If it ain’t broke, don’t fix it: just improve it

Category: Asia, Global
By Joseph Cherian*

Solution could lie in hybrid DC/DB retirement savings systems

A common saying in the American South slang goes, “If it ain’t broke, don’t fix it”. Diametrically, in the more enlightened Northeast, branding gurus and academics usually prescribe rebranding exercises for ailing entities.

Let me explain why Asian economies with prudent social security savings systems are neither ailing nor broke, and why we should actually be celebrating the fact that some of these economies had the foresight and extraordinary prescience to come up with various forms of a mandatory, fully-funded defined contribution (DC) social security savings system that is able to provide for basic retirement spending needs with assurance. As for those Asian countries that have yet to set anything up, maybe it’s time to wake up and do something about it.

A defined contribution plan, such as Singapore’s Central Provident Fund (CPF), Malaysia’s Employees’ Provident Fund (EPF), Hong Kong’s Mandatory Provident Fund (MPF), the 401(k) programme in the US, and Australia’s Superannuation scheme, is one in which the employee, as well as the employer in many cases, makes contributions to his or her individual retirement account on a monthly and tax-advantaged basis.

In a defined benefit (DB) plan, such as Japan’s Government Pension Investment Fund (GPIF), the sponsor promises to provide the retiree with a pension income, which is usually a function of salary, tenure of service, and so on.

The CPF savings scheme, along with its CPF LIFE – a life annuity scheme that invests in special long-term bonds issued by the Singapore government – is quite unique in that the combination is almost a hybrid of the two plans. But that’s where the similarities between East and West end.

In America, many DB plans are going broke or are grossly underfunded, which means they are making promises to future retirees that they cannot keep. As a consequence, the trend around the world is for systems to move towards a hybrid DC/DB retirement savings system, that is, with fully-funded individual accounts that accumulate over one’s working years with some – but not a large – amount of investment and withdrawal flexibility, and that converts to a life annuity upon retirement. This is akin to the CPF social security savings scheme.

Proof is in the pudding

The beauty of the CPF Singapore and EPF Malaysia systems is that they have been practicing this hybrid system for many years, with savings rates of up to 6% per annum in the case of CPF, and dividends of up to 6.75% in the case of EPF. There are also tax-advantaged voluntary supplementary retirement schemes in these two countries.

Retirees are more vulnerable to the risk of inflation than those who are employed, whose salaries, in theory, may at least keep pace with the cost of living. Furthermore, unlike retirees, the employed have some control over their human capital income. This is defined as the net present value of one’s lifetime earnings; given one’s education level, professional training and work experience, the employed can become “portable” human capital, that is, possessing some ability to switch jobs, enter into a private enterprise venture, or simply work from home.

That said, survey evidence suggests that the average retiree is concerned about three fundamental issues during retirement:

(1) Receiving a reasonable level of pay-out every month, that;
(2) Lasts for as long as the retiree lives, and that;
(3) Is indexed to the cost of living. In other words, the average retiree would, at a minimum like to receive a level of “real”, or inflation-indexed, pay-out for life, which enables him or her to maintain his or her standard of living.

A caveat is in order here. As the EPF’s Nurhisham Hussein has argued, people in retirement have different consumption needs as compared to when they are in the labour force. As a consequence, inflation-indexing based on traditional consumer price index measures may not adequately capture such changes in lifecycle spending patterns.

Neither would it cover the risk of standard of living improvements, as Nobel Laureate Robert Merton has argued on many occasions. This is a critical consideration since prices of goods that are especially important for the retiree (such as health care, shelter, food, and leisure) in many countries are increasing at a rate faster than the overall rate of inflation.

So the inflation-indexing of retirement life annuities will not be enough to sustain retiree purchasing power; it should instead be based on a customised “retirement spending” index, or at least one that covers both the risk of the rising cost of living and the risk of standard of living improvements.

As Professor Merton mentioned, such a customised index would be ideal for people who “assess their economic wellbeing on the basis of their standard of living relative to those around them”.

Retirement lifecycle

There are two primary periods in the retirement lifecycle: the savings period during one’s working life, followed by the dissavings period during one’s retirement years.

Savings rates are reasonably compelling and safe in the EPF and CPF schemes. However, financial mathematics will inform us that at the current life expectancy and discount rates in these two countries, their excellent retirement saving schemes notwithstanding, the estimated pay out in their local currency unit from a cumulated retirement sum of S$100,000 (US$73,727) for a male aged 65 today is roughly S$584 - S$615 per month for life under the CPF LIFE’s “Standard Plan”, and roughly 450 ringgit (US$105.38) per month for a cumulated sum of 100,000 ringgit over a period of 20 years, in the case of the EPF’s “Basic Savings” scheme for members retiring at age 55 today.

Whether these amounts are enough for now, or more importantly, in our twilight years where the threat of rising cost of living – and prices – is real, is another matter.

Improving the system

What can we learn from the good and bad experiences of many other countries, as well as academic studies, so we do not unnecessarily change a system that works, and rather, make a good system even better?

I enumerate a few here:

1. Keeping the retirement savings programme’s objectives highly simple and attainable with reasonable prioritisations – for example, saving for basic retirement and medical expenses is key. The same applies for the programme’s schemes and choices, language, brochures and other communication materials.

2. The temptation to dig into one’s retirement pot excessively for current needs, be it for housing, medical expenses or education, can lead to severe underfunding consequences down the road, which is when you need the money the most. This phenomenon may be the reason why an HSBC Insurance Future of Retirement – Singapore Report survey issued in 2015 indicated that 78% of respondents in Singapore worry about having enough money to live on in their retirement. That said, most experts agree that withdrawals for severe emergencies and exigencies should be allowed.

