Only 6% of South Africans retire comfortably. The other 94% generally depend on some form of societal or familial welfare. Why is this the case and what can retirement savers do to ensure that they fall on the right side of this statistic?
Most companies across the world have shifted from traditional defined benefit (DB) pension schemes to defined contribution (DC) schemes.
In the former, the employer calculates a defined pension benefit that the employee will receive upon retirement (the criteria used to determine the actual benefit includes years of service, pension contributions, final salary, etc.).
In the latter case, the pension benefit that the employee receives at retirement is predominantly defined by the contributions the employee makes during their years of service.
The most important distinction between the traditional DB scheme and the modern DC approaches to pension schemes is that in the traditional case, the investment shortfall is covered by the employer while in the modern case, the employee covers their own investment shortfall.
As someone saving for retirement, you are more likely to be saving within a DC scheme (unless you work for the South African government, in which case you are most likely still in a DB scheme). This places a greater emphasis on the choices you make to ensure that you secure a comfortable retirement.
In this regard, there are broadly four important decision areas that you must be aware of:
1. The choice to start saving toward retirement.
2. The decision to remain invested (instead of withdrawing) when changing jobs.
3. The types of assets your retirement savings will be allocated toward.
4. The fees charged by your default (or individually selected) investment manager.
While all the above are crucial, the focus of this article will be on point number four.
In the default regulations for retirement funds published by National Treasury in August 2017, the high cost of access within the retirement ecosystem was cited as one of the largest contributors to South Africans retiring with inadequate retirement benefits.
This cost conversation matters more than most people care to realise.
Anyone who has taken a financial economics or investment management course would have heard of the Efficient Market Hypothesis (EMH).
Developed in the 1960s by Nobel Laureate Eugene Fama, it makes the assumption that it is “impossible to beat the market”, as financial markets are perfectly efficient and any inefficiencies are eliminated as soon as they arise to ensure that no arbitrage opportunities can persist.
In 2003, the Vanguard Group developed what it called the Cost Matters Hypothesis. Its basic thesis is that whether the Efficient Market Hypothesis is valid or not – whether markets are efficient or not – the costs that you pay in gaining access to the market will always matter.
A 2% fee charged on your savings will always reduce in your savings by 2%, regardless of the market environment. So strong is the logical and mathematical grounding of this idea that perhaps a more accurate name for it would be “Cost Matters Fact”.
In most industries, people are familiar with the phrase, “You get what you pay for.” In the investment management industry, Vanguard founder John Bogle is famous for saying: “You get what you don’t pay for.”
He meant that, as a retirement saver, what you pay your investment manager goes to your investment manager. What you don’t pay your manager goes to you.
A simple table illustrates this point. We took the universe of unit trust funds in South Africa’s largest and most popular multi-asset category (Association for Savings and Investment South Africa [Asisa] MA High-equity category) and ranked them by the total expense ratios (TER) that they each charge.
What is clear from the table is that the more expensive funds tend to have lower net returns compared to the less expensive funds.
According to research from Morningstar, which the firm has also replicated for the SA market, costs are the most important determinant of the success of a fund.
This makes the point that the more expensive a fund or retirement solution tends to be, the more the manager gets to keep. And what the manager keeps, the client does not.
Another observation from Morningstar data is that, as a group, investment managers tend to underperform the market (the latest S&P indices versus active (SPIVA) report also provides good evidence of this). This calls for another look at the Cost Matters Hypothesis.
Given that there are costs involved in investing in the market (these include analysts to research shares, brokerage costs, regulatory fees and statutory exchange charges), investment managers as a group will generally underperform the market in any given year.
This reality has led to the rise of index funds. These are commonly referred to as passive funds because they invest in shares according to a set of rules, thus eliminating the need for analysts and portfolio managers who make judgments and predictions about the future potential of a share.
Index funds can be combined with traditional active funds to create what is called a core-satellite portfolio. This combines the benefits of both traditional/active and index/passive investing.
The benefits of the former include the potential to outperform the market and protect against negative movements in market prices. The latter provide you with market returns at low cost and are typically more diversified and transparent.
If your investment manager in your retirement fund charged you the typical fee of 1.49% and you equally blended this with an index fund that charged a TER of 0.4%, your investment management charges could come down from the original 1.49% to 0.95%.
With a vehicle that has lower costs, you would undoubtedly be in a better position to meet your goal of a comfortable retirement.
The graph illustrates this point. All else equal, the less you pay in fees, the higher the probability of achieving being your retirement goals. (This is not to say some managers don’t offer the requisite value that their costs promise.)
As shown in the table, paying lower fees does not mean that one gets lower value for money, particularly if this lower fee is achieved by making an allocation to index/passive funds.
In fact, the difference in your retirement savings by the age of 65 when you pay 0.4% versus 1.49% in fees is an additional R2.8m (37% more value).
An important point is that the greatest cost in the retirement discussion is not the explicit investment costs mentioned above.
Although these can become so exorbitant that they detract from the investor’s future welfare, the most prevalent cost comes from not saving for retirement at all!
We encourage investors to take more deliberate steps to inform themselves about their state of retirement condition.
They should also ask for full disclosure of all the costs that they are paying. Speak to your workplace benefits consultant or your financial adviser for comprehensive guidance on matters relating to how you can get the best value for your retirement savings.
This article is part of our April 2018 Collective Insight supplement, which appeared in the 26 April edition of finweek. To download the entire supplement, click here. Buy and download the magazine here. Subscribe to our weekly newsletter here.