Dear reader

In this newsletter, we provide the Benchtest for September 2010, a very relevant and interesting model for determining the investment risk you or your fund should take based on its retirement goals and the retirement funding rate. For employers participating in the Benchmark Retirement Fund, we draw attention to the ‘Default Portfolio’ and what it aims to achieve. You are also invited to follow the links to some interesting articles.

We hope that you find this newsletter interesting reading, once again. And please feel free to comment: tell us what you value and how we can improve the content.

Regards

Tilman Friedrich

Tilman Friedrich's Industry Forum

BENCHTEST MONTHLY 09.2010

In September the average prudential balanced portfolio returned 4.89% (August minus 1.6%). The see-saw in terms of performance ranking continues. This month, last month’s worst performer, Prudential, takes top spot (6.25%), worst performance delivered by Allan Gray (2.14%), last month’s top performer. For further analyses and our views, click here...

THE BENCHMARK RETIREMENT FUND DEFAULT PORTFOLIO

For employers who participate in the Benchmark umbrella fund and are invested in the ‘Default Portfolio’, it is important to be aware that this portfolio has a more conservative mandate than the typical prudential balanced portfolio. Currently this portfolio comprises of the Prudential Inflation Plus and the Metropolitan Absolute Return portfolios in roughly equal proportions. This portfolio aims to minimise negative returns and has a long-term return objective of inflation plus roughly 3% after fees. Its equity exposure is significantly lower than that of the typical prudential balanced portfolio and one should expect it to produce returns that are around 2% p.a. lower than those of the average prudential balanced portfolio.

It is also important to realize that at this rate of return, the net contribution towards retirement by both, member and employer should be roughly 16% of remuneration, in order to achieve a reasonable income replacement ratio of 2% per year of service. In contrast, the expected long term net rate of return of 5.3% that the average prudential balanced portfolio should achieve, should produce an income replacement ratio of roughly 3% per year of service. The article by Günter Pfeifer below examines this topic in more detail.

The trustees of the Benchmark Retirement Fund have resolved to replace the Metropolitan Absolute Return portfolio with Allan Gray from 1 January 2011 in an effort to raise the expected long term real investment returns to around 4%. This will increase the equity exposure from around 35% to around 50%. While this will also increase the portfolio’s performance volatility, research has shown that Allan Gray’s performance is least correlated with that of the Prudential Inflation Plus portfolio.

SHOULD THE EMPLOYER BE REPRESENTED ON THE BOARD OF TRUSTEES?

Our experience is that funds without true employer participation provide the stage for a ‘free for all’ scenario, where discipline is lacking and decisions are based on short-term self centered objectives. Our clear preference is that employers should be actively involved on the board of trustees. For a more detailed exposition click here...

DOES YOUR FUND HAVE A STRATEGY?

Much is being spoken and written about the need and indeed trustees’ duty of diligence, care and skill, that requires funds to formulate, implement, monitor and regularly review their business strategy. Typically, this should address areas such as:

• fund management (trustees, consultants, administrators, actuary, auditor, underwriter etc),
• member communication,
• benefit structure,
• investments,
• ancillary benefits (e.g. housing loans) and
• reporting.

Once a strategy has been formulated, a structure should be established to implement and monitor compliance with the strategy. In practice, the implementation and maintenance of the required structure, is mostly the responsibility of the fund’s administrator, assisted by the participating employers.

Matters do become difficult when new ideas are tabled at a trustee meetings, without even appearing on the agenda and without supporting documentation. Decisions are then taken on a haphazard basis, without reference to a rational framework as should normally be offered by a proper strategy. This leads to inconsistent, frequently even conflicting policies that have not been considered properly by all parties concerned, that may be inefficient or ineffective and may expose the trustees to legal challenge and censure. By now most trustees will be aware that they may incur liability in their personal capacity, should it be proven that they acted recklessly or negligently.

