Edition: June - August 2015
Editorials

COVER STORY

This time is different?

In the past few decades, market volatility has become more pronounced and more frequent. Since the most recent financial crisis, the bulls have been rampant. What trustees should do if they worry about a big-time return of the bears.

It’s ingrained in long-term investors, notably pension funds, that they stick to long-term investment strategies. But the long-term comprises a succession of short terms. Like it or not, short-termism permeates the industry.

Asset consultants and managers are commonly assessed on short-term performance by trustees sensitive to the swings between euphoria and panic. There’s little they enjoy more than basking in the appreciation of fund members for annual benefit enhancements. The converse applies equally.

Hoping for the best, that the markets’ upward trajectory will last forever, needn’t necessarily exclude a plan in case it doesn’t. Accordingly, these hypothetical questions have been posed to a selection of industry professionals:

We, as trustees of a medium-sized pension fund which offers its members investment choice, are concerned about the high level of equity prices. In recent years our fund has done exceptionally well from these rocketing prices, but now we don’t want to be greedy and prefer to err on the side of caution.

Our asset managers share this market view, at least partially, but are nervous to go too conservative because they worry about short-term underperformance against their peers. As we’re in a pooled portfolio, we’re unable to change their strategy. Certain questions arise.

First, given this view, what can we do (within the prudential guidelines of Regulation 28) to protect members in terms of our perceived higher risk for downside?

Second, National Treasury has proposed in its reform papers that trustees offer their fund members a default investment and annuity option. We’re aware of ‘birthday risk’, where a member who retired at the depth of the 2008-09 financial crisis would have received a lump sum much lower than a member who’d retired a few years earlier or a few years later.

To those trustees as cautious as we are, what would be your best recommendation for the most cost-effective default option for us to propose? What sort of guidance should we offer members, particularly those approaching retirement, on what they should do?

Malcolm Fair

Malcolm Fair of RisCura: These days there are too many retirement options available. The outcome for each investor depends on the type of product purchased. Over time, the lowest common denominator between pre- and post-retirement portfolios are cash-like ones which are believed to be low-risk. In fact, although these portfolios asre safer in the shorter term, they are risky in the longer term as investors may not have significant time to generate return even after retirement.

This is where ‘birthday risk’ comes in. Members’ retirement should not necessarily depend on them timing the market. The idea of retirement funds offering default retirement annuities is welcome. They will provide a clear retirement goal that will allow members approaching retirement to start mimicking this investment strategy and steadily glide into their retirement portfolios from as early as age 55. This will go a long way to mitigating ‘birthday risk’.

The most cost-effective retirement option is where fund trustees take ownership of the default annuity, then leverage off the existing service providers and investment strategy as much as possible. This will make seamless the transition to retirement. For example, the same benefit administrator that contracted to the fund and has been collecting members’ contributions, can be used for paying out pensions to retired members. Similarly, the same investment managers can be used to implement the default options and thus leverage off the institutional fees they already enjoy.

When default annuities are implemented properly within defined-contribution schemes, they should start looking more like the old defined-benefit funds by providing a safe, cost-effective transition for retiring members.

Erich Potgieter

Erich Potgieter of Towers Watson: If trustees believe that their main investment portfolio is too aggressive given their view of current market conditions, they can switch to a lower-risk pooled alternative (most probably a portfolio with lower equity exposure). But we’d caution against tactical switches based on short-term perceptions. To have any chance of switching successfully requires a higher ‘governance budget’ than most trustee boards can muster.

Our preferred default investment strategy, for defined-contribution funds offering member choice, has been to transition members from a balanced market-linked portfolio into a significantly lower-risk portfolio (low equity, capital protected or even money market) as they approach normal retirement age. This assumes that the recommended option at retirement is to invest in a with-profits annuity (a life annuity, not a living annuity). The pricing of with-profits annuities is not sensitive to current market conditions, so money-market assets are a reasonable match for this investment at the point of retirement.

But few members actually buy with-profits annuities, or any other form of life annuity, when they retire. Retirees’ bias towards living annuities is strong and efforts to counter it have been unsuccessful. A balanced portfolio, with lower equity exposure, could be a reasonable option for members who plan to buy living annuities after retirement.

However, high risks come with living annuities – especially for people who try to use high drawdown (income) percentages and aggressive investment strategies in an attempt to turn an inadequate capital amount into an acceptable level of monthly income.

