Retirement policy roundup

In the recent past, we have written frequently about retirement reform. The reasons should be obvious to most readers: retirement assets represent a significant majority of the formal domestic savings pool and the JSE’s market capitalisation, and the conversation about the future shape of South Africa’s retirement system has been on the agenda continuously since 2004. While the first major structural changes resulting from this process – harmonised and capped contribution tax incentives at the individual level, and the gradual phasing out of provident funds – will come into effect on 1 March 2015, the remainder of the agenda has stalled.

The hiatus is primarily due to concerns about the mooted forced preservation of benefits until retirement date. While there is consensus among government and the retirement industry that the lack of preservation of accumulated benefits upon resignation is the key reason why most formally employed workers retire with inadequate retirement benefits, organised labour is not yet convinced that compulsory preservation is desirable. According to Business Day, the National Union of Mineworkers even contemplated yet more strike action in response to this perceived weakening of workers’ rights. As a result, National Treasury issued a press release in early July to provide comfort that government has no intention to nationalise existing assets (including the provision of services to investors), weaken fund members’ vested rights, or to be more prescriptive about how retirement fund assets should be invested. Hopefully this reassurance will help break the deadlock, as much work remains to be done before the next round of changes can take effect.

It appears unlikely that the public consultation processes on default options for fund preservation, investment and retirement income will resume before the preservation issue is resolved. We are also still awaiting the release of the formal Retail Distribution Review by the Financial Services Board.

Given this temporary lull in the local reform process, this issue focuses on global trends in the retirement industry, summarised below.

The next phase in the DC revolution

Defined contribution (DC) pension plans became popular in the early 1980s, when most private sector employers came to the conclusion that the then prevalent promises based on final salary (defined benefits) were unsustainable. The US introduced 401(k) plans in 1980, Australia launched compulsory superannuation in 1986 and Chile introduced their compulsory pension system in 1981 in response. The same approach became popular in South Africa shortly thereafter. Soon, for the first time, the majority of retirees globally will be primarily dependent on market-linked portfolios accumulated through their own saving efforts and investment choices to fund their income needs. A key difficulty in this new environment is providing appropriate support to households in managing the risks that they now bear. This is due to a general lack of willingness and/or ability to make choices themselves, together with low levels of trust in outsourcing these decisions to both governments and financial services firms. The situation is compounded by the fact that the transition to DC was accompanied by a decline in contribution rates in many countries, which increased the probability that the capital available to fund retirement may be inadequate to achieve the expected income replacement ratios. The main policy responses to this predicament have been a focus on appropriate defaults together with ensuring adequate contribution rates over lengthy periods. The Organisation for Economic Co-operation and Development (OECD) recently formalised a set of best practice policy guidelines to deal with these issues in its Roadmap for the Good Design of Retirement Plans.

Playing the birth date lottery

A key benefit of DC plans is the straightforward link between contributions made and eventual benefits received. This is transparent and allows individual control over assets, which is why this approach is adopted in the vast majority of democracies where pension contributions are compulsory or subject to auto-enrolment requirements.

However, this approach also has a downside. In a DC environment, each individual retirement saver’s outcome is defined by the return earned on his or her individual portfolio. Investment returns can vary significantly over different periods. Historical market outcomes on average supported a 6% p.a. drawdown rate over a 30-year retirement, but with a range of between 2% and 11% for different retirement dates. The uncertainty about returns creates the possibility of increasing intergenerational inequality even when all other factors (e.g. contribution rates, asset allocation, length of contribution and employment opportunities) remain constant. Some countries, including the UK, are therefore debating the adoption of collective DC schemes, based on the prevailing Dutch model. In this model, investment risk is shared between all investors in a fund, based on an actuarial smoothing or with-profits model. It is unlikely that this model will find widespread acceptance in markets such as South Africa, where the concept of individual accounts are deeply entrenched, as evidenced by the lack of market support for smoothed bonus portfolios offered by life companies.

