Sanlam Asset Liability Index - SALI Watch June 2008

Beware of Uncompensated Risk

This month’s SALI Watch shows that cash outperformed equity, bond and balanced international indices over the last 12 months. Individuals close to retirement may be tempted to put their funds in cash, hoping interest rates remain high. In this article we show you why this might not be such a smart move.

Most people understand basic economic theory that loosely states that you can only expect to receive a higher return than what you can get from cash if you are willing to take on additional risk. Unfortunately, some people do not read the “fine print” of these theories, which may be why they often make poor investment decisions.

Here are some examples of important information that is often overlooked:

1. There are no guarantees that you will receive any “additional return” for taking on additional risk.
2. You can only expect to reap the rewards for being exposed to the risk over the long term.

There are investment-related risks that will not improve your chances of getting a higher return – the so called ‘uncompensated risks’. Uncompensated risk refers to investment related risks which investors are often exposed to, but they are not rewarded for taking on the risk. Mostly, investors are blissfully unaware of their exposure to these risks, mainly due to a lack of information. Others have the information, but lack the necessary understanding to make the right decision. In both instances the investors are in a lose-lose situation.

To illustrate, consider this anecdote (hopefully it does not sound too familiar!):

With Tom one year away from retirement, his financial advisor arranged annuity quotes from major insurance companies to see what kind of pension Tom could buy with his current level of savings, if he were to retire today. These would give Tom a good indication of the minimum level of pension he can expect to receive in a year’s time, as he will add another year’s worth of contributions and some investment returns. The average of the quotes received was for a monthly pension of around R10 000 which is in line with Tom’s target pension. Being very risk averse, Tom decided to place all his assets in cash to remove all the investment risk, or so he thought. A year passed and Tom again obtained several quotes from leading insurance companies and to his utter disbelief the best quote was for a mere R6 000 per month. How could this be, considering he invested all his assets in cash, contributed regularly, and also worked a year longer?

Where did things go wrong?

Answer: Unfortunately Tom did not know or did not understand that cash is not the asset with the least risk for someone who wants to buy an annuity at retirement. Cash will always ensure that you do not loose capital but it is not effective to protect the pension income someone wants to buy when interest rates are on a downward trend. What happened to Tom is that the cost of his pension increased by 40% over the last 12 months due to a reduction in long term interest rates. The result was that even though Tom’s capital was protected, his assets did not grow by the necessary 40% to offset the increase in the cost of the annuity. A scenario like this may happen soon if the market believes inflation will decrease, causing bond yields to decrease as well.

Lesson: Tom was unknowingly exposed to uncompensated risk.

Solution: Sanlam has developed the Sanlam Asset Liability Portfolios (Preserver, Pensioner and Lifestage) specifically to serve as an asset with the least risk for people like Tom who want to purchase an annuity at retirement and who would like to reduce their risk. These portfolios will perform in line with the change in cost of a monthly pension and therefore protect investors against unpleasant surprises caused by changing interest rates.

Only by fully understanding your definition of risk can you make informed investment decisions.

Click here to read the Sanlam Asset Liability Watch (PDF file 120kb)

The SALI Team
Sanlam Investment Management