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Restoring confidence in the pension system

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SOUTH AFRICA has a well-developed retirement system, with six out of every 10 members of the working population belonging to a pension plan and total pension assets equalling 63% of GDP. However, the system suffers from significant structural deficiencies - primarily relating to poor population coverage - and for those in the system less than ideal post-retirement income replacement rates.

The regulatory framework governing the pension industry hasn't been comprehensively overhauled for more than 50 years, resulting in unnecessary complexity, undesirable inequities and failure to keep pace with new developments, both in financial markets and in global best policy practice.

To address those issues Government will transform SA's pension system over the next three years. The scope of the proposed reforms - contained in a discussion paper released by National Treasury in February 2007 - is ambitious. It includes the introduction of a mandatory social security system (SSS) and significant changes to the structure and role of the existing private sector pension industry.

The key reform objective is to provide basic income protection benefits to as many households as possible. Government also aims to strengthen the social contract between all South Africans through mandatory participation in the SSS. A final aim is a private pension industry that produces better and more cost-effective benefits supported by increased competition and better regulation.

While the strategic imperatives are clear, much of the detail still needs to be resolved in consultation with industry and other stakeholders. Those reforms will fundamentally alter SA's long-term savings industry landscape and should be the key issue on the agenda of any player in the savings industry.

Nine potential implications of the proposed reforms for the existing private sector pensions industry are discussed below.

1. The regulatory environment will become ever tighter

Treasury acknowledges that significant capacity exists in the private sector and that should be built upon. However, they highlight deficiencies in the regulatory and oversight structures that should be addressed. Those include:

* Undisclosed conflicts of interest between funds, trustees and service providers.

* Too much reliance placed by trustees on external service providers.

* Recent governance failures, including the bulking/secret profits, Fidentia and surplus apportionment scandals.

* Excessive costs, especially in existing underwritten individual retirement funding arrangements.

Because the potential of those issues are significant and resolution is relatively clear-cut the process of addressing them has already started, rather than waiting for general consensus on the future shape of SA's retirement system. It's inevitable that the compliance burden placed on funds and fund service providers will increase as a result.

2. The system will become simpler, more consistent and more equitable

All existing retirement vehicles will be unified under one new act, with similar treatment afforded to occupational pension funds, occupational provident funds and individual retirement funds. Current anomalies, such as benefit funds governed by a separate act and umbrella trusts that aren't regulated by the Financial Services Board, will also be removed.

Tax treatment of contributions, regulatory oversight and rules governing payment of benefits will be standardised for all types of funds. That will resolve the current bias against the self-employed and those with irregular employment patterns. It will also lead to administrative savings and a simplified financial planning environment.

3. Forced savings will become a reality

Many fund members retire with inadequate pensions due to starting contributions late, failing to preserve accumulated savings when changing jobs or as a result of crowding out caused by the funding of risk benefits. That will be addressed through the introduction of compulsory contributions and compulsory preservation of built-up benefits to ensure that more people can maintain a reasonable standard of living in retirement.

It's likely that the level of compulsory contributions will be below the current norm of contributing at least 15% of salary to a fund. The importance of freedom of movement within a compulsory system - by requiring portability and regulating excessive exit costs - is also acknowledged.

While compulsion will over time increase the number of savers in SA it's not yet clear whether the private sector industry will benefit meaningfully as a result.

4. Tax policy - fewer loopholes, redirected incentives

While compulsory savings will be introduced, tax incentives for fund contributions will remain in place. It's expected that the full mandatory contribution to a retirement fund will be tax-deductible and that some tax relief will be granted for additional voluntary savings - but only up to a maximum rand amount.

Government argues that there's no reason to provide tax benefits to fund more than a "reasonable" standard of living. That will lead to a less progressive deduction formula than currently in place. That will be net negative for higher income earners. If the maximum contribution deduction levels are set too low there's a real risk that the already depressed household savings rate could deteriorate further as current pension contributions are diverted to immediate consumption.

