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This article was first published in the first-quarter 2012 edition of Personal Finance magazine.
The typical retirement fund member who converted from a defined benefit (DB) retirement scheme to a defined contribution (DC) scheme before retiring prior to 2011 is probably better off. This is the qualified conclusion of the first research undertaken in South Africa into whether the great migration of retirement savings from DB to DC funds, mainly in the 1990s, has given and is giving members of occupational retirement funds security in retirement – or whether it simply let employers off the hook.
The research, which was presented at the annual convention of the Actuarial Society of South Africa in November last year, was undertaken by a team led by Dave Strugnell from the actuarial science department at the University of Cape Town (UCT).
The others involved in the research were Kathryn Dreyer, who is doing a master's degree in actuarial science at UCT, Hugh du Toit of consulting actuaries Hugh du Toit and Associates, and Nico van der Walt, an actuary at Momentum Employee Benefits.
In summary, the team compared whether members would have been better off at their retirement date if they had received a pension from a DB scheme or if they had bought a pension with their cash benefit after changing from a DB to a DC scheme.
On the entire sample of 2 064 data points used by the researchers, 66 percent of fund members were better off in a DC scheme than had they remained in a DB scheme.
The researchers used a DC/DB ratio, with the value of one being the crossover point. Anything over one was a gain for DC members and anything less than one was a loss. Based on this ratio, the sample average was 1.115, the minimum was 0.670, and the maximum was a healthy 2.255, but this comes with qualifications.
The researchers say they make "no such bold claims" as to suggest that the results provide tentative support for a conclusion that fund members retiring over the past 15 years are better off.
They say they took a "typical" member approach in their research, which, while a reasonable first step, "is no substitute for an analysis of actual experience on a representative sample of the DC market".
The researchers also had to make various assumptions on things such as members' salary increases and their investment strategies.
They also warn that the outcomes based on retirements up until this year could be very different from those in future because the period of the study "includes one of the most spectacular (equity) bull markets in South African history".
However, detracting from the results may be members' investment choices based on fear and greed, which could have resulted in worse outcomes – as a worst-case scenario study illustrated. (See "Fund member case studies", below, detailing three different scenarios.)
There are other factors that should favour people who switched to DC funds, including a potential increase in employer liability and administration costs, which employers would have offset by reducing their contributions.
For example, legislation has improved pre-retirement withdrawal benefits from DB funds, and this could have resulted in employer-sponsors of DB funds having to make up shortfalls in retirement benefits. Before the change in legislation, many withdrawing members received their contributions plus interest at a below-market rate. The balance of the investment returns and the employer contributions remained in the fund. However, many funds did move towards more generous withdrawal benefits before the legislation was promulgated in 1998.
The researchers also did not allow for any top-up of member pension benefits as a result of the pension surplus apportionment legislation, which could have slightly improved the benefits of a typical DC member.
The outcomes of a switch from a DB to a DC fund for individual members were affected by the transfer values given to members and the investment choices made thereafter by the DC fund members.
The UCT research took account of three categories of transfer values, namely actuarial reserve only (see "Definitions", below); actuarial reserve plus a 20-percent sweetener; and actuarial reserve plus DC shortfall. Using the DC/DB ratio, those who were best off received the sweetener and those who were worst off received only their actuarial reserve (see table 1; link at the end of this article).
And when a pre-retirement investment choice between a market-linked balanced investment portfolio or a capital-guaranteed, smoothed bonus portfolio is added to the DC/DB ratio mix, the results become even more pronounced (see table 3; link at the end of this article).
The members who have done the best, on average, are those who switched from a DB fund with their actuarial reserve plus a sweetener of 20 percent and invested in a market-linked balanced fund, while the worst off are those who received their actuarial reserve only and then invested in a capital-guaranteed, smoothed bonus portfolio.
Defined benefit (DB) fund. A fund that guarantees you an annual pension at retirement, which is usually calculated as your final annual salary multiplied by the number of years of fund membership multiplied by a factor of normally between 1.5 and two percent. The pension is normally guaranteed by the employer, who is required to make up any shortfall in the fund. If there is a shortfall in the fund, it is unlikely that you will receive annual pension increases, which are discretionary. This means your pension will decline in real, after-inflation values.
Defined contribution (DC) fund. Your contributions to your fund as well as those of your employer are defined in the rules of the fund. At retirement you receive all contributions plus investment growth with which to buy a pension. The amount you receive at retirement is not guaranteed.
DB/DC ratio. The ratio is based on the value of one. Anything above one is to the advantage of members switching to a DC fund and anything below one is to the disadvantage of members switching to a DC fund.
Actuarial reserve. The actuarial reserve of a member in a DB fund has little to do with contributions or investment returns. It is the amount that it is estimated will be required to fund your pension (based on service accrued up to the date of calculation) at retirement. In the early years of membership, your actuarial reserve is likely to be below what is contributed in your name, because it is not anticipated that many members will still be around at retirement age after 40 years of membership. However, the closer you get to retirement, the more steeply your actuarial reserve value will climb.
