Smooth bonus portfolios: the investment world’s blue jeans

Debates in the media about the costs versus benefits of smooth bonus portfolios and the role they fulfil in the retirement industry followed the release of National Treasury’s technical discussion paper ‘Charges in South African retirement funds’. The paper was a thoughtful review - including some criticism - of smooth bonus portfolios. In response to the recent commentary around smooth bonus portfolios, it is worthwhile to consider whether smooth bonus portfolios will be as durable as blue jeans and continue to fulfil an important role in the retirement industry.

 

Smooth bonus portfolios offer the best of both worlds, providing exposure to an aggressive portfolio, but with downside protection through capital preservation. The insurer provides the capital guarantee and capital preservation is therefore not achieved through a conservative asset allocation or via the use of various hedging strategies. The smoothing mechanism in smooth bonus portfolios assists in managing policyholder expectations by reducing exposure to the extreme ups and downs of investing in the market.

 

In the role smooth bonus portfolios fulfil in the industry, it is often overlooked that these portfolios also offer guaranteed benefit payments at the smoothed investment value on unexpected exits which include death, disability, resignation and retrenchment - and not just offer guaranteed benefit payments on retirement. Currently, due to a lack of preservation, these exits constitute the majority of payments from retirement funds; even if preservation is improved, death, disability and retrenchment will remain realities. During times of unexpected and emotional events one needs peace of mind and a reliable blue jean partner in one’s investment selection. Smooth bonus portfolios are also a good fit for investors who have a low tolerance for investment volatility and investors who are close to retirement and wish to protect the value of their investment from a market downturn. If capital preservation is an objective - for example in preservation funds and even for unclaimed benefit funds - smooth bonus portfolios offer a better value proposition than low risk, low return funds.

 

In the technical discussion paper, criticism was raised regarding the cost of the capital guarantee in smooth bonus portfolios; the potential exit penalty on termination; the lack of transparency and the conflict of interest between the insurer’s shareholders and its policyholders. Although the criticism was thoughtful, it is always important to consider how all the threads are woven together to make up the final product.

 

In return for the capital guarantee offered by the insurer, a capital charge is charged. The capital charge pays for the true economic cost of the investment guarantee itself, as well as the regulatory capital that the insurer must hold. The regulatory capital must be met by the insurer to ensure that the promise to the policyholder will always be honoured. The peace of mind that the investment guarantee brings comes with a price. Although it is possible for retirement funds to smooth their own investment returns, this does not provide any investment guarantee. Smoothing inside a retirement fund is equivalent to running an insurer without any capital which, if it is not managed correctly and with the necessary expertise, exposes the fund to significant risks.

 

Smooth bonus portfolios are a form of insurance against adverse market movements. The guaranteed smoothed investment value is only payable on certain insured events. Payments on non-insured events i.e. a voluntary exit or termination, will normally be paid out at the lower of the smoothed investment value and the actual underlying asset value. This feature is wrongly seen as an exit penalty. It is critical and exists to protect the remaining policyholders and prevent anti-selection in the form of sophisticated investors acting on information and skills not available to other fund members by withdrawing from the fund in times of economic turmoil purely to realise the guarantee.

 

Finally the technical discussion paper raised concerns about lack of transparency and conflict of interest between the insurer’s shareholders and its policyholders. Smooth bonus portfolios have evolved over the last few decades, have opened the black box in favour of sensible transparency and are now subject to strong governance principles to ensure that there is a strong voice representing the interests of policyholders. Numerous lines of defence protect policyholders’ interest and these include a statutory actuary who has a statutory duty to protect the interests of policyholders and committees with independent, non-executive director representation. In addition, just as it is vital for Levi to maintain a trusted brand, it is at the heart of an insurer’s vision as well. The strength of business is built upon looking beyond the numbers: because people count.

 

It is important to compare like with like. Just as jeans are different to chinos, smooth bonus portfolios are different to market-linked portfolios and they serve a different purpose. The appropriate use of smooth bonus portfolios should be promoted by improving member understanding of their features and their relative costs and benefits.

 

In the current market environment that includes local and global structural challenges, a lot of uncertainty and markets flaunting record highs, it might be an opportune time to reconsider the merits of the investment world’s blue jeans. The proof is in the performance: a respectable multi-managed partially vesting smooth bonus fund makes blue jeans talk, having achieved a real return in excess of 6% per annum over the last 10 years, net of the capital charge.

 

Yes, it makes blue jeans talk.