The lowdown on KiwiSaver returns

For the first time, in their March 31 statements, KiwiSavers have received a projection of what terminal sum, in real terms (after inflation), their KiwiSaver will have produced when they retire at age 65. 

The estimate is a new initiative from the Ministry of Business, Innovation and Employment (MBIE) to assist KiwiSavers in formulating an appropriate strategy for saving for their retirement, and is also designed to stamp out behaviour which the UK regulator, the Financial Conduct Authority, described as “fund managers competing for business on the basis of unrealistically high projections of future returns”. 

The terminal sum is calculated by the KiwiSaver provider, who looks at the value of the individual’s portfolio as at March 31 and how much the person is saving each year, and then applies various government-sanctioned escalation rates according to what type of fund it is invested in. 

The forecast rates are summarised below, and are after all fees and tax at 28%:  

* Conservative funds - 2.5% pa

* Balanced funds - 3.5% pa

* Growth funds - 4.5% pa

* Aggressive funds - 5.5% pa.

Given the tendency of fund managers to overstate returns and that MBIE is a government department without the need to make fees look relatively low, you might assume MBIE forecasts would err on the conservative side. 

Unfortunately that would be wrong – as we will see, MBIE’s forecasts for equities are high relative to the forecasts of unconflicted experts around the world, and also relative to what other regulators are mandating their financial services industries must use.  

Doing the numbers

To calculate what return MBIE is forecasting for equities (it refuses to divulge the actual numbers), we can make some calculations using the 4.5% figure for growth funds.  

The average growth fund has 20% of its portfolio in bonds; a reasonable estimate of the long-term return on bonds is the average of the 10-year US corporate bond yield and the 10-year US government bond yield (about 1.3%). Tax is 28% and fees on growth KiwiSaver funds average at 1.33% pa. 

So with a little bit of effort, we can deduce the implied return for equities in that 4.5% pa post-fee, post-tax figure. Today MBIE assumes that an individual aged 20 will enjoy a return of 8% pa compound for 45 years.

Some perspective on that 8.0% return. AQR Capital Management and Research Affiliates, quoted in the Financial Times recently, estimate prospective returns from global equities in the long term will be around 5% pa. Similarly, the Global Investment Returns Yearbook notes the long-term equity risk premium for global equities from 1900 to 2017 has averaged 3.2% pa, and that when interest rates are low sharemarket returns are often low too. With US 10-year government bonds yielding less than 1%, that also suggests a 4-5% return.

Impact of fees

In a recent column, a KiwiSaver expert pointed out that if your terminal sum looks too low, there are three steps you can take: increase your contributions; transfer to a higher-growth fund; and keep working past the age of 65.

The expert forgot to mention that reducing the annual fees you pay is another extremely powerful way of improving the quantum of your retirement nest egg – and it's a lot less onerous than increasing contributions, increasing risk or working forever.  

A possible reason for this omission is because MBIE, in its wisdom, has decided the growth rates for all KiwiSaver providers will be the same, irrespective of their annual fees. Ridiculous.  

In a seminal paper, On Persistence In Mutual Fund Performance, published in The Journal of Finance, Professor Mark Carhart of the University of Southern California concluded that “expense ratios, portfolio turnover, and load fees are significantly and negatively related to performance.  Expense ratios appear to reduce performance a little more than one-for-one. The evidence of this paper suggests that the mundane explanation of investment costs account for almost all of the important predictability in mutual fund returns.” So there you go. Professor Carhart’s research confirms the rules of subtraction most of us learnt in primary school.   

This is a fundamental error by MBIE, and its poor numeracy skills can be contrasted with those of the UK's Financial Conduct Authority (FCA), which requires providers to deduct their own fees from the FCA-mandated gross returns.

Whilst MBIE is forecasting 8.0% for the average growth KiwiSaver fund, it has a particularly constructive view of equities in respect of high-fee growth funds by allowing a fund with a 2.34% fee to assume equities will return around 9% pa. In contrast, the FCA’s policy is to use a 6.5% return less actual fees and tax. The FCA number for a fund with a 2.3% fee would be about 4.2%, around half MBIE’s estimate.

Why the divergence?

I emailed MBIE for an explanation on why it had decided to use the same growth rate for all KiwiSaver providers and ignore the wide divergence in fees.

For example, according to the Sorted website, growth KiwiSaver fund fees range from a low of 35 basis points to 234 basis points – a difference of almost 2%. Surely an investor aged 25 and investing for 40 years could expect to have a lower terminal sum if they pay a 234 basis point fee versus a 35 basis point fee?  

MBIE responded: “The primary purpose of providing a retirement savings projection in KiwiSaver annual statements is to encourage investors to think about planning for retirement and consider whether their KiwiSaver settings are working for them.

“Other avenues such as Sorted resources are available for the purpose of comparing different providers on different metrics including fees. MBIE recognises that fees are an important factor when it comes to KiwiSaver. In addition to a retirement projection, KiwiSaver annual statements are also required to include the total fees paid in dollar figures. The rates were based on actuarial advice, and MBIE did not consult on whether the rates should vary between providers.”

Brent Sheather is an authorised financial adviser and a personal finance and investments writer.

This is supplied content and not commissioned or paid for by NBR.