DC shortfall. As an alternative to a flat percentage increase to actuarial reserve as a transfer value for people who switched from DB to DC funds, some funds considered the difference in projected retirement value in the DC fund, taking into account a transfer of the actuarial reserve and future member and employer contributions, and the benefits that would have been attained in the DB fund. The DC shortfall was the value of any deficit in projected DC fund benefits and was added to the actuarial reserve on transfer to the DC fund.
Volatility. The propensity of an investment to go up and down in value.
Balanced portfolio. A market-linked investment portfolio that invests mainly across the asset classes of cash, property, bonds and equities. The proportion of each asset class in a balanced portfolio used by a retirement fund is limited by regulation 28 of the Pension Funds Act, which ensures reduced risk through the diversification of underlying investments.
Smoothed/stable bonus portfolio. The main features are: your capital is fully or partially guaranteed; returns are declared by way of bonuses, which may or may not be added to the guaranteed capital; and in good years some of the returns are held back to be used when investment market returns are poor to smooth investment performance. The advantage is that if markets crash shortly before your retirement day, your retirement savings will not lose value or the losses will be limited.
FUND MEMBER CASE STUDIES
The case studies look at three hypothetical members: a best-case scenario, a break-even scenario and a worst-case scenario. All three case studies are based on the DC/DB ratio, which provides an indication of outcomes, with any result above one being favourable for the member and any result below one being unfavourable for the member.
Case study 1: Highest DC/DB ratio
A woman aged 50 at conversion on July 1, 1992, from DB to DC, after 30 years' membership. She received her actuarial reserve plus a 20-percent sweetener and invested in a market-linked balanced portfolio. She retired on June 30, 2007 with a DC/DB ratio of 2.225.
The researchers attribute the favourable outcome to the fact that she took advantage of the record bull run in equity markets, retiring shortly before the 2008 global financial crisis. Over the last 15 years before retirement, she received average investment returns of 18 percent a year.
They point out that a member retiring in 2007 with a conversion to a DC fund based on actuarial reserve only would have had a favourable DC/DB ratio of 1.750.
Two "identical" members, one retiring in 2008 and the other in 2009, would have been worse off but still in a favourable position because of the preceding equity market bull run. The DC/DB ratio for the 2008 retiree was 1.635 and for the 2009 retiree 1.140.
Case study 2: Break-even DC/DB ratio
A woman aged 55 at conversion on July 1, 1996 from DB to DC after 15 years' membership. She received her actuarial reserve plus a 20 percent sweetener and invested in a smoothed bonus portfolio. She retired on June 30, 2006 with a DC/DB ratio of 1.000.
Case study 3: Lowest DC/DB ratio
A man aged 55 at conversion on July 1, 1995 from DB to DC after five years' membership. He received his actuarial reserve only and invested in a smoothed bonus portfolio. He retired on June 30, 2005 with a DC/DB ratio of 0.670. Investment returns in this case averaged only 11.6 percent a year, compared with assumed salary increases of eight percent a year on average.
SMOOTHED BONUS FUNDS PROVE TO BE A LET-DOWN
Fully or partially capital-guaranteed smoothed bonus investment portfolios provided by life assurance companies may be undermining your efforts to retire financially secure.
As a general rule, it was better for members who retired over the past decade to have kept their retirement fund savings in a balanced investment portfolio exposed to market volatility than in a capital-guaranteed smoothed bonus investment portfolio provided by a life assurer.
This is one conclusion of research undertaken into whether the big switch in the 1990s from defined benefit (DB) to defined contribution (DC) funds was in the best interests of retirement fund members.
But the results are based on average performance, which means individual members could have done better or worse depending on the investment portfolio chosen. Various assumptions were made about contributions, salary increases and costs, also affecting the difference between the research results and the returns of individual members.
To analyse the influence of investment returns for DC fund members, the researchers, led by Dave Strugnell of the University of Cape Town actuarial science department, compared the average performance of smoothed bonus funds and balanced funds.
The balanced funds result was based on the average returns of the 11 largest fund managers on the Alexander Forbes Large Manager Watch.
The smoothed bonus performance was measured by equally weighting the returns of the Old Mutual Guaranteed (smoothed bonus) Fund and the Sanlam Stable Bonus Portfolio.
Using a DC/DB ratio, the balanced fund approach had the best results (see table 2 and the Balanced fund vs smoothed bonus fund graph; links at the end of this article).
The researchers say that most of the relative out-performance of the market-linked balanced funds came from the bull run from 2003, which was briefly curtailed by the 2008/9 global financial crisis. Prior to the bull run, smoothed bonus funds offered market-related returns but with less volatility than the balanced funds. The research team suggests that reasons for the discrepancy in the relative performance of smoothed bonus funds compared with balanced funds between the two periods warrant further analysis. They point out, however, that smoothed bonus returns "will always look relatively worse in periods of very strong equity market performance".
Demutualisation and legislative requirements may also have led "to more conservative asset allocations" by the smoothed bonus portfolio managers, the researchers suggest.
The researchers caution retirement fund members that:
* If there had been a protracted bear market, there could have been very different results.
* Remaining exposed to equity markets at the same level for the 15 years before retirement "is contrary to generally accepted wisdom". The researchers did not consider the outcomes for life-stage investment portfolios, which reduce equity market exposure the closer a member gets to retirement. They say that life-stage portfolios "would lead to less impressive maximum ratios, but should also reduce the volatility of outcomes".