Communicating benefit projections to members of retirement funds
Current retirement benefit projections do not add any value to members!
The Financial Sector Conduct Authority has for some time now, illustrated its intention to set higher standards in terms of the way in which funds are engaging members regarding projections of their expected retirement benefit. Although not yet formally implemented, we believe the proposed changes to be positive and share the sentiment of the objective to improve overall outcomes for retirement fund members and lift the veil of confusion on how to interpret these numbers.
As a starting point, it’s important to understand exactly what a “projection of expected retirement benefits” is, how it is typically calculated, and the shortcomings in the current approach adopted by retirement fund administrators.
In addition to issuing annual benefit statements after the fund’s financial year end, most funds provide access to real-time benefit statements that contain a net replacement ratio. This aims to assist members to plan effectively for retirement as it provides members with a projection illustrating how much he/she can replace their final salary prior to retirement by, with an income in retirement (through the purchase of a particular type of annuity product).
As a simple example, this percentage would be calculated as follows:
Member’s final pensionable salary before retirement = R10,000
Member’s income in retirement by purchasing an annuity = R6,000
This member would have a net replacement ratio of 60%.
This calculation takes several assumptions into account in determining what a current member will end up with at normal retirement age:
Current fund credit;
Years of contributions remaining;
Current pensionable salary with an assumed annual real increase;
Investment returns (in a low, moderate, and high return environment); and
Annuity rates and the type of annuity purchased (most administrators use some form of a guaranteed annuity as the assumption).
Funds often attempt to make this projection more relatable with a graphic representation such as a bar graph where the projection is compared to the objective, which is generally accepted to be around the 70% (of final salary) mark.
The Fundamental Shortcoming of These Projections
…which is aiming to be addressed is that funds provide this projection using the salary on which monthly retirement fund contributions are made, otherwise known as pensionable salary which is still often expressed as a notional amount of, for example, 70% of total cost to company. Coming back to the example of 60% then, this projection would then effectively be 60% of 70% of a member’s total cost to company and an actual, more realistic projection of 42% tells a very different story!
Furthermore, consider an employer that operates a basic plus pay structure, where all benefits are paid for by the employer over and above the member’s net pay including risk insurance benefits and, for instance, a 50% medical aid subsidy. Retirement fund contributions are, in this example, also applied as a percentage of basic salary.
In this approach, the fund will work out a projection of retirement income based on the member’s basic salary and let’s assume this works out to 70%... Everything looks great and the member is “in the green” as far as himself/herself is concerned.
However, when the member eventually reaches retirement, suddenly the risk insurance benefits, and 50% medical aid subsidy paid by the employer falls away. So essentially, risk insurance benefits and the full medical aid contributions are now a cost to the retiree.
Now 70% of the member’s basic salary certainly seems far too little where the member was always under the impression that he/she was on track for a comfortable retirement and made no other provision for income in retirement.
The issue is that the projection had never considered the member’s full cost to company during his/her working life and ultimately led the member to believe he/she would be in a reasonable financial position at retirement. The draft notice issued aims to address this issue through the following proposals which have been extracted from the notice:
4. Information to be contained in benefit projection statement
(1) …the following information must be provided in a benefit projection statement…to each member of a pension fund:
(a) The value of the member’s projected benefit at retirement as a multiple of salary (cost-to-company) and not of pensionable salary;
(b) The projected monthly pension in current day terms;
(c) The projected monthly pension in current day terms compared to the member’s current monthly salary (cost to company), representing the replacement ratio;
(d) A note on the underlying risks and assumptions;
(e) In respect of a provident fund or defined contribution pension fund as applicable, the benefit projection statement should note that the projected monthly pension represents the projected pension that could be purchased with the projected lump sum available, setting out the underlying assumptions relating to the annuity.
How administrators deal with the changes when they come into effect will be challenging as administration systems will certainly require a large degree of updates to now hold pay elements in addition to just pensionable salary.
With the provident fund annuitisation rules coming into effect on 1 March 2021, we also believe strongly that administrators of provident funds must split out vested and non-vested benefits (pre- and post-1 March 2021) clearly to give members an understanding of what their accumulated values are for each “pot of money” and what their retirement options are.