In terms of a new draft regulation, trustees of retirement funds will be compelled to draw up carefully considered investment strategies, instead of hoping that the current best-performing asset manager will produce good returns. But even before the regulation is finalised, pension fund members have the right to take their trustees to task for failing to have an investment strategy and leaving members guessing about what their pension benefits will be.
Most members of retirement funds have little idea about what happens to their money after their monthly contributions to the fund have been deducted from their salary.
Furthermore, until a few years before they retire, most members probably do not know whether the money saved in the fund will be sufficient for them to retire financially secure.
All too often, saving for retirement is a hit-and-miss affair - and it is not just fund members who are in the dark. Many trustees of retirement funds are equally unsure as to how to structure individual retirement packages. This uncertainty has particularly arisen since the advent of defined contribution funds in the 1980s.
In the days when there were only defined benefit funds and company managers effectively managed retirement funds, the trustees' objective was simple: ensure the employer did not have to make up any shortfall in the fund.
Defined benefit funds provide a pension calculated according to a formula, which includes:
- Your salary at retirement (often the average salary of your last two to three years of service);
- Your years of service (or, more precisely, your
period of membership of the fund); and
- A "factor", based on a percentage of your salary at retirement, and which is normally between 1.5 percent and 2.5 percent. Obviously, the higher the factor, the more you receive. Most defined benefit funds are structured to provide you with a pension of between 65 and 80 percent of your final salary.
In theory, if a defined benefit fund fails to perform and the investment growth is inadequate to cover the fund's liabilities, the employer has to pay in. In reality, in the heyday of these funds, this seldom happened. When there was a shortfall, the fund would carry it in anticipation of better performance in future years.
The point is that fund members and financial advisers had a fairly good idea of the size of the pension a defined benefit fund would pay out, and could make plans for the member's retirement years accordingly.
However, the increasing use of defined contribution funds has made it more difficult to assess how much you are likely to be paid out at retirement.
In the case of defined contribution funds, your employer's responsibility to provide for your retirement extends only as far as making monthly contributions to the fund. The assumption is that you, the member, are responsible for ensuring you have sufficient money on which to retire.
The trustees of defined contribution funds have tended to try to get the best investment returns, present and future, by monitoring the comparative performance tables of fund managers and choosing the fund manager who produces the best results. This is like attempting to drive a motor vehicle while only looking in the rear-view mirror.
Quite what returns you will eventually receive over the lifetime of your retirement investment is, in most cases, a great unknown.
The only investment guidelines retirement fund trustees have to follow are contained in Regulation 28 of the Pension Funds Act - the prudential investment guidelines, or PIGs. The main PIG is that a retirement fund cannot be more than 75 percent invested in shares. The balance has to be invested in bonds and other interest-earning investments, and in property.
The purpose of this PIG is to reduce investment volatility. Shares have provided the best returns, historically, but are also the most volatile asset class.
But the PIGs provide little guidance as to what constitutes a sound and comprehensive investment strategy for pension funds. Thus, instead of targeting a specific retirement amount of money that members will receive at retirement, trustees get stuck in the groove of trying to find the fund manager who will provide the best performance.
This leaves fund members and their financial advisers guessing and having to make assumptions about what the retirement fund will pay out.
PIG(gy) goes to market
That is how things are now, but the good news is that this is likely to change. The redrafting of Regulation 28 is aimed at moving away from the PIGs and compelling trustees to draw up well-considered investment strategies. This means that trustees will be forced by law to set targets that are more precise and give serious consideration to the factors that will affect these targets.
The bad news is that it is likely to be some years before the redrafted Regulation 28 is put into effect. Last year, Finance Minister Trevor Manuel announced that the entire Pension Funds Act would be redrafted along with Regulation 28.
But even if there was no plan to redraft Regulation 28, your retirement fund trustees have a fiduciary duty to you to draw up a proper investment strategy.
Jonathan Mort, a leading pension funds attorney at law firm Edward Nathan Friedland, says it is simply not sensible for a board of trustees to fail to construct a properly considered investment strategy.
"An investment strategy protects the trustees, the fund and its members," Mort argues.
It is quite possible, he says, that a fund member could sue the trustees for not having an investment strategy, even without a redrafted Regulation 28 - particularly if the member were able to quantify a loss.
With a properly considered investment strategy, trustees will no longer simply aim at "getting the best return", taking the risk, in the process, that today's top-performing fund manager will be tomorrow's worst-performing fund manager.
Selecting a fund manager can be a hit-and-miss affair for numerous reasons. These include:
- Style. The investment style of a manager can affect the results. At certain times the market may be performing in such a way that it favours either the strategies of growth or value managers.
