According to South African Finance Minister, Pravin Gordhan, only about 10% of South Africans enjoy a ‘decent retirement’. For the rest, retirement means financial hardship or, at least, a drop in lifestyle.
The problem is that the retirement industry habitually blames savers for these poor outcomes. They start too late, they save too little, and they do not preserve when they change jobs. Invariably, the call is for more investor education. But, this achieves very little if employees refuse to engage, or take an active interest in the retirement fund. Unfortunately, these employees are in the great majority.
Even committed savers fall short. According to a study by Alexander Forbes, the average final income replacement ratio of long-term retirement members is only around 30% – half the recommended minimum.
Retirement fund trustees are unable to regulate their members’ savings habits, despite their best intentions. Four changes to a current fund strategy can significantly boost members’ savings over the long term, giving them up to 140% more money in retirement. The four key areas that should be considered in a fund strategy are: asset allocation, fees, switching and default preservation.
This is the most critical investment decision, as it has the biggest impact on the long-term savings outcome. Although most trustees appreciate that shares (equities) deliver a higher return than cash or bonds over the long term (averaging around 7% pa versus 1-2% pa, after inflation), few truly appreciate the dramatic impact that the asset allocation has on the fund member’s retirement income.
Given that the share market has outperformed the other two asset classes by a factor of 40 or more, making even modest changes to the asset allocation can have a significant impact on the long-term savings outcome. For example, increasing the exposure to growth assets from 60% to 77%, would (based on historical returns), increase the annual, long-term, real (after-inflation) return of a balanced portfolio by some 1% pa. This would give the investor 30% more money at retirement.
The retirement industry’s high fees have come under scrutiny in recent years, not least of all by National Treasury who delivered a 90-page indictment in its 2013 Retirement Reform Discussion Paper ‘Charges in South African Retirement Funds’.
While no-one will argue that, all else equal, lower fees are preferable to higher fees, again few people fully appreciate the insidious, long-term impact of fees.
Some may believe that, short term, paying a higher fee for the prospect of a better return is a worthwhile gamble. This may pay off once in a while but in the long run, the house – or rather the market – almost always wins.
Investment choices has become an ever-present in South African retirement funds. Most funds allow members to choose from a selection of funds, investment styles and investment strategies, as well as switch on a regular basis.
However, it is the trustees who are best-placed to design or select the optimal portfolio to this end. For uninformed members, investment choice is a curse rather than a blessing as it tempts them to do the wrong thing at the wrong time. Despite all good intentions, they are likely to make emotional decisions and ditch the fund that has just done badly, and embrace the one that has just done well. This approach is based on short-term thinking, which effectively leads them to buy high and sell low.
It takes a disciplined, informed, even detached person, to withstand the urge to react to market movements and adhere to the original plan. A trustee can significantly improve members’ savings outcome by setting an appropriate ‘do-nothing’ default portfolio strategy that excludes choice and switching.
Of course, a trustee’s good intentions and fund design will count for little if fund members do not stay the course and cash-in when they change jobs. A member’s opportunity cost of not preserving and missing out on the tremendous savings boost generated by compounding returns in the last quarter of a forty-year savings term can be the difference between retiring comfortably or not.
To illustrate (using a high equity, 1% pa fee example), a forty-year savings term will reap almost four times more money than a twenty-year term. The reason, over the last twenty-years, more than 80% of the fund’s gains derive from investment returns on an ever-increasing base, rather than from additional contributions.
The great majority of fund members do not preserve when they change jobs, mostly due to short-term lifestyle considerations, such as taking off for a period or paying down debt. Although there are no laws that compel preservation, the opt-out principle that underlies the National Treasury’s default preservation design intends to raise the current preservation rate.
Trustees can take a proactive stance on this by providing a default preservation option before this becomes compulsory; and by implementing a communications policy that unambiguously brings the preservation option – and the cost of not preserving – to the exiting employee’s attention.
Individually, each of these changes will greatly enhance any fund members’ retirement; together they can completely transform it.
The choice is clear: retirement fund trustees can kick the proverbial ‘can down the road’ and let fund members live with the consequences of this short-termism – or, they can make a big difference and leave a lasting legacy by implementing these four cornerstones, potentially achieving up to 140% more money for members at retirement.
Tracy Jensen is the Chief Product Architect at 10X Investments.