Solving SA’s underfunding problem for retirees

It’s a common mantra in South Africa: preservation, preservation, preservation. The universal problem is that individuals do not preserve their retirement savings during the course of their working lives, particularly when they change jobs, and is widely accepted to be the major contributor to underfunding at retirement, said Lesley-Ann Morgan, global head of defined contributions and retirement at Schroders UK, presenting at the Sanlam Investments Institutional Insights conference in Johannesburg in September.

Being underfunded implies simply that you have insufficient capital at retirement to support your future withdrawals for the rest of your years.  So, how do we get to a workable post-retirement solution for South Africa, asks Morgan?

Morgan laid out a variety of workable annuity structures for trustees, principal officers and investment committee members.  Governments the world over, including South Africa’s, have stressed the need for a “default solution”. Default funds are simply investments that employees’ retirement savings are placed into should they choose not to make a decision themselves about where they wish to invest.

But remember that certain risks have to be taken into account, says Morgan. Life expectancy has risen. Lower investment returns are a fact of life at present. Higher inflation in South Africa means expenses in terms of consumption expenditure during retirement have gone up.   Add to this the need for certainty about stable investment outcomes and flexibility with choices, and it is obvious that investment professionals, fiduciaries and asset consultants all have a major challenge on their hands.

How do we take the most “efficient risk”?

Weigh up the needs and the wants:

Morgan said that the needs people have in post-retirement are very different to their wants and tend to pull in opposite directions. For this reason it can be very challenging to find the appropriate investment solution.

At retirement, said Morgan, people have three fundamental “wants”:

• a nominal predictable income,
• an easy to understand structure that provides adequacy, and
• inheritance benefits in terms of their fund’s legacy that they can pass on to their beneficiaries.

But this has to be balanced with their “important four needs”: longevity protection, inflation, simplicity and flexibility of choice.

To effectively address these opposing needs and wants, there is certainly no ‘one-size fits all’ solution.  Actuaries need to be aware that life expectancy often differs with income levels and a buffer is needed to create a solution that won’t leave anyone out.

Different countries provide different solutions, shared Morgan. In Hong Kong you are given cash, to do with what you will. In the EU, people tend to expect a guarantee. In the UK and US, you are given a choice, but with no advice attached. Australia is considering a post-retirement default package, specifically designed to protect against longevity. And then you have combinations of the above, as it applies to the likes of South Africa and Chile.

No killer answer, but a hybrid solution could be it

The three traditional ways to provide for retirement include a cash lump sum, a guaranteed annuity, and a living annuity, while other obvious options include:

1. You can take as little capital risk as possible, put it all into bonds, and eke out a living (risk: it won’t last me my retirement but at least it will be safe).
2. OR maximise your risk and put as much as possible into growth assets such as equities (75%) and put the rest into something else and hope for the best (risk: you could suffer potential irrecoverable capital losses if the markets fall in the early stages of retirement).
3. OR you can take a punt on multi-asset active management and hope to close the funding gap (risk: attempting to time asset class switches can similarly erode your nest egg).
4. OR do you take the certainty of an income from a guaranteed annuity (risk: it gives you a level of income below the level of consumption required by most people)?

All of the above options grapple with the basic challenges of providing investment growth and downside protection, while at the same time guarding against spikes in inflation that can erode retirement income.

“Some sort of hybrid between cash, living annuity, and guaranteed annuity would have to be devised if governments ever want to introduce a workable default retirement solution…”, said Morgan.

The hybrid model

At Schroders, Morgan used ‘model scenarios’ to determine what a nominal savings amount would provide in terms of targeted income, and how this would affect the drawdown on the lump-sum savings. For instance, a diversified portfolio made up of 40% South African equities, 10% global equities and 50% local bonds came close to meeting targeted requirements.

“However, it was still not quite right,” she said. “So we constructed a hybrid model that contained 30% in a guaranteed annuity and 70% in a diversified basket of assets in a living annuity”. Although the target income was met, the model could not withstand market shocks and hence carried heavy longevity risks. Additionally, although inflation-linked guaranteed annuities looked attractive, they were very expensive and people underestimated both their longevity and the effects of inflation on their post-retirement lifestyles.

“There is still no single solution,” said Morgan, who stressed that underfunding remained the biggest problem worldwide. Even in Australia, who she calls “the poster child” for the industry, people are not fully funded despite reasonably high, mandatory contributions during their working lives.

Different defaults for different groups

In South Africa, the most workable solution would probably be to have different default portfolios for different groups according to their post-retirement needs and wants, she said. Those with extended families, for example, may require an annuity structure based on a benchmark that is different from someone whose target is funding their projected longevity.

Morgan concluded by reiterating that tweaking a diversified portfolio was relatively simple, which involved certain ‘add-ons’ depending on the retiree’s basic wants and needs for guaranteed income and protection against risk. Less easy to solve was the underfunding problem.

What we’ve come to realise, says Morgan, is that investment alone is never going to save the day. At best it can help make up some of the shortfall. People have to recognise that saving is important.  The most successful financial education has been shown to happen at the point of decision (ie, close to retirement) rather than early on when you sign up to a job, and it is important to note that many young people currently don’t grasp the basic fundamentals.  This education should also include an essential element that creates an awareness of the role debt plays.

Obviously, contributions also have to be a big part of the picture. But there are problems with compulsory savings due to the low socio-economic status of some. So the ideal would be to introduce ‘compulsory with opt-out’, like in the UK. Interestingly, this has been a popular option and opt-outs have been surprisingly low. This could be especially favourable for those at the lower end of the income scale who may not be able to afford to contribute at all stages of their life. You have to start, but at least you can choose to opt out.

“Clearly we all have to work longer and defer retirement, but the reality is that while we can keep on extending the retirement age, we just never catch up because we’re too far behind.”

In an ideal world, says Morgan, the answer would be to maximise returns prior to retirement age, ie getting people to take as much risk as possible when they are younger, and this could mean allocating to non-traditional asset classes and perhaps even using leverage in the early pre-retirement years.

However, the ultimate and most workable solution for South Africa, says Morgan, would most likely be different defaults for different people, taking into account all the different needs, wants, income and socio-economic status.