Member choice

05 August 2004 Angelo Coppola

(4.8.04) The effect of member choice on a pension fund portfolio.

The "one product fits all" approach for members of retirement funds is a thing of the past, says Geoff Blount, head of asset manager research at Investment Solutions.

In the old defined-contribution retirement fund environment, asset managers typically had one product, the traditional balanced portfolio or their best house-view portfolio, as reported in the Alexander Forbes Large Manager Watch and similar surveys.

However, as retirement fund members have come to demand more say in the management of their assets, managers have become increasingly averse to bearing the risk of shortfalls, prompting a swift and dramatic move to defined-benefit or member-choice products in South Africa, explains Blount.

"In terms of the speed of the switch to defined benefits and the manner in which asset managers have responded to adjusting their businesses and portfolios, South Africa has been further ahead of the curve than many other mature pension fund markets, such as the UK," says Blount.

Member choice implies that retirement fund members are able to select different investment options approved by the fund trustees. Typically, these options are risk profiled by:

* the aggressiveness of the equity portfolio (ie the higher the investment in equities the higher the risk exposure);

* the equity type (ie a more diversified portfolio focusing on blue-chip companies versus an aggressive portfolio investing in more volatile companies such as Small Caps);

* the investment style of the equity portfolio (ie Value, Growth, core or quantitative asset management);

* the selection of the asset manager.

In turn, investment options have given impetus to a trend towards specialisation in the asset management industry and a move away from the one-portfolio or traditional house-view offering that invests across all assets for the client.

Specialisation includes the specialisation of portfolios, asset classes and blends of those asset classes by asset managers.

It has also given rise to specialist investment teams and investment processes within asset management houses, and facilitated specialisation across asset managers.

Subsequently, new boutique quantitative asset managers such as Umbono and Prescient, as well as more style-defined managers or asset-class specialist houses such as Tim Allsop's Polaris Capital, have developed.

Blount says the trend towards specialisation has resulted in not just how the underlying asset classes are managed, but also how they are blended and risk profiled for member choice.

It has also enabled the launch of real-return type mandates, propelled by the demand for more certainty by retirement funds, as well as the specialist skills and processes developed to manage these new mandates.

Large retirement funds typically have the size to effectively benefit from this specialisation by being able to give specialist mandates to various investment teams and asset-management houses that have the optimal offering.

Through the use of multi-managers small retirement funds have also been able to benefit from specialisation introduced by member choice.

The move to member choice has driven a large portion of the growth in the multi-management industry in South Africa in recent years, leading in turn to specialist mandates being given to specialist teams.

Blount says specialisation makes sense, and believes that focusing on a core competency or building specialist teams seems appropriate, as not everyone can excel at everything all the time.

"However, it isn't necessarily an investment panacea. Specialist mandates are more expensive than balanced portfolios, making member choice a more expensive option.

"In addition, fund members are not always keen to make decisions, which could result in them being defaulted to portfolios that may not be appropriate, making the exercise ineffective.

"It also means pension funds or members of pension funds may inappropriately follow short-term investment fads."

Another potential risk is that members who do not have the necessary skills or knowledge start inappropriately timing the market and adjusting asset allocation.

In the longer term in South Africa, the average balanced retirement fund earnings have been more than 6.5% ahead of the inflation rate -- not a bad return for traditional investing.

Based on this figure he advises fund managers opting for member choice to ensure that the benefits, should specialist mandates be used, are more advantageous than for traditional balanced mandates.

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