Natasha Huggett-Henchie, Retirement Matters Committee, Actuarial Society of South Africa, Principal Consulting Actuary from NMG Consultants and Actuaries
Actuarial modeling by the Retirement Matters Committee of the Actuarial Society of South Africa (ASSA) suggests that National Treasury’s “two-bucket” proposal is likely to result in significantly higher monthly retirement income for pensioners by allowing future retirement savings to benefit from the power of compounding.
Recent analysis of fund administrator data shows that more than 80% of retirement fund members cash in their retirement benefits when changing jobs rather than preserving their savings. While all retirement funds are compelled to encourage preservation in terms of the retirement funds default regulations introduced by the National Treasury in 2016, members are still allowed to take their full benefit in cash.
The majority of people take their benefits when changing jobs despite the punitive tax levied on the withdrawal of retirement benefits. To make matters worse, cashing in retirement benefits also reduces the tax-free lump sum normally available at retirement. In other words, members are making bad choices by prioritising their short-term needs and wants, sacrificing future investment growth on their benefits and risking double taxation resulting in lower pensions at retirement.
National Treasury is therefore proposing to introduce a new system, referred to as the “two-bucket system” to allow retirement fund members to access a portion of their retirement benefits for emergencies such as the Covid-19 pandemic. The access comes with the condition that the other portion of the retirement benefit cannot be accessed before retirement (the earliest age is 55). This results in the so-called “two bucket system” where one bucket is accessible and the other is preserved for future retirement benefits.
A well-designed, actuarially sound two bucket system will therefore solve two problems for retirement fund members: they will have access to emergency funding when needed and their savings will benefit from compound growth leaving them with a substantially bigger nest egg on retirement.
It is the compounding effect over time that accelerates the growth of your retirement savings. For this reason, she adds, Albert Einstein famously referred to compound interest as the most powerful force in the universe, while Warren Buffett attributes his wealth to “a combination of living in America, some lucky genes, and compound interest”. Compounding is enabled when the returns earned on your retirement savings together with any capital growth is left to attract further gains. The effect of earning income on income and further growth on capital gains is referred to as compounding.
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To illustrate this, the members of the Retirement Matters Committee modelled the following scenarios:
Scenario 1: A retirement fund member who joined a fund at age 20 changes jobs every seven years and withdraws (and spends) the full benefit every time. However, once the member reaches age 50 they will focus on saving for their retirement and start preserving their benefits until age 65.
Scenario 2: The “two bucket” system has been implemented and the member, who joined a retirement fund at age 20, has access to one third of their benefit in the access pot. The member withdraws the full available amount in the access pot every five years until they reach age 65.
The results – Scenario 1: The member in the first scenario is likely to retire with a net replacement ratio (NRR) – the ratio of the member’s pension expressed as a percentage of their pre-retirement salary – of around 15%, which means that they will have to learn to survive with a monthly pension equal to 15% of what they earned in the year before they retired. If this member further reduced their retirement benefit by taking another cash portion at retirement, their NRR drops to 10%. Therefore, someone who was earning R20 000 a month before retirement would now have to survive on R3 000 a month, reducing to R2 000 if they take a lump sum at retirement.
The results – Scenario 2: By contrast, the member in the second scenario will retire with an NNR of 36% on their full benefit, or 32% if the cash portion is accessed. In other words, their monthly income is more than three times higher than if they had been allowed to follow the path of the person in the first scenario. Despite withdrawing their full one third over their working years up to retirement, the remaining savings were able to benefit from compounding. Staying with the example of someone who was earning R20 000 a month before retirement, this person would have access to a monthly pension of R7 200, reducing to R6 400 if they take a lump sum.
By far the best outcome at retirement is achieved by retirement fund members who never access their retirement savings, thereby enabling the power of compounding to deliver the best possible outcome. Someone who doesn’t access their benefits ever could end up with an NRR of almost 52% if they don’t take cash at retirement, or 32% if they do. The rand equivalents are a pension of R10 400 per month, or the same R6 400 if they take a lump sum, relative to the salary of R20 000.
For this reason, all retirement fund members should be provided with meaningful information about the impact of accessing their emergency bucket on their long term retirement aspirations.
Rules regarding access
While National Treasury is still working out the details of how the “two-bucket” system will work, the Retirement Matters Committee has made a number of recommendations for consideration based on its modelling work, especially regarding the rules and restrictions regulating the accessibility of the emergency portion.
The committee feels strongly that there should be absolutely no need based rules as this is open to abuse and very onerous and costly to administer. Our modeling indicates that forcing the compulsory two thirds preservation actually improves outcomes at retirement, and members are going to find a way to borrow against or spend their one third anyway. Access to the one third should therefore be available to all retirement fund members regardless of need. The actuarial modeling indicates that the frequency of withdrawal from the access pot does not affect the ultimate net replacement ratio at retirement. If you withdraw more frequently you just get a smaller cash amount each time as it doesn’t have time to build up, but the preservation part remains unchanged.
There will, however, be an administrative burden to pay the cash amount and therefore some restrictions would be needed to reduce frequency. Here we would suggest that the regulators allow annual withdrawals, with a free once off withdrawal, and a free withdrawal every five years. Additional withdrawals should be subject to an administration fee deducted from the benefit.
I recommend putting in place a rand limit on the withdrawal amount at any point in time to avoid abuse by high income earners.
The biggest concern for retirement funds is the potential for a proverbial “run on the bank” if all retirement fund members are allowed to withdraw their emergency funds immediately after the legislation is promulgated. To avoid this there some initial controls and safe-guards will have to be put in place.