Capital flows, you say?
In a world where many factors and considerations can have an impact on financial markets, it has become increasingly more difficult for an investor to know what to pay attention to. This leaves the question: what is the impact of capital flows?
Empirical analysis shows a positive relationship between foreign direct investments (FDI) – which forms part of net flows, and economic growth of the country. Foreign flows into the country come in the form of increased investment in domestic assets, either real or financial, and thus provide capital for economic growth.
Without adequate stable inflows of capital, an emerging market economy is left susceptible to market shocks, which will impact on economic growth, such as the now-titled “Nenegate”.
What does this affect?
South Africa, recently identified as a part of a group of vulnerable emerging markets called the “Fragile Five”, is troubled with many internal turbulences, such as socio-economic problems, political instability and financial market volatility, which reduce its ability to grow organically.
As such, the country relies on money from the rest of the world to grow. In short, the impacts of not getting these capital inflows are far- reaching, with primary effects being on three topical issues currently, namely:
• economic growth;
• currency stability; and
• sovereign credit ratings.
What are the impacts on retirement investments?
Members and trustees often ask about the impact of currency volatility on the retirement investments within their funds, with particular regard to older members who are closer to retirement age.
The changes in capital flow, into and out of the country, directly affect the stability of the domestic currency. Large and sustained outflows, as previously mentioned, can depreciate the currency substantially, making imports more expensive and therefore cause economic pressure through increasing inflation. Oil is a key import in South Africa. If it was not for the concurrent sharp reduction in the price of oil, South Africa may experience a much sharper increase in inflation.
Once the sudden firing of finance Minister Nene hit the market in December of 2015, the currency depreciated by 10.3% in two days, and remained at that weak level for a number of months.
From a retirement investment perspective, the most obvious impact is the decrease members see on their benefit statement, which is caused by domestic stock market declines from the weaker currency effects on rand-denominated companies.
As such, the stock market loses value in the global market. In the longer term, the effect through inflation will be a risk to the buying power of savings.
And the sovereign credit ratings?
As the financial cash flows to the country drains out, volatility gains momentum and investment in the economy is affected by the lack of price stability.
The current debt (especially offshore debt) becomes expensive in domestic terms through increasing interest payments, and therefore there is less money available to spend on other government projects, such as education, security, housing and social security. In South Africa, the social impact is therefore significant.
These are some of the factors considered by the top ratings agencies, Standard & Poor’s, Fitch, and Moody’s when determining the credit worthiness of a government. Key considerations for these agencies include whether or not the government can comfortably pay back debt obligations on time. What are the risks associated with money lent to the government? Is it utilised appropriately to create value and initiate growth in the economy? Or is the money dwindled without adding value? These factors cause typical chain reactions.
There are many different views on the outcome of a downgrade. From an investment perspective, that which is expected is generally priced into markets, which translates into a reduction in share prices.
What should you do to protect your retirement savings?
The short answer is to stick to your long-term investment plan!
In a long-term investment such as retirement savings, market fluctuations will impact your investment throughout, and it is impossible to try and time the market.
Despite the ups and downs of the equity market, it offers the best returns over the long term. In fact, evidence shows that equity market risk decreased substantially over a longer period of 20 years and more. There are, however, significant risks in the annuitisation process as you approach retirement. The transition mechanism of a good life stage strategy should, however, protect you against any market turns as you near your retirement age.
At the Sanlam Benchmark Symposium earlier this year, we spoke about innovative employers who are beginning to understand that staff engagement is necessary for them to differentiate themselves from their competitors. We asked the question that, if staff members are the face of each employer, how do we ensure that they have vibrant, happy faces?
What we keep hearing from the research and focus groups is that employees want to get back to a world, where their employer looks after them. Even though most employers converted from defined benefit (DB) to defined contribution (DC) many, many years ago, most members still have a DB mind-set, they expect or would like the employer to take care of this matter for them. The employer, of course, is in the best position (and has a vested interest) to design and implement the most effective financial wellness strategies.
Why, you may ask? Well, let’s look at the average life cycle of an employee in the simplified diagram below:
Every time an employee changes jobs, they have to make critical decisions that could impact their quality of life in the future. Research in the UK suggests that members change jobs 11 times in their careers and this is predicted to increase to 20. These decisions include, but aren’t limited to:
When a member joins a company:
• Preservation of their retirement savings
• Investment choice
• Contribution rate
• Medical aid option
When a member has a baby or gets married or divorced:
• Adjusting the member’s death benefit level or nomination of beneficiary forms
• Updating of wills
• Upgrade of medical aid option
To be able to make these decisions, members typically turn to the employer for advice first. The employer is not only expected to know the answers, but also enjoys a high degree of trust. Why should an employer bother? Because the intervention will ensure greater productivity, more vibrant and smiling employee faces, and will save them money.
