Illustration: Colin Daniel

This article was first published in the 1st quarter 2018 edition of Personal Finance magazine.

Two new, separate analyses emerged recently proclaiming that South African retirees invested in living annuities risk running out of money, with many already living on half the income they enjoyed just six years ago. This heartbreaking situation is exacerbated by the widely accepted idea that local markets are likely to produce low returns over the next 10 years.

The confluence of a variety of forces in the 1980s and 1990s led employers to largely abandon traditional defined-benefit (DB) pension schemes in favour of defined-contribution (DC) pension schemes. These forces included the rising power of unions, the ending of apartheid, the growing cost to employers of providing pensions to employees, and a long bull market that was producing high real returns relative to the values assumed by actuaries.

DC schemes were welcomed with open arms because they gave the benefit of these returns to the members rather than the employer.

Along with the DC schemes came a new freedom of choice as to how members’ contributions would be invested while saving for retirement. Again, this was welcomed with open arms; South Africa was going through a huge socio-political shift and freedom and possibility were in the air.

Different pension funds offered different levels of choice and different options. Discussions at dinner parties and braais often focused on exciting new investment opportunities and how best to structure portfolios.

Choice was also introduced into the post-retirement space in the form of living annuities. These allowed pensioners to choose where their accumulated “pot” of money would be invested to provide them with an income for life.

But, too much choice is not always a good thing. A widely cited human behavioural study by Columbia University researchers in 2000 demonstrated this. Researchers set up a booth with samples of well-known jams, switching between offering a selection of 24 and six jams every few hours. Both the large and small assortments attracted a similar number of people. Surprisingly, however, the study found that buyers sampling the smaller assortment were almost seven times more likely to buy jam compared to those sampling the larger assortment. This suggests that even though we think offering choice will be appealing to buyers, the reality is that buyers find too much choice debilitating.

This has certainly played out in the retirement arena. As advisers to retirement fund trustees, we are constantly saddened by how many boards of trustees report that their members show little or no interest in exercising their right to choose how their retirement savings are invested. This is not simply apathy; it is paralysis.

A recent UK survey by Price Bailey found that 40 percent of respondents did not even know which type of scheme (DC or DB) they belonged to. Respondents, even in a country where consumers are viewed as relatively educated and financially sophisticated, cited lack of knowledge and understanding as barriers to active retirement planning. About a quarter of participants felt they had more important priorities, or that it was “too complicated”. 

The same is true in South Africa, where a vast majority of pension fund members are hamstrung by the daily financial grind and inadequate financial education. It Is therefore not surprising that nearly 42 percent of pension fund members end up in their scheme’s default option. This is not necessarily a bad thing provided trustees have applied their minds to their members’ best interests.
 
Options at retirement
Once members retire from their funds, whether they are compulsory employer funds or retirement annuities, they are thrown into the even more baffling world of post-retirement options.

Not only is there a wide range of types of products; there is a long list of product providers. It is rather like trying to choose a car in today’s congested market. Ultimately, it is about the brand. There are also trends to worry about. Guaranteed annuities (also known as life annuities) were thought of as the right choice several years ago. Then it was living annuities, and more recently the trend is towards a combination of both.

If you choose a living annuity, structuring the underlying investment portfolio on an ongoing basis is the next problem for you and your adviser. Then there is the issue of how much to take as an income without running the risk of depleting your capital, especially as people are now living longer, healthier lives than ever before.

Each year, the Association for Savings & Investment SA publishes the average rate at which pensioners are drawing from their capital, and this year the average was 6.62 percent. One recent analysis came from Marriott. They modelled a series of drawdown rates from four percent to seven percent, increasing by inflation every year, to see whether the retirees’ money would last 30 years.  The difference between drawing down four percent, which is generally agreed by the industry to be a “safe” drawdown rate, and six percent is enormous in terms of failing to provide for 30 years of income. At four percent, they calculated the failure rate to be six percent, while a drawdown rate of six percent resulted in a massive failure rate of 47 percent.

Systemic flaws
The current approach to retirement funding is beset by a number of flaws, the first being that the move to DC retirement funds engendered a new focus on the total return a member would have at retirement when he “cashed out” of his scheme. In other words, how large a “pot” of money would be available with which to buy an annuity.

This was a complete sea change in how pension funds had traditionally been managed. In the old DB era, the focus was squarely on what liabilities the fund would have in the form of pensions to be paid out, and investment portfolios were structured with the objective of meeting these liabilities. From the members’ point of view, there was the certainty of knowing they could bank on receiving an income of about 70 percent of their final salary for the rest of their lives, provided they had continually contributed to their fund and preserved their savings for at least 35 years.

The advent of DC funds also resulted in a chasm opening up in the retirement journey between the pre-retirement and post-retirement phases, with different products and providers for each. Trustees of DC funds turned their attention to maximising a member’s pot as much as possible, within an appropriate risk framework. They no longer had any responsibility for that member thereafter, as the relationship between the company and the employee was severed.
 
Cradle to grave
We need to return to the “cradle to grave” approach of the DB environment. Fortunately, the government has realised this, and in August last year, amendments to the Pension Funds Act regulations were gazetted.

Known as the retirement fund default regulations, the amendments require trustee boards to assist members during the accumulation and the retirement phases of their lives. Trustees will have to formally implement default investment and annuity arrangements for current fund members and for retiring fund members. This means that, once again, members will be able to enjoy an integrated solution that allows for a seamless transition from pre- to post-retirement.

Petri Greeff is an executive at RisCura retirement fund consultants.