If you, as a member of a defined-contribution (DC) retirement fund, think you are on track to receive a pension equivalent to 75 percent of your final salary when you retire, you may have to review your calculations, the latest Alexander Forbes Pensions Index indicates.
The main reason is that bond yields have fallen sharply since January 2002. This, in turn, has made it more expensive to buy a guaranteed annuity (pension), John Anderson, the head of research and product development at Alexander Forbes, says.
The Pensions Index provides an indication of how the pension that a DC fund member can expect to buy has changed since January 2002. The index tracks the replacement ratios of four retirement fund members, born on January 1, 1982; January 1, 1972; January 1, 1962 and January 1, 1952.
The replacement ratio is a measure of a pension (monthly income in the year after retirement) as a percentage of pensionable pay. Most retirement funds aim to provide their members with a replacement ratio of between 60 percent and 80 percent, provided they have been in a fund for long enough.
On January 1, 2002, the retirement fund members born in 1952, 1962 and 1972 were 30, 40 and 50 years old respectively, and all were on track to receive a pension equal to 75 percent of their salaries when they retired at age 65. In other words, their index value was 75 on January 1, 2002. The member born in 1982 began saving in 2007, at the age of 25, under different investment conditions and, as such, from the outset was on track to replace only 46.9 percent of his salary when he retired.
As the table shows, all four savers have lost ground since they started to save, although their index values improved slightly in the last quarter of 2014. At December 31, 2014, the index values for the savers born in 1952, 1962, 1972 and 1982 were 66.7, 50.1, 40.3 and 37.8 respectively.
Pensionable pay, also known as a retirement-funding income, is a percentage of your total cost to company; it is typically your basic pay and excludes remuneration in the form of allowances.
The rate at which you and your employer contribute to your retirement fund is based on your pensionable pay. The contribution rate of all four savers was 13.3 percent after deducting administration costs and premiums for group risk life assurance benefits.
The effect of lower bond yields is that a person who wants to buy a guaranteed, or life, annuity must have saved more capital in order to receive a reasonable pension in rand terms, Anderson says. For example, a retiree has R1 million and wants to buy a pension for himself and his wife, with inflation-linked annual increases and a 10-year guarantee. In August 2007, his R1 million bought an income of R3 753 a month; in February 2014, it bought a pension of R3 203 a month.
Bond yields are not the only factor influencing the cost of a pension. Anderson says the cost of converting capital to a pension is a function of:
* Your age – the younger you are, or the longer you are expected to live, the more expensive it is;
* Factors that are likely to affect your longevity – for example, whether you smoke, your health status, and your income level;
* Whether you want to make provision for your spouse, and if so, for what amount;
* Whether you want to leave an inheritance to your children;
* The level of pension you require;
* The level of pension increases you require (for example, five percent a year or an increase linked to the inflation rate); and
* The type of annuity you buy and its underlying investment strategy.
Another reason for the decline in the index values is that the returns from all asset classes are expected to be lower, while salaries, on average, continue to increase above the inflation rate (see “High salary increases may mean a lower replacement ratio”, via link below).
Anderson says your retirement benefit will consist of:
* Your contributions to date;
* The past returns on those contributions;
* Your future contributions; and
* The future returns on those contributions.
In the past, real (after-inflation) returns were very high, Anderson says. The 1952-born saver is faring better than the other three savers, because he contributed more during the period of high returns and has had more time to benefit from those returns. The accumulated contributions of the younger savers are lower and therefore they do not benefit to the same extent.
When the 1982-born saver began saving in January 2007, expected returns were lower than they were in 2002. This meant that a contribution rate of 13.3 percent was insufficient to provide a replacement ratio of 75 percent, Anderson says.
The returns on all asset classes are expected to be lower than they were in the past. The younger savers will be saving in this lower-return environment for longer than the older individual. This means that younger people will have to save more than the older generation to achieve the same pension, he says.
The youngest saver should be invested in higher-yielding assets, but the reality is that the expected returns on all asset classes are lower than those achieved historically, he says.
The 1952-born saver has only three years to retirement, and it is clear that he is not going to achieve a replacement ratio of 75 percent. What, realistically, are his options?
Anderson says there are three things he can do:
* Save more – although he has only a few years left, every little bit will help.
* Review his budget. He should work out his likely income and expenditure in retirement and look for areas where he can cut back.
* Work for longer. It is important that the 1952-born saver looks for ways to supplement his pension by doing some form of work.
Lower returns across all asset classes are a problem for younger savers. Does this mean that fund members are invested too conservatively?
Anderson says that most retirement funds with default investment options use investment strategies that comply with regulation 28 of the Pension Funds Act (also known as the prudential investment requirements). Younger fund members are typically invested in the most aggressive investment strategies.
Members who are approaching retirement are typically phased into a default option with a more conservative investment strategy. At the most extreme, some funds phase fully into cash, Anderson says.
“For these extreme cases, all else being equal, I would agree that the investment strategy would typically be too conservative. In these cases, it is better to have higher-yielding and income-generating assets; in many instances, it would mean substantially reducing the cash allocations to other asset classes,” he says.
However, Anderson says it is important to weigh the risks and benefits before making any changes, to ensure that your investment strategy is not too aggressive close to and in retirement, because market volatility will have a significant impact, and there will be more limited scope to deal with this impact on your income.
In addition to preserving your savings when you change jobs and not retiring early, Anderson says you should do the following to retire financially secure:
* Ensure that you are contributing enough relative to your total cost to company;
* Regularly check that you are on track; and
* Review whether you are getting value for money in relation to the fees you are paying;
* Ensure that your investment strategy is appropriate for your retirement goal and risk tolerance – an appropriate strategy is one that has the greatest likelihood of meeting your goal with the lowest likelihood that your minimum requirements will not be met.