What income are you targeting in retirement?
One of the biggest challenges in the pension fund space is the lack of a clear income goal for retirement, an industry expert argues.
Shaun Levitan, chief operating officer of liability-driven investment manager Colourfield, says most defined contribution funds in South Africa lack a clear income-goal focus for individual members.
“If you are in a fund, do you really know what you are on track for [to receive as an income in retirement]?”
He says fund members are confronted with a piece of paper that shows their total fund credit at the beginning and the end of a particular investment period. But unfortunately this often creates a situation where people are trained to think of their pension fund in a similar manner to their bank account (which also reflects the money available at the beginning and the end of the month including deposits and withdrawals).
Levitan says as a result pension fund members often feel their pension fund credit is within reach.
He believes that the behaviour of pension fund members could change for the better if they considered their retirement savings in terms of an income target and not one large pot of money.
Ultimately members join a retirement fund to get a stream of income that will enable them to maintain their standard of living in retirement.
“We are used to thinking of life in terms of what expenses can be met from income and it is no different when you get to retirement,” he says.
While actuaries working in a defined benefit environment (where the benefit is guaranteed and the employer carries the investment and longevity risk) have used a liability-driven investment approach to address investment risk for many years, in the context of individual fund members in a defined contribution environment (where members carry the investment and longevity risk) the term goals-based investing is more prevalent.
But these are really two sides of the same coin – there is an explicit recognition that what you are trying to meet is a liability or goal and to make sure that you are best positioned to meet that goal. For individual members in a defined contribution fund, this goal is targeting a specific income in retirement, he says.
How much income do I need?
Levitan says the reality is that most people are unengaged with their retirement in the early stages of their careers.
People in their thirties can’t be expected to know how much money they need in retirement. Moreover, any good retirement system would do that on their behalf, he says.
Ultimately, there does come a point where people do become engaged.
“At that point you really want the tools to be available for them to be able to do more than what is really a default that is being chosen by a board of trustees.”
But what members can do is to recognise that there is a liability (the income that they need in retirement) and acknowledge that their asset is the level of contributions they will be making into the fund (on top of the current fund credit) to get a better representation of their own balance sheet.
It is fairly easy for an actuary to calculate what the cost would be of buying an annuity at some future date that would provide for a particular level of income (the liability that the member is trying to meet). The actuary would also be able to determine whether the specific member is on track to buy that income, considering the current fund value and contribution levels at various points along the way to retirement, Levitan says.
For example: The individual might need R25 000 a month in retirement, but is only on track to get R12 500.
This would create a much more sobering picture than an aggregate fund credit (a million or two often looks like a lot of money, but in a retirement context it is not) and could act as an incentive to save more, retire later or to take on more investment risk.
“Why would you save more if you didn’t know why you needed to save more?”
Apart from the clear focus the goals-based approach provides the member, it could potentially also reduce the risk in the portfolio.
Levitan says if the calculations suggest that investing the fund credit and future contributions in a risk-free asset would guarantee a 75% replacement ratio (an income of 75% of the member’s final salary, assuming that is the targeted income), theoretically the question becomes why the member would still want equities in the portfolio.
“The reality is that if I look at the real return of 2% on inflation-linked bonds it is never going to be enough to reach most income goals for younger members unless you are contributing at a much higher rate.”
But by matching the investment strategy to the specific income requirement in retirement, the member would get a real understanding of why a certain equity exposure may be necessary, he says.
Levitan says by following a goals-based approach the individual would be less concerned about a sell-off in equity markets because he or she would understand that it was the only way to reach the income goal over time.
While a selloff in equities may have a detrimental impact on the fund value in the short-term (if the exposure to equities was meaningful), if real rates on the long end of the curve went up as well (as was the case on Black Monday late in August) the cost of the annuity would become cheaper.