Contact: Mercer Feedback
Now that defined contribution (DC) plans will become the sole source of retirement funds for most people around the globe, it’s a good time to ask some probing questions about their effectiveness. Are DC plans an efficient vehicle for the accumulation of adequate retirement benefits? Even when comparing cost-equivalent DB and DC plans, are there structural inefficiencies in DC plans that result in lower retirement benefits?
To learn from the experience of others, we looked at countries in the Asia Pacific region that have some of the more mature mandatory first or second pillar DC systems. This article examines the mandatory systems in three of these countries – Australia, Singapore and Malaysia – to see how successful these DC systems have been in providing retirement benefits for their citizens.
A little background
First, let’s look briefly at the key details of the three DC systems under review. The criterion for inclusion was that all needed to be relatively mature systems, and the Singaporean Central Provident Fund (CPF) certainly makes the grade, having commenced in 1955. Malaysia’s Employees Provident Fund (EPF) is also mature, having commenced in 1958. The Australian system commenced development in 1987, with the inclusion of mandatory superannuation contributions added to industrial awards, but commenced fully in 1992 with the introduction of the Superannuation Guarantee Charge. While a little younger than its two cousins, the Australian system is regarded by many as one of the most advanced in the world.
The Australian model is considered second pillar, in that it is distinctly separate from the government and from the first pillar age pension system. Both the Singapore CPF and the Malaysia EPF are first pillar systems – they are centrally run, and there is no basic state pension in either country. Some key features of the three systems are as follows:
From the table above, it appears that a large difference in retirement income would result based on the contribution rates alone, with Malaysia and Singapore requiring much higher contribution rates than Australia would. However, we will see later that you can’t necessarily judge a book by its cover.
In order to consider the success of these mature DC systems, what can be learned from their experiences, and where improvements can still be made, we have conducted a performance review based on several key factors, set out below.
Let’s have a look at how the DC systems of Australia, Malaysia and Singapore have performed in these areas:
As can be seen from this summary, by no means are these three systems consistent in all aspects of their successes and failures. However, there are still several areas in which each system is facing the same problems.
In both Singapore and Malaysia, contribution levels should be sufficient to secure an adequate retirement benefit, although we address below the main shortcomings that limit the impact of this success. In 2007, the Malaysian government improved the allocation of contributions for retirement purposes, from 60 percent of total contributions to 70 percent. Further, around 26 percent of employers make additional contributions (typically 3 - 4 percent) to the EPF – something both Australia and Singapore have failed to achieve to any great extent.
All systems are operated in a manner that provides a level of security to the assets held (investment risk aside), and all offer benefits in a tax-effective manner. In Australia, the tax treatment has improved with time, with all taxes on retirement benefits removed in 2006.
Australia has been particularly successful in developing a private delivery system (in contrast to the centrally run CPF and EPF), and provider competition has promoted low fees, wide choice for employees and value-added features, such as access to low-cost banking products, education, and effective online and telephone support. Competition within the market was, in fact, strengthened in 2006, with the introduction of the “Choice of Fund” – referring to choice of provider, not of investment fund (which was already commonplace). While only about 5 percent of the workforce has utilized this choice, allowing employees to nominate the provider to which their employers must make contributions has encouraged providers to keep fees low and features high.
Areas for improvement
A 2009 Mercer poll of Australian employees found that 69 percent supported an increase in minimum contributions from 9 percent to 15 percent. Of these, 49 percent suggested that this increase should be jointly funded by employers and employees.
In Singapore, retirement benefits may be significantly limited through “leakages” from retirement savings. While total contributions are significant, at 34.5 percent of salary for employees under the age of 55, only 5 percent of salary is specifically allocated to the Special Account for retirement purposes. The remaining contributions are allocated to an account for medical expenses and to an account that may be used for housing purposes. While these are certainly important commitments throughout an individual’s lifetime, we believe that insufficient focus is being placed on retirement savings.
All three countries face significant problems regarding the use of the ultimate retirement savings, as all allow benefits to be taken as a lump sum. With lack of employee knowledge concerning how to manage a potentially significant lump sum benefit, often these benefits are exhausted far too quickly. In Malaysia, it is estimated that around 70 percent of benefits (which may be taken from age 55) are exhausted within 10 years, typically on expenses such as children’s education or wedding celebrations.
In Singapore, all benefits may be taken as a lump sum from age 55, with the exception of the Minimum Sum of S$106,000. This Minimum Sum is paid in installments over a 20-year period, beginning from age 62, although it may also be used to purchase a life annuity from an insurer. However, with average annual incomes of around S$50,000, such an annuity or installment plan represents only a fraction of preretirement-income.
Australia historically has also had a lump sum mentality, and this has not been discouraged by the minimal tax advantages of taking income-style benefits.
Actions being taken
All three countries have made, and are continuing to make, efforts to improve the effectiveness of DC delivery:
It is also clear that improvements are required in the area of education. Many individuals simply do not understand what is considered an adequate retirement benefit, what level of contributions are required to accrue this benefit, how to manage investments in the accrual phase, and then how to manage assets in the drawdown phase. This is a significant challenge that each of the countries is attempting to address in its own way. The conflicting human desire for “a bird in the hand” versus a steady income amount is a significant obstacle to overcome. The traditional Asian practice of being supported in old age by one’s children is certainly a valuable cultural trait. However, as this is unlikely to be dependable, individuals will need to develop a mindset of greater preparation for their own retirement.
Refocusing to boost the retirement pot
The DC systems of Australia, Singapore and Malaysia are all unique in terms of their structural approach to saving, investment and plan management, and all have been successful in producing retirement benefits for the broad population. There are a number of characteristics against which pension systems elsewhere might be tested:
However, there are two common areas needing improvement:
1. All countries must encourage greater accrual of retirement income – through higher contributions (Australia), reduced leakages (Singapore, Malaysia) and reduced access to lump sums (all). A key challenge for authorities is the development of a system of affordable lifetime annuities. Conservative pricing, due primarily to longevity risk concerns and a lack of suitable investment vehicles, means that existing annuity products tend to be expensive.
About the author
Ben Facer is the ASEAN leader for Mercer’s retirement, risk and finance consulting business, based in Singapore. Ben has extensive experience in DC consulting across Australia, the UK and South East Asia, in the areas of design, administration, governance and member services.