CPF member choice: Default option is good enough for most

Jan 19, 2015 at 5:10 pm | Hits: 2202

By Christopher Gee

In September last year, the CPF Advisory Panel was commissioned by the Ministry of Manpower to consider (amongst other things) whether or not to provide more flexibility for CPF members who are prepared to take on more risk. In a working paper published in December 2014 (which I co-authored with Peter Ryan-Kane, Mark Whatley and Will Rainey of Towers Watson, a global investment advisory firm), we concluded that the returns available from the CPF Board are broadly equivalent to a portfolio invested 60:40 in global equities and bonds, but with considerably less downside risk. We noted that the returns from the CPF are more financially efficient, and that these returns therefore represent an attractive benefit to CPF members compared to other available investment opportunities.

I would go further and argue here that the default return-risk balance provided by the CPF Board is good enough for most members. Adding more choice and flexibility may add complexity and lead to poorer outcomes for retirees’ financial adequacy.

Providing more flexibility without ensuring adequate levels of financial literacy amongst CPF members and potential retirees may result in sub-optimal decision-making which causes such underperformance. The array of investment options in the CPF Investment Scheme – already a relatively small sub-set of the wider universe of investment alternatives for one’s funds outside of the CPF – creates what American psychologist Barry Schwartz calls the Paradox of Choice[1]. He says that whilst having some choice may be good, that does not necessarily mean that more choice is always better, as there are psychological and decision-making costs resulting from an overload of choice that may reduce one’s well-being.

The CPF Investment Scheme already offers quite a lot of flexibility currently for members aged 18 and above with more than $20,000 in their Ordinary Accounts (OA) and/or more than $40,000 in their Special Accounts (SA). They can invest in a range of instruments including fixed deposits, Singapore Government Bonds and Treasury Bills, investment-linked products, unit trusts, exchange-traded funds, equities, corporate bonds and gold.

According to an article in The Straits Times published last year, CPF members who have withdrawn some of their OA balances in excess of $20,000 to invest in the CPFIS-OA have not done very well, with 47% incurring losses on their investments between 2004 and 2013, whilst 35% realised net profits equal to or less than the default 2.5% per annum OA interest rate that prevailed during that period. Only 18% generated net profits in excess of the OA interest rate. During this period, the Straits Times Index (STI) rose 85%, and a $100 retained in the CPF member’s OA in excess of the $20,000 threshold would have compounded to $128.

Given that members are allowed to invest CPF balances in excess of $60,000 in CPFIS (a threshold that is still well below the Minimum Sum level), many people who realise losses on their CPFIS investments are at greater risk of not meeting their Minimum Sum when they reach 55 years of age.

Our working paper on investment risks considered a 20-year investment time frame with varying outcomes. This was based on certain rigorously-developed assumptions regarding key economic and market parameters, such as inflation, GDP growth and interest rates, among others. What we did not discuss in the paper in significant detail is the impact of varying sequential returns on different cohorts of CPF members, nor the effect on individual members who may have pursued different investment strategies and taken on different investment risks.

Sequence risk in retirement financial planning is the risk that a saver experiences lower or negative returns towards the end of their savings accumulation phase. This would affect the size of the CPF member’s accumulated retirement savings, or impact the member early on in the decumulation phase, when withdrawals from the nest egg are being made for income.. Whilst the magnitude of long-term average returns has a significant impact on a retiree’s accumulated savings, the timing of those returns also matters.

We can illustrate the effects of sequence risk with a case study involving three workers. For purposes of this case study, we will assume that the CPF scheme offers more flexibility, such that a member’s full account can be invested outside of the CPF, and hence, two of the workers have opted out of the system to make their own arrangements, with the third choosing to remain within the CPF. All three have identical starting annual incomes ($39,000) and wage growth (3% p.a.), enter the workforce at age 26 in 2015, and work until their 65th year.

Worker A who has opted out invests in an exchange-traded fund that generates annual returns in a sequence that follows the Straits Times Index in the 20 year period from 1991-2010 and repeated in the subsequent 20 years. Worker B, who has also opted out, invests in another exchange-traded fund that generates a similar 5.2% compound annual return to worker A, but with the sequence of annual returns adjusted [2] such that the average annual returns in the first 20 years is 23.3%, and for the second 20 year period of savings accumulation is -4.6% per annum. Worker C remains in the CPF Scheme and contributes to the CPF throughout his working lifetime at prevailing rates of contribution and interest. He does not withdraw funds to finance housing or other investments, nor to pay for medical expenses. The accumulated savings balances of the three workers are set out in Table 1 below.

Table 1 Case study illustrating sequence risk for three workers with identical lifetime income and savings

Return experience

Retirement savings balance ($)

Annual income $

Year

Age (years)

A

B

C

A

B

C

39,000

2015

26

21.9%

73.7%

4.0%

16,010

19,747

14,723

40,170

2016

27

2.8%

28.3%

4.0%

31,529

42,302

30,414

41,375

2017

28

46.0%

46.0%

3.9%

64,863

80,591

47,199

42,616

2018

29

4.6%

73.7%

3.8%

83,977

161,565

65,049

43,895

2019

30

-2.7%

64.5%

3.7%

97,732

287,253

84,007

45,212

2020

31

1.9%

-27.6%

3.7%

116,476

222,391

104,127

46,568

2021

32

-27.6%

1.9%

3.6%

99,181

244,010

125,450

47,965

2022

33

-14.6%

-2.7%

3.5%

101,152

254,929

147,965

49,404

2023

34

73.7%

4.6%

3.5%

200,716

285,356

171,726

50,886

2024

35

-17.9%

46.0%

3.4%

181,931

439,778

196,788

52,413

2025

36

-19.4%

2.8%

3.4%

164,148

471,756

223,218

53,985

2026

37

-14.4%

21.9%

3.4%

159,047

597,232

251,086

55,605

2027

38

28.3%

10.1%

3.3%

227,542

679,165

280,456

57,273

2028

39

18.0%

64.5%

3.3%

291,598

1,145,252

311,397

58,991

2029

40

14.3%

-50.4%

3.3%

356,684

584,371

343,978

60,761

2030

41

24.5%

22.6%

3.3%

469,307

741,461

378,273

62,584

2031

42

22.6%

24.5%

3.3%

601,142

949,112

414,359

64,461

2032

43

-50.4%

14.3%

3.3%

316,007

1,110,390

452,315

66,395

2033

44

64.5%

18.0%

3.3%

552,320

1,337,038

492,224

68,387

2034

45

10.1%

28.3%

3.3%

634,685

1,744,303

534,174

70,438

2035

46

21.9%

22.6%

3.3%

802,597

2,167,523

578,263

72,551

2036

47

2.8%

24.5%

3.3%

852,290

2,728,698

624,599

74,728

2037

48

46.0%

14.3%

3.3%

1,278,352

3,148,528

673,280

76,970

2038

49

4.6%

18.0%

3.3%

1,366,290

3,746,305

724,410

79,279

2039

50

-2.7%

-14.4%

3.3%

1,358,337

3,234,059

778,098

81,657

2040

51

1.9%

-19.4%

3.3%

1,412,997

2,632,459

832,822

84,107

2041

52

-27.6%

-17.9%

3.3%

1,048,385

2,188,052

890,281

86,630

2042

53

-14.6%

-14.4%

3.3%

922,899

1,900,580

950,018

89,229

2043

54

73.7%

-19.4%

3.3%

1,643,789

1,558,732

1,011,796

91,906

2044

55

-17.9%

-17.9%

3.3%

1,376,638

1,306,806

1,075,687

94,663

2045

56

-19.4%

2.8%

3.3%

1,128,759

1,364,944

1,133,109

97,503

2046

57

-14.4%

21.9%

3.3%

985,938

1,687,444

1,192,479

100,428

2047

58

28.3%

10.1%

3.3%

1,289,215

1,880,199

1,253,864

103,441

2048

59

18.0%

-14.6%

3.3%

1,544,436

1,625,389

1,317,337

106,544

2049

60

14.3%

-50.4%

3.3%

1,788,060

822,088

1,382,973

109,741

2050

61

24.5%

-14.6%

3.3%

2,241,401

714,670

1,443,098

113,033

2051

62

22.6%

-27.6%

3.3%

2,763,094

529,144

1,505,342

116,424

2052

63

-50.4%

1.9%

3.3%

1,380,667

552,927

1,569,783

119,917

2053

64

64.5%

-2.7%

3.3%

2,289,184

551,415

1,636,500

123,514

2054

65

10.1%

4.6%

3.3%

2,534,678

590,693

