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The only defence - increase your rate of contribution

The global financial crisis that started in August 2007 developed into an economic crisis in the fourth quarter of last year, which plunged the global economy into its first recession since the Second World War.

The economic crisis in turn resulted in an employment crisis, with unemployment expected to continue rising.

For example, in the OECD countries as a group the unemployment rate has risen from 6.8% to 9.9% and in South Africa job losses have exceeded the 400 000 mark.

Many of the job losses that occurred during the past year might be permanent owing to the structural shifts taking place. Consider, for example, the drastic changes in the financial and property sectors and the motor industry.

A dynamic economy will obviously create new jobs in other sectors over time, but whether those who have lost their jobs recently will benefit from this will depend on how adaptable they are.

However, there is a fourth crisis about which less is being written and said, namely the crisis in retirement provision. This crisis has a public as well as a private dimension.

The public dimension arises from the drastic deterioration in the fiscal positions of countries, especially European countries, which rely largely on government pensions and are already facing the challenges of rapidly aging populations.

The downscaling of pension benefits in these countries is even more unavoidable now, inter alia by raising the qualifying age. Consequently people will be compelled to keep on working for longer and to supplement their government pensions from own funds.

However, in many countries, including South Africa, most workers are responsible for their own retirement provision by means of defined contribution funds, and the private dimension of the pension crisis therefore has to do with the sharp decline in asset values as a result of the drop in equity prices.

In many countries the rise in bond prices as long-term interest declined has acted as a buffer to some extent.

Unfortunately this has not quite been the case in South Africa, where declining equity prices have been accompanied by declining bond prices at times.

In the meantime asset prices have recovered well, but not fully. In die US, for example, the Standard & Poors 500 Index has increased by 46% from its low early in March.

However, this is only 9% higher than at the end of 2008 and still 37% below its high in October 2007.

In South Africa the JSE All Share Index is currently 35% higher than its low in March, or 14% higher than at the end of last year, but is still 26% below it high.

The total asset value of a person who invested 60% of his pension assets in equities is therefore still 14% lower than it would have been had equity prices remained unchanged since May 2008.

Investors' nerves have also been tested by the exceptional volatility in markets.

However, an important question is what investors can expect with regard to the return on different types of assets over the next few years. This will obviously depend on what the economic environment will be like.

It is fairly safe to say that the global financial crisis has at least stabilised as a result of the actions of governments in the relevant countries, although it has not yet been fully resolved.

It also seems that the global economy bottomed in the second quarter, mainly because the drastic correction in inventory levels has ended. Markets have therefore breathed a sigh of relief and risk appetite is returning.

The economic and financial market environment is likely to be characterised by the following trends in the next two to five years:

• Policy interest rates will remain relatively low and any increases will be gradual so as not to jeopardise the economic recovery. Yields in the money market will therefore also be low and struggle to keep pace with inflation, especially if the interest earned is taxable. In fact, after-tax money-market rates are so low relative to dividend yields that equity prices will only need to improve slightly to yield a better return.
• Yields on long-term government bonds will be under upwards pressure as a result of higher and more uncertain inflation expectations, as well as a higher public sector borrowing requirement and an increasing public-debt-to-GDP ratio. However, interest rates are already discounting much of the bad news following the increases over the past six months.
• Equity prices will rise more slowly as profits will increase more slowly owing to slower economic growth and a declining share of profits in national income. Lower profit growth could also result in a lower market rating. 
• Increases in property values will be restricted by slower economic growth. The property cycle is longer than the economic cycle and, unlike in the previous bull phase (which started in 1999), it will not be fuelled by declining interest rates.

The result is therefore that in the next few years investment returns will be lower on average than in the five years ended mid-2008, while inflation is likely to be slightly higher.

A balanced portfolio comprising 60% equities, 20% bonds, 10% listed property and 10% cash yielded an average return of 19,3% per annum during this period.

For the same portfolio, the best one can hope for over the next five years is an average return of between 8% and 13% per annum.

Especially those who will or have to retire in the next few years must remember this: the only defence against lower investment returns is to increase your rate of contribution.