The income replacement ratio and its influence on pension choices in South Africa.

Abstract

It is estimated that millions of workers in South Africa do not save enough to have adequate pension upon retirement, in spite of the impending risk of increased longevity. Knowledge gaps in the contributory pensions market in terms of how income objectives of retirement plans are met confound the risks. Defined as how much of the final salary the pension benefit will replace; the income objective or income replacement ratio (IRR) is an explicit statement of benefits payable as a percentage of pre-retirement income and an important indicator of performance. Many contributory retirement plans are facing the problems of benefit adequacy in the face of aging populations/membership. There are differences in how the benefit adequacy is measured. Most studies point to the high costs and the lack of regulation of the different components of a universally accepted income replacement measure as contributing to these problems. This paper sets the conditions around these issues and discusses the thinking around pension designs in terms of parameters that have to be optimised. The main conclusions are that the runaway costs render the system unsustainable and the absence of effective measurement systems compound the issue. While economic growth is capable of offsetting some of the costs associated with pension system the debate is now focused on active management of costs in the system value chain. Mandatory contributory pension is an option to manage these costs. With compulsion it is assumed that the government would administer part of the system, with some of the system costs to be financed from general tax revenues. The IRR enquiry takes place in the context of information gaps in the private pension system that disempowers the contributors with the results that run-away cost, irrational decision making in the system and complex choices are commonplace. The paper provides theoretical tools for assessing the effect of performance optimisation measures which affect pension choices and must be optimised to bring about the desired outcomes in contributory pension system. These are: contribution rate, benefit preservation, investment returns, cost management and, to some extent, the education of the members of pension schemes. Collectively these different components contributes to a unified the unified measure namely IRR.