Willem le Roux

Willem le Roux of Simeka Consultants & Actuaries: Trustees are ideally positioned to engineer good retirement outcomes for fund members. The default investment strategy represents trustees’ collective view of an appropriate strategy for most members. If it addresses the right risk at the right time, it need not be changed at different points in the economic cycle. But if trustees believe that they should take steps to reduce risk, it can be done by

  • Changing the underlying investment exposure by partially or fully switching assets to a more conservative portfolio. Trading costs may apply;
  • Adopting hedge strategies. These tend to be complex. A futures contract can alter the fund’s underlying exposure; an ‘option’ can limit downside risk at the cost of a sizeable premium paid upfront, and a zero-cost structured option can curb potential returns on the upside and downside.

But these hedging strategies can introduce significant risks of a technical nature. For example, there’s basis risk (where the hedge does not usually apply to exactly the same assets as the fund’s); timing risk (the protection may end up being inappropriate for the fund), cashflow risk (where the hedge may be inappropriate due to the change in fund value through cashflows, affecting members leaving the strategy and those remaining), and management risk (where derivative instruments require continuous market-to-market management).

Any protection may dilute long-term returns if the timing is imperfect. Trustees should communicate to fund members any changes in understandable language. Where members have investment choice, the privilege and responsibility to manage risk belongs to members who exercise their choice.

Andrew Davison

Andrew Davison of Old Mutual Corporate Consultants: Although the current environment arguably offers greater risks to individuals’ investments, saving for retirement is a long-term objective.

Even for individuals approaching retirement age, the retirement date is not the end point for investing. Most pensioners who invest in an annuity nowadays select a living annuity, meaning they will remain invested beyond retirement date. A 60-year old has a potential time horizon of over 20 years, not the five years to retirement at 65.

Of course, the investment strategy in a living annuity may be different to the pre-retirement strategy. But the pensioner will still need a mix of growth assets (e.g. shares and property) as well as defensive assets (e.g. cash and bonds).

For most of an individual’s working life, a growth strategy is required as many South Africans find it difficult to contribute more than 15% of their salaries towards retirement savings. Being too conservative simply isn’t an option, given the need to outperform inflation.

Trustees should determine the level of return they need for their members, and then ensure that the investment strategy targets this return. A focus on avoiding short-term volatility can distract trustees from ensuring that they are targeting the best retirement outcomes for their members in the long term.

Ensuring that the majority of members remain invested in a growth strategy for as long as possible is thus in those members’ best interests. A more conservative option should be available to members approaching retirement.

Michael Prinsloo

Michael Prinsloo of Alexander Forbes: Getting the right long-term strategic asset allocation and de-risking strategy leading up to retirement are probably more important than short-term performance or tactical asset-allocation calls.

If trustees are trying to protect those closer to retirement, there are strategies to protect these members without limiting access to necessary growth assets for younger members. And if trustees still want to take short-term action, there are several options within the ambit of Reg 28:

  • Invest in a less aggressive portfolio (measured against different metrics) and provide members with a more aggressive individual-member choice;
  • Invest in a mandate less fixated on peer performance, a mandate closer aligned to the trustees’ strategy allowing managers to be more flexible and react to market risks relative to the fund’s strategy;
  • Hedge out some of the equity risk using derivatives. (This is not to be undertaken without expert assistance and probably not as a first resort. Understand the costs.)

There are risks in taking action and in not taking action. Downside can occur in other asset classes, not only equities.

Life-stage investing has become popular in defined-contribution pension funds. This is a strategy where the investment portfolio for members far from retirement is long-term growth-orientated, and as these members approach retirement they are progressively moved into more cautious or targeted portfolios. Today these latter portfolios reduce equity exposure but also have inflation-hedging assets to limit the point risk of buying annuities.

Members approaching retirement should be invested in portfolios that protect their incomes, with the secondary aim to provide some capital protection and real growth.

Thabo Khojane of Investec Asset Management: Pension funds should define their primary risk as not beating inflation. To be overly concerned about potential short-term corrections could result in a portfolio that’s too conservative which, most likely, will not meet inflation-beating objectives.

The two types of balanced investment funds are peer-relative and inflation-relative. The former try to outperform a peer group or composite of different markets, and manage money on the premise that outperformance of the peer group should provide decent long-term returns. These managers may not be as averse to short-term capital declines.

