The defined-contribution (DC) retirement-funding system fosters a mind-set of saving a lump-sum amount “for” retirement, whereas it would be better if members and funds devised a system that provides an income “through” retirement. This is one the proposals made by Paul Stewart, the head of fund management at Grindrod Asset Management, on how to provide a sustainable pension.
If you think he is advocating a return to the days when defined-benefit (DB) funds dominated the pension landscape, you would be only half-wrong. Stewart believes fund members would receive the best pension with a DB-style income (your income is a percentage of your final salary) within a DC structure. He believes that, in the context of today’s highly mobile work environment, the portability (taking your retirement savings with you when you change jobs) that characterises the DC structure is essential, but a DB-style focus on generating an income would provide the financial security that most people want in retirement.
The government and the financial services industry believe they have identified what must be done to fix the retirement system, but Grindrod is not convinced they are entirely right. Stewart says Grindrod agrees that:
* People need to save longer and that it should be compulsory for every employee to save for retirement. In his view, the age at which members can retire from their funds is far too low, given the increase in longevity. It is inappropriate to allow people to access their retirement savings at 55; for the average white-collar employee, the retirement age should be 75.
* Costs must come down, and one way to achieve this is to simplify the retirement-funding system. Instead of pension, provident, retirement annuity and preservation funds, there should be a single type of fund that serves as a savings and preservation vehicle and that generates a sustainable income during retirement.
* Retirement planning must be simplified and coherent. Stewart says fund members often receive conflicting advice from trustees, consultants and asset managers, who are not always working towards the same goal.
Grindrod takes issue with the view that passive investing will necessarily produce better returns for fund members, and it does not agree that there should be consolidation of pension providers, so that fund assets are bulked among fewer companies. Stewart says that fewer providers will result in less competition, which, ultimately, will be bad for members.
He says it is the size of the assets under management that should determine whether an active or a passive investment strategy will produce the better outcome for fund members. The greater the value of assets under management, the more difficult it is for active managers to beat the index consistently, and therefore a higher percentage of their assets should be invested passively. On the other hand, it is easier for small managers to find investment opportunities that will generate out-performance, and with them an active strategy should dominate. (And, yes, Grindrod counts itself one of those small active managers, although it does also offer index-tracking funds.)
Grindrod also believes that the life-staging approach to asset allocation is completely wrong. The life-staging approach is that, as you get older, you “de-risk” your retirement savings by reducing the allocation to the more risky asset classes, such as equities, and increasing your exposure to low-risk assets, such as bonds. Stewart says de-risking does not make sense in the context of low returns and increasing life expectancy.
But is maintaining a high exposure to highly volatile assets the wise thing to do, even though many retirees have a longer investment horizon because of increasing longevity? Unlike, say, the average employed 45-year-old, a retiree cannot bank on an inflation-linked increase in his or her income each year, not to mention “income boosters” in the form of increases linked to career advancement and annual or performance bonuses. More importantly, massive medical bills (and no employer-subsidised medical scheme cover) are dealing pensioners’ finances a heavy blow. If a retiree has to pay for a major health event, or a series of events, while the equity markets are down, there may not be enough time for the markets to turn and recover so that the pensioner can make up those losses.
Stewart’s response is that if you are drawing down four percent a year to fund your lifestyle and your portfolio is generating an income of six percent, you can afford to have a highly volatile portfolio, because you are not selling your capital to fund your income. Even if the market dropped by 50 percent, it would make no difference, if you have invested in assets that produce more income than you require.
He says the average balanced (multi-asset) fund produces an income of two percent a year – and, because of high costs, some of the large funds effectively produce none. If the equity markets fall by 50 percent and you are selling capital to fund your income, you will be in a big hole that you will be unable to get out of.
Stewart says the average retiree needs an income that keeps pace with an inflation rate of almost 10 percent, mainly because of the high medical inflation rate. If the retiree has an investment-linked living annuity, he or she has to factor in total costs of about two percent a year. In other words, your portfolio will have to generate a minimum total return of 12 percent a year if you want to break even.
So where are you going to invest to generate an annual total return of 12 percent (the Consumer Price Index plus six percent)? He says cash, bonds, corporate bonds (with a decent credit rating), inflation-linked bonds and preference shares won’t do, because their starting yields are too low. You could invest offshore in the hope that a major devaluation in the rand will save the day, but what if the rand doesn’t devalue? Local equities and listed property are the only asset classes with the potential to deliver inflation plus six percent a year.
Stewart says the DC structure leads people to regard the date of retirement as separating two distinct phases. The aim of the pre-retirement phase is to have saved a certain amount of capital by the day you retire, and everything revolves around calculating what that amount should be and trying to identify strategies that will enable you to hit the bull’s eye. The aim of the post-retirement phase is to protect your capital by avoiding risk and volatility while hoping that the drawdown from your capital will at least keep pace with inflation.
In Grindrod’s view, in an environment of low returns, the focus should be on how to manage assets both before retirement and in retirement so that they will generate a sustainable income. Your retirement should not herald a sharp break between a high-risk and a low-risk investment strategy; all that should happen is that you “unplug” from the fund as a contributing employee and become a pensioner.