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Funds should provide adequately for retirement

Most trustees would probably know that the purpose of their fund is to provide adequately for retirement, perhaps for disablement and death as well. But, ‘to provide adequately for retirement, or disablement or death’ – what does this actually mean? Why do you actually need a fund for these purposes? We all know that we can individually make our own insurance and savings arrangements according to our own needs and requirements, without being ‘straight jacketed’ into the employer’s retirement fund.

Why have a pension fund?

Let’s revisit the main reasons for setting up a retirement fund to provide for retirement, disablement and death before we examine what ‘provide for’ means. Honing in on the many reasons, one needs to recognize the main stakeholder of retirement provision which are: firstly, the government, secondly the employer and thirdly, the member.

Government is a key stakeholder in retirement provision

Government clearly has an interest in its subjects providing for retirement, disablement and death to relieve the burden on the fiscus to look after those that can no longer provide for themselves and their families due to superannuation, incapacity or death. To encourage its citizens to make their own provision, government offers special tax incentives via the Income Tax Act, not availed to any other savings vehicle. In addition, government has thrown a special protective net over retirement fund savings via the Pension Funds Act that is not availed to any other savings vehicle.

The employer is a key stakeholder in retirement provision

Let’s now turn to the employer as another key stakeholder. Considering that there is currently no legal obligation on an employer to offer a retirement fund arrangement to its staff, the question begs to be asked, why an employer would have any interest in a retirement fund and why is it then that the majority of employers do actually burden themselves with the responsibilities and obligations linked to the introduction and maintenance of a retirement fund? Why does the employer not simply hand over the cash to the employee and let the employee care for himself? After all, they are all mature adults and the employer not their tutelage. Fact of life unfortunately proves these assumptions wrong! So the employer has to think long-term on behalf of his employees, a social responsibility that will allow the employer to sleep in peace. But this is not the only reason. In today’s competitive labour market, an employer who does not offer pension benefits, will be at a distinct disadvantage when it comes to attracting and retaining scarce skills, so market forces pressure the employer into offering pension benefits.

The employee is a key stakeholder in retirement provision

Where does the employee as third key stakeholder stand with regard to pension arrangements? As we just read, employees of course prefer to have the cash in their back pockets, at least while they are young, healthy and in a sound financial position. When any of these parameters change and as the employee gets older, starts thinking about his kids and their future and about his own old age, the perspective starts changing. Trying to make personal arrangements at this point would be either too late or one would be barred for reason of pre-existing conditions that no one in his right mind would be prepared to underwrite anymore.

Government wants the private sector to make provision for retirement

The long and the short of this is that government wants the employer and the employee to make provision for old age and other situations and offers very attractive incentives to the employees in particular. Employers feel a moral and competitive compulsion and employees are probably split equally on the issue.

‘To provide adequately’ – is it in the eyes of the beholder?

Having considered the reasons for retirement funds the next question to answer is what ‘to provide adequately for retirement, disablement and death actually means. Since all of us incur regular monthly costs to live that are related to our income, while we incur ad hoc outlays only infrequently. The main objective of a retirement fund should then be to replace one’s regular income come retirement. For retirement, an accepted international norm is to achieve an income replacement ratio post retirement of 2% per year of service. This means that you would only be able to replace your income before retirement one on one, if you have been employed for 50 years! Most of us won’t be in that category but would look rather at 30 or 40 years of service at best. Considering that the capital available at retirement is a function of contributions made and investment returns earned.

How much do I need to put aside to retire with dignity?

If we assume that when I retire at 60, the pension of 2% per year of service is to provide for my surviving spouse at a reduced pension after my demise and that this pension is to sort of keep up with inflation, I would need capital at retirement of around 7 times my annual cost of living at the time. To get to 7 times my annual cost of living, I would have to put aside a net 14% of my cost of living (or monthly income) earning a net 3% above inflation. If my money earns a net investment return of 5% net above inflation, I only need to set aside 10% net, or if I earn 7% net above inflation, I only need to set aside 7% net of my cost of living (or monthly income). Higher investment returns imply higher risk, but in the reasonable safety offered in the retirement fund environment, a return of 7% net above inflation can be achieved in the most aggressive pension fund portfolios. A note from the market here – in Namibia the average gross contribution towards retirement is in the region of between 10% and 11%, between employee and employer.

