Retirement fund members, particularly of defined contribution funds, need to be aware that their funds are, or soon will be, drawing up investment strategies in terms of new draft regulations under the Pension Funds Act. The issues raised in the draft regulations affect everyone who belongs to a retirement fund.
The main purpose of the regulations is to ensure that trustees do their best to see that the retirement savings of individuals are invested in a way that your reasonable expectations are met at retirement. You must be aware of what your trustees are planning and why.
This has become increasingly important now that most members contribute to what are called defined contribution retirement funds. With defined contribution funds, you take the investment risks that will determine whether or not you will receive a reasonable pension at retirement. Defined benefit funds, where your employer has the responsibility of meeting a pre-defined benefit based on your salary at retirement, are disappearing fast.
Constructing an investment strategy, even with the help of experts, is not an easy exercise for trustees, because they are faced with making choices on behalf of members of the fund.
It may seem easy for trustees to say: "Let us give members all the individual choice they want" - especially when products that permit this degree of choice are freely available. This approach appears to absolve the trustees of any responsibility for investment returns.
However, I do not believe that this approach does absolve trustees, because what happens when a member, who is given individual choice, makes all the wrong decisions and at retirement finds he or she does not have nearly enough money on which to retire?
The member could argue that although the trustees allowed for individual investment choice, they should have realised that the member was not capable, given a lack of expertise and time, to make the choices.
Even if trustees ensure that each member is given investment advice, they cannot ensure that the advice given is either appropriate or sound.
There is also the question of costs. Greater choice means higher costs. In a low-inflation environment, costs can have a crippling effect on returns.
In my view, retirement fund members should be given choices, but the choices should be kept simple, and the relative appropriateness of each option should be explained fully to members.
Two basic choices
Retirement fund members should be given two simple choices. These are between investing their portion of the fund in market-linked investments or in capital guaranteed smoothed/stable bonus life assurance products.
- Market-linked investments are made in a range of asset classes - including shares, bonds, cash (money markets) and property - to provide a diversified low-risk investment.
However, the value of your retirement fund investment is directly linked to the value of the underlying investments made by your fund. If there is a share market crash (as has happened over the past few years), at retirement you may receive far less than you expected.
Trustees must ensure that money in market-linked investments is properly invested and will not be subjected to inappropriate investment strategies.
- Capital guaranteed smoothed/ stable bonus life assurance products have been getting some bad publicity of late, mainly because of significant misunderstandings about how these products work, but also because of the totally reckless manner in which the now-dismembered Fedsure handled guaranteed products, both for retirement funds and individual policyholders. The Financial Services Board is already moving to stop a recurrence of the Fedsure fiasco, which saw a number of building industry retirement funds lose more than R60 million.
Capital guaranteed smooth bonus products are a powerful weapon in anyone's financial planning arsenal, whether you are investing as an individual investor or as a retirement fund. But they must be appropriately managed and used.
The main feature of these products is that your capital (what you pay in) is guaranteed at retirement. In good investment years, some returns are held back for poor investment years. Returns are paid by way of bonuses. See graph
Traditionally, these bonuses have been declared as vesting bonuses, which once granted cannot be taken away, and non-vesting bonuses, which can be taken away if there is exceptional poor performance either as a result of poor asset management (as in the case of Fedsure) or extreme market conditions (as we currently have). The problem with this structure is that in the years of extremely poor performance, the investment reserves disappear and the capital may not be sufficient to meet the payments implied by bonuses already declared.
The result is that in the good years, following a market crash, reserves have to be built up again, which may result in low bonuses for a number of years. This can mean that at times members who leave the fund may be cross-subsidised by future members, as the exiting members take their capital and whatever accumulated bonuses they have, even though the value of the underlying investments may be far less, while the new and remaining members must make up the losses.
However, the reverse also happens when there are strong reserves. Effectively you are buying assets which are worth more than the price you are paying in contributions The result is that on an ongoing basis one class of members is nearly always cross-subsidising another class.
With the next generation of these products, which were introduced a few years ago, bonuses once granted vest (they cannot be removed). However, the cross-subsidisation problem still remained.
The latest generation product enables each member's funds to be managed separately, so that there is no cross-subsidisation, but the bonuses are vesting. In other words, both your capital and all historical returns are guaranteed. If there is a shortfall because of market conditions in the actual value of your underlying investment, the shortfall is made up by the life assurance company using shareholder money.
The other significant factor is that there is a cost for the guarantees offered by smoothed bonus products, which will result in you receiving a lower average performance than a market-linked investment.
An age-appropriate approach
So the question is, what do you choose and when? You should have your retirement funds invested in equity-based, market-linked products when you are young. Equity markets will rise and fall, but in the long run they have historically out-performed inflation, and you do not have guarantee costs nibbling away at your returns.
However, at least five years before you retire, you should start phasing your funds into a capital guaranteed smooth/stable bonus investment to ensure that by the time you retire and want your money, you will not be subject to any violent market fluctuations. You should transfer about 20 percent a year into the smoothed bonus product to smooth out any market fluctuations, rather than switch all your funds at once.
If you are really cautious, using a money market fund as the underlying investment in the years before retirement may be an option, because you will have no equity market risk and consequently the risk of low future bonuses and of non-vesting bonuses will be removed. However, you face the risk of receiving a return that is less than inflation, particularly after tax.