Retirement

Retirement fund reform - still debated

In previous articles covering retirement fund reform, we have shared our views on some of the choices being debated between stakeholders (see Quarterly Commentary 3 and 4 of 2008). In this issue Christo Terblanche considers how national pension benefits should be determined, i.e. whether a future state system should be defined benefit or defined contribution in nature. Both these options can be fully funded (where current accumulation goes towards the current workforce's retirement one day), or pay-as-you-go (where current accumulation pays the pensions to the current non-contributing pensioner community). We are strong pundits of a funded system and have considered the alternatives within the context only of a fully funded environment.

As a reminder: the headline objectives of retirement fund reform are to encourage adequate provision for retirement; to ensure retirement arrangements are cost-efficient, fair, prudent and transparent; to improve fund governance and to provide a basic safety net for those in old age. It is important to keep up to date with the major design choices to be made in the new system, as the end result will have an impact on every South African.

It is not yet clear whether the new National Savings Fund (NSF) will be a defined benefit (DB) or a defined contribution (DC) fund this is an area of some disagreement between stakeholders, including those within government. The key differentiator between the two types of schemes is the allocation of risk and reward between the individual and the scheme provider. In our view, for a national retirement fund of the kind being proposed in this country, and especially where there is an old age grant 'safety net' already in place, a DC scheme is preferable.

Transparency and ease of understanding

Being able to understand a scheme and monitor the growth in benefits is very important as it builds trust in the system and thus increases support.

In a DC scheme, the value of a member's benefit is simply the market value of the accumulated and invested contributions in the investment account. This is much akin to a bank account. With a moderate investment in education, a national DC scheme could have as a side benefit that South Africans gain a better understanding of the benefits of savings and the power of investment compounding.

In a DB scheme, the level of benefit is also easy to understand, and often based on a simple percentage of earnings in the final years of employment. However, the formula used to derive this benefit relies on actuarial calculations, taking into account discounted future income streams and including assumptions about future investment returns, mortality, etc. Changes in the benefit formula can therefore be very difficult to explain or justify, whether they are based on unexpected changes in individual earnings or on unexpected investment returns. Even leaving aside the impact of the world economy, South Africa faces considerable uncertainty in both our capital and labour markets and formula changes would undoubtedly be required. A DB scheme would ultimately be hard to trust and do little to improve financial literacy among South Africans.

Choice and flexibility

Generally, as explained in Table 1, DC schemes allow members some level of control over choice of investment manager and asset allocation. In a DB scheme, the investment aspects of the funds would be pooled and managed for all members collectively.

This is a common argument for why a DB scheme is desirable, because the government as sponsor should provide a 'fixed' benefit to members, since the average member does not have the necessary skill to select investment portfolios in a DC environment.

But a DC scheme does not have to require members to make choices. All members in a particular category (e.g. based on age bands) can be pooled in a default portfolio. The point is that in a DC scheme, those who are comfortable making a selection of their own could be given a limited set of alternatives to choose from. Too much choice generally causes confusion (see Marisa Kaplan's article in the Quarterly Commentary 3 of 2009, 'The cost of too much choice'), but it would not be hard to provide the right amount of choice under even a very basic DC system. Marketing regulations are already effective in the unit trust environment and these could be used to regulate providers of the limited additional investment choices. South Africa has a strong community of financial planning experts who could assist members who decide to select their own portfolios in the selection process.

Defined benefit versus defined contribution

The combination of a good and cost-effective default, a limited range of additional investment portfolios and informed decision-making (members on their own or with the assistance of financial experts), would naturally lead to healthy competition among investment managers. A healthy competitive environment in turn should lead to value-for-money fees and attractive investment performance.

Being able to understand a scheme and monitor the growth benefits...builds trust in the system and thus increases support

Risks in DC schemes are easier to manage over long periods

Both DB and DC schemes have investment risk. In a DC scheme, sensible scheme design can help members to manage this risk. In a national DB scheme the investment risk is pooled between individuals, so that there is no disparity in individual investment outcome. But the investment risk in the pool itself is carried by the state. DB scheme contributions are expected to accumulate to the benefit value in future, based on assumptions of future mortality and investment returns. If investment returns end up being worse than expected, the cost of the scheme increases. The state may not be in a position to fund increased contributions, and the scheme may either run into a deficit (which means there are insufficient assets to meet all the benefit promises), or the government may have to reduce the benefits.

South Africa has a safety net for pensioners in the form of an old age grant, funded by taxes, currently set at R1 010 per month. The government has avoided calling this a state pension because a grant is not a permanent commitment. Rather than taking on the funding risk in a national DB scheme, policymakers should make a long-term commitment to providing this basic state pension.

Risk and reward

In summary, in a DB scenario provided by government, the member faces the risk of reduced benefits or indirectly higher cost through increased taxes over time. On the other hand, in a DC environment the member has the potential to understand, monitor and to a large extent control the funding of his or her own pension, and in doing so to optimise his or her own trade-off between risk and reward.

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