1,705,578

Average annual returns

Retirement savings as multiple of last drawn income (x)

5.2%

5.2%

3.4%

20.5

4.8

13.8

Whilst the average annual return and the distribution of these returns over the 40 year accumulation phase for both A and B are the same, the different sequence of those returns results in widely differing outcomes that very significantly impact on the retirement adequacy of these two workers. A would begin retirement with $2.53 million of savings with which to purchase an annuity, equivalent to 20.5x last drawn income, whilst B would have only $590,693, or 4.8x last drawn income. In contrast, C has generated an average annual return of 3.4% during his accumulation phase and would have CPF balances totalling $1.71 million, or 13.8x last drawn income. C could withdraw almost all of his OA balance at age 65 and still have more than B in his Special, Medisave and Retirement Accounts.

One could imagine A and B being of two different generations (a father and son, perhaps) who enter the workforce twenty or so years apart, with the older worker retiring towards the tail-end of a multi-year bull market, whilst the younger comes to the end of his working life in a prolonged market downturn not dissimilar to Japan’s lost decades. Such disparities in outcome over time could pose significant structural challenges to a country’s social safety nets and fiscal position, and potentially result rising political tensions across the generations.

The CPF system does very well in shielding its members from sequence risk, in addition to many other investment risks that we examine in our working paper. A national pension system with the primary objective of ensuring Singaporeans have a secure retirement through lifetime income must take into account the impact of this risk factor on intergenerational equity. The current system transfers this sequence risk, together with most other investment risks to the government and its investment management agencies, in exchange for a defined rate of interest subject to certain minimum levels. The government can absorb these investment risks given its perpetual nature and extremely long-range investment horizon, as well as pooling its unencumbered assets with CPF funds to shield its citizens from most of the investment risks that individuals would be exposed to in a do-it-yourself strategy.

Although there are a number of areas in which Singapore’s retirement financing system may need to be improved, I believe the CPF system already offers more than sufficient flexibility to members who wish to take on more investment risk. The current setup, with low-risk investment returns backed by a triple-A rated sovereign credit, generally provides outcomes that are good enough for its citizens over successive generations.

Christopher Gee is a Research Fellow at IPS. A shorter version of this essay was published in The Straits Times on 19 January, 2015. It is the second in a series of essays examining risks and returns in Singapore’s retirement financing system. The first essay can be found here.

Top photo from here.

—————

[1] Schwartz, 2006, The Paradox of Choice: When More Is Less.
[2] We have re-arranged the annual returns of the Straits Times Index from 1991-2010 with the higher average returns in the first 20 year period, and lower average returns in the second 20 year period for B.  A similar 40 year historical return profile can be seen with the Nikkei 225 index series, which experienced a 17.2% average annual return in the period 1970-1989, followed by a -3.6% average annual loss in the subsequent 20 year period from 1990 to 2009.  Over the 40 years, the average annual return of the Nikkei 225 index was 6.2% from 1970-2009.

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