How to lower the costs of retirement
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The present model of annual fees and a lack of preservation is unnecessarily driving up retirement expenses, said Anton Gildenhuys, head of Sanlam Personal Finance's actuarial division.
The national treasury has produced statistics that show that South Africa has among the highest retirement industry fees in the world.
Figures are not available for the average length of time South Africans retain their retirement funds. However, because members can access them before retirement, fund assets are held for a shorter period compared with countries that have compulsory preservation. Research shows that about 70% of people changing jobs do not preserve their retirement funds. Retirement product providers have to recoup their fixed costs over a shorter period and therefore charge higher annual or upfront fees.
"If we could improve the tenure of funds, the industry could charge lower fees," said Gildenhuys, who believes that members should be allowed to move assets between providers as long as the assets remain in the retirement industry.
"Compulsory preservation should not protect product providers and portability allows competition. Some will gain funds and others will lose funds but as long as the funds remain in the retirement net then costs will come down," he said.
Gildenhuys is concerned about government regulation on fees as experience shows that a fee the government sets becomes the standard for the industry because it is seen as "acceptable". This could have the unintended consequence of driving fees higher. This has happened in the credit industry where providers now all charge the maximum fees allowed. However, if regulated fees are too low, it makes the industry unsustainable.
"You want the market to find the price; there are too many examples where regulated prices become the norm."
Gildenhuys said greater transparency can develop competition because members can easily compare prices. The principle of "treat your customer fairly" – a programme under way by the Financial Services Board – will be the primary driver of transparency.
A single investment pot
The current system that allows people to have several retirement funds that have accumulated also needs to be reformed, said Gildenhuys, because this also adds to the cost.
When a person leaves a company they either leave the pension fund the employer provided or transfer to a preservation or retirement annuity. At the next job that person is required to take out a new preservation fund. Although you can amalgamate preservation funds, you cannot add to an existing one. It becomes more complicated because you cannot transfer from a preservation pension fund to a preservation provident fund because of different fund rules.
The fund rules need to be standardised and the red tape to transfer retirement funds into one investment vehicle needs to be removed. The national treasury has indicated that work has started on the interaction between different vehicles.
Cost of annual fees
Over the past decade there has been a significant move away from upfront premium-based fees to charging annual fund-based fees. For long-term investments this shift has significantly increased the costs of retirement funding. There is little appreciation of the effect of annual fees on long-term savings, said Gildenhuys.
Investors believe that investing 100% of their premium each month and paying an annual fee provides the best result over time as all premiums are "exposed to the market" from day one. However, using a simplified example, Gildenhuys demonstrated that an investor would be better off with a 23% upfront fee on each contribution, rather than paying a 2.38% annual fee.
This is based on the assumption that an investor pay an annual R6 000 premium over 20 years with the product provider's target present value of income of R10 000 over the period. The present value of total income is required over the 20 years of the product to meet all expenses over the 20 years with a profit margin of around 2% (R850 in this case).
By year 15 the annual fee of 2.38% would make up more than half of the annual contributions to the fund and by year 17 the fees would make up 70% of the annual premium.
At the end of the period the investor would receive R245 378 on the assumption the fund delivered a before-cost return of 9%. In comparison, an investor paying an upfront fee of 23% would receive R257 579 after 20 years.
Under the annual fee model the investor would have paid R46 566 in fees compared with R27 619 in upfront fees. This had less effect on the final return because 100% of the premium was invested with the annual fee model. However, this additional growth fails to fully offset the total costs.
Gildenhuys said that under both charging structures the product provider would make the same profit. The driver of the difference in maturity value is the mismatch over time between when expenses are incurred and when charges are levied.
"Irrespective of the business model, there will always be some upfront expenses and there is a cost to fund this if the bulk of fees are only levied towards the end of the contract term. This cost will exceed the expected investment return on the fund, and hence will require higher charges – postponing charges therefore create a drag. Annual fees sound negligible when compared to the upfront fees but the compound interest effect is phenomenal," says Gildenhuys.
The current model of postponing fees and shorter tenure of investments is creating a hotbed for costs. Product providers have to carry costs for longer yet have less time to recoup fees, which means they have to charge more to earn the same profits. The irony is that the product that is required to reduce costs, in other words a product that has a compulsory investment period with high upfront fees, is the model that traditional retirement annuities used.
The problem arises because in the early years the high upfront fee erodes returns, resulting in negative performance.
Using Gildenhuys's example the upfront model would show negative returns until year five. It is only after year seven that fees charged under the annual fee model start to exceed the upfront fee. Each year this fee gap widens until the final year when the upfront fee remains at R1381 but the annual fee has reached a massive R5 487 – nearly four years' worth of the upfront fee.
The upfront fee model only provides a benefit if invested for 17 years or more. Any shorter period and the returns from the annual fee model are higher.
There were also concerns about the transparency of these products and their exact charging structures – it was never clear about how much of their investment was going to fees.
Gildenhuys believes that if the structure of the industry changes and investors are better informed about the effect of fee structures then costs could come down dramatically. He argues for full transparency where investors can clearly see the rand value of what they are paying rather than the industry hiding behind percentages.