Edition: Jun - Aug 2014
DOES YOUR INVESTMENT ABSORB MARKET SHOCKS?
Smoothing is a win-win for fund members and trustees, advises Craig Aitchison, general manager of corporate customer solutions at Old Mutual Corporate.
Investing in risky assets is like driving a car without shock absorbers
The performance of equities over the past few years is starting to show that markets can be very volatile. This has served to entrench the attitude of South African investors, especially those making decisions on behalf of retirement fund members, to be risk averse.
It creates a major challenge for trustees when it comes to helping their members achieve their investment objectives as risk-averse investors prefer more stable, lower return (conservative) investments. If investments are too conservative, members are unlikely to have enough to retire on.
However, investing in riskier assets during market turmoil is much like driving a car without shock absorbers where every bump in the journey to retirement is felt. How then do we get exposure to investment assets that provide the best long-term growth, but limit the volatility of investment return to a comfortable level?
Smoothing is viable option for market shock absorbers
Investors need consistent growth while avoiding the impact of negative returns. A smoothed-bonus product seeks to provide access to growth asset classes, while reducing investment-return volatility. They are designed to act as shock absorbers for volatile returns and so provide trustees and members with peace of mind.
These products trim the extremes from the peaks and troughs of the market, and give investors who are risk averse some level of comfort by investing in assets that can give them higher real returns in the long run.
How does smoothing work?
An investment portfolio to which a smoothed-bonus technique applies doesn't declare all the earnings made in profitable years, though these returns still reside in the investment portfolio in a reserve. When markets tumble, the reserves are used to supplement the returns declared.
Trustees are, therefore, able to position their clients in an investment portfolio that has the type of assets needed to produce strong real returns, but with a smoother journey.
The move from defined-benefit schemes to definedcontribution schemes means that the member can retire with benefits that are too low if they choose a very conservative portfolio.
However, as the member carries the risk of a poor investment outcome, portfolios with high investment volatility can leave a member without sufficient retirement assets if they retire when the markets are low. The smoothed-bonus products enable investors to meet their long term objectives without shying away from the volatile assets.
What protection does a 'guarantee' provide?
A guarantee is the protection given against capital loss when access to a fund is needed, especially useful when markets are in a down cycle. For example, during 2008/09 Old Mutual Corporate paid out about R15 billion in benefits when markets were down 20%-25%, without anyone suffering a loss in capital from that dramatic fall.
Consider the cost of guarantees
With a smoothed-bonus product, the lower the guarantee, the more cost-effective it will be. The right level of guarantee will depend on an investor's risk tolerance. For example, if one is not prepared to take more than 20% of the loss, then a product that provides a guarantee of 80% may be appropriate.
What is the right product for you?
An appropriate product can be chosen once trustees of the fund understand the risk profile of their membership. A membership that is not comfortable with investment volatility would benefit from smoothing.
The trustees can also select a level of guarantee that would be suitable for their members. The lower the members' appetite for investment losses, the higher the level of guarantee that should be considered.
For more information about Old Mutual Corporate, visit www.oldmutual.co.za/corporate