What you need to bear in mind in all of these calculations though is that you need to be a member of the fund when you enter employment until you reach retirement. The contribution towards the fund must be based on your total remuneration throughout, rather than perhaps just the cash component. When you change job you must preserve your accumulated capital for retirement. Given this, you should be able to replace your income before retirement at a ratio of 80% if you join the fund at 20, retire at 60 and maintained the appropriate contribution ratio, and achieved the required investment return throughout. Should you have joined the fund only at age 30, the replacement ratio would decline to 60%.

What about death and disablement?

So now you should have an idea what it means to provide adequately for retirement. What we have not looked at yet is what it means to provide adequately for the event of death or disablement. This we will be looking at in the next newsletter. Suffice it to point out here that this has a cost implication that would have to be added to what we have arrived at when considering retirement. And of course nothing comes for free, so on top of all these elements you will eventually also have to add the cost of managing such an arrangement.

What about death and disablement?

In the previous newsletter we suggested that the main purpose of a retirement fund is to allow you to retire with dignity. We also pointed out that, depending on the net investment returns you will be able to achieve over the course of your membership, you need to set aside between 10% and 14% of your total remuneration in order to achieve an internationally accepted norm of a pension equal to 2% of your total remuneration, per year of retirement fund membership, i.e. 60% after 30 years or 80% after 40 years of membership.

Your, and your dependants’ needs should be provided for adequately

This rate of saving does not yet provide for any needs you and your family may have in the event of your death or disablement. Again it would be most meaningful to determine the needs of you and you dependants in terms of a regular monthly income, by reference to your regular monthly cost of living. Needs obviously vary widely depending on your life stage and the number of people dependant on you. Typically when you are young and have no dependents, you probably have little or no need for death cover. As you grow older, get married and your family expands your need for death cover increases, to eventually start decreasing again as your children leave the nest and your life expectancy decreases, until you reach retirement.

How much does your family need in the event of your death?

If you want to provide for your and your dependants’ needs in the event of your death, including the need to make provision for future inflation, you need to have capital at death of between 8 and 16 times your total annual remuneration, depending on your life stage and status of dependants. This amount would typically comprise partially of the retirement capital you have accumulated to that point and life cover making up the difference. For a retirement fund with a normal age spread, average capital required for death benefits would thus be around 12 times aggregate annual member remuneration of which, typically, between once and twice aggregate annual member remuneration would be derived from members’ accumulated capital. The difference of around 10 times annual member remuneration thus should be provided by insurance. At that level of insurance cover, you can expect the premium to be between 2% and 4% of aggregate annual member remuneration. Typically insurance companies provide in the event of death, either a lump sum or an income benefit to your spouse and/or children, or a combination of both benefits. Clearly an income benefit is preferable as it better matches the monthly cost of living across the different life stages of your dependants.

How much do you and your family need in the event of your disablement?

Now, what is the position in the event of your disablement. Here your needs are probably higher than they would be in the event of death, because you are still alive and you probably require costly care. Typically insurance companies provide in the event of disablement, either a lump sum or an income benefit, or a combination of both benefits, with a limit of replacing 100% of your remuneration. Once again the income benefit is preferable as it better matches the monthly cost of living across the different life stages of you and your dependants. The cost of a benefit that meets your needs, is typically between 1% and 2% of aggregate annual member remuneration.

Conclusion

To conclude this topic, you should now ‘have a good feel’ for what your retirement fund should aim to achieve and what you can expect the total cost of this package to be. Does it make sense to offer a retirement fund arrangement that does not, at least, adequately provide for retirement? Remember, if your competitor offers a better arrangement, you might find it difficult to attract and retain the right caliber of staff. And just one last thing, we have not addressed the costs of managing your fund, another cost factor to keep in mind.

Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. RFS Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of RFS.

 

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