Issue: December 2007/February 2008

As promised in our introductory article on requirements for the Investment Policy Statement, outlined in the previous TT edition, guest columnist Scott Harvey (head of STANLIB’s Institutional Client Service Department), looks in more depth at some of the key features that trustees should address when developing an IPS that respects the FSB’s good governance guidelines. . .

Good governance the foundation of good returns

The underlying thrust of the Financial Services Board (FSB) message to trustees in their document Good Governance of Retirement Funds is that good governance practice is not an imposition, but rather a way of assuring good, consistent investment returns.

Annexure B of the FSB document emphasises that a key driver in the formulation of any Investment Policy Statement (IPS) is the fund type. Defined benefit funds (where benefits are defined in the rules of the fund and the employer has an open ended liability) have different priorities to defined contribution funds (where contributions to the fund are defined in the rules and members carry investment risk).

Most of today’s workers are covered by DC funds; so it is useful for our purposes to focus on FSB guidance in this area.

In many respects, the FSB suggests that the board of trustees do what any prudent, reasonably well informed individual would do when putting his/her own investments in order. This process on an individual level is usually needs-driven. The focus is on personal circumstances, needs and appetite for risk.

The FSB recommends a similar approach for the mix of members as a whole. The “needs and reasonable benefit expectations of the beneficiaries” are crucial when preparing the IPS, it notes.

The implication is that trustees have an obligation to ensure good data is collected about members, enabling trustees to be familiar with the membership profile, expectations and needs.

Risk and risk tolerance are repeatedly mentioned in the guidelines. In a retirement context, risk is often linked to a person’s age and time to retirement date. These are obviously important factors when gathering information about members and presenting data to professional advisers.

A well informed trustee should know the average age of the membership, the average term to retirement and the percentage of members and member assets in various age groups.

A key requirement of older members is normally low investment risk and high liquidity (meaning that investments are not subject to high volatility and can be quickly converted to cash at no great cost). However, the FSB says trustees should also consider “variation in risk tolerance levels of members in the same age group”. This indicates that trustees cannot simply use age as the sole determinant of risk tolerance. Other factors may apply.

For instance, a white-collar membership that frequently makes use of additional savings and investment products may have higher risk tolerance than a membership that is almost totally dependent on the retirement fund.

The trustee should therefore have a wider appreciation of membership feelings on investment risk and the provision of individual member choice can be considered in the correct circumstances.

The FSB not only links the mix of members to risk, but to ‘growth levels’ – a suggestion that the required real growth in capital (ahead of inflation) over the long term is a key consideration when looking at asset allocation.

The FSB emphasises that a holistic view has to be taken and that the purpose and objectives of the fund are crucial when deciding “the appropriate mix of assets”. Fund specifics such as contribution rates and replacement ratio targets are also important.

Precise asset allocations will usually be decided in consultation with professional advisers, but again the FSB is telling trustees that they should do what a prudent, seasoned investor would do when considering portfolio composition.

A smart, well-advised investor would diversify his portfolio to manage investment risk and avoid over-reliance on any single asset class or instrument while looking for solid yield and reasonable, inflation-beating growth in the long term. Trustees can usefully adopt a similar mindset.

By way of interest, historical domestic data since 1960 shows that whilst equities have provided an annual average return of around 20% they have also been the most volatile and risky traditional asset class. The volatility of each asset class is however reduced the longer the time horizon and investors can take comfort from the fact that the domestic equities market has never lost money over any four years since 1960.

When formulating the IPS, the board of trustees is expected to consider:

  • Categories of investment (look at a range and consider alternatives)
  • Diversification of investments to mitigate risk (don’t put all your eggs in one basket and if you opt for some relatively high risk categories consider an allocation to some lower risk alternatives to achieve a good overall balance)
  • The mix of assets and the expected rate of return (consider the capital growth potential and the real yield from each component in the mix and from the portfolio as a whole, it is also important to have an understanding of the possible outcomes of investing in different asset classes)
  • Liquidity requirements (expected benefit payment amounts and frequency or projected timing thereof)
  • Voting rights attached to the investment (underlying holdings may carry voting rights, trustees should consider voting policies and the implementation of proxy voting guidelines where necessary)
  • Valuation procedures for investments not publicly traded (if the market doesn’t decide what your stake is worth, who does and how?)
  • Related party transactions (any transaction involving a party which is linked to the fund e.g. employers or service providers)

This list covers some quite technical issues. The expected rate of return across a mix of assets can be difficult to assess, for example. Those return expectations could be materially affected by market movements, the economic climate and changes in the policy environment or interest rate cycle.

Once again, we come to implicit recognition by the FSB that a prudent board will seek expert advice where needed in developing an appropriate IPS.

In conclusion, the development of an appropriate IPS is not a once-off exercise but requires continues review. This, along with other issues such as benchmarks and communication will be considered in our next and final article.

  • Institutional Client Service is a division of STANLIB, a leading institutional asset manager and South Africa’s largest unit trust company.