According to the 2016 PWC Employee Financial Wellness Survey, employees’ lives are significantly affected as a result of financial worries. Worryingly, three out of 10 said it caused health problems and 25% said it reduced productivity at work, even resulting in missing work occasionally. These findings follow international research and reinforces the fact that financial wellness cannot be separated from general wellness.
During 2015, “Millennial’s” surpassed “Generation X” to become the largest group in the US workforce. Surveys, however, show that their personal finances tend to be in worse shape than their older counterparts. Half of the Millennial employees found it difficult to meet their household expenses each month, 42% had student loans and four out of five noted that their student loans have a moderate or significant impact on their ability to meet other financial goals. Millennials are also more stressed than their older counterparts (81% vs 46%) and are more likely to raid their retirement funds (57% vs 40%).
Millennials are different. By all accounts, they will have an even greater need for guidance and support.
A practical solution
How best can employers assist and support employees on the road to total wellness? We recommend a combination of healthcare and retirement fund offerings, and allow them to leverage off each other. The challenge is to get these service providers to engage and put together a combined offering that takes savings, risk management, healthcare, retirement preparedness, financial stress and productivity as a minimum into account.
In this process, we identify and remove inefficiencies in the traditional offerings and develop solutions for identified shortcomings. The savings we secure in this way are used to provide a more holistic offering. At clients where we implemented these savings to subsidise wellness programmes, we have had resounding success. Employee engagement has increased significantly – at no extra cost to the employer!
Given the war for talent and sharply competitive nature of our economy, employers have an additional means not only to attract and retain talent, but to ensure that it is deployed as effectively as possible by delivering holistic wellness as a key aspect of its employee value proposition. It is very clear from PWC’s Employee Financial Wellness Survey that
employees that are less stressed due to financial difficulty are more productive, and that the provision of total wellness services to employees goes a long way towards the “Employer of Choice” status in the eyes of employees.
In short, an employer that actively integrates retirement fund ing with healthcare and wellness enables a win-win situation for themselves and their employees.
Implementing in-fund living annuities
What makes them attractive?
In-fund living annuities are tax-effective, flexible and convenient post-retirement investments and can be offered at competitive institutional asset management- and administrative fees. It can be designed to allow members a seamless transition from pre- retirement investment strategies to post-retirement strategies. As such, the trustees can filter out a plethora of retail options on offer and put a more digestible menu in front of the ordinary retiring member. It can even be offered to dependants of members who die in service.
Funds (employers) provide in-fund annuities because they wish to enhance the retirement outcomes of their members. Because of their access to professional advice and their negotiating power, they are able to offer a solution that members could not have secured on their own.
Post-retirement investment- and annuitisation strategies are arguably the most complex and difficult decisions members are required to make. An in-fund solution is, therefore, attractive for members who are uncomfortable with making complex financial decisions and choosing a financial adviser if it offers value and enjoys the trustees’ (employer’s) endorsement. However, individual advice or counselling remains essential. In-fund living annuities are also attractive to those members who have more comprehensive plans prepared once they realise the cost advantages and flexibility they offer.
New frontier in benefit design
Many standalone funds are now in the process of investigating and implementing this option. Most commercial umbrella funds, on the other hand, have already implemented it.
However, there are challenges. Even though the standalone funds that have not yet converted to umbrellas are, generally speaking, the ones with sufficient scale for in-fund annuities, it introduces a new member category that is retail in nature and more complex to manage (i.e. the retired member now interacts directly with the fund and not the Human Resources or Payroll departments). As a result, the communication, governance and compliance protocols will require adjustment.
Trustee responsibilities will expand to include a duty to communicate with living annuitants and to test for vulnerability and sustainability of in-fund solutions. To be effective, the administrator needs to demonstrate the capability to perform this function at a reasonable fee.
A change in the Income Tax Act already requires funds to allow the new generation paid-up benefits and phased retirement options. Members typically have multiple careers in a working life and, at retirement, it often makes sense to consolidate various retirement savings with the fund credit at retirement. Funds will have to be able and willing to accept such transfers at retirement where legislation permits. The mobility of members into and out of the fund, therefore, requires special attention. It is important to allow transfers to other funds or to allow members to terminate the in- fund annuity and purchase guaranteed-type solutions later in life. Section 37C remains applicable for the death of an in-fund annuitant. A related matter is a demand for beneficiaries to be able to continue with the living annuity.
