Decline in bond yields drives decline in projected retirement benefits

The Alexander Forbes Pensions Index has shown that members of Defined Contribution retirement funds are now projected to have significantly lower retirement benefits than what was expected at the start of 2002.

The Index considers three savers, born on 1 January 1972, 1January 1962 and 1January 1952, making them 30, 40 and 50 years old respectively on 1 January 2002.

The Index indicates the percentage of their income that each of the savers is projected to replace with a pension at retirement at age 65. On 1 January 2002, all three were expected to afford a pension providing them with 75% of their pre-retirement income when they retired and hence had Index values of 75.

As of 30 June 2012, their Index values were 58.4, 47.8 and 41.4 respectively.

In other words, the 60-year old saver born in 1952 is now expected to afford to replace only 58.4% of their income in retirement, according to John Anderson, Head of Research and Product Development at Alexander Forbes.

“The deterioration in the Index value can be attributed to the fact that bond yields have fallen sharply since January 2002. Over the period since 1 January 2002, investment returns have resulted in members’ accumulated credits growing slightly faster than expected relative to salary growth,” says Anderson.

Anderson adds that although adverse investment market conditions have dominated headlines, it is the decline in bond yields that has driven most of the decline in the Index since inception.

According to Anderson, bond yields impact on the Index in three ways. Firstly, lower bond yields can signal lower investment returns which reduce the amount of capital each of the three members is expected to have when they retire. Secondly, lower bond yields drive up the prices of the annuities that each of the three members would buy with their accumulated capital at retirement. Thirdly, falling bond yields benefit members who are invested in them by raising the capital value of bonds. The investment return has generally been in line with salary inflation which means that retirement funds have grown in line with spending power to date. However, this is partially due to the good return on bonds generated by the falling bond yields.

The decline in the Index is attributable to events Alexander Forbes expects will happen in the future, based on experience to date, namely increasing annuity prices and future investment returns.

Members of retirement funds might not be aware of the fact that their projected retirement benefits are expected to be so low, cautions Anderson. Members should thus seek financial advice in order to evaluate whether they are on track for a comfortable retirement and take appropriate action advice where necessary.

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The following table shows the gains or losses in the index values over various time periods to 30 June 2012: