Edition: May/July 2018
Solutions for retirement-fund industry are being reinvented in SA, believes Robert Merton*.
Retirement goals should be to sustain the standard of living enjoyed in the latter part of one’s working life. With each member’s income goal in mind, a personalised investment strategy needs to be created for individual members so that each of them has the best chance of meeting their goal.
By the small proportion of members able to retire comfortably, it’s evident that the current approach to funding is not working. Alexander Forbes has developed a solution through the newly-launched Clarity retirement-fund products. They focus on each member by defining their personal income goal at retirement and by taking their unique circumstances into account in allocation of their savings.
The appropriate retirement objective for evaluating the member’s benefit at retirement is the provision of an inflation-protected level of income that will be payable for as long as the member lives, while keeping pace with the cost of living.
Visiting SA for the launch of Clarity, I spoke about the 10 essential design functions that a retirementproduct offering must have to qualify as a 21st century solution for funding retirement. Clarity qualifies and standard life-stage funds fail.
Current practice in funding of retirement is analogous to a doctor who prescribes the same medication for all his patients. Just as each patient has different symptoms, responds differently to medication, and thus needs different treatments, so the correct approach to treating retirement funding must be personalised to suit each member’s individual needs and trade-offs.
SA has shifted from defined-benefit (DB) to defined-contribution (DC) funds. In doing so the focus changed from the amount of income benefits payable during retirement (DB) to the amount of savings accumulated at retirement (DC). Current practice life-stage funds centre on defining a risk tolerance for DC fund members based on age as the single parameter. But age is only one of several key elements defining an individual’s financial circumstances.
Because the member’s age at any future date is already known now, life-stage funds make no adjustment to the member’s portfolio allocation in response to future changes in a member’s circumstances e.g. in their income or how close they are from achieving their goal. These are key attributes which clearly influence the appropriate amount of risk for the member to take.
Further, investment decisions focus on value of the funds and their expected returns. Risk is measured by fund-value volatility and not by its retirement-income volatility.
Yet the primary concerns of the saver remain what they always have been: “Will I have sufficient income in retirement to live comfortably?” “How much risk of lower income can I tolerate in return for the possibility of a higher retirement income?”
Clearly, the risk and return variables that drive fund investment decisions are not being measured in units that correspond to savers’ retirement income goals and their likelihood of meeting them. Using the wrong measures of risk, one cannot possibly manage well the risk elements of savers’ funds.
Investment value and asset volatility are simply the wrong measures if your goal is to obtain a particular future income. Communicating with savers in those terms, therefore, is unhelpful and even misleading.
Imagine that you are a 45-year-old individual looking to ensure a specific level of retirement income to kick in at age 65. Assume for simplicity that we know for certain you will live to age 85. The safe, risk-free asset today that guarantees your objective is an inflation-protected annuity that makes no pay-outs for 20 years and then pays the same amount (adjusted for inflation) each month for 20 years. If you have sufficient money in your retirement account and want to lock in that income, the obvious decision is to buy an annuity now.
But, under conventional investment metrics focused on fluctuations in market value, your annuity would almost certainly look too risky. As interest rates move up and down, the market value of annuities – and other long-maturity fixed-income securities – fluctuates enormously. However, when measured in terms of volatility of retirement-income benefits, your annuity has no volatility at all!
Clearly, there is a big disconnect about what is and is not risky when it comes to the way we express the value of pension savings. It’s time for the retirement industry to realise it can’t provide solutions for the ‘average’ member. Each one of us is unique.
* Merton, a Nobel laureate in economic sciences, is professor of finance at the MIT Sloan School of Management.