A default investment portfolio for the typical in-fund annuity that aligns the accumulation strategy is essential. The phasing portfolios of a life stage strategy should, therefore, be reviewed as well.
A member counselling and advice network designed around the in- fund solution is highly recommended. It is important that advisers buy into the process so that external and internal solutions are correctly positioned to members.
Pulling it together
In-fund annuities cannot be considered in isolation as it interrelates to the preservation and the wider investment strategy. Furthermore, it will need to harmonise the institutional and retail forces of the retirement provision market through a creative new servicing model. Despite its obvious benefits, the success of this offering will depend on an effective communication and education drive, which will be a joint effort between the fund and the employer.
The solution will be unique for each fund. Having designed and implemented a number of in-fund living annuities, our experience is that the complexities and concerns are much more manageable than they may appear.
Does your fund’s preservation offering hit the right notes?
Despite the value that many in-fund preservation options offer, they often do not attract much business. This may be because the window of opportunity for the preservation of benefits is very short and there are many competing interests. History is likely to judge a fund’s efforts by the following three key factors: when was it offered, at what cost and did it also offer a second or separate basket such as a preservation fund.
When a member terminates employment, the preservation options available in his or her old fund are often not selected because the member is moving on and is breaking ties with the employer. Before the member can be introduced to the new employer’s offering, the member would typically have had to complete an election form or would have been encouraged to invest in a product recommended by a financial adviser. The result is that neither the old nor the new employers’ carefully crafted preservation offerings are very effective in attracting preservation business.
It would appear that the only way for trustees and employers to assist new members to preserve in their offerings is to attach their preservation information brochure and application forms to the appointment letter when recruiting staff. They may also have to engage with the new recruit and offer assistance at that point.
The cost of the offering
The second aspect is the cost of the preservation offering. The best that any fund can do is to offer an in-fund preservation option. Such a solution will typically offer much the same investment portfolios at the same institutional prices payable by the members of the fund. Where the withdrawal benefit is transferred to the new employer’s fund, there is typically no additional administration fee or any other cost or commissions.
If a preservation fund option is selected, the offering will typically attract asset management fees at retail (not institutional) prices. A once-off ad min and ad vice fee may also be payable. On an ongoing basis, a platform fee and a retainer advice fee may be payable. The graph shows that these additional costs can red uce the benefit payable in 25 years’ time by a significant margin. For in-fund preservation, we assumed an ad ministration fee of R150 per month and an asset management fee of 1%. On the retail side, we assumed that the asset management fee, commission and platform fee could amount to 2.25%, 2.5% and 2.75% in total. No initial fees are assumed.
The flexibility offered
The third consideration links in with the lack of flexibility of in-fund preservation and phased retirement. A termination (withdrawal) or retirement from an employer’s service, the member can elect to leave the money in the fund and request payment at a later stage.
These are attractive propositions for members who are in a position to preserve their entire benefit on withdrawal or retirement, as the money will continue to grow in the most tax- and cost-efficient vehicle available to them and they can elect to take it when it suits them.
A member can however only consider in-fund preservation if they can preserve the entire amount. If they need a portion of the withdrawal benefit in cash, they can only preserve the balance in a preservation fund. The position is much the same for phased retirement. A member can, only consider phased retirement if they can afford to leave the entire benefit in the fund when they exit and have other funds or other income during the period before they annuitise or begin to draw down their retirement benefits.
Members who require flexibility and need to withdraw some cash has to preserve in a separate preservation fund and should not put it in the same basket with the rest of their pension benefits. The concern here is that most preservation funds have morphed into retail offerings with different value propositions as explained above. However, there are exceptions, though. One or two preservation funds have adjusted their prices to align with the costs and charges of in-fund preservation offerings.
Finely tuned strategy
According to the Sanlam Benchmark Survey®, only 24.5% of members preserve their withdrawal benefits. There are a number of reasons why this happens – mostly because members need the money to tie them over a difficult time and because they do not understand the importance of preserving. To be able to assist those members who are in a position to preserve, retirement funds need a finely tuned strategy. The question that trustees and employers need to ask themselves is, will the information of your offering reach the members at the right time, does it offer good value and does it offer a separate basket?