By Brian Kantor
It is retirement plans for the future that should concern us, not those of the past that have done so well in South Africa.
The weekend newspapers were full of exhortations for South Africans to save more than they appear inclined to do for a comfortable retirement. Personal Finance, in a caption (Weekend Argus 18 May 2013) reports: “You need to save more than you planned to do if you want to have a financially secure retirement, because of interest rates and investment market expectations.”
Given the decline in long term interest rates (and so expected market returns), it will take a larger capital sum to purchase a highly predictable flow of monthly annuity income from a life insurance company. Or, in other words, for any given life expectancy, a million rand of accumulated savings will now buy you significantly less monthly income from an annuity supplier than it would have 10 years ago, when long term interest rates and so expected returns were much higher than they now are.
The article in Personal Finance is accompanied by a figure describing the monthly “inflation-related” pension that could be purchased “by a 65 year old man with provision for spouses annuity and a 10 year guarantee” with R1m. The figure shows the contracted monthly pension as having declined from over R3 700 per month in December 2007 to about R3 000 per month today. A vanilla annuity without any inflation protection would provide about a fixed R60 000- R70 000 per annum for the same retiree.
Interest rates on an RSA bond with 10 years to maturity have declined markedly since 2002 from over 12% for a generic 10 year bond, to their current levels of about 6.3% while inflation linked real yields offered by the RSA government have declined even further, from 4.93% in early January 2002 to their current levels of about 0.6% (see below).
The expected return on a bond is its yield. The expected return on an (on average) risky equity is the bond yield plus an equity risk premium of an extra four or five per cent per annum. If realised returns approximate expected returns – a very large presumption – the lower the market interest rate and the lower the expected returns from bonds or equities, the more you will have to save to secure a given monthly income.
It is these largely certain income streams, a certain nominal 6.3% per annum or so from a 10 year RSA, or a real 0.6% (that is 0.6% plus actual inflation from an inflation-linked 10 year RSA), that form the basis on which a guaranteed annuity of either the inflation exposed or inflation protected variety will be offered by a life insurance company (the R36 000 or R70 000 annuity per annum referred to).
Realised and expected returns may however turn out to be very different. In the US for example, on 31 January 2002 very long dated US Treasury Bonds offered a yield of about 5.43%. Total annual returns from these long dated bonds, calculated each month end between January 2002 and April 2013, averaged approximately 8.75%. Total returns are the sum of interest yield, interest/capital values plus the annual change in the market value of the bond.
As long term interest rates in the US trended significantly lower over the period, long bond prices went proportionately higher, so providing unexpectedly good returns from US bond portfolios – on average 3.3% per annum above the expected returns of 5.43% offered by a 30 year US Treasury Bond on 31 January 2002. By contrast the average US equity investor realised well below expected returns. Equity returns would have been expected to realise about 9% a year in January 2002. Actual returns on the S&P 500, including dividends and capital gains and losses, averaged a mere 2.8% per annum. over the 11 year period. US inflation averaged 2.44% over the period, well ahead of short term interest rates that were an average 2%. Unexpectedly low inflation a brought down long term interest rates and pushed up bond prices to the advantage of bond holders. They did very little for equity investors who would have expected to have earned a premium return over bonds given their greater volatility.
Contributors to a reasonably well managed defined contribution SA pension fund since 2002, that would sensibly have included a good weighting in equities, have realised excellent real returns on their pension funds, than might have been reasonably expected early in 2002. The returns realised in the RSA bond and equity markets over the past 10 years have been well ahead of inflation.
And the actual inflation expected by bond and equity investors and implicit in long dated bond yields in 2002 proved to be greatly overestimated. The fact that interest rates fell over the period, so increasing the market value of any bonds held by a pension fund, added meaningfully to these bond market returns. Very long term interest rates in SA in January 2002 were 14.16%. They have more than halved since then. Actual returns on these bonds since then have averaged over 12% per annum. The return on the All Bond Index (with an average term to maturity of six years) was an average 10.13% per annum. The JSE, represented by the All Share Index, returned an average 15.5% a year while short term interest rates averaged about 8.6%. These returns were especially impressive when compared to inflation that averaged an unexpectedly low 5.9%. A balanced SA pension plan over these 11 years and four months was thus adding real purchasing power to savings at a most impressive rate – a most helpful outcome to those contributors to pension funds intending to retire today.
High real returns from the RSA bond market, combined presumably with excellent real returns from the share market, in which even a conservatively managed pension fund would have benefitted, plus good real returns from the money market, meant that the capital value of any SA pension fund should have grown rapidly enough since 2002 (after management fees) to overcome the reality of lower expected returns in 2013.
Some simulation exercises can help make the point about just how well the current cohort of those facing retirement today have been served by the exceptionally good returns provided by the SA capital markets since 2002.
For example, consider an intended retiree of 65 years today, who had a defined contribution balance of R5m in 2002 and earned a salary then of R500 000. Let us say that his salary grew at 8% a year over the period and he continued to contribute 10% of his growing salary to his pension plan. If the pension plan had a modest 50% weight in equities, 40% in bonds and 10% in cash based on realised returns since 2002, his nest egg would have grown to over R22m by April 2013. Had he not added to his savings, his wealth would have mounted to about R20m. His salary by 2013 would have grown to over R1.1m and his R22m would have bought him an inflation protected retirement income of about R792 000 a year. If he were prepared to take on inflation risk he might be able to secure an annual constant nominal income of about R1.5m for as long as he lived. His post retirement income would thus seem to bear a highly satisfactory relationship to his pre retirement income. It would not make a great deal of difference to these outcomes if part of his 2002 nest egg of R5m was in the form of equity in his own home. The return on homes in the form of implicit rental yield plus capital gains (especially until 2008) would have compared well with alternative investments.
What about the future?
It is therefore not so much the savers of the past that we should be worrying about, but the savers of the future who now have to face lower expected real returns in the market place. Their ability to build up an adequate store of purchasing power for old age is being compromised by low expected real returns. These low expected returns may well turn out to be low realised real returns, in which case a higher rate of real savings is urgently called for by all those intending to retire in 10 or more years.
The danger to investors in long dated fixed interest securities is unexpectedly higher, not unexpectedly lower interest rates. It is not lower nominal interest rates but higher rates that make it more difficult to build savings for the future, as we have shown. Lower inflation can compensate fully for lower nominal interest rates when a fixed annuity is purchased.
Lower expected real returns, all other things equal, demand a higher rate of real savings to sustain a desired rate of post retirement real purchasing power. A higher rate of real saving can be expressed as a larger percentage of nominal income contracted to a pension or retirement savings scheme. But the danger to current savers is that these real and nominal interest rates will rise over time, reducing the value of any bond portfolio. This is the opposite of the benign winds of lower interest rates that have blown over capital markets over the past 20 years.
It should therefore be appreciated that the current level of real interest rates expressed explicitly as the real return on long dated inflation linkers issued by governments is exceptionally low. Real interest rates close to zero are well below long term averages that have been of the order of two or three per cent. In normal times real interest rates can surely be expected to regress back to long term averages. If they do, does it make sense for those retiring today to commit their capital permanently to such low returns? Furthermore, those planning to retire in the next 10 or 20 years might well judge it appropriate to accept more risk in their retirement portfolios – that is the risk that real interest rates will rise as the economy grows and so the demand to invest more capital in real assets raises the competition for savings. Proportionately more equity (that promises higher returns in exchange for more risk) seems to us to be a sensible response to what may be a short lived world of very low interest rates.