The latter tend to be more cognisant of downside risk. Primarily concerned with capital preservation, they would typically lag peer-relative funds in strong equity bull markets. If the pooled portfolio is in an inflation-relative fund, the manager will naturally be more cautious.
‘Birthday risk’ can and should be managed. Some retirement funds begin the process before the member retires e.g. transitioning the portfolio from a 75% growth/25% cautious split at five years before retirement to 50%growth/50% cautious at retirement and 100% cautious after retirement. This process can be managed mechanically in the default option without the member having to do anything.

Target funds are able to do the same. These funds are actively managed by balancing the capital growth and income needs throughout a member’s life, even after the target date (typically the retirement date) is reached and passed.

Trustees should carefully consider the default construct because this is where the overwhelming majority of members will choose to invest. As a guideline, bundled “cost-effective” solutions should be avoided. Rather procure investment services separately from administrative services. In the long run, the return generated is a more important driver of replacement ratio than the fees paid.

Danie van Zyl

Danie van Zyl of Sanlam: First understand the risk profile of your members. Younger members face an investment horizon of 30-plus years. It favours investing in assets such as equities and property. These members can afford to tolerate short-term volatile returns to benefit from the capital growth these assets offer over the long term. Members closer to retirement, or those who experience uncertainty regarding their employment duration, are less likely to be able to withstand sudden falls in their investment values in the short term.

The concerns of those closer to retirement does not automatically exclude them from participating in growth investments. There are a variety of pooled portfolios available such as smoothed-bonus portfolios. They typically have a similar asset allocation to balanced funds, but offer either a full or partial guarantee on capital and returns.

The 2015 Sanlam Benchmark survey found that more funds are introducing a default annuity for members at retirement while also aligning their pre-retirement investments with this default annuity. The most popular default annuity options are with-profit annuities, inflation-linked annuities and living annuities (depending on the profile of the fund membership).

While trustees can put in place default investment and annuity options, members are still entitled to opt out. It is therefore important that members receive guidance on annuity options a few years prior to retirement – not only so that they may make informed decisions at retirement, but also that they may align their investment strategy with the annuity they aim to purchase at retirement.
A well-constructed life-stage investment strategy may be cost-effective for the fund if accessed as a pooled solution offered by an insurer or asset manager. Life-stage strategies automatically change a member’s asset allocation as the member approaches retirement, usually switching to a lower-risk strategy close to retirement.

Tarunova Mashamhanda

Tarunova Mashamhanda of Momentum/MMI Holdings: Because markets are unpredictable, particularly in the short term, frequent strategy changes should be avoided. Pre- and post-retirement strategies should be aligned i.e. looking through to the investments underlying the annuity choice and using similar portfolios pre-retirement. This will be the primary guidance for members and for default options.
For default annuity options, cost-effectiveness can be enhanced where

  • They don’t lead to disinvestment and reinvestment of assets, causing transaction costs;
  • Investments underlying the options give higher real returns within the risk tolerances. Generally, the higher the expected real returns the lower the cost of an annuity;
  • They are at a lower cost compared to when a member individually sources an annuity;
  • They are priced with underlying rates more favourable than retail (individual) rates.
Tarunova Mashamhanda

Hannes Viljoen of Stanlib: As members of this particular pension fund have flexibility, the option to move to a portfolio that holds less equity and more bonds and/or cash could provide some protection against an equity market downturn. But take into account that at present bonds are on the expensive side and yields are at very low levels.

Hence a portfolio with a high holding in cash would provide a level of downside protection (although, in real terms, cash usually doesn’t outperform inflation). For Reg 28 purposes, a higher allocation to cash should not breach any limits, given that the allocation is diversified.

A possible alternative, should the managers prefer to keep their allocation to equities, would be to invest in a fund with equity exposure to lower beta, more defensive stocks. These stocks would in theory decrease by less than the overall market should a crash occur. In market downturns, unfortunately, theory does not always hold.

Recommending a default option is difficult, especially if the average member’s age and risk profiles are unknown. However, given that saving for retirement is a long-term endeavour, a portfolio that has a high allocation to equities should be top of mind. Being too cautious over the long term can be costly as the compounding effects of inflation eat away at purchasing power. This could result in vastly inadequate funds at retirement.

