The focus in discussions about saving for retirement is often on how to choose the best asset manager and save on investment costs. But neither of these factors is the most important in ensuring that what you manage to save will provide you with sufficient income in retirement, Anne Cabot-Alletzhauser, the head of the Alexander Forbes Research Institute, says.
She says the order of importance of the factors that will affect how much you will be able to save is:
1. Whether you preserve your savings instead of withdrawing them when you change jobs;
2. Whether your retirement fund contributions are a meaningful proportion of your salary and are not reduced by the fact that contributions are based on your pensionable salary (which typically excludes your bonus and any allowances), rather than your total pay;
3. When in your working life you start to contribute to a retirement fund;
4. How much of your and your employer’s contributions are allocated to retirement savings and how much to life and disability cover;
5. How much of your contributions are eaten up by costs;
6. The long-term asset allocation strategy of the fund; and
7. Over and above the fund’s long-term asset allocation strategy, the value derived from using a fund manager. “Alpha” is the term used to describe the value that a fund manager delivers in addition to market performance.
The problem is that retirement fund trustees are not focusing on all of these issues, Cabot-Alletzhauser says. Instead, they allocate most of their fund’s fees to asset management, in the belief that paying for high-performing fund managers and the investment returns they earn is what will most influence the outcome of members’ efforts to save for retirement.
Impact of costs
Alexander Forbes has found that, on average, the asset management fee paid by a member of an employer-sponsored fund at the age of 35 makes up 45 percent of the total fees, while the administration fee makes up 41.8 percent. The effect of the compounding of these fees means that 30 years later the asset management fee makes up 82 percent of the costs, while the administration costs are 13.3 percent, Cabot-Alletzhauser says.
The problem with paying an asset manager a high fee to out-perform the market, she says, is that although it is possible to identify a manager who is skilful, rather than simply lucky, it is not possible to determine which skills will be rewarded by the market.
In addition, Cabot-Alletzhauser says that retirement funds diversify across asset managers to reduce risk, but this also reduces the alpha.
Cabot-Alletzhauser says you can reduce the cost of investing by using passive investments that track an index and have lower fees, but the difference between the cost of passive investments and paying a fund manager to manage an institutional investment, such as a retirement fund, is about 0.5 percent. This could make a difference of five to seven percentage points to your replacement ratio – the percentage of your total salary package that you will receive as an income in retirement, she says.
Although the reduction in costs can make a difference, it is not what makes the biggest difference to how much fund members will manage to save.
Cabot-Alletzhauser says that fund managers have been delivering returns of 10 percentage points above inflation for the past 15 years, but many fund members are still retiring with a replacement ratio of only 33 percent. This indicates that the problem is less with asset management performance or fees and more with the other factors that influence how much you will have saved by the time you retire, she says.
Uber-consultants
Cabot-Alletzhauser argues that employers should appoint “über-consultants” who can address the connections between the factors that influence retirement savings.
The über-consultant should clearly understand the demographics and needs of all the members of the fund.
Investment strategies should then be developed to meet those individual needs or retirement-savings requirements over time, she says.
This is a vastly different model from simply identifying the asset manager that performs best relative to its peers.
The über-consultant should ensure that the employer’s human resources policies on, for example, retirement age and sick leave, tie in with the benefits that the fund provides, Cabot-Alletzhauser says.
The über-consultant should also ensure that members pay only for the employee benefits they need. For some members, income protection and life assurance are more important than saving for retirement, she says.
The über-consultant will also be able to focus on finding the most cost-effective asset manager, the costs that the fund pays for trading shares and other securities, and the administration fee that best suits the fund and its members, Cabot-Alletzhauser says.