before retirement, but you can afford less group risk assurance once your children leave home, allowing you to increase the portion of your retirement fund contributions that go towards retirement savings.

You should also consider increasing your fund contributions. Most occupational retirement funds set a minimum contribution level but allow you to make additional contributions.

For many people, increasing their contributions to their occupational retirement fund will be far more cost-effective than paying the money into a retirement annuity fund, which has commissions and higher asset management costs.

Table: Benefit of delaying retirement relative to project pension

Graphs: Retirement age and guaranteed pension


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