Issue: June 2012 / August 2012
Expert Opinion

For the sake of certainty

Smooth Bonus Funds should be considered for capital protection and positive returns in these tough times, suggests Momentum Employee Benefits marketing actuary Deane Moore.

Moore . . . significant advantages
Although unfashionable with advisors seeking to justify ongoing fees by attempting to replicate smooth payoff profiles through complicated market instruments, for over a generation Smooth Bonus Funds (SBFs) have shown their durability by meeting the needs of retirement-fund members. Whilst many ‘new wave’ products failed to deliver to expectations during the financial crisis, SBF investors continued to enjoy full capital protection of their accumulated benefits.

The past year proved extremely difficult for retirement investors. Marked by huge volatility and strong headwinds in many of the world’s largest economies, it’s precisely this type of environment for which SBFs were designed. Our experience is that, given a choice, two-thirds of individuals choose SBF portfolios for their retirement savings.

Any investment in a volatile instrument, such as equities where market values can quickly change, is only appropriate if the investor’s time horizon is longer than at least five years (a typical investment cycle). Against this, an SBF is appropriate for those who plan to stay invested in the fund until a benefit payment is made.

SBFs are offered through insurance companies. They allow investors to benefit from the upside potential of exposure to growth assets such as equities and property, but with significantly lower downside risk than normally associated with investing in these asset classes.

The insurance company accepts the underlying fluctuation in investment value and passes on a smoothed bonus to investors. It broadly comprises a vesting bonus (a guaranteed return effectively locked in for future benefit payments) and a non-vesting bonus (a return from unrealised capital gains). Pension-fund members who remain in the SBF will receive their original contributions plus accumulated smoothed bonuses when the benefits are paid.

The significant advantage of investing in SBFs is that the member of a defined-contribution pension fund can plan for retirement with a high degree of certainty. This compares with the situation of members who were fully invested in volatile instruments in 2008 during the global financial crisis. The value of their retirement benefit fell significantly before retirement, forcing some to postpone retirement.

SBFs are not appropriate for investors seeking short-term speculative gains. Because the insurer is sometimes required to use its own capital to smooth bonuses in adverse conditions, it applies a market-value adjustment to investors leaving the fund voluntarily (through switching investments or terminating). This is in order to protect the long-term investors for whom this product is designed and who rely on smoothed returns in their retirement planning.

SBFs can be:

Partially vesting.  Investors who remain in the fund until benefit payment date are guaranteed a return of their original capital plus the accumulated smoothed bonus. They could expect this fund to provide a return similar to a well-constructed balanced fund, less an annual charge of about 1% for the capital adequacy requirement that an insurer has to hold against the risk of adverse market movements. The capital is supplied by the insurer’s shareholders and the 1% annual charge is to compensate them for this tied-up capital.

Fully vesting. Similar to the partially-vesting fund except the entire bonus vests each month. Because there’s higher risk to the insurer, the capital charge is higher (typically 1,5% to 2%) and the bonuses tend to be slightly lower.

Absolute growth funds. These are completely different. They guarantee a return of only that portion of capital specified in their name (e.g. if the name says 80%, only 80% of the accumulated investment is guaranteed).

How do insurers smooth SBF returns? 

Typically, it’s by holding back a portion of the investment return during strong bull runs and using this to declare bonuses during market downturns. Because SBFs are managed to smooth bonuses over a typical investment cycle, it’s of limited value to compare track records of less than five years.

In an extreme market downturn, an insurer may be forced to protect the fund for the benefit of members; for example, by using the reserve built before the downturn to smooth investment returns. It might even allow this reserve to become negative, but there is a legal requirement for SBFs to restore the reserve at least to zero over three years.

In a severe and sustained market crash, some of the unrealised capital gains declared as non-vesting bonuses might be partially removed over time. When and if the market recovers, they’re reinstated.

At worst, the insurer’s own capital will be called upon to ensure that investors in SBFs (distinct from absolute growth funds) will always receive back their original capital plus their accumulated vesting bonuses.