A status check on the retirement fund industry

The FSB has overseen and regulated a significant change in the retirement fund industry in the recent past. In 1999 there were approximately 16 500 funds. The 2017 annual report indicates that there are 1 758 active funds and some 3 361 funds that are classified as “Other” but this category includes funds that are in liquidation and funds that are awaiting deregistration.

The Financial Services Board (FSB) recently released its 2017annual report. The FSB will shortly be transformed into the Financial Sector Conduct Authority (FSCA), now that the Financial Sector Regulation Act 9 of 2017 has been promulgated. This is the result of a long process since the financial crisis of 2008 to introduce a twin peaks regulation model, where the SA Reserve Bank will focus on financial stability and the new FSCA will focus on market conduct in the financial services industry. It is therefore clear that there has been a significant clean-up of records. More importantly, regulation introduced especially since the so-called surplus legislation of 2001, has moved many funds into consolidation and/or closure. It is quite possible that these numbers could have been significantly lower if it were not for legal action and an impasse on processes to be followed in closing down funds.

Contributions (R’m)
Although care must be taken in interpreting these numbers, as not all retirement funds have the same financial year-end, some observations include:

• The industry has been cash flow negative (contributions less benefit payments) before administration costs and
• has increased – double counting is likely to occur due to hybrid funds and members belonging to occupational funds and retirement annuity funds.
• The 16.4m membership of funds comprises 11.1m active members and 5.3m pensioners, dependants and unclaimed benefits.
• The assets in retirement fund s are just over R4 trillion (tn), of which the GEPF, Transnet and Telkom retirement funds hold approximately R1.7tn.
• Almost 27% of all contributions to retirement funds are made to the GEPF.

New participating employers registered in umbrella funds and rule amendments during the reporting period are 6 348, with 2 889 section 14 transfers (transfers between funds) that have been approved.

The stated objective of the regulator to reduce the number of funds and encourage consolidation to improve supervision and interaction, is therefore being achieved. The compliance requirements have certainly increased significantly since 2001, which has moved many boards to look for cost savings and to reduce the onus on board members. It is quite possible that further regulatory changes such as the default regulations will move more funds to consolidate, in an attempt to find sufficient scale to meet the required standards.

The negative cash flow and slow asset growth (before investment returns) in the retirement industry are of concern and reflect the state of the economy (low growth in employment and economic activity). This has been the case for some time and is perhaps more a function of economic policy and a reduction in savings than regulatory activity. It is also hoped that the cost of saving will eventually reduce with this scale. Some improvement has been indicated in the annual Sanlam Benchmark Survey, but it is clear that economic growth will also be needed to realise this objective.

• Investment returns for all three periods shown, with a marked increase in 2015.
• Asset values have increased despite negative cash flows.
• has increased – double counting is likely to occur due to hybrid funds and members belonging to
occupational funds and retirement annuity funds.
• The 16.4m membership of funds comprises 11.1m active members and 5.3m pensioners, dependants
and unclaimed benefits.
• The assets in retirement fund s are just over R4 trillion (tn), of which the GEPF, Transnet and
Telkom retirement funds hold approximately R1.7tn.
• Almost 27% of all contributions to retirement funds are made to the GEPF.

New participating employers registered in umbrella funds and rule amendments during the reporting period are 6 348, with 2 889 section 14 transfers (transfers between funds) that have been approved.

Is a retirement fund investment really that
much better?

If you missed the opportunity to join your employer’s retirement fund you should know about this proposed change in the tax laws:

Scrapping the 12-month limitation on joining a newly established pension or provident fund
Currently, when an employer establishes a pension or provident fund or joins an umbrella fund for the first time, existing employees are not compelled to join the new fund. They have up to 12 months to make an application to join that fund. An employee who fails to make an application to join within the 12-month period is not permitted to join that fund at any later stage. (In contrast, when an employee takes up employment with an employer who offers a retirement fund, the law states that membership is compulsory if the member is eligible.)
This old law will be removed with effect from 1 March 2018. This means that employees who missed the opportunity to join their employer’s retirement fund will be given the opportunity to do so from next year.

Is a retirement fund really that much better than any other long-term investment a member can make in his/her private capacity?