A portion of the "savings" resulting from the capping of contribution incentives will be redirected to lower income earners through wage subsidies aimed at formalising the income protection benefits for people currently below the tax threshold.

A very positive development was the abolishment of retirement fund tax (RFT), which enables tax-exempt build-up of benefits. It also completely removes tax as a factor to be taken into account when making investment decisions on behalf of retirement funds.

The recent simplification of the formulas governing tax relief on lump sums paid out of retirement funds is a clear sign of things to come: a simple system with no loopholes to be exploited by the wealthy. Hopefully, that will provide a wider tax base that will eventually lead to lower rates of tax.

5. The role of the private sector industry will change

The role of the private sector in the future pension system will be ancillary rather than primary. Basic benefits for all working people will be provided by the SSS, while the private sector will be tasked with providing additional benefits to ensure a reasonable standard of living for middle- and high-income earners.

The potential for existing fund members to opt out of the SSS, partially or completely, will be one of the most contentious debating points in the forthcoming consultation process.

6. A preference for annuity income

Treasury expresses a strong preference for a lifetime inflation-adjusted income in retirement while allowing for a limited tax-free lump sum withdrawal at retirement.

Income drawdown products, such as living annuities, are seen as (at best) suitable to provide additional income after buying a suitably large conventional annuity. That approach is aimed at managing longevity risk but doesn't represent the only viable policy approach.

An alternative solution to the longevity problem may be to make that risk insurable by lengthening the term structure of Government debt. Long-dated bonds will make it easier for insurers to underwrite the payment of an annuity starting 20 or 25 years in the future. Households should be allowed to balance their need to manage longevity risk with the ability to allow future generations to inherit excess capital.

It's also important to avoid creating an unrealistic and unaffordable burden in terms of minimum prescribed pensions for defined benefit funds.

7. Occupational retirement funds: consolidation ahead

Treasury makes the point that more than 80% of the 13 500 registered retirement funds have less than 100 members. In addition, the 88 largest funds have 73% of members. That leads to potential inefficiencies due to a lack of scale economies and increases systemic risk due to the low probability of detecting potential governance failures with the current available enforcement capacity.

The reform proposals therefore support consolidation of the long tail in the industry.

That could be achieved through more competitive personal pensions, industry funds, umbrella funds (with stronger governance structures than at present) and the SSS. Based on current proposals, consolidation will be accelerated by the potential to divert more than R20bn of annual contributions from the existing private sector pension system to the SSS.

8. Individual retirement funds: A more important role?

With tax treatment similar to that of occupational funds and a more competitive landscape through the introduction of simplified "savings-only" personal pensions, individual retirement funds will play a more significant role in the future. That's not dissimilar to trends in other markets, such as Australia, the United States, Germany, South Korea and Chile, where personal pensions make up an increasing share of pension assets.

9. Investment regulation to be modernised

Because members rather than employers carry the investment risk in many funds, it's envisaged that quantitative asset allocation limits (as currently embodied in Regulation 28) will remain a part of the future landscape. In line with an often-repeated industry request there's recognition that the current limits are outdated and should be reviewed to accommodate developments in the financial markets. More clarity on issues such as socially responsible investing and shareholder activism will also be provided. Furthermore, large funds will probably finally be allowed to deviate from the quantitative limits and apply the more appropriate "prudent expert" approach.

Conclusion

It's clear that the retirement landscape will change significantly beyond 2010. The principles defined by policymakers have the potential to assist in building a better, fairer SA over the long term, with a better social safety net and private pensions industry worthy of trust.

It's imperative that all stakeholders engage constructively in the public consultation process to ensure that the implementation challenges are adequately met and to minimise the potential for unintended negative consequences.

Pieter Koekemoer

KOEKEMOER, is a senior executive at Coronation Fund Managers, is responsible for all aspects of its retail business activities since 1999 and is the current chairman of the Association of Collective Investments. He's a CA (SA) a CFA and a CFP.

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