Issue: June 2005

Individual Member Choice: Lifestage as default option – good or bad?

Deon Booysen, Executive Head – Client Solutions at Sanlam Employee Benefits By Deon Booysen: Executive Head – Client Solutions at Sanlam Employee Benefits.

The National Treasury discussion paper on retirement reform has made some recommendations with respect to individual member choice. Without discussing the relative merits of the suggestions, one of these in particular is that where individual member choice is granted to members, a default option should be made available. Many funds may already have a default option, but where this is not the case, one should in future be made available.

The question therefore arises what is the “best” option for the default portfolio. It may be useful for all trustees of funds that offer individual member choice to consider (or reconsider) this question.

Before individual member choice was granted in a defined benefit scheme, the trustees had to set up an investment strategy that would meet the needs of their members, balancing the need to provide real returns for those members far removed from retirement against the need for capital protection for those members nearing retirement. One of the potential advantages of this approach was that the trustees would make “better” investment decisions, as they were not as emotionally linked to the outcome as the members themselves – in particular the investment strategy would be more aggressive than the members themselves would have chosen. However there are also some disadvantages, one of these is that the strategy ignores the particular circumstances of each member. For example a strategy based only on the information that the trustees are privy to may be substantially different from one based on a complete financial analysis of a particular member.

To address the point above, one would have to provide investment choice to those members who differ from the average member and who have access to a complete financial analysis. Unfortunately, not all members want or have access to such an analysis – for these members the default portfolio should really provide the same benefits as those the member would have received in a scheme without individual member choice.

So how should a default portfolio be constructed? If one intended to reproduce the investments of a scheme without individual member choice, this default portfolio would be a mix of a number of investments, as no single product would meet the needs of all members. This mix could include a smoothed bonus product for members close to retirement and a number of market related products with increasing aggressiveness as the term to expected retirement increases.

A lifestage portfolio takes this concept one step further. The above mix would still provide all the members the average of the benefits of all the components of the mix. Ideally one would prefer to customize the default portfolio so that it met the particular requirements of a member, rather than the average of all the members. This is where lifestage comes to the fore – instead of a single portfolio, one creates a portfolio for a particular tranche of members, and then adapt the mix of underlying investments to move in line with the needs of the members in that tranche as they move closer to retirement.

Lifestage as described above is therefore an ideal solution for the default portfolio. However as with many things in life, the devil is in the detail. The solution will only be as good as the implementation of the mix over time – and here one would be well advised to take professional advice. The good news is that the skills required to set up the mix are the same as those that are applied to schemes that don’t have individual member choice. The eventual success of a lifestage solution is therefore dependent on the actual strategies proposed at each stage or term to retirement. We expect to see quite a bit of competition between investment consultants in this area going forward.