The typical occupational (employer sponsored) retirement fund is a group scheme intended to offer a fair compromise for the average member, between what is nice to have and what is economically justifiable. Of course the minority more sophisticated, financially knowledgeable member wants to have a wide range of choices in terms of contribution, benefits and investments while the majority less sophisticated member does not benefit from such flexibility but has to share the costs.

We have in the recent past seen many funds convert from the protected interim/final interest regime to the market linked monthly investment return regime. This was of course at the time markets only knew one direction, and that was up. With the more recent experience of markets turning down, many of the less sophisticated members will not be pleased with what the next benefit statement will show and will start asking questions that trustees may find difficult to answer. How many funds have actually effected this change in consequence of a strategy review and redefinition and how many have done so as the consequence of opportunistic self centered pressure by specific individuals?

What to do?

Trustees, more specifically, the chairperson should resist discussion on any changes in the fund’s strategy that does not flow from a formal strategy review and that is not supported by a formal, documented procedure. All parties to the fund should have been given an opportunity to comment and to highlight all potential implications in terms of risks, costs, procedures, formalities, member communication, income tax, rules. For good measure and as a matter of principle, all parties to the fund should be required to formally declare their interest.

Gunter Pfeifer's Benchmark Notes

THE RELEVANCE OF THE SALARY REPLACEMENT RATIO

Most of us save for retirement in some form or another. All of us, however, hope that when we retire, enough investments have accumulated for a dignified retirement. Instead of just hoping for the best, one should plan for retirement and one of the tools that can be utilized is the salary replacement ratio. This ratio expresses the pension that will be received on retirement as a percentage of the pensionable salary in the last month before retirement. The table below reflects this ratio, based on certain assumptions.

You will realize that we place a lot of emphasis on ‘real investment returns’ and on ‘income replacement ratios’ and you may ask, are the figures used in the table good, bad or indifferent? Firstly, if you invested in equity only, history as shown that you can expect a ‘real investment return’ in the long term of around 7%. Pension funds, however, are only allowed to invest a maximum of 75% in equity. So ‘real investment returns’ from a typical prudential balanced pension fund portfolio, should be around 5% in the long term. The table uses 5% as the maximum as more conservative portfolios are likely to achieve lower real returns in the long term. You will notice that the table does not produce an income replacement ratio of anywhere close to 100% for any of the scenarios. Internationally pension fund structures aim to achieve an income replacement ratio of 2% per year of service, i.e., if you worked and saved continuously for retirement for 40 years, a well structured fund should be able to offer you a pension equal to around 80% of your last salary before retirement. An income replacement ratio of 100% is therefore essentially unachievable.
 
The table is read as follows: a member that has invested in a portfolio (or combination of portfolios) that yields 4% above inflation (i.e. ‘real investment return’ of 4%) and who has contributed 14% of pensionable salary to a retirement fund will have a replacement ratio of 63%. The pension to be received will be 63% of the last pensionable salary. It is important to note that contributions listed above are after risk premiums and other costs, i.e. it is the actual portion that is set aside for retirement. Total contributions to a retirement fund for this member could be something like 17%, where perhaps 3% is used to pay for death and disability cover as well as administration and other costs.

Another important assumption underlying the above ratios is the number of years that the member contributes to the retirement fund. In this case we have assumed 30 years of contributions until retirement age 60. Life expectancy after retirement has been assumed as 20 years. Where a member changes jobs, it has been assumed that any accumulated fund credit is preserved in a preservation fund and not eroded through a cash withdrawal.

Four factors are crucial to ensure a dignified retirement:

• Net contributions and investment returns need to be balanced. Where a moderate risk portfolio is chosen that yields on average 4% above inflation (after fees), net contribution rates should not be lower than 13%. Use the table to establish where you or your fund lie. Make changes while you still can.
• Pensionable salary should not be significantly lower than total remuneration package. Your standard of living is largely a function of your total remuneration. It is the pensionable salary however that determines the pension you will be earning one day.
• Setting retirement savings aside is a long process. The longer the period you save for retirement, the better. As a minimum it needs to be 30 years.
• Do not access your retirement funds when changing jobs, no matter how tempting it may be.