Gandy Gandidzanwa & Itai Mukadira
In this second and final part of our two-part series on the topic, we explore the long array of quick fixes that have been rolled out to address the shortcomings, as highlighted in Part I, of the current corporate Defined Contribution (DC) Pension regime.
But first let’s emphasize that, that the DC pension regime has failed rather spectacularly across many measures of assessment of value should not come as a surprise. The 401(K), the bases on which the current DC regime was designed was never intended to be the primary vehicle through which workers would save for retirement purposes. Instead, it was designed to save as a secondary, and even a tertiary, vehicle for those workers who would have had the need to make further contributions into a separate vehicle as part of a comprehensive retirement savings plan.
Only Very Few Can Retire Comfortably Today
That only a proportion, very close to 0%, can afford to retire comfortably after having diligently and loyally gone through our current DC regime is a clear testimony of the inappropriateness of the model for the job at hand. It’s a result of a structural and design problem as much as it is a result of the prevailing economic situation. Our neighbours down south, with a much more stable and robust economy, are nowhere very far from us. Their system currently can only deliver under 6% of workers into comfortable retirement. That confirms that we are dealing with a structural issue here that is over and above our economic challenges.
Globally, the numbers are not that much better either. The only difference between us and them is that they have admitted that the system does not yield the intended results and are working hard to find real solutions to the problem. South Africa, for instance, is investing heavily, both financial and human resources in a long term effort to salvage the situation.
Main Retirement Objective Missed
Where the advocates of the DC regime fundamentally went astray was when they changed the focus of the objective of retirement savings from income in retirement to accumulated wealth at retirement. If there was only one thing to be blamed for the challenges of what we are having to deal with today – that would be it. That whole “savings pot” analogy is a failure and for four decades has misled members and practitioners alike to think of retirement savings management as simply an exercise of growing fund credits. That most benefit statements capture the “Fund Credits to Date” as the main metric just confirms the misguided understanding of the objective at hand – sadly, this is so by both members and practitioners alike. Quoted very closely to the accumulated fund credits figure are the annual returns over the past year – and yet, when members display extreme short-termism, that we know has made them collective losers, we cry foul.
Quick-Fix Attempts Have Failed
Attempts to quickly fix and plug the shortcomings of the current system, where they have been made, have failed enormously. Their common, and rather narrow, approach to focus on the member as the mechanism through which to improve the system has largely contributed to their collective failure.
Additional voluntary contributions, for instance, were touted as a viable solution for members to improve the balances in their “savings pot”. No doubt, such a solution flies against observed human behaviour – the propensity to pursue immediate gratification ahead of anything else far ahead into the future no matter how great. Given a choice, many members would rather pay new instalments on a piece of household item that gives them instant gratification on delivery than allocate any of those funds to a retirement savings vehicle whose benefits are only accessible several decades away if they are lucky enough to survive that long. Flawed as the behaviour could be, it is the reality.
The other “Do-It-Yourself” quick fix proposed by the proponents of the DC regime is through the introduction of the so called Individual Member Choice options. This suggests that members would be able to improve their prospects of retiring comfortably from a very flawed system by simply selecting and picking investment portfolios that will yield returns high enough to help grow their “savings pot” significantly to the point where it would be able to buy them an over-sized pension. Investment manager selection and blending is such a mighty challenge for a savvy investment professional – it certainly can only be an impossible “herculean” task for everyone else. That members can read different names of investment management firms does not in any way make them capable of choosing the right ones for themselves – let alone blend them strategically enough for optimal results.
Life-staging also became a much hyped-about strategy along the way. The argument forwarded being that as members near retirement they need to transition from high growth-seeking-investments to capital protection investments. The principle makes sense in all aspects but has been designed quite badly in most instances – with members transitioned into conservative portfolios with as many as ten years to retirement in some cases. That is like spending a quarter of their contributing period stuck in conservative portfolios. Even where this is not the case – nearing retirement should never be misconstrued as “nearing death”. Members still have a lifetime after retirement, in some instances just as long enough as their entire working life if not even longer. So whatever de-risking strategy implemented should take that into account. Where this is done poorly, de-risking into cash could turn out to be actuarially up-risking the potential for the member to outlive their retirement savings.
Educate members on the benefits of building a big “egg nest”, some of the proponents have made the emphasis. While our level of literacy in general is amongst the world’s highest, our financial literacy level is amongst some of the world’s lowest – with some putting it at under the 10% mark of the quality required for us to make sensible long term investment decisions. So whatever education that might be forced down members’ throats will only be way too little and coming rather way too late in their adult lives. It is bound to fail on arrival, just like it has been everywhere else where it has been tried. Access to information does not necessarily mean that the information will be put to good use – millennials are making all the wrong decisions today with buckets of information on their fingertips (literally).
One other attempt at plugging the holes in the current DC regime has been the advocacy for living annuities. The blunt truth is, if it may be told, this is a desperate attempt to give members a false comfort that they can still maintain their standard of living in retirement as it was during their working life. Nothing could be further from the truth. Before long, they realise that they are fast running out of capital. This is because, for most of them, they are reaching retirement with way too little in accumulated fund credits to afford them the living annuity option.
A Two-Pronged Approach Solution
So what are some of the options we have to really overhaul the system and be certainly back on track to providing a system that has real, not just imagined, potential to deliver more of our members into comfortable retirement.
What we need is a solution with a two-pronged approach. On the one hand we need to attend to the framework aspects of the solution while, on the other hand, we focus on the principles aspects of the solution.
