Employees in their twenties could be tempted to postpone saving for retirement for a decade or two, arguing that they would make up the shortfall later on when they earn a bigger salary.
Even where young workers do save from day one, the fact that many people don’t preserve their retirement benefits when they change jobs, effectively mean they also defer saving for retirement. More than two-thirds of pensioners who participated in Sanlam’s Benchmark Survey 2016 indicated that they did not preserve their savings when changing jobs and it is no surprise then that only 35% of the same group believed they have saved enough for retirement.
A research paper by David Blake, Douglas Wright and Yumeng Zhang called Age-Dependent Investing: Optimal Funding and Investment Strategies in Defined Contribution Pension Plans when Members are Rational Life Cycle Financial Planners investigates a retirement funding model that spreads the income earned as smoothly as possible from the time an individual starts working until the day she dies.
Discussing the implications of such an approach at the launch of the survey, Willem le Roux, actuary and head of investment consulting at Simeka Consultants and Actuaries, said quite controversially, the model demonstrates that the member would save nothing before the age of 35, but from age 35 she would save every increase received above inflation towards her retirement.
“So you are basically capping your standard of living from age 35.”
However controversial such an approach would be, at the very least anyone aged 35 and younger has no reason to bury her head in the sand in the belief that retirement is going to be tough, Le Roux said.
“In fact, the future can still be very rosy.”
But postponing will come at a cost. Based on the average member, contribution rates could get as high as 35% by the age of 60, according to the model.
Le Roux said as an actuary he wouldn’t recommend that everyone under the age of 35 should contribute nothing towards their retirement.
Saving is a culture and it would be very difficult to start saving large portions of your income towards retirement when you’ve saved nothing for a decade.
It would also be extremely challenging to cap your standard of living from age 35.
There are also other factors to consider.
In South Africa, a member won’t be able to contribute 35% of his or her salary in a tax-efficient manner.
“You can deduct from tax 27.5% contributions and of course if you are a high income earner, you’ve got the R350 000 rand cap to worry about as well,” Le Roux said.
The model also suggests that contributions should be fully invested in equities until around age 50. After 50, the member should gradually start converting from equities into inflation-linked bonds and the equity exposure should reduce to between 20% and 50% by retirement age, depending on your risk profile.
“Now this confirms what I always like to say – that the secret to investing is addressing the right risk at the right time. Investing in equities addresses the risk of insufficient returns for the long-term whereas investing in inflation-linked bonds protects the income that you can purchase after retirement.”
In the local market however, Regulation 28 of the Pension Funds Act, only allows a 75% equity exposure.
“There are ways around it, but that is another challenge.”
Le Roux said it would also be difficult for the industry to communicate effectively with members about such an approach.
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 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 would be more practical.
However, if a member could manage to contribute 25% of her salary from age 20 to age 35, she could stop contributing at age 35 and still be in a comparable position.
“So ignore contributions before age 35 at your own peril.”
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 will be improving the outcomes for the members of your fund. Ideally you would like to give young members exposure or access to a super aggressive portfolio. Under the current Regulation 28 you can’t be 100% in equities, but you can use alternative asset classes to get there.
“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 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.”