Optimal retirement savings : a South African perspective

Abstract

is worldwide concern that people do not save enough towards retirement. To stimulate savings, tax incentives are a method employed by governments to encourage retirement savings. In this context, the asset allocation decisions that individuals make and the asset allocation restrictions that are imposed by regulators in an attempt to protect retirement savings, potentially impact the retirement ending wealth, which could be accumulated in the pre-retirement phase of an individual. The objective of the study was to determine the impact of tax legislation, Regulation 28 of the Pension Funds Act (24/1956) and asset allocation choices on accumulated retirement ending wealth and what could be deemed appropriate for most individuals considering different time horizons. Therefore, the aim of this study was two-fold: to determine whether pension fund legislation which limits the exposure to risky asset classes resulted in sub-optimal accumulated retirement ending wealth despite the associated tax savings; and to determine whether life cycle retirement funds, as opposed to different balanced retirement funds, were appropriate for most individuals. The study did not find support for the notion that direct investment funds dominated high equity balanced retirement funds that complied with Regulation 28 as measured by firstorder and almost stochastic dominance. Despite the higher asset allocation to equities that was possible with direct investments, this benefit was outweighed by the tax savings attributable to retirement funds. Additionally, the results of the study refuted the notion that a direct investment fund could be optimal over a long investment horizon. The implication of the finding was that an individual saving for retirement should, firstly, do so by taking full advantage of the tax savings that retirement funds offered. Hence retirement funds are an effective retirement saving tool despite the limitations on high-risk asset class allocations. The study found only limited support for the hypothesis that a theoretical retirement fund with a 100 per cent allocation to equities dominated a high equity balanced retirement fund that complied with Regulation 28 (particularly in the case of a 100 per cent local equity retirement fund compared with a Regulation 28 high equity balanced fund with no foreign equity exposure). Because the South African equity asset class was very volatile (annualised standard deviation of 19.8 per cent against 17.4 per cent for local against foreign equity in the data used in the study), a high exposure could lead to very low accumulated retirement ending wealth values; the intent of Regulation 28 was to protect the retirement savings of individuals against such adversity. Despite being perceived as very restrictive on the individual, the findings could not conclude that Regulation 28 restrictions on asset classes were inappropriate. This study provided no support for the notion that a life cycle fund dominated a balanced fund with similar starting asset allocation from the perspective of accumulated retirement ending wealth. This raised the question whether life cycle funds, which are often included as default options for members of retirement funds, have a place. Hence they were likely not the optimal choice compared with a balanced fund counterpart with similar starting asset allocation. However, they could be attuned to the preferences of the individual (such as risk and personal preferences) rather than a rational objective assessment of one fund compared with another. The study provided mixed support for whether a life cycle fund dominated a balanced fund with dissimilar starting asset allocations. This indicated that whether there was a place for a life cycle fund in any retirement fund default options, or whether it was optimal compared with an alternative balanced fund, strongly depended on the underlying asset allocations of the funds while the length of the glide path, the investment horizon as well as the risk and return characteristics of the investable universe could also influence the conclusion. The study uniquely contributed to the retirement savings question with evidence that did not support the notion that Regulation 28 of the Pension Funds Act was necessarily inappropriate to serve the purpose of protecting retirement savings. The study also showed how the lower risk attribute of life cycle strategies impacted on accumulated retirement ending wealth, how it compared with balanced funds and which choice would be appropriate for most individuals. Because the life cycle industry is a fast-growing portion of the retirement fund market and becoming more popular as default options in retirement funds, the study contributed by contrasting life cycle funds with balanced funds and showed that the choice of which fund was optimal, was driven by the different characteristics of the funds such as investment horizon, starting and ending asset allocations as well as the length of the glide path.