Stokvels point the way for reform in the retirement industry

The South African economy is limping. With the Rand falling to its lowest level in 13 years, persistently high levels of unemployment and rising income tax, saving has become even more expensive for the average South African.

Not that South Africans have ever been that good at saving. Research from the Finmark Trust released in November 2014 showed that, despite an increase in the number of South Africans owning bank accounts in the past decade, this has not had much impact on savings levels. Just 20% of banked adult South Africans have savings either in banks or non-bank financial institutions.

In 2014, the Old Mutual Savings and Investment Monitor similarly found that about one-third of South African “baby-boomers” – those born between 1946 and 1964 – have made no formal provision for their retirement, with 46% believing that their children should care for them. A further 63% of all South Africans are expecting to support family members when they are old, and a staggering 30% don’t budget for the future at all. Statistics SA reports that more than three million people depend solely on State Old Age Grants from the age of 60 onwards; but at ZAR 1,350 per month, this does not come close to meeting basic needs.

This speaks to a huge, untapped market for the retirement industry. Which, despite being a strong performer in the region and now worth an estimated ZAR 2.74trn ($231.92bn), is still only reaching a fraction of the population.

Part of the reason is that retirement funds are fiendishly expensive – especially for an emerging economy. This is largely because they are forged in a classical paradigm, bound by the no-arbitrage assumption or law of one price, which restricts the fund’s ability to outpace market gains without taking on more risk. Even in developed markets, these models have been shown to be less than ideal. Simply put, they are not flexible enough to manage the enormous risks encountered by pension fund management. For example, aging populations have caught the industry entirely off guard. The current difference between pension obligations and the resources set aside to fund them, caused by the double whammy of population growth and longer life spans, is leading the industry to scramble towards reform in various guises.

Another significant issue is that retirement funds are almost always constructed in such a way to prioritise liquidity; in other words, by assuming that the funds can be withdrawn at any time. And indeed the 2015 Sanlam Benchmark Survey, an annual review of South Africa’s retirement industry released in May‚ has found that 63% of members and 57% of pensioners used withdrawal benefits to reduce debt in the past year.

This is perhaps a luxury that the industry can ill afford.

The problem is that classical theory is too narrow; the assumptions made are too constraining. The retirement industry is in dire need of an alternative that is more appropriate, especially in the case of longer-term contracts such as retirement funds. In principle, we should be able to create financial contracts and hedge them in a way that is less expensive than what classical theory propounds. And there is a less restrictive and economically very reasonable notion of no-arbitrage that could be used in these circumstances.

In seeking to illustrate what this means, there is an excellent example right on the doorstep of the South African retirement sector: stokvels. The rising popularity of stokvels as a savings tool shows that South Africans are finding ways outside of the formal system to save, precisely because the products in the formal sector are not meeting their needs.

It is estimated that around 11.5 million South Africans belong to stokvels. And according to a paper by African Way Stokvels – A Hidden Economy, they save collectively around R44bn a year, offering options for funeral policies, buying groceries for members, and enable savers to not access money for a specified period.

So what do stokvels have that are so appealing to so many South Africans?

Firstly, they are low cost. Essentially a member-based club with individuals sharing similar interests who manage own money, stokvels exist outside of costly regulatory restraints and associated charges. The stokvel is governed by its members, who decide on a goal and the rules for the savings. The amounts contributed can vary from a few to thousands of Rands, paid either weekly, fortnightly or per month.

Secondly, they share risk. If anything happens, all members take the hit. If things go well they all benefit equally.

Thirdly, there is usually a clearly defined saving period, which means that people don’t seek to withdraw their savings or cash-in early – thereby reducing liquidity risk – and costs.

In essence, the success/innovation of stokvels lies in the freedom, flexibility, transparency and direct control over the saver’s assets that formal saving lacks.

These principles could easily be scaled up to initiate more widespread retirement saving that is appropriate and cost effective. Of course there would need to be a regulatory board to oversee the administration of the money and put protocols in place to ensure discipline and the pay-out of annuities. The scheme could choose a specialist to run it – this could be a financial services company or not – and they would have to be underwritten by government although it should ideally remain independent of both government and the established financial sectors.

Such a scheme should be diversified in terms of age of participants and have a large base of participants and allow for constant adjustment of the pay out, depending on changes in life expectancy and economic conditions with the aim of getting the highest possible payout in the least expensive way.

This is not just pie-in-the-sky thinking. The reforms suggested here have been explored and tested by rigorous theoretical modelling, using the Benchmark Approach, which is a more general theory than classical finance.

The Benchmark Approach first appeared in 2002 and has been refined and adapted in the intervening years. It provides a general framework for financial market modelling, which extends beyond the standard risk-neutral pricing theory. It permits a unified treatment of portfolio optimisation, derivative pricing, integrated risk management, and insurance risk modelling. The existence of a narrowly-defined risk-neutral pricing measure is not required. Instead, it leads to a pricing formula with respect to the real-world probability measure. This yields important modelling freedom, which turns out to be necessary for the derivation of realistic, parsimonious market models.

In recent years there have been encouraging moves towards reform in South Arica. In 2012, National Treasury (NT) initiated a retirement reform programme to address shortfalls in the current system proposing compulsory preservation of retirement savings, better incentives for saving and compulsory annuitisation during retirement, among other things. And in recent months, the first-of-its-kind in Africa tax-free savings account (TFSA) was launched, which will allow people to save and invest for retirement tax free. But more needs to be done.

A strong culture of savings, and strong retirement fund industry in particular, is good for a country. Leaving aside the Keynesian-inspired debate as to whether saving is good or bad for economic growth (most evidence now points to the fact that it is), savings also contribute to maintaining standards of living and social stability, which cannot have price put on it.

South Africa as an emerging market is in the fortunate position of being young enough to learn from the mistakes that the retirement industry has made in the developed world. There is an opportunity here to create a vibrant industry here that brings more people into the savings fold and thereby invest in a more stable future for all. If that takes letting go of some long cherished beliefs in classical theory – so be it.


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