As a pension fund member you will no doubt be disappointed with the investment returns your (probably) biggest investment has earned over the last number of years. This investment is to carry you through retirement and in order to ensure a comfortable retirement. This assumes a typical total contribution by you and your employer of around 17% of salary and on the underlying expectation of long-term returns that your pension fund investment should earn of 5% per year in real terms, i.e. above inflation. Where inflation for the year to 30 September was 3.2%, your investment should thus have earned 8.2% for the year to 30 September. The average return of typical pension fund investments for the same period however, was only around 3.4% (after fees). Over a 5 year period inflation was 4.7% per year. Your investment should have thus earned 9.7% per year while the average return of typical pension fund investments for the same period however, was only around 6.8% per year (after fees). So over both periods, your investment has substantially underperformed the underlying expectation. One will have to extend the period to 8 years to get to the first measurement period where the average return of about 9.8% per year (after fees) actually achieved the expected real return of 9.9% per year (inflation of 4.9% plus 5% real return).
Any member of a fund who has been in the fund for 7 years or less certainly has good reason to be disappointed and to be concerned, however, only if you are approaching retirement and you have not preserved your pension capital for all the years you have worked until 7 years ago. The underlying expectation for you to retire in comfort is that you will have worked and saved up uninterruptedly for your entire working life of at least 30 years, i.e. you only started to work at age 30 and will already go on retirement at age 60. Most people in fact start working at 20 and retire earliest at age 60, actually giving them 40, not 30 years of saving up for retirement. If you are one of the diligent fund members who has indeed saved up uninterruptedly for the past 20 years (or longer) your return should have been 11.8% per year as opposed to inflation over the same period of 6.3% per year, i.e. a real return of 5.5% per year including the disappointing past 7 years.
If you diligently started to save up from the day you started to work (at age 25) and this was 7 years ago, and you intend to remain as diligent, you still have 28 years to save up. Why should you be concerned now? Clearly it is only those fund members that have reneged on their commitment to save up from their first to their last working day who may find that they will not be able to live comfortably on their pension. Unfortunately this is not how pension funds are designed and these members should rather look critically at themselves than at the performance of their pension fund over the past 7 years. Over the past 10 years, pension funds have achieved the return expectation of inflation plus at least 5% per year per year (after fees).
Having referred to the past, you may well ask “but what about the future”? Can I be certain that over the next 28 years my pension investment will recover what it fell short over the past 7 years? Of course, no one will be able to look into the future, and indeed one may have valid concerns considering that ‘things’ have changed in financial markets globally since the financial crisis in 2008/ 2009.
It seems, the law of economics, of demand and supply, no longer has any bearing on the behaviour of markets today. Savers are paying off the debt of borrowers through artificially low interest rates that are set by monetary authorities across the world. So-called ‘safe haven’ investments are earning negative real interest rates and the investor is now conditioned to accepting that he will have to work until he passes away, instead of realising his dream of retiring at an age where one might still be able to enjoy life for a while. Retirement ages are extended while pension entitlements are at best being questioned already, and even reduced in some countries.
It is pretty much common knowledge that the situation we are and have been facing in investment markets globally for the past nearly 10 years, is the result of ‘ultra-loose’ monetary policy by central banks across the world, including Namibia. After the financial crisis, central banks poured money into the financial markets in order to encourage the consumer to pick up spending levels again after these had fallen flat in the aftermath of the financial crisis. Artificially low interest rates, designed to encourage spending, were great for the borrower, but bad news for the depositor, pension fund members and pensioners to a significant extent. In many instances depositors would earn negative real interest rates.
With negative real interest rates seemingly having become the ‘new norm’, asset valuation models are now being questioned. Why should this be of concern to a pension fund member? Well as we pointed out above pension fund contribution structures were established over the course of the past century or more based on the assumption of cash returning around 2% above inflation, bonds around 4% above inflation, property around 5% above inflation and equity around 8% above inflation. A typical balanced portfolio comprising of a mix of these assets based on conventional investment theory was expected to return roughly 5% above inflation, net of fees. Pension theory then arrived at a net retirement funding contribution rate of 11%+, to produce an income replacement ratio of 2% per year of membership, that is 60% of the member’s last salary before retirement after 30 years, or 80% after 40 years uninterrupted fund membership.
Indications based on the ‘new norm’ are that one is now only looking at a net return of between 2% and 3% per year as opposed to 5% per year. If this were to become true, the retirement funding contribution rate would have to be raised from 11% to at least 16%. Add to this a typical cost element of 6% for risk benefits and management costs, the ‘new norm’ for a total retirement fund contribution rate is now at least 22% instead of the 17% before the advent of the ‘new norm’. Alternatively the retiree would now have to settle on an income replacement ratio of only around 40% after 30 years of service, instead of his expected 60%!
We are certainly living in a different world today to what it was 30 years ago. What we expected of the future may be materially different and we will have to find ways and means to deal with the impact these changes have on our lives and on our retirement planning. One can only find some comfort in the fact that we are all ‘in the same boat’, from ‘top to bottom’, the answers have not been found and a lot of energy and time will be spent all across the globe to find answers how to still have time in retirement to enjoy.
The global economy just has to get going again by getting consumers to start spending again and governments across the world are making every effort to achieve this goal. We are all consumers and we all know that we have an urge to spend our money, to buy a new TV, a new motor vehicle, to go on leave etc. but we are able at times to also to hold back on spending when times are bad, only to feel the spending urge growing as time goes by. There are many possible scenarios that are likely to lead to increased spending. Namibia has experienced a terrible drought for the past few years that has resulted in many Namibians holding back on spending. At some stage it will start raining again and this will then lead to the pent up spending urge to be unleashed. Globally there is much talk about the ‘4th industrial revolution’ evolving right now where the advancement in technology is in the process of changing the world of work ever faster. Any revolution will lead to the destruction of existing infrastructure and reconstruction of new infrastructure that will require large-scale investment.
With the prevailing exceptionally low interest rates, borrowers have a ‘hay-day’ while depositors (and pension fund members) are suffering. This is turning conventional money wisdom upside-down and must and can be corrected in different ways.
We are convinced that the prevailing situation cannot continue for too long and that conventional money wisdom will return. Which investor in his right mind will invest in an asset that gives him a return of 0% or even a negative return, i.e. his investment declines in value as time goes by? And this is currently in nominal terms and the situation is exacerbated by prevailing inflation as the result of which the decline in value is actually accelerating. Either interest rates will return to normal or we will see deflation (or negative inflation) meaning that goods and services will become ever cheaper as time goes by.
Pension fund members we believe do not need to be overly concerned about the poor investment experience of the past 7 years, provided they have been and remain diligent and focused on saving up for retirement throughout their working life. A pension fund is designed to deliver only over the working life of a member of 30 to 40 years. Those that are at the end of their working life and have saved up right through should still be able to retire in comfort, given that 7 years ago the picture was a lot rosier, but we are still on target! If you are at the beginning of the road of still saving up for another 30 to 40 years, markets still have a lot of time to correct and the pension fund member ultimately can influence the growth of his pension savings by saving more at a time when interest rates are low and house and rent prices have declined as the result of the prevailing economic environment.
Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions 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 Retirement Fund Solutions.