Issue: Oct 2010/Jan 2011
Back to Basics 2

Mind the gap

Rowan Burger

Burger...a concrete example

Rowan Burger, head of investment strategy at Libfin, explains the difference between investment and fund performance.

A pension-fund member recently complained, near the completion of his five years of service, that he had not recovered the total contribution paid into the fund over what is deemed to be a sufficiently long period. The immediate blame was attributed to poor investment performance.

But now deconstruct the return from the investment portfolio to the member. This is instructive because it helps to understand why there is a disconnect between the fund and its members.

The lesson for all in the pensions-service industry is that we will think that we are delivering in fund members’ best interests. But the lack of financial understanding will lead many members to be disillusioned about the performance of their pension funds, and many trustees might be oblivious to this reality.

Actual case study

Let’s consider a R4 000 per month contribution (15% of salary) to a defined-contribution fund. The member had presciently selected a ‘moderate conservative’ portfolio for the past five years. The total contributions of R240 000 yielded a benefit value of R239 380 on 25 June 2010 (accessed online). The effective internal rate of return for the member was a negative 0,11%.
The immediate blame for this loss is placed on the trustees. Horrified as to the value, the instant reaction is that the problem lies in the investment performance.
Straightaway, a call is made to the asset manager. He responds that the benchmark performance for the portfolio was 15,50% annually over the five years to end-May 2010. The manager delivered a time-weighted return of 15,21%. While disappointed that the benchmark return was not achieved, this marginal underperformance (similar to peers), was accepted.

So where is the disconnect and to whom do the trustees turn?

Return reconciliation

  Return Drag Explanation
Benchmark Return for Portfolio 15.50%    
Manager Return Achieved 15.21% 0.29% A
Time Weighted Return 14.52% 0.69% B
Money Weighted Return   8.01% 6.51% C
Net Internal Rate of Return for Client  -0.11% 8.12% D

The drag on performance is explained:

  • The manager marginally underperformed the benchmark by 0,29%;
  • There is a one-month difference in the reporting period. The difference between the May to June numbers is considerable, given the addition of a poor June 2010 and the loss against a high-returning May 2006;
  • There is a difference in returns earned, comparing a single-premium to a recurring-premium investment. Performance surveys are done on a time weighted (single premium) basis as this removes the distortion of cashflows. Given the shape of returns - very high during the early years of the policy and then hit by the financial crisis near maturity - the money-weighted return (recurring premium) is a significant 6,51% lower than the time-weighted return (initial lump sum) reflected in the surveys (see graph).
  • Members sometimes forget the expenses in running a fund. These expenses lead to a strain of 8,12% on the return. They are reconciled as follows:
  Actual Charge Approx Strain
Admin Fee (of salary) 1% p.a. 2.95%
Death Insurance Premium (of salary) 1.5% p.a. 4.42%
Investment Fees (of asset value) 0.5% p.a. 0.58%
  • The analysis of strain is dependent on the order, and is multiplicative.

Premiums required to secure death benefits are deducted from members’ contributions prior to these being invested. To forget this probably causes the most common misunderstanding that leads to member unhappiness. This expense is often blamed on the administrator.

Some useful advice

Ideally, when communicating performance to members, trustees should include some form of money-weighted return. But bear in mind that, because each member has a unique starting point and salary-increase profile, no single number applies to all.

A sound understanding of the fund and its charges is imperative. So too is an understanding of how the investments deliver performance.

Proper communication of investment performance is key to ensuring reasonable member expectations.