How tax efficient are retirement funds?
Example: Consider a 40-year-old individual who earns a salary of R10 000 per month and in respect of whom the employer makes a monthly contribution of R1 000 to a provident fund over a term of 20 years. Compare this to a similar investment in a tax-free investment (TFI) or collective investment scheme (CIS). We assumed the contributions are placed in a balanced fund earning a return of 5% above inflation in each investment.

Our projections show that for a member that earns R10 000 pm, the provident fund investment will be 13% better than the TFI and 26% better than the CIS.

If the individual earns R120 000 pm (taxed at the highest marginal rate) the provident fund investment will be 55% better than the TFI and 64% better than the CIS.

It is clear that individuals who are subject to a higher tax bracket will benefit more from contributing to a retirement fund. The above analysis also shows that the provident fund investment will produce the best after-tax retirement outcome by far. It really is a virtual tax haven.
The provident fund and TFI have the same advantage over the CIS in that they are exempt from dividend, interest and capital gains tax. The tax efficiency of the provident fund is amplified by the fact that contributions are tax deductible. That means the full amount is available for investment while the contributions to TFI and CIS are made with after-tax income. At retirement, however, the provident fund benefit is subject to retirement lump sum benefit tax. In this example, we have assumed that the full tax- free lump sum allowance has been used. The comparison shows the favourable taxation enjoyed by retirement fund investments despite this tax.

You will not find a more tax-efficient, cost-effective and convenient retirement vehicle.

• As shown above, retirement funds are virtual tax havens.
• Retirement funds can also be cost effective. This is because they are group or wholesale arrangements that enjoy the benefit of economies of scale as they grow in size.
• Furthermore, the trustees – with the help of their benefit consultants – are able to negotiate with service providers to develop and offer the best benefits at institutional prices.

If an individual wishes to build up an additional nest egg, one that they can have access to in the event of a life crisis, a tax- free investment would be an excellent choice.

Retirement

investment strategies

The key to investing is addressing the right risk at the right time. This is a well-known and general truth but –

Not many investors fully understand the implications of the sequencing risk which arises when drawing an income from assets (such as in a living annuity). A concept called the “flaw of averages” is an amusing play on words but at the same time it is helpful in order to understand sequencing risk in investment terms.

Consider two scenarios of investment returns over 20 years. The two scenarios provide exactly the same return over the full period, but the second scenario follows the opposite order to the first (see chart 1 below). As an example, the first year’s return in scenario 1 is 20%, as is the last year’s return for scenario 2. The last year’s return in scenario 1 is -4%, as is the first year’s return in scenario 2. And the same applies to all the years in between.

Simply put, if you invested R1 in both scenarios, you would have had the same value (just under R5) after 20 years (see chart 2 below).

However, for a living annuitant drawing a starting pension of 7% of capital and increasing that pension by inflation every year, the results would offer a stark contrast (see chart 3 below, which shows the level of capital as it changes over time).

The red dot on scenario 2 indicates that already in year 6 the living annuitant would hit the 17.5% drawdown rate cap applied to living annuities, while the living annuitant in scenario 1 would still be sailing below that cap after the full 20-year term! The “flaw of averages” would be to think that the two scenarios give the same outcome by virtue of providing the same average return.

There is one undeniable conclusion from this example – when you are drawing an income, you would ignore the timing of returns at your own peril. Michael Finke, PhD, CFP® and David Blanchett, CFA, CFP® write in An Overview of Retirement Income Strategies: “If the real return on investments is volatile, then the dates that the assets are depleted will depend on when the real returns are realised in the retirement life cycle.”

It is therefore reasonable to infer that the management of the

volatility of returns after retirement should enjoy much greater priority than for investment strategies in the accumulation phase of the retirement saving cycle.

The reason for this phenomenon is intuitive. If returns are negative early on in the retirement phase, more units of assets need to be sold to cover the same income need, leaving less assets to recover when market returns recover.

We performed some modelling to evaluate the expected outcomes of different investment strategies, but also looking at the distribution of potential outcomes and paying particular attention to those less favourable market environments. The purpose was to investigate the merits of different investment strategies in order to gain sufficient expected returns without exposing the pensioner to the substantial risk of running out of money very soon. Here are some interesting conclusions:

Protection (such as investment in guaranteed portfolios, income fund s, etc.) does improve the upside/downside combinations for living annuities.
Full protection (say 100% investment in guaranteed annuities) does not stand up to scrutiny against strategies that make use of protection for the cash flow requirement and retain substantial investment in more aggressive strategies.