For example, growth management was all the rage a few years ago. Growth managers seek out companies that are expected to grow rapidly and show remarkable profits in the future. Value managers have been on top of the pile for the past three years, but growth managers are now edging back. Value managers seek out companies whose share prices they believe are undervalued (mainly in relation to the underlying value of their assets and the profits they make).
- Expertise. Although many asset management companies have a "house view" (in effect, an investment blueprint), there is no doubt that some investment managers are better than others. When those individuals leave their companies, as they are wont to do, they leave a gap. The problem becomes even worse when a whole team walks out, as has happened on more than one occasion.
- Industry consolidation. There has been a succession of asset management companies merging and disappearing in recent years. So the asset manager you have today may not be the one you have tomorrow. And your new asset manager might adopt a totally different investment approach, which may or may not produce better results.
- Competition. Those fund managers who try to out-perform benchmarks, such as the JSE Security Exchange's All Share index (Alsi), and/or their competitors, are often tempted to take bigger investment risks. When the risks pay off, the manager is a hero, but if they do not, you could well enter retirement with far less money than you expected.
With all the above problems in mind, the Financial Services Board, which regulates the retirement fund industry, wants the new Regulation 28 to require the trustees of pension funds to sit down with financial experts and consider an investment strategy. The trustees must then have the strategy signed-off by an independent actuary.
STEP ON IT
Drawing up an investment strategy is a complicated process and requires a step-by-step approach.
Step 1. Set the target
The trustees of the fund (either a defined benefit or a defined contribution fund), in consultation with the sponsors of the fund (for example, the employer) have to calculate the size of the pension they would like you to receive as a percentage of your final salary.
For example, they may decide they would like all lifelong employees to retire with a pension amounting to 75 percent of their pensionable salary at retirement. To achieve this, they would have to aim at a total lump-sum payout value (that is, the total retirement fund savings) of 10 times the required annual pensionable income. So, if you were earning a pensionable salary of R400 000 a year (excluding allowances and other perks, such as a car allowance) at retirement, you would require an annual pension of R300 000, or a lump sum of R3 million, assuming an after-costs return of 10 percent a year.
Step 2. Set the contribution levels
These are the monthly contributions made by both yourself and your employer. In terms of the Income Tax Act, members of defined contribution funds may contribute a maximum of 7.5 percent of their pre-tax pensionable salaries a year, and their employers may contribute up to 20 percent. So, in effect, neither you nor your employer pays any tax on money contributed to your retirement fund.
As a general rule, employers' contributions should at least match those of their employees, but employers also have their eyes on their balance sheets and want to restrict, as far as possible, the amount they pay in. Obviously, the more you and your employer pay in contributions, the easier it is for your fund's trustees to set higher targets for how much capital you will have at retirement.
Step 3. Set the period
The trustees must base their calculations of the pension you will receive on how many years you will contribute to the fund. In most cases, this will be between 40 and 45 years. Whether you, personally, belong to the fund for 10 or 45 years is not the consideration. The trustees must work on the assumption that the target should be achieved during the maximum period that you may be employed.
Step 4. Define the growth
This is one of the trickier considerations. If investment growth is based solely on attempting to find an investment manager who will out-perform all the others, the trustees and you, the fund member, are going to have little idea of how the fund will perform over the long term and therefore how much you will actually receive on retirement.
The trustees need to have a clear idea of their investment targets and the risks they are prepared to take to achieve them. This means they have to aim at absolute returns, rather than relative returns, which are judged in terms of what other asset managers are achieving.
Once the trustees have determined the investment targets and risks, they have to provide specific investment mandates to the fund managers to achieve the returns required. Using the example in Step 1, a fund may need to provide a return of five percent, after costs and inflation, to meet a required pension level of 75 percent of final salary. If, however, member contribution levels are very low or the trustees are aiming at, say, a pension level of 90 percent of final salary, they need to ask an investment manager to achieve significantly higher returns. The higher the required returns, the less assurance the trustees have that an investment manager will achieve the targeted levels, because the investment manager will be forced to take high risks, which could result in very poor results.
Step 5. Decide on the asset mix
The investment manager and the trustees have a range of weapons at their disposal to achieve the required returns and manage risk. Primarily, this entails investing across the different asset classes of cash, bonds, shares and property, and also, increasingly, the derivatives market (only to reduce risk). All these options are available locally and in foreign markets.
