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According to an article in The Straits Times published last year, CPF members who have withdrawn some of their OA balances in excess of $20,000 to invest in the CPFIS-OA have not done very well, with 47% incurring losses on their investments between 2004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.

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[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.