Managing sequencing risks

Selecting an in-fund living annuity at retirement is a good start for many pensioners – given the convenience and institutional pricing structures typically offered. However, selecting the underlying investment portfolio(s) will take more than the usual levels of conventional investment skills. The timing of your retirement date is also critical, as market conditions at the time may support your planning or may destroy value. There is an element of chance or luck in setting your retirement date that cannot be removed completely. However, no matter when you retire, much can be done in terms of the portfolio selection for a living annuity investment strategy to address the potential sequencing risks at the time.

From this quick investigation it is clear that both trustees and members would benefit greatly from advice on in-fund living annuity investment options.

Default preservation and portability

With the default preservation regulation, National Treasury aims to improve preservation, portability and ultimately, the consolidation of retirement fund benefits.

They aim to achieve this by introducing retirement benefit counselling (free member education and support), automatic paid-up status, in-fund preservation and measures that will compel a new fund to arrange for the transfer and consolidation of all similar benefits, free of charge.

Compulsory paid-up status

The rules of pension and provident funds will have to be amended by no later than 1 March 2019, to provide that members who terminate service before retirement become paid-up in the fund, (and will remain in the same portfolio unless the rules provide otherwise) until the fund is instructed by the member in writing to make payment or transfer his/her benefit.

Retirement benefit counselling

In terms of the default regulations, withdrawing members must be given access to retirement benefit counselling before any withdrawal benefit is processed. The regulations will require the fund and/or the HR office to adjust their processes and procedures somewhat. The member should be invited to consider an explanation of his/her preservation options under the fund as well as the risks, costs and charges. Our interpretation is that this information can be provided in writing (or via such other medium that may qualify or be prescribed) but, in addition, the member should have access to a counsellor on request.

In-fund preservation – Transfer out of the fund – Paid-up membership

Those members who would like to preserve their benefits (and practically anyone else that has not submitted written instructions to withdraw or transfer their benefits) will remain invested in the fund. To make in-fund preservation attractive, the investment fees and charges in respect of the portion of the member’s benefit invested in the default investment portfolio, may not differ on the basis of a member’s paid-up status. The administration fees for paid-up members must be fair, reasonable and commensurate with the cost of providing the administration service to members still in the employ of the participating employer. As a result, in-fund preservation offerings compare favourably with typical retail solutions.

Portability – Transfer into the fund – Consolidation

The rules of the fund must allow for transfers into the fund from any other fund. Within four (4) months of a member joining the fund, the fund must obtain a list of all paid-up membership certificates in respect of any retirement savings of that member; request whether the member wishes these benefits to be transferred into the fund; and if the member so elects, arrange the transfer of all such retirement savings into the fund without levying a charge on such amounts in respect of the transfer. This provision also applies to transfers from defined benefit funds, provided that such transfers comprise a defined contribution benefit component.

These new duties are placed on the fund. The fund, however, will not be able to process these requirements if they do not have the support of the employer and do not have access to the personal contact details of all new members. Employers should therefore expect retirement funds to become much stricter on the provision of member data, especially tax numbers, cell phone numbers and e-mail addresses. It appears possible for most of these requirements to be integrated and complied with when the member (new employee) goes through the onboarding procedures of the employer.

In-fund preservation options, however, are not equal

From a planning perspective, the consolidation of benefits in the new fund should be a priority, as the cost of participating in two funds will typically be much higher and there is a bigger chance of a separate benefit becoming forgotten and unclaimed.

On withdrawal a member will be in a position to compare the preservation offering of his/her old fund (paid-up membership), new fund (transferred/consolidated benefit) and a preservation fund offering. The decision will primarily be made on the basis of price, investment choice and other membership features such as when and to what extent the member will have access to his/her benefits.

In respect of the latter aspect it is worth noting that transferred benefits can only be withdrawn when there is a benefit event, such as resignation. A paid-up member can withdraw the entire paid-up benefit at any time. In addition, it affords the member the opportunity to do a phased retirement by using some of the paid-up benefits to tide him/her over while pursuing a second career.