Index-tracking unit trust and exchange-traded funds provide cost-effective entrants to the market. With the introduction of balanced or multi-asset index tracking funds, investors can gain access to a balanced portfolio with exposure to multiple asset classes at attractive management fees.

Trustees may also wish to investigate target-date funds. They bucket members into cohorts by age and manage the portfolio for each cohort dynamically as each cohort approaches retirement.

One golden rule is not to make attempts at timing the market. Another is to diversify. A well-diversified portfolio across a broad range of asset classes will ensure that a sharp reduction in the value of any single asset class does not influence the total portfolio value in a catastrophic way.

Andrew Kemp

Andrew Kemp of Liberty: Trustees concerned about current valuations should start by asking whether the range of portfolios offered to members is wide enough so that members can move into a more conservative risk profile if they want, and whether there is a sufficiently robust advice framework to support the member choices offered.

A concern over high market valuations may introduce the need for a strategy that allows members to reduce the risk of a severe market downturn while trying to capture as much growth as possible. Under this scenario it may be worth considering the addition of a risk-managed solution that attempts to target a relatively high growth rate (e.g. cpi+5%), but manages the risk of severe downturn through the use of protective derivative strategies.

Typically these types of portfolios will offer good growth should the market perform well, but are likely to lag slightly behind portfolios which are not protected due to the cost of the protection. In market downturns, however, these portfolios do relatively well as they will protect the investor from catastrophic loss. Even these types of solutions will not protect 100% of capital; rather, they offer protection below a specified loss.

Generally, the default option involves some form of life-stage strategy. This approach works relatively well in preserving capital, but has been criticised as it does not really take into account the type of annuity the member will purchase at retirement. For this reason, trustees should spend time trying to understand their membership and attempt to determine what type of annuity respective members are most likely to purchase. Their life stage should then be designed accordingly.

Various members may want something quite different to the default. It’s crucial that members are educated about the various types of annuities, and the implications of each choice.

Nick Curtin

Nick Curtin of Foord: People are living longer and their pension savings must work harder. Therefore, the premise that members are saving for a lump sum cash payout or guaranteed annuity purchase at retirement age should be forcefully challenged.

Pension-fund members should rather lengthen their investment horizons to the date of death of the last surviving spouse or dependent, and remain invested in a well-diversified balanced portfolio seamlessly through the pre- and post-retirement stages. Modern retirement and living annuity products facilitate this outcome.

If members commenced saving sufficiently early in life, the better long-term returns will provide an adequate safety margin in the post-retirement phase to weather any short-term market gyrations. Trying to time the markets is a sure way to destroy the value of retirement savings.

The retirement industry generally over-emphasises protecting long-term growth portfolios against short-term volatility. This comes with significant and usually understated opportunity costs in the long term. Therefore, well-intentioned trustees’ concerns about short-term market valuations are misguided when one assumes a much longer investment horizon.

Trustees concerned about short-term valuations should not aim to alter the long-term investment strategy of their fund’s investment manager. They must rather implement investment and retirement policies that lengthen investment horizons by facilitating members’ continued investment in well-diversified, balanced portfolios both before and after retirement.
They should also select an investment manager that acts in terms of fund members’ best interests rather than its own business risk.

Shaun le Roux

Shaun le Roux of PSG Asset Management: We like to invest with a margin of safety and are happy to walk away from investment opportunities where we think it possible that clients could lose money.

Our summation of current conditions is that investment into some of the traditionally lower-risk asset classes (government bonds, property and low-beta equities) carries a high likelihood of capital loss and most of these assets are overpriced. Accordingly, we do not own government bonds, property and bond-like equities.

Within equities, we have been finding significantly fewer opportunities on the JSE to invest in higher-quality businesses at reasonable valuations. As a result, our portfolios are not fully invested in domestic equities. Our domestic funds have utilised the full extent of their mandates to buy attractively priced global businesses with quality franchises.

Many of the equities we do own can be characterised as being out of favour and hence trading at a wide margin of safety. They are selected security by security. Some are tied to the global economic cycle, have underperformed in recent times, and would be expected to perform well in a rising interest-rate environment.

The result of limited exposure to duration assets, and being less than fully invested in equities, is that our Reg 28-compliant portfolios sit with relatively high levels of cash.

The value of cash at this stage of the investment cycle is both attractive and under-appreciated.