3. Life annuities are a necessary and prudent retirement product for meeting one’s basic retirement and medical expenses. Given that it’s a life product, the more guaranteed the better – after all, it would be very painful to find out in 20 years that one’s insurance provider of the life annuity has gone from being AAA-rated to a ward of the state overnight!

CPF LIFE, which provides principal guarantee and stable pay-outs, is hence the prudent basic life annuity product that could potentially be replicated across the Asian retirement landscape. Note that in 2018, an additional CPF LIFE plan with annuity pay-outs that increase at a fixed 2% per annum will be offered, which retirees can opt for if they so desire. Again, all Asian national retirement schemes should try to emulate the CPF LIFE programme, while ensuring that pay-outs are able to meet retirees’ basic lifelong expenses and needs during their dissaving period.

4. For accounts that allow for it, providing too many investment choices is not a good thing, as it leads to “investor paralysis”. What is needed instead is a few well-diversified and low-cost asset allocation-type pooled funds within the retirement scheme that the more investment-savvy and confident investors, who wish to seek higher risk-adjusted returns, can pick from. The default asset allocation fund, for those who don’t, should be the most conservative one.

The higher-risk investment strategies, however, should only be available to those who have met – or show the potential to meet – via their current savings levels, say, a minimum sum of basic savings (as in the CPF), which in itself should convert to a guaranteed life stream of pay-outs for basic life needs at retirement (as in the CPF LIFE). This part of the programme can be managed by the social security savings scheme, government-linked entities, the private sector, or a combination of all three as a private-public partnership.

5. Lump-sum withdrawals at retirement are a bad thing, irrespective of your nationality and education level. The universal temptation across the income divide is to spend lump-sums quickly on unnecessary leisure and pleasures, and realising too late that there’s little left for one’s basic retirement needs. This is the reason why many advanced nations are intro­ducing mandatory subscriptions of life annuities into their retirement programmes.

6. An apartment or a house is a perfect real asset to monetise so as to supplement and enhance our income for life’s basic needs, leisure and pleasures in retirement. To that end, Singapore’s Housing and Development Board (HDB) has various home monetisation programmes, such as the lease buyback scheme launched in March 2009 and available for CPF members.

Hong Kong, and Taiwan also offer a “reverse mortgage” scheme for the elderly (a.k.a. home equity release or home-for-annuity programme), which is carefully regulated by their government agencies. It guarantees that the elderly will receive a monthly stipend by taking some or all of the equity out of their owner-occupied homes, and more importantly, will never face eviction whilst on this programme.

The Hong Kong reverse mortgage programme, launched in July 2011 by the Hong Kong Monetary Authority and Hong Kong Mortgage Corporation (HKMC) in partnership with local banks, is privately-managed but highly-regulated, while the Taiwan programme for elderly singles (yi fang yang lao) is fully managed by the government.

Such programmes should be kept simple for the layman to understand and participate in, with minimal calculus and mathematical inequalities, and with shelter-for-life assured to the retiree (preferably in his or her own apartment).

That all being said, another proviso is in order here. One cannot deny the speculative nature of home prices and the attendant illiquidity of the asset class. As the US experience from the global financial crisis shows, one’s home can not only drop precipitously in value, but also be highly illiquid just when one needs to release one’s equity in it the most!

7. Basic financial and retirement savings education for all is necessary and an imperative, but it is not the panacea to our retirement planning woes. Some fundamental decision-making with respect to our retirement savings still has to be handled benevolently at the state level.

Ensuring adequacy during our retirement years is critical, hence a good national retirement savings programme should emphasise the following:

- nvest Wisely: Buy safe securities. Save up enough to buy inflation-indexed life annuities in retirement to sufficiently fund basic retirement expenditures (consumption and health care needs). Life annuities should be preferably issued or guaranteed by the government;
- Flexible Human Capital: Work longer. Extend the retirement age if necessary;
- Unlock Real Asset Values: If personal property is a large component of one’s wealth (as is the case with most Asians), one should be open to monetising this asset if the financial need arises in retirement by:

a. Entering a reverse mortgage or lease buyback scheme – preferably underwritten by, or conducted under the auspices of the government;
b. Renting out a room, or;
c.Downsizing personal property.

The World Economic Forum (WEF)’s timely and excellent report, We’ll Live to 100 – How Can We Afford It?, which was produced as part of its retirement investment systems reform project, recently assessed opportunities for reforms that can be adopted to improve the likelihood of extant retirement systems supporting future generations adequately and sustainably.1 The WEF’s findings on this sustainability and affordability issue include:

- The challenges faced and the current savings shortfall;
- System design recommendations for policymakers; and
- Actions for policymakers.

To conclude, for those Asian economies that already have prudent retirement savings systems schemes, it is incorrect to say that they are broke or badly designed. That said, they may need certain improvements. With one’s retirement savings, housing monetisation, government “Silver Support” and other prudent financial support schemes for the needy and retired, Asians should be in extremely good shape to avoid inadequate retirement savings. And those who haven’t jumped on this bandwagon yet should do so soon.

*Joseph Cherian is a practice professor and director of the Centre for Asset Management Research & Investments (CAMRI) at NUS Business School. This article is based on a commentary by, and radio interview with, the writer in Singapore, entitled Seven Pillars of a Good Retirement Savings System, published in The Straits Times newspaper and aired on 938LIVE in August 2014.

1 We’ll Live to 100 – How Can We Afford It? World Economic Forum, White Paper - Case Studies in Retirement System Reform, May 2017, Rachel Wheeler, Project Lead, Investors Industries, World Economic Forum (on secondment from Mercer): https://www.weforum.org/whitepapers/case-studies-in-retirement-system-reform