After-inflation, or real, returns on your retirement savings are being reduced by about 75 percent, on average, by costs. And many retirement fund members are probably having any investment returns they make wiped out by costs. This startling conclusion was reached by passive asset manager and product provider 10X Investments.
The research comes a week after Finance Minister Pravin Gordhan announced a review of the entire financial services industry, with costs and the lack of proper disclosure by product providers among the areas that will receive special attention.
10X Investments has used as the base for its analysis the influential research published by actuary Rob Rusconi in 2004, which showed that the average costs of retirement funds in South Africa amounted to about three percent of assets every year. The three percent covers the total administration costs of the average retirement fund, including asset management and advice.
10X Investments has overlaid these costs with the average annual market returns of a prudentially managed portfolio invested in local equities (60 percent of the portfolio), foreign equities (15 percent) and local bonds (25 percent). This reflects the maximum percentage of equities permitted in terms of regulation 28 of the Pension Funds Act. The regulation sets limits for the amounts that any portfolio or retirement fund may invest in a particular asset or sub-class.
This portfolio has provided, on average, an annual real return of about five percent going back to 1900. The last 20 years provided 5.2 percent, the last 30 years provided 5.3 percent and the past 40 years provided 5.4 percent.
The chief executive of 10X Investments, Steven Nathan, says costs make a huge difference to retirement fund members over the long term. Each one percent in costs reduces the final investment value over 40 years by about 30 percent.
10X Investments found that if you invest, say, R1 000 a month for 40 years and earn an average real return of five percent a year, you will have R1.5 million at retirement if you have zero costs. The breakdown is about R500 000 in contributions and about R1 million in investment returns, after taking account of inflation.
Put a one-percent cost in place and this reduces your investment returns to R660 000 and the final value to about R1.1 million. So one percent in costs reduces your real returns by about a third.
Pay the average “Rusconi costs” of three percent and that reduces your investment returns by about 75 percent to R240 000 and the final investment value to R720 000 (capital plus returns).
Nathan says three percent is the average, so many retirement funds will have higher costs, meaning that there are thousands of retirement fund members who are receiving little or nothing in real investment returns. The impact is most severe for individuals investing in high-cost retirement annuities.
Nathan says many investment managers mislead investors into thinking that their money is increasing in value – it is not; you are simply seeing inflation growth, not real growth.
Nathan also points out that the costs you are told about are normally based on your total assets (what you have saved plus the returns) and, even worse in the case of occupational retirement funds, costs are normally quoted as a percentage of your pay. This, he says, is done to make the percentage deducted seem small.
Nathan says it is wrong that costs should be calculated and shown as a percentage of your total earnings or assets. The only reason is to make the costs seem low when in fact they are punitive.
He says costs of one percent translate into 20 percent of your investment returns if you are receiving a real return of five percent. Costs of two percent equate to 40 percent of real returns; three percent to 60 percent and five percent to 100 percent of your real returns.
Nathan warns that the more investment choice you are given, the higher the costs. Choice also has the potential to reduce returns further, because wrong investment choices are often made at the wrong time.
Choice, however, provides a useful excuse for product providers because they can, with hindsight, point out that you made the wrong choice, as other funds on offer would have provided better performance.
The next problem, he says, is that you are paying high costs for active management, and active asset managers have a dismal track record. Over one year to December 31, 2010, only 39 percent of general equity unit trust managers out-performed the benchmark FTSE/JSE All Share index; over five years only 14 percent managed to achieve the feat; and over 20 years the figure drops to five percent.
Nathan says it is almost impossible for the average investor to identify the five percent of asset managers who will out-perform. As every investment manager will warn you, “past performance is no guarantee of future performance”.
In the meantime, you are paying high management and performance fees for active managers who out-perform, “but receive nothing back from the active managers who under-perform”.