Drawdown strategies are winning

Statistics recently released by the Association for Savings and Investment South Africa (ASISA) confirm the ongoing strong preference for living annuities (where retirees draw a percentage of their portfolio while retaining full control and ownership of the underlying capital) over underwritten annuities (where investors exchange capital for a guaranteed income stream payable for life). In 2013, 89% of all rands used for compulsory annuity purchases was invested in living annuities. This market preference is consistent with existing market behaviour in the US and Australia, which has a similar private sector pension fund structure to South Africa. It is anticipated that the UK retirement income market will end up in the same position following the surprise reforms, effectively abolishing forced annuitisation, announced in their 2014 budget. This view was reflected in the 50% to 60% declines in the market value of listed specialist annuity providers such as Just Retirement and Partnership Insurance immediately after the UK budget. Even traditionally risk-averse continental Europeans are responding to the low-interest rate environment by increasing investment in drawdown income plans.

This trend does mean that more pensioners are choosing not to insure longevity risk. A key unanswered question remains why deferred underwritten annuities – where retirees use a small portion of capital at the time of retirement to purchase a guaranteed income that will only become payable late in life – remain unpopular in most markets around the world.

World Bank reforms have disappointed

Over the past two decades, the World Bank’s formal ‘five pillar’ model (see the following table) has provided the framework for most pension reform initiatives around the world. The current South African pension system consists of a combination of pillars zero and three, and the next phase of the local reform debate will focus primarily on how to convert the latter into a pillar two solution.

The World Bank five pillar pension system model:

Pillar zeroBasic, universal state old-age grants, which are tax-funded
Pillar oneMandatory contributions to a pay-as-you-go social security fund, provided by government
Pillar twoMandatory contributions to fully funded privately managed funds
Pillar threeVoluntary contributions to fully funded privately managed funds
Pillar fourGeneral household savings, including home ownership

Most countries attempt to provide a basic state pension, whether as an old-age grant funded by general tax revenue (pillar zero) or as an entitlement to a minimum benefit claimable against a social security fund (pillar two). While sustainable affordability levels are debatable, the OECD recommends that this minimum guaranteed benefit should not exceed 30% of the median wage paid in the relevant local economy. In rich countries, this minimum benefit is typically 50% to 70% of the minimum wage. This means South Africa’s existing old-age grant of R1 350 per month is consistent with global affordability parameters for pillars zero and one combined, given prevailing minimum and median wage levels.

The majority of emerging market reform initiatives in the 1990s and 2000s were aimed at introducing pillar two systems, with the dual objectives of enhancing household welfare in a manner consistent with the aforementioned affordability constraint, and to aid the development of domestic capital markets. Over the past two decades, 29 countries, mostly in Latin America and Eastern Europe, adopted this model. It should be noted that, unlike South Africa, the vast majority of these countries did not have well-established capital markets or a pillar three system at the time of introducing the reforms. The typical blueprint for these reforms was the Chilean design for simplified and commoditised benefits (described in detail here:, which was also briefly fashionable in South Africa around a decade ago.

Since the 2008 financial crisis, at least ten of these countries have fully or partially terminated the pillar two components of their systems. In many of these countries, including Russia, Poland and Argentina, all or most assets accumulated were transferred back into first pillar solutions and contributions were terminated or reduced.

According to the World Bank, the high failure rate in the reform process can be blamed primarily on political responses to fiscal pressures, with funded retirement benefits being diverted to government coffers. This was made possible by low levels of public trust in the newly created private pension systems. A number of factors affected public perceptions of the value proposition:

  • Returns produced were poor, primarily due to overly conservative asset allocation (many countries had systems where more than 70% of assets were invested in short-duration government bonds).
  • Governments did not follow through with the reforms required to assist the development of local capital markets, which are necessary to underpin funded pensions.
  • Some countries were also the victims of unfortunate timing, launching mandatory systems just before the 2008 financial crisis.
  • In many countries, wage growth was significantly higher than fund return, further reducing perceived value.
  • The perception of high fees relative to the value added also contributed to low trust.

It remains clear that to ensure sustainability, it is imperative for a pension system to be viewed as credible and being operated in the interests of fund members, especially when contribution is mandatory. Adequate returns, appropriate asset allocation, sensible default options with the opportunity to opt out, defendable cost structures and the availability of suitable retirement income options remain the foundation stones on which this credibility can be built.

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