PFA goes after smoothed bonus products

31 May 2006 Angelo Coppola

The pension funds adjudicator issued a landmark ruling dealing with the operation of a smoothed bonus policy, in the case Mungal v Protektor Preservation Fund and Old Mutual.

According to the PFA this case involves the first ruling against a preservation fund, underwritten by an insurer, which follows the same principles as the series of rulings against the retirement annuity funds issued during the course of 2005.

The background: 
In October 1997, Mr Mungal elected, on leaving employment with the University of Durban-Westville at the age of 51, to transfer his pension benefit of R193 560 to the preservation fund.  This transfer represented a single contribution to the fund.  

The preservation fund, as an underwritten fund, then invested this amount in a smoothed bonus endowment policy with the administrator and underwriter of the fund, Old Mutual.
The complainant elected to receive his benefit in the fund halfway through the term of the endowment policy initially agreed on. His fund value as at 10 June 2003 had grown to R295 920, but because the underlying insurance policy was surrendered prior to maturity, a downward adjuster, known as the  Market Level Indicator (or MLI for short) of 10% was applied to his benefit and he was penalized R29 592.
Mr Mungal complained to the Adjudicator, stating that he had never been informed in advance of the penalty.   

The complaint concerns the legality of the funds application of a MLI to the complainants benefit on his withdrawal from the fund some five and a half years prior to the elected retirement date. The MLI essentially reduced the complainants benefit by 10% (R29 592).

The issues: 
At the heart of this matter is the structure of so called smoothed bonus products, the nature of which were called into question by the Adjudicator.

The principle of a smoothed bonus product is that in years of good market returns, a portion of the investment return is held back in order to prop up years of poorer return. This, so it is said, insulates members from leaving the fund at a time where there has been a market downturn, since their investment returns have been smoothed out.
However, there appears to be a marked lack of transparency in the allocation of investment return in these products, leading to instances such as the present complaint where the members who withdraw early are effectively subsidizing the guarantees on the later remaining members benefits.

This is effected through making the early withdrawing (as opposed to retiring) members bear the brunt of protracted economic downturns by applying negative MLIs to their benefits (downward adjustments to compensate for the underfunding level in the fund).

It was expressly conceded by the fund that it never applied positive MLIs. In other words, when a member withdraws and the fund is in an overfunded (surplus) position, a proportion of that profit is not passed on to him.

The questions:
Which raises the question: where do all the profits go?
What happens to the accumulation of the funds (now swelling the stabilisation reserves in the insurers books) where there is no market adversity for many successive years?

Does it remain in the insurers stabilisation reserve until years of negative returns come along, and is it then used to top-up the policy values of remaining policyholders?

Is it shared between remaining policyholders, on the one hand, and the insurers shareholders at the end of the insurers financial year, on the other?

Or is it treated as a profit and declared as a dividend for the benefit of the insurers shareholders?

These questions were left unanswered in the determination, since it was decided on other grounds, but the fact that the Adjudicator has raised them, signifies his concern about transparency and possible abuses in this type of underlying product.
The Adjudicator found, in line with the approach adopted in the retirement annuity fund rulings, that where such a penalty was not authorized by the rules of the fund, or the policy document, then that deduction could not be effected.

In the present case, he was not persuaded that either the rules or the policy permitted the penalty, and he therefore ordered it to be reversed and paid to the member with interest.
The ruling serves as an important reminder for trustees of funds and insurers that whatever fee or penalty (including a MLI) is imposed on the members account must be authorized in the rules or policy document, otherwise it cannot be debited to the members account.

To read the actual ruling click here

Editors thoughts:
* In what has been hailed as the biggest single ruling to date the PFA has called into question the transparency of certain aspects of smoothed bonus products.

* While not directly related to the ruling paragraph 49 of the PFA ruling also makes for interesting reading its about Annual Benefit Statements.

Reliance has also been placed on annual benefit statements as authorising application of the MLI (Market Level Indicator or Market Level Adjuster or Market Value Adjuster) upon early surrender of the policy here in issue. But benefit statements hardly constitute a binding agreement of rights and obligations between two parties. Benefit statements are, well, precisely that. Their purpose is to keep members informed of the values of their investments at various times in this case, on an annual basis. It is to registered rules and, for underwritten funds, the policy document that regard must be had to find what is permissible or not. Benefit statements are not intended for that purpose

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