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In this newsletter, we consider stress testing the life stage model and provide a final contribution on the rationale for setting up a retirement fund, and more...

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Tilman Friedrich

Tilman Friedrich's Industry Forum

BENCHTEST MONTHLY 07.2010

In July, the average prudential balanced portfolio returned an incredible 5.1% (June minus 1.5%). RMB and Allan Gray swapped last months rankings, top performance delivered by RMB (6.2%) and worst performance by Allan Gray (1.6%). For our views and detailed performance analyses, click here...

STRESS TESTING THE LIFE STAGE MODEL

When trustees are confronted with the question whether their fund should introduce member investment choice, there will be a number of arguments in favour and a number of arguments against this notion. How can you as a trustee and a layman then take a rational decision? Here are some guidelines that may assist:

• You should know what the fund would like to achieve.
• You should know what the needs of the fund’s stakeholders are.
• You need to ascertain that you apply the basic principles of governance.
• You should be wary of flawed arguments, such as “member carries the investment risk so the member should be entitled to make his own investment decisions” and “the life stage model is international best practice, so there can’t be any question”.

The 5 year period from July 2005 to June 2010 is a very representative period in terms of long-term investment returns as it covers both a bull and a bear run in the markets but produced returns reflecting what one can expect over the long-term.

We have used this period to put the life stage model on the test bench and were intrigued by the outcomes and observations that this produced. Our conclusions follow.

Conclusion

The 5 year period from July 2005 to June 2010 has been a highly volatile period in investment markets encompassing both a severe down turn and a dramatic recovery. In real terms, the returns generated over this period are quite representative of long-term expectations. Because of these features of this particular period they make for good testing ground of the life stage model.

From the results of this particular research project one can deduce the following:

• Returns are linked to risk and higher equity exposure (or higher risk) produces higher returns;
• The average balanced portfolio outperforms the lower risk portfolios;
• The life stage model will lose returns for a fund’s membership overall, unless the lower risk can be compensated by higher risk in the earlier life stages;
• Smoothed, systematic switching to the conservative and cash portfolios, produced a higher end value than remaining in the balanced portfolio over the full period (this is similar to the principle of ‘Rand cost averaging’);
• Switching at specified times produced higher end values in some events, but there is a significant risk of losing value compared to the average balanced portfolio as well;
• What combination of portfolios to use depends on one’s objectives as measured in terms of absolute outcome, volatility of outcomes and probability of underperforming the average balanced portfolio;
• Assuming the objective would be to maximise the absolute outcome, to minimise volatility and to minimise the probability of underperforming the average balanced portfolio and applying different weightings to the increasing levels of desired outcomes, a combination of balanced and conservative portfolios produces the highest score;
• As the result of the fact that balanced and conservative portfolios both contain a significant equity component, their behaviour in volatile markets is synchronous while cash typically behaves counter cyclical.

Based on the experience of this 5 year period, trustees contemplating the introduction of the life stage model, should be very clear on what their objectives are in terms of absolute returns, volatility and probability of underperformance.

They need to be aware that employing lower risk portfolios will reduce the returns for the fund and its members overall unless this can be compensated with a portfolio presenting a risk profile higher than the average prudential balanced portfolio.

The cash portfolio should preferably be by member choice, and for member specific reasons only. This choice should require special individual attention by the trustees to avoid any undue risk exposure.

Furthermore, considering that human nature finds losses more painful than missed opportunities, instead of switching at particular dates, it is advisable to switch a regular amount in respect of the aggregate value of all relevant members’ retirement capital on a regular basis, because the pain of losing outweighs the pleasure of gaining. This would have to be done by the trustees on behalf of their members and cannot be left to the individual.

For the full article, figures and analyses, click here...

WHAT YOUR RETIREMENT FUND SHOULD AIM TO ACHIEVE

In our previous newsletter we discussed the following issues:

• Funds should provide adequately for retirement
• Why have a pension fund?
• Government is a key stakeholder in retirement provision
• The employer is a key stakeholder in retirement provision
• The employee is a key stakeholder in retirement provision
• Government wants the private sector to make provision for retirement
• ‘To provide adequately’ – is it in the eyes of the beholder?
• How much do I need to put aside to retire with dignity?

What about death and disablement?

In the previous newsletter we suggested that the main purpose of a retirement fund is to allow you to retire with dignity. We also pointed out that, depending on the net investment returns you will be able to achieve over the course of your membership, you need to set aside between 10% and 14% of your total remuneration in order to achieve an internationally accepted norm of a pension equal to 2% of your total remuneration, per year of retirement fund membership, i.e. 60% after 30 years or 80% after 40 years of membership.

Your, and your dependants’ needs should be provided for adequately

This rate of saving does not yet provide for any needs you and your family may have in the event of your death or disablement. Again it would be most meaningful to determine the needs of you and you dependants in terms of a regular monthly income, by reference to your regular monthly cost of living. Needs obviously vary widely depending on your life stage and the number of people dependant on you. Typically when you are young and have no dependents, you probably have little or no need for death cover. As you grow older, get married and your family expands your need for death cover increases, to eventually start decreasing again as your children leave the nest and your life expectancy decreases, until you reach retirement.

How much does your family need in the event of your death?

If you want to provide for your and your dependants’ needs in the event of your death, including the need to make provision for future inflation, you need to have capital at death of between 8 and 16 times your total annual remuneration, depending on your life stage and status of dependants. This amount would typically comprise partially of the retirement capital you have accumulated to that point and life cover making up the difference. For a retirement fund with a normal age spread, average capital required for death benefits would thus be around 12 times aggregate annual member remuneration of which, typically, between once and twice aggregate annual member remuneration would be derived from members’ accumulated capital. The difference of around 10 times annual member remuneration thus should be provided by insurance. At that level of insurance cover, you can expect the premium to be between 2% and 4% of aggregate annual member remuneration. Typically insurance companies provide in the event of death, either a lump sum or an income benefit to your spouse and/or children, or a combination of both benefits. Clearly an income benefit is preferable as it better matches the monthly cost of living across the different life stages of your dependants.

How much do you and your family need in the event of your disablement?

Now, what is the position in the event of your disablement. Here your needs are probably higher than they would be in the event of death, because you are still alive and you probably require costly care. Typically insurance companies provide in the event of disablement, either a lump sum or an income benefit, or a combination of both benefits, with a limit of replacing 100% of your remuneration. Once again the income benefit is preferable as it better matches the monthly cost of living across the different life stages of you and your dependants. The cost of a benefit that meets your needs, is typically between 1% and 2% of aggregate annual member remuneration.

Conclusion

To conclude this topic, you should now ‘have a good feel’ for what your retirement fund should aim to achieve and what you can expect the total cost of this package to be. Does it make sense to offer a retirement fund arrangement that does not, at least, adequately provide for retirement? Remember, if your competitor offers a better arrangement, you might find it difficult to attract and retain the right caliber of staff. And just one last thing, we have not addressed the costs of managing your fund, another cost factor to keep in mind.