A South African retirement story – Two sides of a saved coin

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By Ronelle Kind*

In order to completely appreciate and influence something, it needs to be understood. The history of retirement funding in South Africa is no exception to this rule. Exploring the changes that have taken place in retirement funds, and the reasons for these changes, can assist us in understanding the challenges involved in sufficient retirement provision experienced by members across the industry today.

Ronelle Kind
Ronelle Kind

Beginning in the 1980s and continuing into the 1990s, thousands of defined benefit pension funds in South Africa started to convert to defined contribution structures. The first round of conversions took place at the urging of trade unions, who pushed for simpler, more transparent withdrawal benefits and lump sum benefits at retirement.

The second round of conversions was driven by employers, often after being advised to convert by their consultants. In many ways, defined benefit funds were a liability and employers in general were relieved to do away with them.

However, before we investigate the reasons for and the implications of the change any further, it is necessary to gain a clear understanding of the difference between the defined benefit (DB) and defined contribution (DC) fund structures.

The two sides of the coin explained

Defined benefit

DB funds offer a predefined benefit in terms of members’ final salary, years of service, and an accrual factor. Members usually contribute a fixed percentage towards the fund but the ultimate responsibility of the funding of the benefit provision lies with the employer.

In the example below, the accrual factor of 2% means that a member’s pension accrues by 2% for each year of service. After retirement, the actual monthly pension increases annually, in line with the retirement fund’s pension increase policy.

Annual Pension = 2% x Final [average] Salary x Service (years)

If a member is entitled to 2% of final [average] salary for each year and completes 30 years of service, he/she will receive a guaranteed pension of 60% of his/her final [average] salary.

Contributions to DB funds are either ‘pay as you go’ (current contributions subsidise retired members’ pensions) or funded by contributions of the employer and active members for their own future benefits. The latter is how South African DB pension funds operate.

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Advantages of DB funds for members:

  • Guaranteed benefits
  • Can be used to attract and retain staff
  • No member investment risk
  • No member longevity risk

Disadvantages of DB funds for members:

  • Not flexible – no member choice
  • Possibility of benefits being reduced if the employer cannot afford them
  • Very complicated – members do not understand how their benefits are calculated
  • Expensive to administrate

Defined contribution

DC funds provide a lump sum at retirement (comprising the member and employer contributions that have been invested, and the returns thereon, less costs) which is used to purchase a pension. Risk benefits are usually outsourced and based on a multiple of the member’s salary. The member carries all the investment risk.

Advantages of DC funds for members:

  • Transparent
  • More options/flexibility for members
  • Caters more easily for employee mobility
  • Simpler surplus distribution
  • Easier and cheaper to administrate
  • Possibility for member to share in good returns

Disadvantages of DC funds for members:

  • No guaranteed retirement benefits for members. Retirement benefits are dependent on market performance
  • If interest rates decrease the cost of purchasing a pension might lead to reduced retirement income
  • Members often do not accept their responsibility to understand and to plan carefully
  • Members underestimate how much they need
  • Educating members costs money

Summary of DB versus DC

DB funds:

  • Were the norm, and were based on offering a package (salary and benefits over and above salary). In other words, pension contributions did not affect take-home pay.
  • Provided a clear, predetermined retirement income in the form of an annuity.
  • Encouraged long service, due to accrual factors/vesting scales.
  • Allowed for member peace of mind, as all risk and responsibility (and therefore control) was employer’s.
  • Were secure, but not optimal: employers often kept surplus and members did not benefit from good investment returns.
DC funds:

  • Are now the norm, based on cost to company (contributions taken from net pay, and contribution level determines benefits).
  • Provide options to members, and the onus is on the members to make sufficient retirement provision, by making the right choices at the right times.
  • Caters more easily for job mobility in an uncertain economic environment. No vesting scales/accrual factors to disadvantage members who change jobs after only a few years.
  • Risk and responsibility (and therefore control) is member’s: he/she decides how to invest his/her contributions, and how much these amount to, i.e. member needs to take responsibility for own future financial security.
  • Potential to provide better retirement income if correctly managed.

Explanations and implications

For all the reasons discussed above, members appeared to welcome the change to defined contribution. They did not seem to be either aware of or concerned about the risk they would be taking on under the new arrangement. It is human nature to appreciate a tangible lump sum far more than the promise of an income for one’s old age. Unfortunately, the temptation to use that lump sum for other purposes is very often impossible for members to resist. We will discuss this further in the next section.

Surplus legislation

The Second Amendment to the Pension Funds Act was promulgated on 7 December 2001. In terms of this legislation, if a fund had a surplus, it had to be shared out between all of the former members, pensioners, employers, current members and deferred pensioners. This was yet another reason for employers to change over to DC.

Read also: What is the 4% Rule for Retirement?

