This is the fifth in the series on whether to swap from a defined benefit to a defined contribution scheme.
Most defined benefit retirement funds in South Africa have what is called a surplus, which is an excess of assets in the fund over what is likely to be needed to pay benefits to members at retirement (liabilities).
Last week I dealt with the sometimes misleading lure to get you to move from a defined benefit to a defined contribution scheme improved group life benefits. This week the subject is the bigger lure a share of the surplus in the defined benefit pension fund.
This is a fundamental issue and could have a considerable impact on your decision. Any payment of a share of a surplus should be included into your calculations.
The surplus is worked out by actuaries who take two issues into account. One is the anticipated liabilities of the fund and the other is the assets of the fund.
* Liabilities:
These are what it is anticipated the fund will eventually have to pay out in pensions to its members. Actuaries need to take a number of factors into account in arriving at the figure for the liabilities of a fund, such as how long members will live, how many dependants members have on average and how long they will draw on the fund; and how many employees will remain with the company and as members of the fund until they retire.
* Assets:
These are the accumulation of your contributions and those of your employer, plus the investment growth of the funds.
An actuary has to take a reasonably conservative stance in valuing both the assets and liabilities. In others words the liabilities must not be assessed in the way most of us draw up our monthly budgets, namely not taking the unexpected into consideration.
Chris Newell, president of the Institute of Retirement Funds and a director of Old Mutual Actuaries & Consultants, says that assumptions made by actuaries must be based on what is expected to happen in the long term. Current experience at any particular time may be considerably different from long-term assumptions, making the actuary appear conservative.
Account has to be taken of what would happen if, for example, the stock market collapsed and dividend yields and profits reverted to levels consistent with longer-term expectations.
Newell says the most important thing is that the surplus, defined as being the difference between the actuarial value of the assets and the actuarial value of the liabilities, is determined on consistent assumptions. The market value of assets could be considerably more than the actuarial value at any time.
Newell says although this could be viewed as an additional part of the surplus, it is also a reserve against future investment fluctuations.
This conservative approach on its own helps build up an unquantifiable surplus in a fund.
Large surpluses, currently in many funds, have, however, been driven by the significant growth in value of shares listed on the Johannesburg Stock Exchange over the past 209 years.
Actuaries have worked on real returns (growth after deducting the inflation rate) of two to three percent while actual real growth has on average been closer to six percent.
There are many arguments about who owns the surplus in a fund. Many employers argue that the surplus belongs to them because they undertake to make whatever contributions are necessary to ensure the defined benefits can be paid. Against this many employees claim that the surplus is a result of their total package and should belong to them.
Currently there is no legal obligation on an employer to hand over any of the surplus of a fund to members. In fact they can take what are called contribution holidays, where they pay nothing into the fund until the surplus is whittled away.
However, the chief actuary at the Financial Services Board, Peter Milburn Pyle, has proposals to change legislation resulting in employers being able to withdraw the surplus but only under very stringent conditions. The conditions are so tough that employers will have to make a deal with members to virtually split the surplus.
There are no proposals currently to stop the contribution holidays.
In moving to a defined contribution fund you need to make your own assumptions about future investment returns. You will no longer have your employer to supplement amounts that may be needed to prop up your fund if markets turn sour. In other words, you carry the investment risk.
Newell says for this reason "it is reasonable to expect the employer to offer the member who converts to a defined benefit arrangement, a share in the surplus and particularly the investment reserve".
In making the choice to move from a defined benefit to a defined contribution fund, you need to know whether you are being given a share of the surplus and how much that share will be and what effect it will have on your retirement benefits.
Again a word of advice: get a properly calculated comparison of end benefits you would receive by remaining on the defined benefit scheme or swapping to a defined contribution fund based on the same assumptions.
If your employer intends to use the proposed legislation on surplus withdrawal, find out what will be on offer as your share of the surplus. For example there could be additional retirement benefits.
Incidentally your employer, particularly if a fund is being closed down, can transfer a surplus in to a defined benefit fund and hold it separately without distributing it to members.