How Much Will Be Enough?
By Pieter Gericke, Consulting Actuary, Simeka Consultants and Actuaries
Quarter 1: 2015
With the switch from defined benefit to defined contribution funds, the responsibility falls on retirement fund members to ensure they save enough money to provide a decent income for themselves in retirement. Unfortunately, most fund members do not know how much they need to save for retirement, and have no idea how much income their accumulated savings will generate once they retire.
To help guide and support members to plan their retirement Simeka developed a Projected Pension Ratio (PPR) calculator. It shows members how likely they will be to maintain their current lifestyle in retirement, based on their current retirement savings and likely future contributions. The PPR calculations show members their estimated income in the first year of retirement, as a percentage of their total guaranteed remuneration (net of contributions) in the year just before retirement. The only way in which one can project 30 to 40 years into the future is to make a number of assumptions about the future. We adjusted some of these assumptions recently in response to our changing economic and demographic environment.
The long-term investment returns of a retirement fund is determined by the asset classes the fund invests in, the returns achieved by each asset class and the investment fees paid. To derive the investment return assumptions, we incorporate Sanlam’s research and long-term views of the investment returns on various asset classes with our view of the exposure to various asset classes that we would expect from aggressive, moderate or conservative balanced funds, and the investment fees incurred.
We have now lowered our investment return assumption for aggressive balanced funds from CPI+5,5% p.a. to CPI+5% p.a. in response to the market conditions and the shift to passive investment strategies which makes it less appropriate to take into account any future outperformance by the asset manager. The assumption for moderate and conservative balanced funds is now CPI+4% and CPI+2,5% p.a. respectively.
The Annuity Assumption
At retirement pension fund members have to buy an annuity, which will provide them with an income during retirement. There are many options to choose from such as guaranteed annuities, with-profits annuities and investment-linked living annuities.
Guaranteed annuities offering annual increases equal to inflation are often seen as the gold standard, as pensioners are guaranteed an inflation-protected income for life. However, these annuities are conservatively priced by insurers (who carry all the risks), which makes these annuities extremely expensive. Industry statistics have correspondingly shown that very few retirees buy inflation-linked guaranteed annuities.
A with-profit type of annuity appears a more affordable and more appropriate benchmark at this stage. These annuities provide a guaranteed income for life, although the annual increases depend on the investment performance of the assets backing the annuity. We assume members will purchase an annuity with a 2.5% post-retirement interest rate, so any investment returns above 2.5% can be declared as pension increases. Pensioners could therefore expect increases roughly equal to inflation over the long term, although it is not guaranteed.
We assume that no part of the benefit will be commuted in cash and that the pension will be payable for at least 5 years, following which the spouse will receive 50% of the pension on the pensioner’s death.
Increase in Longevity
We also adjusted our assumptions to make provision for the fact that people live longer. The longer retirees live the more costly the annuity. We improved our normal mortality assumptions by 1.5% for the first 10 years reducing to nil percent for the next 10 years.
Link to Living Annuities
Living annuities are extremely popular choices at retirement – Industry statistics show that almost 90% of retirees will purchase a living annuity. Living annuity policy holders can draw between 2.5% and 17.5% of the value of the policy each year. The ideal drawdown rate differs from person to person, depending on the amount they have saved, their age, income needs, living standards, dependants to support, attitude to risk, other sources of income and bequest motives. The average current withdrawal rate from these policies is around 6.6% p.a.
The with-profits type annuity used in our assumptions will produce roughly the same income as a retiree drawing around 5.3% at age 60 and 6.0% p.a. at age 65 from their living annuity.
How much to contribute?
Based on the revised assumptions, a member needs to make a contribution of 14% (13.8% rounded) net of the total guaranteed package for a period of 40 years, earning a return of CPI + 5% p.a. on average, to enjoy a projected pension ratio of 75% at retirement. The required contribution rate in terms of the revised assumptions is 1.3% higher than before. We therefore encourage trustees and employers to consider these assumptions and assist their members to adjust their retirement plans.
Disclaimer: This publication provides information and opinions of a general nature. It does not constitute advice and no part thereof should be relied upon without seeking appropriate professional advice. Simeka Consultants & Actuaries (Pty) Ltd. is an authorised Financial Services Provider