The role of Net Replacement Ratios
Are you taking care of your future self?
By Mayuri Reddy , Market Strategist: Sanlam Employee Benefit Investments
As much as fund members struggle to interpret information presented to them on their current levels of retirement savings, even more complex is determining whether the capital amount on their benefit statement will be sufficient to retire on, given all future decisions they are likely to make. Enter here Net Replacement Ratios – a measure created by the industry to assist members to determine whether they are “on track” towards an adequate retirement or not with one quick glance.
But is this measure adding value to members?
There are two issues inherent with the manner in which net replacement ratios (NRRs) are currently being used: firstly, there is no standard definition of how NRRs are calculated, and secondly, the manner in which they are currently presented doesn’t give the member (or trustee monitoring their members’ NRRs) any way to answer the question “so what?”. You have a low projected NRR, but so what? What next?
The first issue is a complex one as there is no consistency in the industry on the “right” way to calculate and report on a net replacement ratio. This in turn makes it difficult to say what the “right” level of NRR is to target. In the broadest sense, the Net Replacement Ratio is the member’s pension in retirement divided by their pre-retirement salary.
Multiple definitions of pre-retirement salary
One of the biggest areas of contention is how the pre-retirement salary is defined. From the 2016 Sanlam Benchmark Survey, 77% of funds that have a target pension said that they define the pre-retirement salary as “pensionable remuneration (PEAR)” while 8% define it as “total remuneration, net of retirement fund contributions”. Other permutations being used are PEAR net of income tax, PEAR net of retirement fund contributions, and total remuneration net of income tax. As PEAR can be set as a percentage of total remuneration which is less than 100%, income tax can be to up to 41% and retirement fund contributions can be anything up to 27.5%. Using one or the other of these definitions can have a material impact on whether you meet your NRR target or not.
This has implications for the NRR that is being targeted. While the “ideal” NRR bandied about in the industry is around 70 – 75%, and in fact the majority (61%) of funds who have a target pension set the target in this bracket, is based on some important assumptions:
- A pensioner will experience a lower level of tax in retirement
- A pensioner does not need to make contributions towards retirement
- A pensioner has lower levels of debt repayment in retirement
- A pensioner experiences higher levels of medical inflation in retirement
All-in-all, the assumptions above lead to the conclusion that a pensioner will need about 75% of their pre-retirement salary to maintain their lifestyle. So say, for example, that a member is contributing 20% of their salary towards retirement savings. Simplistically, a 75% targeteted NRR on a total remuneration net of retirement fund contributions basis would equate to only a 60% NRR on a total remuneration basis. Now assume this member has a pensionable remuneration value defined as 80% of total remuneration – if their target NRR of 75% is based on PEAR net of retirement contributions, this equates to a 48% NRR if the basis was on total remuneration. A member’s outcomes can be very different, simply because of a small change in definitions! And this doesn’t yet consider how one determines the post-retirement income or pension value – is this based on an inflation-linked annuity? A level annuity? A living annuity?
How do you use a Net Replacement Ratio?
This brings us onto the second area of concern – how do you actually use a Net Replacement Ratio? Current Net Replacement Ratios are simply a projection of a point-in-time level of income – what will the lifestyle of a member with a 75% NRR look like 5 years into retirement, if their post-retirement income is based on a level annuity rather than an inflation-linked annuity? Assuming your capital will be converted into a regular, level pension, you may get closer to your NRR target as this is a cheaper annuity than an inflation-linked one. However, a level annuity does not keep up with living expenses which are increasing. So an attractive 75% NRR at retirement may provide a sustainable living standard in the longer term, depending on what annuity choice is assumed.
Furthermore, currently a member is informed of just their current NRRs – and if a member is missing their target, they receive little guidance as to how to rectify this. There are a few things a member can do – increase contribution rates, change investment strategies, and factor in other retirement savings, to name a few – and this is where technology can play a far greater role in members’ retirement planning going forward.
Use the tools at your disposal
New Net Replacement Ratio calculators are not static, with a set assumption plugged in behind the scenes. New tools allow members to play around – what happens if I increase my contributions by 0.5%? What happens if I assume an investment return of 7% rather than 10%? What happens if I don’t take a 1/3 lump sum at retirement, but choose to annuitise the full capital amount? And so on. While it may be intimidating for a member at first, such tools are essential – not only in warning members who may not be on the right track to their target NRR, but also in assisting them to understand what factors are contributing to their retirement adequacy and what factors they need to be paying more attention to. They can also help to illustrate the differences in income profiles provided by different forms of annuities.
Technology as an enabler
More and more often we see this being done visually – making such projections more accessible to the average member. These tools and illustrations put more power in the hands of the members and speak to the “mass customisation” needed to move members to more positive outcomes by factoring in a member’s personal circumstances. Encouragingly, trustees and service providers are also searching for ways in which to better assist members to engage with their retirement savings – whether this be through simple “rule of thumb” laws such as the one below. Facial aging technology makes us more aware of ourselves in 40 years’ time, while more comprehensive member apps and guidance tools can assist members in making specific decisions. Applying our knowledge more intelligently and through the use of technology can assist members to visualise their future, and in doing so spur them on to take better care of their future selves.
Sanlam Life Assurance Company (Ltd) is a licensed financial services provider.