This article was first published in the first-quarter 2016 edition of Personal Finance magazine.
Reducing your investment risk as you approach retirement, or lifestaging, has long been regarded as a prudent strategy for members of retirement funds.
After years of saving, the last thing you want is for a market crash, or even a severe downturn, to destroy the value of your savings when you do not have time to wait for the markets to recover before you buy an annuity (pension) to provide you with an income for the rest of your life.
According to Sanlam’s annual Benchmark survey, some 60 percent of South African retirement funds have adopted lifestaging as their default investment strategy, allocating a higher percentage of fund members’ money to less volatile assets, such as cash, to mitigate investment risk as they approach retirement.
Despite its widespread use, the traditional lifestaging model has flaws that may result in a gap – or even a chasm – between the lump sum you save and the income or pension you need in retirement. In recent years, there have been moves to adapt the model to address what Sanlam has dubbed the “lifestage gap”.
Meanwhile, retirement fund trustees are facing a new challenge. National Treasury has published draft regulations proposing that all funds have a default investment strategy. Trustees, however, will not always know what type of pension you plan to buy when they design an investment strategy.
At the Actuarial Society of South Africa’s annual convention late last year, a Harvard professor and an actuary presented a paper suggesting how trustees could attempt to bridge the gap between your retirement savings and your retirement income.
The paper highlights the need for you, as a retirement fund member, to focus on the income you will receive in retirement, rather than the lump sum you will save, and to be aware of the risks of moving into low-volatility investments close to retirement.
Professor Robert Merton, a finance professor at the MIT Sloan School of Management and emeritus professor at Harvard University, and Shaun Levitan, the chief operating officer and co-founder of investment manager Colourfield Liability Solutions, say that, instead of a uniform asset allocation for all retirement fund members of the same age (the current lifestaging model), trustees should adopt a default lifestaging strategy that takes into account members’ individual financial needs.
Although retirement fund administrators are in favour of an individualised approach to lifestaging, not everyone agrees with Merton and Levitan’s proposed default investment strategy. Merton and Levitan’s arguments, however, may help you to understand the decisions taken by your fund’s trustees, as well as why you should take a keen interest in your journey to retirement.
Merton and Levitan argue that achieving an adequate income in retirement, rather than accumulating a lump sum, should be the goal of any retirement fund’s investment strategy.
However, some defined-contribution funds do not provide their members with information that tells them whether or not they are on track to receive a reasonable pension.
Merton and Levitan cite the example of 55-year-old Lindiwe, who receives a statement from her retirement fund informing her that her fund credit is R1 million. Lindiwe thinks R1 million means she is on track for a secure retirement. In fact, she does not have any insight into her likely standard of living in retirement, because she cannot easily calculate how this fund credit will translate into a pension.
Lindiwe would have a much better idea if her statement stated that R1 million meant she was on track to receive a pension, in today’s rands, of R6 100 a month, Levitan and Merton argue. Your fund’s actuaries can easily provide this information.
Many funds already regularly inform their members of the ratio of their salary they are likely to receive as a pension – their replacement ratio.
Levitan and Merton say the fund should also tell Lindiwe how her contributions over the next 10 years, until she retires at 65, will increase her pension. For example, if Lindiwe is told that her future contributions will add R1 100 a month to her pension, she will know that she is on track for a pension of R7 200 a month.
Merton and Levitan’s arguments about informing you of what your retirement savings represent in terms of an income echo comments by retirement fund administrators, Sanlam’s Benchmark survey and Alexander Forbes’s Benefits Barometer.
The 2014 Benefits Barometer, for example, suggested that funds inform you of your projected post-retirement income. They should also inform you of the implications for your pension if certain variables are changed – for example, you contribute more to your retirement fund, you increase your group life cover, or you delay your retirement by a few years.
Setting your income goal
In order to tell you whether or not you are on track to achieving your desired pension, retirement funds need to establish the income towards which you are saving.
Merton and Levitan suggest that, where possible, your retirement income should be shown as your replacement ratio. They further suggest that, rather than trustees determining a one-size-fits-all replacement ratio for all fund members, the ratio should be customised to take each member’s particular circumstances into account.
Merton and Levitan suggest that you should have the option of deciding on the income you want to target and of adjusting it over the course of your working life. Typically, you would need expert advice when doing this.
If you do not engage with your fund about your goal income, your trustees should set it for you, based on the number of years you are expected to belong to the fund and your gender (women typically live longer in retirement than men).
Merton and Levitan’s view that your particular circumstances should determine your income goal is in line with arguments put forward by Alexander Forbes and Sanlam.
At its Benefits Barometer presentations for the past two years, Alexander Forbes has emphasised that the income you target will depend on your circumstances, and your employer or fund should provide you with tools to enable you to determine how much you will need.
It has also emphasised that a fund’s replacement ratio can be customised for members.
The presentations have noted that studies have found that a replacement ratio of 75 percent, which is the percentage commonly targeted by funds, is not sufficient for 90 percent of retirees, because their expenses in retirement do not decrease by 25 percent of their pre-retirement income.
The 2015 Benchmark survey found that 57 percent of stand-alone employer-sponsored funds target replacement ratios that their investment strategies and contribution rates have been designed to deliver. This is an increase on the 41 percent of funds that had these targets in 2013.
Risks at retirement
Merton and Levitan say you face three main risks when you use your lump sum to buy an income in retirement:
* Investment risk – your investments may or may not provide the returns you need;
* Inflation risk – your pension needs to increase each year by inflation or more, to ensure that your money does not lose its buying power; and
* Longevity risk – you need to ensure that your savings will provide a pension for as long as you live.