The investment manager is by no means on his or her own when it comes to deciding how to achieve the required returns. Some academics have compiled performance figures of financial markets covering the past 77 years, which show how each asset class has performed and how volatile each class is. (See "Performance of asset classes table" here.)
Brian Molefe is the chief executive officer of the Public Investment Commissioners, who look after all the government pension funds (the biggest funds in South Africa). He says asset managers should start with bonds. According to Molefe, returns on bonds will cover most pension fund liabilities (that is, the return wanted by trustees to pay the targeted level of pensions) without any significant investment risk.
Molefe says the comparatively new inflation-linked bonds issued by the government are a particularly strong investment weapon, because trustees and investment managers can be sure of receiving a return at a certain level above inflation. After bonds, equities can be used to try to out-perform the targets.
The reason trustees have to forego the superior long-term returns - and higher volatility - of share markets, for the lower returns of bonds, is that they have to be sure, at all times, that when a member reaches retirement age, he or she will receive the targeted pension despite any market fluctuations. Market downturns, with drops in value of more than 20 percent, have not been uncommon in recent years. If a fund is fully invested in shares and there is a market slump, your retirement savings could be severely depleted on the day you retire.
Apart from agreeing on the asset mix, trustees should insist investment managers follow particular sub-strategies when managing the various asset class components. For instance, in the case of shares, trustees might prefer investment managers to follow a value investment style or use passive management (that is, invest in indexed investments that track a particular benchmark, such as the Alsi) rather than actively manage the funds, where the asset manager makes all the underlying share selections.
Step 6. Decide on member choice
Many funds offer members a choice of investment portfolios. The most common options are:
- A market-linked portfolio, where the value of your retirement savings rise and fall in relation to the value of the investments; or
- A portfolio where your capital is guaranteed and investment returns are smoothed - in other words, part of the growth earned in good years is saved so that it can be paid out in years of poor performance. The advantage of smoothed portfolios is that at retirement you will not lose out if there is as a sudden drop in market values.
Some retirement funds also offer a wide choice of underlying investments, particularly unit trust funds, but these mainly involve umbrella funds, which can be a very high-risk option for both trustees and members.
Trustees have to decide on a default investment option if members do not make a choice of the type of investment they want.
Step 7. Perform the balancing act
By now, your fund's trustees should have a good idea of all the variables they need to consider. They should use all the variable factors at their disposal, including investment growth, investment risk, contribution levels, period until retirement and retirement-saving targets, to get the right asset mix. In most cases, they will not be able to play with contribution levels or periods until retirement, because these are set by the employer. At all times, trustees have to be realistic in getting the balance right.
Step 8. Get actuarial sign-off
Although your trustees would probably (and should) have been using actuaries to help them with the calculations when compiling an investment strategy, they need to get an independent actuary to sign off the strategy. This provides the trustees with a final opinion about whether or not they have got the figures right. Obtaining actuarial sign-off is required in terms of the redrafted Regulation 28. "Independent" means that the actuary is not linked to the actuaries advising the trustees or to the fund's actuary.
Step 9. Choose an asset manager
The choice of asset manager should be one of the last decisions, instead of one of the first - as is often the case. A large fund might decide to put together a team of investment managers, each one a specialist in managing a different asset class.
For example, one asset manager might look after bonds and another control the share portfolio. For medium to smaller funds, it would probably be more appropriate to use one investment management company that has the wherewithal to meet the investment mandate given by the trustees.
At a recent convention of the Pension Lawyers' Association, Malcolm Wallis, a respected senior counsel, suggested that proper performance benchmarks should be set for asset managers, and that they should be forced to meet the benchmarks by providing guarantees. This, Wallis said, would "have a salutary effect on those who hold themselves out as experts in the field of the administration of pension schemes and the investment of funds".
"If that is how they choose to describe themselves," Wallis said, "then perhaps the time has come when they should be obliged to put their money where their mouths are!"
Step 10. Keep you informed
Your trustees should keep you, the member, informed about the investment strategy and ask your opinion before finalising or implementing the strategy.
WHAT YOU, THE FUND MEMBER, MUST DO
If you are a member of a defined contribution fund, the bottom line is to ensure that your trustees have drawn up an investment strategy and that you understand what the strategy is and how it is likely to affect your retirement plans.
The key pieces of information you must look at are the targeted pension level and the number of years you are required to belong to the fund to receive it.
You need to take account of the number of years you expect to belong to the fund and the expected (and probable) shortfall between what the fund will pay out and the amount you believe you will need to retire financially secure. You will then have to make up any shortfall with additional savings.
This article was first published in Personal Finance magazine, 2nd Quarter 2004. See what's in our latest issue