In my column last week on swapping from a defined benefit to a defined contribution fund I dealt with the issue of the investment risk being transferred from your employer to yourself.
This week I will deal with a few more elements of risk you need to take into account. These can apply to both defined benefit as well defined contribution schemes.
I must thank Chris Newell, president of the Institute of Retirement Funds and a director of Old Mutual Actuaries and Consultants, for his input to these columns.
One of the main risks of swapping to a defined contribution scheme is an under-performance of investments. However, you could also see over-performance which has happened in recent years, placing you in a far better position on retirement. Here are some more risks:
Armageddon Risk
The Armageddon risk is that your employer goes to the wall and you lose your job. Your pension money that has already accumulated in the fund should be safe because it is not part of the company's finances.
There is always a chance, however, that the company could have illegally "borrowed" the money from a self-administered fund as happened recently. There are proposals under consideration presently that will give protection under these circumstances while the risk here can also, in most cases, be considered slender.
The Non-Preservation Risk
This is the risk that you will not have sufficient money on which to retire, particularly if you have been changing jobs and not preserving your past contributions to retirement funds.
Retirement Funding Gap Risk
It is unlikely that any retirement fund will put you in the position where you will receive the same amount you were earning before retirement. This is called the "retirement funding gap". You need to be aware of your particular gap to ensure it is not too large.
There are many computer programmes available to calculate the gap. Speak to your financial adviser and have the gap identified. You may need to make further investments to cover the gap through retirement annuities or other investments.
Inflation Risk
Inflation is a major risk to a contented retirement along with the associated risk of living too long.
Most defined benefit pension funds have a set formula for how much you will receive. For example two percent of your average salary for the last two years of employment multiplied by the number of years employment. So if you have worked for the same company for 30 years and your average salary for the past two years was R100 000 a year, you would receive R60 000 a year as a pension (30 years x 2% = 60% of R100 000). This ignores a conversion of one third to a lump sum.
This would give you a pre-tax monthly income of R5 000. That is fine for the first year but let us assume that there is an inflation rate of 10 percent a year. In five years time your R5 000 pension will be worth less than R3 000 a month and in 10 years less than R2 000. Believe me the figures are right. (See graphic)
Here you are in the hands of the trustees. If the assets of the fund are growing well they may grant you an increase in your pension every year linked to inflation. If the assets are not growing above the inflation rate you can virtually forget it.
Newell says historically few funds have given increases equal to the full inflation rate over the longer term. However, in recent years, helped by high positive real returns, many funds have given full increases but this is no guarantee for the future.
This problem applies in a different way to provident funds. If you are a provident fund member you have to take an even bigger bet against inflation and how long you will live. If you die soon you will be fine but to you may live to be 90. The question is whether you will have sufficient funds to meet both inflation and longevity?
These issues are critical in deciding how to structure your retirement benefits. There is a range of products available. No one case is exactly the same as another and you need to get professional advice.
A fellow of the Institute of Life and Pensions Advisers may be a good place to start.