Merton and Levitan say the only financial product that can meet the challenge of these risks is an inflation-linked guaranteed annuity, where the annual pension increases are equal to inflation and the pension is paid for the rest of your life. The risk, however, with this product is that if you die soon after retirement, your dependants will not receive any of the savings you built up.
They suggest that trustees, when designing default investment strategies, should assume that you will use an inflation-linked guaranteed annuity to provide your goal income in retirement. Trustees can determine the capital you will need to buy such an inflation-linked annuity and design a default investment strategy that will provide this amount.
Although Merton and Levitan suggest that an inflation-linked guaranteed annuity be used as the default annuity, they say trustees can apply their approach to other types of annuities the trustees deem suitable for fund members.
Merton and Levitan’s suggestion does not necessarily mean you have to buy a guaranteed annuity at retirement, but you will probably need personalised advice to determine your best course of action.
Viresh Maharaj, the chief marketing actuary at Sanlam Employee Benefits, says the decision about whether or not a fund should use an inflation-linked annuity when setting an income goal, and, therefore, its investment strategy, will depend on the fund’s membership profile. Many defined-contribution funds may find that their members cannot afford to buy an inflation-linked annuity, in which case Merton and Levitan’s proposals will not be practical.
Cost of a pension change
Merton and Levitan’s paper highlights another issue with which retirement funds are grappling, namely, that the cost of buying an annuity changes over time.
They say a fund member who retired with R1 million at the end of 2009 could buy an inflation-linked guaranteed annuity that started at R6 500 a month. But a member who retired with R1 million at the end of 2014 would be able to buy a pension of only R4 650 a month. The pension dropped by 30 percent over those five years, Merton and Levitan say.
The Sanlam Benchmark survey shows that 60 percent of retirement funds use lifestage portfolios and 54 percent of these funds convert all of their members’ savings to cash in the year before they retire, to preserve the value of the accumulated lump sum.
Merton and Levitan say that most funds and their members regard cash or money market instruments as risk-free, while government bonds are regarded as low-risk assets suitable for the investment portfolios of members close to retirement.
Although the returns from cash are stable, and the returns from bonds are generally more stable than those from equities, these two asset classes are not risk-free if you want to be able to buy the annuity you need. Merton and Levitan demonstrate this with an analysis of the income you could buy after investing a lump sum in a cash or a bond portfolio for one year. The analysis shows that, in more than 60 percent of rolling one-year periods between August 2007 and June 2015, members retire with less real (after-inflation) income after a year of investing their savings in either a cash or a bond portfolio (see link to table at the end of this article).
The problem posed by the change in the cost of a pension has also been highlighted by the Alexander Forbes Pension Index, which shows the effects of both the cost of buying an income and market returns on the replacement ratios of members of various ages who, when the index began, were on track to retire with a 75-percent replacement ratio after contributing 13.3 percent of their income for 40 years. Although all the members’ ratios have declined, the effect has been most dramatic on younger members.
In some countries, but not South Africa, you can buy a deferred annuity long before retirement to secure your pension and obviate the risk that the pension will be more expensive by the time you retire.
However, Merton and Levitan say South African fund members can construct a portfolio that tracks the value of the annuity they want to buy at retirement. This portfolio mimics the change in the cost of a deferred annuity that can be used to buy an inflation-linked income in retirement, Merton and Levitan say.
Your retirements savings should be allocated between a growth portfolio, with a relatively large exposure to equities, and a risk-free portfolio of inflation-linked bonds, Merton and Levitan say. Once you have saved enough to achieve your goal income, you should secure your savings by moving them into risk-free assets, they say. Your allocation to the growth and risk-free portfolios should change over time so that you can optimise your likelihood of achieving your income goal, Merton and Levitan say.
Whether or not an asset is risk-free will change over time, depending on, among other things, the number of years before you retire, the availability of inflation-linked instruments and changes in real interest rates.
Merton and Levitan say the allocation to risk-free assets should be tailored to suit the needs of each member, because risk-free assets for someone aged 30 will differ from those for someone who is a year away from retirement.
They say the allocation to the risk-free and the growth portfolios will not simply be determined by your age, but will be based on:
* Changes in the financial markets, including:
– A change in the value of your savings; and
– A change in real interest rates and the inflation rate, which affect the amount you need to meet to achieve your income goal.
* Changes in your circumstances, including a change in your salary, contribution rate, income goal or retirement date.
Maharaj says the problem with moving into cash before retirement is not only that cash does not track the cost of the annuity you will buy, but also that you want to maximise the after-inflation returns on your retirement savings when your fund value is reaching its peak in the years prior to retirement. It is unlikely that you will be able to do this if you are invested in cash, he says.
Maharaj says if your or your trustees’ main goal is to protect the value of your capital shortly before you retire, the better alternative to moving into cash is to invest in a smoothed-bonus portfolio.
He agrees that matching your pre-retirement portfolio to the annuity that you plan to buy will provide you with a hedge against the risk of being underfunded when you have to annuitise.
He says Sanlam launched the Sanlam Liability Index in 2006 to help funds track the cost of an inflation-linked annuity. Sanlam has a dedicated portfolio that tracks this index for members close to retirement who want to buy an inflation-linked annuity.
Maharaj says Sanlam’s survey has found that funds have started to evolve their lifestage strategies to address the problems with this strategy.
He says about half the funds included in the Benchmark survey that use lifestaging report that their investment strategy is aligned to their members’ annuity strategy, while last year 42 percent of funds (up from 32 percent the previous year) allowed members to choose more than one portfolio for the final stage of the lifestage strategy. This allows members more closely to align their pre-retirement investment strategy with their annuity, Maharaj says.