By restructuring the way we save for retirement we could halve the cost of retirement savings vehicles. The current model of annual fees and a lack of preservation is unnecessarily driving up retirement costs according to Anton Gildenhuys, head of Sanlam Personal Finance Actuarial.

National Treasury has produced statistics that show that South Africa has one of the highest level of retirement industry fees in the world, however Gildenhuys argues that the countries that we are compared to have compulsory preservation of retirement funds which fundamentally changes the costing structure.

Although figures are not available as to the average length of time a South African retains their retirement funds, due to the fact that members have the ability to access their retirement assets before retirement, retirement fund assets are held for a shorter period compared to countries with compulsory preservation. Research shows that approximately 70% of people changing jobs do not preserve their retirement funds.

Retirement product providers therefore have to recoup their fixed costs over a shorter period of time and therefore charge higher annual or upfront fees. The longer the funds are invested, the more time the company has to recoup the fees which would result in a lower reduction in yield.

“If we could improve the tenure of funds, the industry could charge lower fees,” says Gildenhuys who still believes however that members should be allowed to move assets between providers as long as the assets remain within the retirement industry. “Compulsory preservation should not protect product providers and portability allows competition, some will gain funds and others will lose funds but as long as the funds remain in the retirement net then costs will come down”.

Gildenhuys is concerned about government regulation on fees as experience shows that a fee set by government becomes de facto the standard fee for the industry as it is seen as “acceptable”. This could have the unintended consequence of driving fees higher. This has already been experienced in the credit industry where credit providers now all charge the maximum fees allowed.

At the same time if regulated fees are too low then it makes the industry unsustainable. “You want the market to find the price; there are too many examples where regulated prices become the norm”. Gildenhuys says competition can be developed further with greater transparency that allows members to easily compare prices. This will be driven primarily by the principle of “Treat your customer fairly” – a programme currently underway by the Financial Services Board.

Creating a single investment pot

Gildenhuys says there also needs to be a reform of the current system where people have various retirement funds that have accumulated as this also adds to the cost in the system. When a person leaves a company they either leave the pension with the employer or transfer to a preservation or retirement annuity. The next job change they would be required to take out a new preservation fund. Although you can amalgamate preservation funds you cannot add to an existing one. This is further complicated by the fact that you cannot transfer from a preservation pension fund into a preservation provident fund due to different fund rules. The reform process needs to standardize the fund rules as well as removing the red tape to transfer retirement funds into one investment vehicle. National Treasury has already indicated that work has started to harmonise the interaction between these different vehicles.

The cost of annual fees

Over the last decade there has been a significant move away from upfront premium based fees to charging annual fund based fees. For long-term investments this shift has significantly increased the costs of retirement funding. Gildenhuys says there is little appreciation of the impact of annual fees on long term savings.

Investors believe that investing 100% of their premium each month and paying an annual fee provides the best result over time as all premiums are “exposed to the market” from day one.

However, using a simplified example, Gildenhuys demonstrates that an investor would be better off with a 23% upfront fee on each contribution, than paying a 2.38% annual fee. This is based on the assumption of an investor paying an annual R6000 premium over twenty years with the product provider’s target present value of income of R10 000 over the period. The present value of total income is required over the 20 years of the product to meet all expenses over the 20 years with a profit margin of around 2% (R850 in this case).

By year 15 the annual fee of 2.38% would make up more than half the annual contributions to the fund and by year 17 the fees would make up 70% of the annual premium.

At the end of the period the investor would receive R245 378 on the assumption the fund delivered a before cost return of 9%. In comparison an investor paying an upfront fee of 23% would receive R257 579 after 20 years.

Under the annual fee model the investor would have paid R46 566 in fees compared to R27 619 in upfront fees. The fact that this had less impact on the final return is due to 100% of the premium that invested with the annual fee model – however this additional growth fails to fully offset the total costs.

Gildenhuys says that under both charging structures the product provider would make exactly the same profit.  The driver of the difference in maturity value is the mismatch over time between when expenses are incurred, and charges are levied.

“Irrespective of the business model, there will always be some upfront expenses and there is a cost to fund this if the bulk of fees are only levied towards the end of the contract term. This cost will exceed the expected investment return on the fund, and hence will require higher charges – postponing charges therefore creates a drag. Annual fees sound negligible when compared to the upfront fees but the compound interest affect is phenomenal” says Gildenhuys.

Side Bar: Babies and bathwater

The current model of postponing fees and shorter tenure of investments is creating a hotbed for costs. Product providers have to carry costs for longer yet have less time to recoup fees which means they have to charge more to earn the same profits.

The irony is that the exact product that is required to reduce costs, in other words a product that has a compulsory investment period with high upfront fees, is the model that was used by traditional retirement annuities. The problem arouse due to the fact that in the early years the high upfront fee erodes returns resulting in negative performance.

Using Gildenhuys’s example the upfront model would show negative returns until year five. It is only after year seven that fees charged under the annual fee model start to exceed the upfront fee. Each year this fee gap widens until the final year where the upfront fee remains at R1 381 while the annual fee has reached a massive R5 487 – nearly four years’ worth of the upfront fee.

The upfront fee model only provides a benefit if invested for 17 years or more. Any shorter period and the returns from the annual fee model are higher.

There were also concerns about the transparency of these products and their exact charging structures – it was never clear about how much of their investment was going to fees.

Gildenhuys believes that if the structure of the industry changes and investors are better informed about the impact of fee structures then costs could come down dramatically. He argues for full transparency where investors can clearly see the rand value of what they are paying rather than the industry hiding behind percentages. 

This article first appeared in the Mail & Guardian