Can you still retire financially secure?

Can members still retire financially secure even if they couldn’t save sufficiently before 35?

Recent findings from the 2016 Sanlam Benchmark retirement survey showed that retirement fund members could take advantage of greater disposable income later in life to make up for lower contribution rates when they were younger and had other financial commitments. From March this year, members could claim more of their retirement fund contributions as a tax deduction against their taxable income or remuneration, says Willem le Roux, Head of Investment Consulting at Simeka Consultants and Actuaries.

This means if members were not able to contribute sufficiently when they were younger, earning less and trying to establish themselves, they could still increase their contributions (aggressively) from around age 35 in order to make up. Theoretically, they could still achieve a replacement ratio (percentage of income paid as a pension) similar to what would have been achieved if they had contributed at the same rate over a working life. Better yet, thanks to the power of compound interest, if members contributed a high rate early on in life, they may not need to contribute at all later on in life. Remember, contribution rates include both members and employer’s contributions, but exclude the cost of group risk cover that is often associated with retirement funds.

You can still retire financially secure
Young adults who are unable to contribute large amounts to their retirement savings can still retire financially secure, provided they ramp up their contributions quite aggressively as they get older. However, in order to do this, the retirement fund would have to allow them to adjust their contributions as their circumstances changed. Many funds do not allow this. In reality, many younger members of retirement funds struggle to contribute as much as they should to their funds, because they have pressing financial commitments, such as home loans and raising children.

To make up for lower contributions earlier in life, at age 35 members would have to start increasing their retirement fund contributions quite dramatically until they reach 27.5% of total income at age 50, and maintain that contribution level until 65, when they retire (see the yellow line in the chart below). This should provide members with an initial income in retirement equal to 72% of their final salary, based on standard assumptions. This replacement ratio is similar to the ratio that would have been achieved if member and employer had contributed 12.5% for 45 years, or 15.5% for 40 years.

But postponing till 35 will come at a cost!

The graph below highlights the impact of various contribution strategies on a pensioner’s net replacement ratio (the percentage of the member’s salary just before retirement that he/she can expect to receive as an income in retirement).

Source: Sanlam Benchmark Survey 2016 presentation

Contributing 12.5% of your salary for 45 years from the age of 20 would put the member in a similar position to someone who contributes 5% from age 20 until age 35 and who increases it by 1.5 percentage points every year until the age of 50, keeping it at 27.5% until age 65. Le Roux said this approach may be more practical for certain individuals. Le Roux warns that high- income earners will have to take account of the R350 000 annual cap on tax deductions for retirement fund contributions.

Shockingly, if a member could manage to contribute 25% of their salary from age 20 to age 35, they could hypothetically stop contributing at age 35 and still be in a comparable position.

“Ignore contributions before age 35 at your own peril!”

The challenge to adjusting contributions, as members grow older is that, according to the Benchmark Survey, 75% of funds do not allow flexible employer and member contributions. Viresh Maharaj, the chief marketing actuary at Sanlam Employee Benefits, says funds that do not allow flexible contributions need to set contributions at levels that will be sufficient to enable members to create retirement wealth, or “members are being set up for failure”.

Default contributions
Maharaj says default contribution levels, which are intended to provide members with a minimum targeted income in retirement are better than leaving the choice entirely to the individual. The reasons for this are that where funds allow members to decide their contribution levels, members are often not aware that they have the option to contribute more, or procrastinate in taking advantage of this opportunity.

The difference between average total contributions and the maximum tax-deducible contribution of 27.5% is 9.87 percentage points for stand-alone funds and 10.89 percentage points for umbrella funds.

Increasing the contributions to the maximum of 27.5% could increase a member’s fund value over 20 years by an average of 56% if they belong to a standalone fund and 66% if they belong to an umbrella fund, assuming an average annual return of 10%.

Members can sabotage their ability to build up sufficient retirement capital
On average, members’ contributions are typically based on 80% of their total cost-to-company package. But if members are allowed to select the proportion of their retirement contributions when structuring their cost-to-company package, contributions as a percentage of pensionable earnings drop to 73% for members of stand-alone funds and 67 % for umbrella fund members, the survey shows.

Maharaj says this suggests that members reduce their pensionable earnings in order to maximise their take-home pay, because this will reduce their retirement fund contributions. So, although you may be contributing, say, 15 % towards retirement, in reality this may only be 15% of 63% of your cost-to-company package, which will negatively affect your ability to save enough for retirement. Reducing your pensionable pay usually results in a reduction in your group life assurance benefits, the impact of which you will fully realise only if you need to claim.

The secret to investing is addressing the right risk at the right time
He says that ideally funds should provide tailor-made investment strategies for each member. However, this would introduce complexity for members and fund administrators. A practicable solution is to link investment choices to their age, and address the right risk at the right time, which leads to current lifestage models. Such lifestage models address the risk of insufficient returns by investing in aggressive assets for the long term and protect the income that members can purchase after retirement as they approach retirement. The pertinent risk to be addressed in the years leading up to retirement depends on the type of annuity that the member would like to make use of. Similarly, members’ contribution rates can be linked to their age, and tailored to the needs of the members of that particular fund. The complexity associated with flexible contribution rates “cannot be left to members with no support”, and this is why it is important for funds to have default contribution rates, investment strategies and annuities (pensions). Members require advice and support when selecting an annuity at retirement, he says.

Le Roux says the biggest problem with leaving it up to members to decide how much to contribute to their funds is that most members do not save enough for retirement or do not preserve their retirement savings. As a result, they have to:

• lower their standard of living in retirement
• invest their retirement savings in a living annuity, so that they can draw down a higher pension than they would be able to do with a guaranteed annuity (but this results in them quickly depleting their capital, leaving them dependent on their family and friends and the state)
• delay retirement and work longer, which allows them to remain invested in higher-risk growth assets, such as equities, for longer.

The latter option is aligned with phased retirement and can improve outcomes significantly for members.

What trustees should consider
Le Roux said life-stage strategies (adopting an asset exposure in line with the investment horizon related to retirement) should be about optimising the timing of different risks, which members face in any case. If a fund provides conservative exposure to members, it should change that, he cautioned.

“You would be improving the expected outcomes for the members of your fund. Ideally you would like to give young members exposure or access to a super aggressive portfolio as well, as a choice portfolio. Under the current Regulation 28 you can’t be 100% in equities, but you can use alternative asset classes to get to a similar result.

“Furthermore, we’ve seen confirmation that life-stage strategies should be about protecting appropriately in the lead-up to retirement and investing in cash does not do that. Investing in cash does not protect the income you can purchase after retirement from an insured annuity and even if you want capital protection there are better ways of getting capital protection but still having exposure to upside if markets do really well.”

Trustees and other retirement industry players are positioned perfectly in order to add significant value to members in general and improve outcomes, by providing appropriate defaults and guidance amongst other things. Every decision made at a trustee level can be related back to the impact on the membership of that fund. We have seen a significant trend towards trustees taking responsibility for influencing retirement outcomes for their membership – long may the trend continue.

See Willem le Roux’s presentation here.

Sanlam Life Insurance Limited is a licensed Financial Service provider.