The change allowed employers to take a big step back from retirement funding…but as a consequence, members are now obliged to take a big step forward and start thinking long term.

Member representation

From 15 December 1998, dual employer/employee representation on a board of trustees to a retirement fund became compulsory. This means members have the right to elect at least 50% of trustees on all retirement funds. The remaining trustees are appointed by the employer. This has led to many new trustees being appointed who do not necessarily have the skills and the knowledge required for them to function optimally.

All trustees need to be trained so as to understand what is at stake, in order to make good choices on behalf of the members. Investment risk must be managed, and other factors (such as member longevity) also need to be taken into account.

Where does this leave us?

The goal of saving for retirement is to maintain one’s standard of living, and this is best measured by the monthly income one’s savings will generate, not by the lump sum. The trustees should choose an appropriate replacement ratio to target and provide members with feedback regarding their progress towards that goal. The only choices members should be making are those regarding the income they require during retirement and how to get there. (Professor Robert Merton, MIT, in the Harvard Business Review).

South Africa does not have a culture of saving. Many of us are victims of procrastination, impatience, temptation (instant vs delayed gratification), and the overwhelming consumer culture in which we function. We are hard-wired to think short term. This means that often, when we are given a choice, we do not take the best option available to us. For example, we contribute the minimum amount so that we take home more cash each month, or we invest too conservatively, or we withdraw our savings when we change jobs.

It is for these reasons that the government is implementing retirement reform measures, which act as an incentive for South Africans to get into the habit of saving:

  • Mandatory preservation (delayed legislation)
  • Tax incentives to encourage saving
  • Enhanced portability of investments (delayed legislation)
  • Transparent and cost-effective management of funds
  • Taxation harmonisation and fund consolidation
  • Simplification of retirement products

Industry insights

The necessity for saving has become exponentially important over the last decade. This is partly due to greater longevity. In a country where, statistically, only 30% of all citizens will retire within their means, and only 13% believe they have enough money left for savings after covering all their spending needs, effective communication of the right message is crucial. An alarming 3.5 million South Africans have seriously considered cancelling an investment in order to service debt (Finscope South Africa 2015 Survey). More than 80% of our pensioners qualify for social grants. Incidentally, more than 70% of South Africans never obtain professional financial advice either.

Preservation needs to be actively encouraged and the implications of withdrawing retirement savings at retirement or when leaving an employer needs to be explained in a way members can easily understand and relate to. Member apathy also needs to be addressed as a matter of urgency. This can be done by means of high-impact, hard-hitting induction, and member guidance from day one of their employment. If members are educated effectively, they will invest correctly according to their individual needs, and voluntarily revisit their decisions whenever necessary. Finally, if all of this can be achieved, DC funds will succeed in their aim of providing the best benefits possible to members.

The next step – purchasing the right pension

Life annuity

Members who purchase a life annuity pay over their savings to an insurance company at retirement. The insurer will look at the amount available and inform the member as to how much he/she can receive as a monthly annuity (pension) for the remainder of their lives. The annuity will depend on factors such as current interest rates, assumed future interest rates, age, etc. In order to maintain his/her standard of living, it is estimated that the average member would need to target a pension equivalent to 75% of their pre-retirement income.

The missing link

Members very often compare an escalating or inflation-linked annuity with a level annuity and opt for the increased starting pension of the latter. The value of their pension is soon eroded due to the effects of inflation, which leaves the pensioner in a compromised financial situation. It is important to provide members with the tools and information to understand this and make sensible comparisons between the various options available at retirement.

Living annuity

In this case the member invests a cash lump sum with an insurer and then withdraws a monthly pension from this amount. Regulation provides limits on the annual percentage that may be withdrawn, however, the larger the capital and the higher the investment returns, the more the member will be able to withdraw. The member’s money remains invested after retirement and is still subject to the rise and fall of investment markets. To ensure that the investment provides an adequate income for the rest of the member’s life, he/she needs to select an appropriate level of withdrawal that does not deplete the capital investment amount leaving him/her without an income at older ages.

Conclusion

The large-scale conversion from Defined Benefit to Defined Contribution arrangements and the legislative changes over the last 20 years have increased member responsibility tenfold. Members have not embraced this responsibility, which leads to a large shortfall in funding for retirement across the industry. Assisting members to make the transition can not only be achieved by the communication efforts of retirement funds, but will have to involve human resources departments and the organisation as a whole. Education will have to be frequent and continuous, supplemented and enhanced by employee wellness programmes.

Ultimately, however, it is the responsibility of employers and board of trustees to accept the obligation and fulfil the role of education leaders. By guiding employees instead of dictating to them, by ensuring they understand why they should be making certain decisions, instead of merely telling them what decisions they ought to make, the retirement industry in South Africa is sure to become progressively healthier.

  • Ronelle Kind, Chief Operations Officer: Liberty Corporate Consultants and Actuaries.
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