Edition: October / December 2016
Winds of change
Fund trustees must fundamentally change their approach to the SA retirement conversation. Louis Theron, Head of Liaibility-Driven Solutions at Liberty Corporate, explains why.
Until about 20 years ago defined-benefit (DB) retirement funds involved themselves in the financial wellbeing of members from the date they joined a fund (typically the start of employment) until the date of death whilst in retirement. In the 1990s this all began to change.
Today, DB funds are the exception and defined-contribution (DC) outcomes are prevalent. In a DB environment a fund committed itself to pay retired members’ benefits that were defined i.e. monthly amounts and often also medical benefits. In DC, a fund defines how much it will contribute to a member’s post-retirement kitty and the choice of a post-retirement income is up to members themselves.
Typically, retiring DC fund members will take what has been deducted from their salaries over the years, plus the amounts contributed by their employers and add any investment gains attributable to them. From that point, the majority of members find that they are on their own; to make their own arrangements relating to their financial wellbeing post retirement. It’s been shown that the vast majority of employed people entering retirement do not have sufficient financial means with which to maintain themselves at retirement.
At worst, members simply take their payouts in cash. They either quickly spend what little savings they have or try to sustain themselves on meagre interest from banks.
For those who do want some sort of annuity income, until today most retirees have been directed by their funds – or by their funds’ financial advisors – towards retail offerings from life insurance companies. These typically attract much higher commissions and fees than those paid by people remaining in DB outcomes. (Outside of the benefit structure, economies of scale apply. Big funds can negotiate low fees while individuals can’t.)
The vast majority of those taking up retail offerings have opted for living annuities where they must pay for financial advice. Under these offerings, members are allowed to draw down a certain percentage of their “pots” every year but are never guaranteed any specified monthly amounts. There’s a real risk that members will outlive their retirement funds, not to mention potentially adverse impact of investment markets on their incomes.
Whereas, in the old days, retirement funds concerned themselves with the member from the date of enrolment, past retirement and until death (and even beyond in the case of surviving dependants and beneficiaries). The relationship today effectively ends at retirement.
To say the least, the result has not been good -- certainly not good for typical, average retirees who have found themselves invested in annuities to which are attached complicated, expensive fee structures, unpredictable outcomes (e.g. investment returns) and the ever-present danger that too much money will be drawn too soon.
Now things are about to change fundamentally. National Treasury is expected soon to release revised draft regulations on default retirement annuities. From the first draft of the regulations in 2015, we know that Treasury’s intention is to prevent individual members being enrolled into inappropriate, expensive retail annuities. Instead, Treasury wants funds to set defaults into which members will all be enrolled unless they actively choose to chart their own post-retirement courses.
The thinking behind the requirement that funds set defaults is based on an understanding of human behaviour. Faced with a bewildering array of choices, the majority of individuals choose the path of least resistance i.e. whichever option is suggested to them. Up to now, in a DC environment it usually means opting for a living annuity. But is a living annuity the optimal choice? This will be asked more frequently as winds of change blow.
The alternative to a living annuity is a life annuity. Here, fund members receive either a fixed monthly amount for life or an amount plus an annual increase typically linked to inflation. Life annuities don’t require nearly as much advice, on-going monitoring and decision making as do living annuities. A life annuity, on average, is more expensive compared to a living annuity providing the same monthly income. But we can possibly see a change in pricing levels should retirement funds start using their bulk purchasing power on behalf of members.
The current situation, and member behaviour, will change completely when fund trustees are required to set default-annuity strategies for fund members. Most members are likely to take up those defaults.
Once the regulations are implemented, trustees will be obliged to prove to the Registrar of Pension Funds that their chosen default is the most appropriate for those members who take up the default. (The draft regulations don’t actually speak about defaults being appropriate for a “majority” of members but this is precisely what will happen. Most people will tend to follow the default.)
For many funds, probably most, the profile of their memberships will be such that a straightforward living annuity will be inappropriate. Certainly, as the draft regulations contemplate, where a living annuity is the chosen default, funds will be required to monitor how individual members fare under such a regime – and suggest that they convert to more predictable life annuities as and when required.
The rigours attached to maintaining an in-fund (trustee managed) living annuity and the fact that in some funds a majority of members simply won’t have sufficient accumulations, or sufficient access to expert advice, to justify this option might see an upsurge in the number of people taking out some form of life annuity. This will almost certainly be a good thing.
Whereas until now little objective thought has been given to what sort of annuity is in the best interests of a retiree, in future retirement funds will be compelled to consider what is actually best for the majority of members; not just until the point of retirement but after. In effect, this will mean a return to the DB-type environment. By defining a default annuity strategy that works for a majority of members, and regularly having to report to the Registrar, trustees will have to define benefits that are effective and sustainable.
For trustees this is going to be a whole new conversation. It could help keep hundreds of thousands of retired South Africans in much better financial health.
Developing, designing and then communicating an optimal default annuity will be a considerable burden on trustees -- most of whom are part-time non-professionals. In ensuring that trustees create the best default outcomes for members, the role of the life insurance industry -- with its skills, experience, insights and products -- will be of utmost importance.
An industry used to communicating with individuals and DB funds must quickly learn to converse with DC funds wanting DB outcomes. And if the default regulations’ objectives are to be realised – more relevant, more robust and more affordable annuities – a whole new consensus should be the primary objective of the new conversation.