On the framework aspects, we need a solution that has several, if not all of the following qualities. We need a framework that makes it easier to make contributions, is cheaper and assured, and delivers a higher rate of return. There has to be also an element of guarantees for life-long income in retirement.
The principles aspects of the solution will need to put emphasis on two key attributes – a spirited focus on “income in retirement” as the end objective – and not “wealth accumulation at retirement”.
Firstly, it must leverage on goal-based investing principles. Under the proposed framework, every worker builds a retirement reserve, through compulsion. To regain lost trust in our system that has seen members’ retirement savings decimated twice in ten years, and to compensate for the compulsory nature of the approach, government could step forward to provide a guarantee of the capital-only component of the members’ accumulated fund credits at retirement. The guarantee will most likely not cost the government anything as its chances of biting are quite minimal as the guarantee is on the capital component only. Research, contacted elsewhere, has shown that it is almost certain that after a period long enough like forty years there is no properly structured institutional investment that will fail to provide a return that is at least above zero at the very minimum. Same research has shown that in the extreme of cases such a guarantee would only cost the government only about 0.0156% of Gross Domestic Product, and yet its trust re-building effect can be quite tremendous.
Secondly, members’ reserves would be pooled at a national level and benefit from economies of scale. Note, we are not implying nationalisation here. Such a large scale investment pool would more easily facilitate prudent investments into illiquid, non-listed, high return-generating investments. And of course, we also know that the real need for liquidity is often over-rated in most pension schemes.
Thirdly, high investment return strategies would facilitate contribution levels affordable by many. With forced savings, members would need the satisfaction that their delayed salary allocations, in the form of contributions, will work for them.
Contrary to the current system of tax-deductible retirement savings contributions, the proposed framework would use flat tax credits for lower income earners instead. This is to ensure that the tax system is wealth redistributive and is a benefit to those that really need it. Income inequality, as mentioned in Part I of this series, is one of the social ills that the United Nations has highlighted for global eradication.
Upon retirement, the accumulated reserve is annuitised to provide a guaranteed income for life. With a nationwide centralised pooling system, expenses will be thinly spread due to size and economies of scale. Government incentivised providers of life annuities would be required to not overly load their annuity rates for things like profits, longevity risk premium and expenses. Failure to abide by this could result in the licence to offer such products withdrawn.
The centralised nature of the system makes portability straightforward to implement. It also makes it a system for all – from those in the informal sector to those in the highest offices of corporate ladders.
Anchoring the solution on goal-based investment principles would ensure a much more member-centric approach in the way investment strategies are developed. Sounds a bit awkward of course to be talking about goal-based investing only now – warranting the question, “If we have not been investing according to goals how exactly have we been investing our members’ money”?
The goal-based investment principle calls for a drastic mind-set shift from general wealth accumulation to focused inflation-protected retirement-income generation. It brings back the old DB mindset. It also recognizes the three key risks faced by members in retirement – investment risk, inflation risk, and longevity risk.
The principle demands specificity in retirement income budgeting. Specifically, it advocates for the separation of members’ goals in retirement into needs, the Essential Goals – from wants, the Aspirational Goals. The principle further requires that members be content with successfully achieving their Essential Goals through a “risk-free” manner even if it is not necessarily the path that creates the most fund credit accumulation at retirement.
Once separation has been done, the investment strategy is then built around the two retirement goals – Essential Goals are secured first using “risk-free” safe building blocks. Aspirational Goals are targeted second – using performance–seeking building blocks. This is a dynamic allocation strategy between inflation-linked bonds, the “risk-free” building block – and growth/illiquid assets and equities(listed), the performance-seeking building block. It is a forward-looking strategy too as it calculates individual member funding level using both accumulated fund credits and present value of future contributions. Risk exposure is increased, or reduced, based on funding level resulting from prevailing market and economic metrics. Allocation between the two blocks is also further influenced by changes in individual member circumstances – change in salary, retirement date, contributions, etc.
This approach also requires that members start to visualise a different set of risks. They would find more meaning in, and engaging with, specifically new types of risks. Contributions at Risk (CaR) is the risk of the change in the contribution rate a member may have to make to maintain their same expected pension level and retirement age. The second one is Retirement at Risk (RaR) – the number of additional years a member may have to work to maintain their same expected contribution rate and pension level. The last one is Pension at Risk (PaR), and that is, the change in pension level a member may have to accept if they maintain their contribution rate and retirement age.
While this is certainly close to completely overhauling the entirety of the current system, not every change needs to be effected overnight. An incremental process with a clear direction and end goal could suffice for now. It is important though that the industry is seen to be moving towards a fine-tuned regime that would help the industry regain the lost members’ trust in the system.
We hope this short write-up, together with Part I of the series, will nudge us all as a collective to face and tackle head on the challenges we have as an industry.
In the next article of our monthly “State of the Pension Fund Industry” publication we will explore other solutions that have been adopted by other countries.
***Our monthly publication is aimed at inviting conversations from like-minded individuals with a view to engaging in forward-thinking-led discussions on how we can collectively improve the state of our industry.
Gandy is a Director at RIMCA (Risk and Investment Management Consulting Actuaries), is a global speaker and thought-leadership contributor with 20 years of financial services experience across three different countries.
email: gandy@rimcasolutions.com
Itai is a Director at RIMCA (Risk and Investment Management Consulting Actuaries), is a seasoned Consulting Actuary with 20 years of experience consulting to some of the biggest retirement funds across many different countries in the region.
email: itaim@rimcasolutions.com