Unearthing hidden pension costs

“High costs may well threaten the very structure of our retirement industry,” said David McCarthy, a technical adviser to the treasury on pension-fund reform, for whom product costs are the highest priority.

“The ultimate function of the complex design of many existing retirement products may be to hide costs from customers.

“When I studied actuarial science 20 years ago, actuaries wrote exams on how to design products in ways which made product charges hard to identify,” said McCarthy, who studied in South Africa and worked for the life industry for two years before obtaining his PhD from the Wharton School at the University of Pennsylvania in 2002.

McCarthy subsequently held a position at Oxford University and is at present a senior lecturer at the  Imperial College Business School in London.

In November last year he signed a three-year contract with the treasury to work on retirement reform.

Greater impact
“It is a fantastic time to be here with all the changes and this is an opportunity to make a difference. I just felt that this is a better way to use my skills — I can make a greater impact,” said McCarthy, who has published several research papers on the subject.
The issues faced by South Africa’s pension funds are not unique.

“Many of the issues we face in South Africa are faced across the world,” said McCarthy. They included a low rate of participation in retirement funds and high retirement costs.
“Retirement fund costs are an international problem. We need to find ways to reduce costs in defined contribution schemes and to make defined contribution schemes function better for their members.”

He said that, in many ways, South Africa was better off than other countries. The South African government and private companies did not carry massive pension deficits and the country had higher real returns than the developed economies where interest rates were close to zero.

In those countries, companies and governments were struggling to meet their defined benefit pension fund commitments and had cut benefits not only to existing employees but also to those already in retirement. In South Africa both the private and public sectors moved to defined contributions in the mid-1980s, avoiding that liability.

Higher rates of return
According to McCarthy, South Africa had the trade unions to thank for the move because they supported the defined contribution system, unlike in the United Kingdom where an ageing trade-union membership (median age of 53) had resisted the changes as their members were closer to retirement. In South Africa the unions were more concerned about providing access to pension funds for a younger member base whose pensions were often their only form of savings.

McCarthy said South African pension fund members had also enjoyed higher rates of return than those in Europe and South Africa’s economic growth was higher.

Ironically, that had been responsible for the high cost structures going unchallenged. For example, they had not come under the same level of scrutiny as in the UK. But that was changing.

“South Africa is moving away from the past of high inflation and high nominal returns on assets to a lower return environment, which I believe may be coming. This will impose pressure on fees, which is why we are seeing an increased focus on costs,” McCarthy said.

Retirement products
Generally, people did not understand that annual charges had a massive impact on their retirement benefits.

Guaranteed funds are a particular bugbear for McCarthy, who has published a study on the costs of guaranteed funds in retirement products.

“If you value a guarantee, have a particular need for a guarantee and are fully informed about the costs then there is no problem buying them. But in a retirement fund, which is a long-term investment, it is prohibitively expensive to roll over short-term guarantees. It is extremely inefficient and the reduction in yield is phenomenal.”

There was a relationship between the complexity of a product, its costs and the intermediaries involved, something he meant to study formally. “This means the more complex the product, the more likely it is to be expensive and more likely to be sold through an intermediary. We need to ask what benefit is the complexity serving and why are complex products sold through intermediaries?”

One of the key focuses of retirement reform was the possibility of “disintermediation”, which would allow people to save for retirement without an intermediary, he said.
“One of the advantages of an employer-based pension is that the need for an intermediary is removed, which is why company pension funds can offer one of the best and cost-effective ways for an employee to save for retirement.” 

Simplifying living annuities
On retirement, or in the case of resigning, fund members have little choice but to enter the retail market, with its high costs and products that require intermediaries.
“The situation with living annuities is not great. They require significant financial advice, which needs to be paid for, and purchasers have to make complex trade-offs all the time, such as which provider to choose, what investment profile to select and what drawdown level is optimal.”

That is why a rethink of post-retirement products is next on his priority list. The treasury also has to deal with the cost of post-retirement products before it can require provident funds to buy annuities on retirement.

McCarthy said the treasury aims to create a default retirement income product that will suit the majority of retirees and remove the need for intermediaries.

The treasury will publish the costs of living annuities within the next month, but McCarthy said the costs are extremely high and there are many layers of them, including asset management fees, financial adviser fees and platform costs.

“The effect of those charges on retirees is unconscionably high.”

South Africa is not alone in grappling with the issue of choice and its inherent costs, he said. Although choice can increase the income of some people, for most it simply drives up costs. For example, industry sources have told the treasury that about 80% of the funds of those on living annuities are invested in about six portfolios that are very similar. Therefore, although only about 20% of investors make use of the wider choices available, every­one pays for them.

“The 80% would be better off without choice,” said McCarthy.

The other 20% should pay for the costs of investment choice themselves, rather than relying on subsidies from others, he said.

Increasing savers
Third on his list of priorities is to increase the level of participation in retirement funds.

McCarthy said the government is concerned that there is not sufficient provision for low-income workers, in particular, and that they will have to rely on the state or their families. That is putting immense pressure on the younger generation, who could be doing other things with that money, such as building up their own wealth and savings.

The treasury will make use of the National Social Security Fund to address this issue. There is a long-term strategy to eliminate the means test for old-age pensions and, over time, the income level to qualify will be raised until it is eliminated completely.

In 2011, the level of income a person can earn and still qualify for a pension was raised to an annual income of R45000 an individual (R90000 for a couple) and accumulated assets of less than R750000 (R1.5-million if married).

Not only do participation rates have to be raised to provide for individuals in retirement, they are also critical for a developing economy. Much of the infrastructure, mines, shopping centres and power stations were built with retirement savings. Without savings, the country has to borrow elsewhere, ultimately increasing the cost.

Protecting pension assets
McCarthy said that the current regulatory structure in South Africa, which requires trustees to invest assets in the best interests of their members, while being cognisant of environmental, social and governmental issues, is adequate.

So it is not clear why there was a move to have pension fund members to carry the costs of development.

“Our pension funds already invest substantially in infrastructure, and infrastructure is a good investment opportunity for pension funds,” he said, and there are other ways to fund national objectives. “In these tough times where, globally, there is pressure to use pension fund assets, our law is very clear on whose money it is, namely the members.”
McCarthy is enjoying his stint in public service. “It is a very open environment with no restrictions on what you can think or say internally.  It is a very organic environment, which is healthy for making policy.

“I am just one source of expertise for the treasury and I bring a different perspective, but the policies that are selected are part of a collaborative process, which includes all stakeholders.”

His only regret is the challenge of trying to implement reform during a very difficult economic period. “Globally, the downside risk at the moment is enormous; we are walking on eggshells.

“So far, the world has postponed but not eliminated a possible catastrophe. This increases dramatically the already substantial challenges of forming policy.”

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Maya Fisher French
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