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Smoothed Bonus Funds and their Practices Explained

08 June 2006 Lucienne Fild

In a recent determination, the Pension Funds Adjudicator raised a number of questions about smoothed bonus funds, their use of the Market Value Adjuster (MVA) and the purpose of smoothed bonus fund stabilisation reserves.

Jannie Venter, convener of the Life Offices Association (LOA) Products Standing Committee, says while it is not the intention of the LOA to comment on the actual ruling, it is important to explain how the practices mentioned above are used to protect policyholders, both by South African life insurers as well as international financial services providers.

Venter also points out that during the demutualisation of life insurance companies some years back, the workings of smoothed bonus funds were described in detail in the Demutualisation Rules.

These Rules were approved by the High Court to ensure adequate policyholder protection after demutualisation. Included in these rules are detailed descriptions of how these funds are managed, including how and when Market Value Adjusters can be applied and how they work.  The High Court recognized that these mechanisms are necessary for the protection of policyholders.

Understanding smoothed bonus funds

In South Africa they are called smoothed bonus funds, while the British invest in a similar product referred to as with-profit funds. Both essentially operate in similar ways.

Designed to combine stability with the benefits of stock market exposure, smoothed bonus funds aim to provide investors with inflation-beating smoothed returns over the medium-to-long-term (these funds are only available through life policies for a minimum term of five years or through retirement annuities). These funds are designed to smooth out the fluctuations in the market returns of the underlying assets, namely local equity, property, fixed interest instruments, as well as foreign securities. 

Venter explains that this is achieved by retaining a portion of the returns during times of excellent market performance in order to beef up the investment returns in bear markets.

Returns are allocated to policyholders in the form of an annual bonus. The percentage depends on the state of the funds reserves, as well as the companys outlook for investment markets. Bonuses are normally declared annually and added to the fund value.

Venter points out that bonus rates are not arbitrarily determined. They need to be approved by a companys Statutory Actuary, who needs to comply with professional guidance notes which cover smoothed bonus business.

It is common for a portion of the annual bonus to be guaranteed. That means it cannot be taken away from investors once it has been declared, provided the policy is held until maturity. Further, it is also common for a minimum bonus to be guaranteed over the term of the policy, often in the form of a minimum maturity value.

An interim bonus rate is set at the same time as the Smoothed Bonus rate is declared. It is set in advance with the aim of providing a fair return to policyholders who exit the fund due to contractual claims prior to the next bonus declaration. The interim rate may be adjusted upwards or downwards during the year depending on market movements to ensure fair values for both exiting policyholders as well as those who remain invested.

The Market Value Adjuster (MVA)

During extremely adverse market conditions a downward adjustment may be applied to the policy values of clients leaving the smoothed bonus fund before the maturity date. A common exception is if the early exit is as a result of the policyholder passing away, in which case no adjustment will be made.

Venter says if the market value of the fund is less than the smoothed value, the fund - and hence the remaining policyholders - will suffer a loss on claims paying out the smoothed value.

The MVA therefore provides the market value, rather than the smoothed value, to investors who choose to leave the fund early. The aim is to protect the interests of those investors who remain in the fund by making sure that the assets available are not eroded by investors leaving the fund during a market downturn. The fund needs this protection because policyholders can choose to leave early, and hence select against the fund.

He explains that smoothed bonus funds do not apply positive MVAs in times of good market conditions for similar reasons.

If a fund has to pay out a value over and above the smoothed value of the fund, it would not be able to build up a stabilisation reserve, because there would be no funds to hold back. So it is treating maturing policies and those leaving early in the same manner.

Stabilisation reserves

A smoothed bonus fund enables policyholders to share in the investment returns accrued in a fund through bonuses. Not all of the returns are apportioned to clients via bonuses. Some of the money is held back in years of good market performance to bolster the stabilisation reserves, which allow the fund to smooth the effects of poor market performance.

Venter stresses that no portion of these reserves is ever distributed to shareholders in life companies.  However, he says, the life company is the final guarantor of the health of the fund, should the smoothing mechanism fail.  For this guarantee, the life company charges a guarantee fee against the fund.  

Smoothing versus marked-linked investments

Venter says research shows that over the longer-term the returns of smoothed funds are very competitive relative to those delivered by market-linked balanced portfolios. In addition, the market-linked portfolios do not provide the stability of returns offered by smoothed bonus portfolios.

The smoothed bonus fund, through the smoothing process, also significantly reduces exposure to short-term investment market volatility. This is very important for policyholders who cannot delay taking the policy benefits and cannot afford to be directly exposed to the market right up to the maturity date of their policies.

Before investing in smoothed bonus funds investors should:

 -  Check the long-term track record of actual bonus declarations delivered by the smoothed bonus portfolio you are considering.
 -  Consider their appetite for risk. Smoothed bonus portfolios were not designed to outperform equities over the longer-term. Therefore, if you have a long-term view and you can stomach the equity roller coaster, you may want to consider more aggressive investment options for a portion of your investment portfolio

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