Typically, the fund would aim to replace your salary while you were working with a suitable replacement income once you retire. In South Africa this ‘replacement ratio’ is usually 70% to 75%, meaning your monthly income during retirement needs to be about three-quarters of your salary on the day of your retirement. This is based on amounts before tax.
‘The equation to solve for in order to ensure that a given set of design features will have a solid chance of delivering the target replacement ratio is readily available,’ says Ipeleng Swedi. ‘Unfortunately, many retirement funds have not been designed to deliver replacement ratios that are anywhere near the stated target.’
Where theory meets practice
So let’s amend that opening sentence. Designing a good retirement fund is easy in theory. In practice it requires a trade-off between today’s benefits (your take-home pay while you’re working) and tomorrow’s benefits (your retirement provision). And consider the reality for most South Africans: you’ll probably have more than one employer through your career, which means you’ll probably contribute to more than one retirement fund along the way.
For this reason, preserving your savings when changing employers is one of the most important moves any employee can make to reach the best replacement ratio. But it is not the only one, and other key factors upon which the fund itself is built, can be the real game changer.
These other factors include the five key elements of benefit design for a defined contribution fund:
• normal retirement age
• definition of pensionable salary
• contribution percentage (after costs)
• default investment strategy (real return target, after fees)
• annuity strategy
‘These elements are all interrelated,’ says Swedi. ‘A change to one means you’ll need to adjustment one or more of the others if you’re still going to deliver your desired replacement ratio.’
Small changes, big differences
It’s a delicate balance, then. For example, if you lower the fund’s normal retirement age from 65 to 60, you will have to increase your contribution percentage. ‘Normal retirement age has a significant impact on the ability of members to accumulate sufficient capital,’ says Swedi.
‘Although this is typically an employer decision, it is important for members to keep it in mind if they’re considering an early retirement – and for trustees to consider its impact on the other elements of design.’
Sound retirement outcomes should not be a something left to chance, but a matter of choice.
Another key point that’s often overlooked (or misunderstood) is the definition of pensionable salary. ‘Pensionable salary that is lower than cost to company salary is an outdated concept,’ says Swedi.
‘Funds should seek to shift their design to use CTC as the definition of pensionable salary.’ This is because the CTC is the full income that members are using to support their lifestyle while working so that’s the income they need to replace. If not, they risk having to adjust their standard of living.
When looking at the contribution percentage, Swedi says trustees could consider structuring the fund to assist members to catch up on retirement savings as they approach retirement, by increasing contributions.
‘As an example, the default contribution might be, say, 15% for members up to age 50, which then increases by 0.5% per year from age 51, so that contributions are 20% by age 60.’ This helps members to close any gaps in their retirement plans and these members are often able to set more money aside as their living expenses start to reduce when children reach the age where they are able to support themselves.
Again, it’s an example of how even if dramatic changes to benefit design don’t seem possible, small incremental changes can make a significant difference over time.
What can fund members do?
‘Sound retirement outcomes should not be something left to chance, but a matter of choice,’ says Swedi. ‘Replacement ratios of 70% or more are achievable.’ To make that happen, though, members and retirement funds each have a crucial role to play. ‘For their part, retirement funds need to be carefully designed to ensure they enable members to accumulate sufficient assets while they are a member of that fund,’ says Swedi. ‘Members, in turn, need to join the links in the chain, by preserving every time they change jobs.’
Is it really as simple as that? ‘It’s as simple as that,’ Swedi says.
Mark van Dijk
An award-winning writer who has written for publications ranging from Sports Illustrated to the official magazine of the JSE.