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Babies and bathwater: A comparison of unit trust and underwritten retirement annuity funds

03 May 2007 Karin MacKenzie

Retirement Annuity Funds (“RA funds”) have been the subject of much unfavourable press in recent years, mostly due to the high costing structures. This article was first published in the Industrial Law Journal, January 2007, and is reproduced with the pe

But not all RA funds engage in the sort of practices that have become the focus of such negative attention, and there is a real danger of jettisoning a very valuable segment of the retirement industry when both are tarred by the same brush. This article is aimed at a comparison between two distinct models of RA fund: the underwritten fund and the unit trust fund.

The different manner in which these respective types of fund are structured determines the method by which administrative and other costs are recovered from members, and consequently also the extent of the associated costs. Historically it has also impacted on the question of freedom of transferability between funds.

The description that follows is not intended as an exhaustive definition of either type of fund, but simply a brief sketch of the main features of each. Firstly, though, it may be helpful to distinguish a RA fund from other types of pension fund.

RA funds and the Income Tax Act

The concept of a RA fund was introduced into the Income Tax Act 1 by an amendment whose purpose was to incentivise savings for retirement funding outside of the traditional occupational pension funds, through tax concessions.

This was to afford people who were not members of pension funds through their employment circumstances the opportunity of saving for retirement in a tax-effective manner. Such groups include the self-employed, and employees whose service conditions do not include membership of a pension fund. In addition, persons who wish to supplement their occupational retirement funding can also use RA funds as vehicles.

It is important to note in this regard that non-compliance with the provisions of the Income Tax Act by a RA fund does not deprive it of the status of a pension fund, but it could negate its preferential tax status to the detriment of its members. Accordingly, in order to preserve this financial advantage, RA funds are structured in a way that align them with the requirements of the Income Tax Act, and this is reflected in the obligations and entitlements set out in the rules of the fund concerned.

In broad summary, the most important requirements of RA funds in terms of the Income Tax Act are that they undertake to provide for retirement benefits between the ages of 55 and 70, and that a member may not access the savings prior to age 55, unless he becomes permanently disabled 2. The fund investment may however be transferred to another pension fund. There is therefore no provision for a withdrawal benefit, unlike most occupational funds, which is in line with the policy of incentivising preservation of savings until retirement.

In addition, unlike provident pension funds, a RA fund is precluded from paying out the whole benefit at retirement. The member may only take up to one third of it in cash, and the remainder must be utilised to fund an annuity from the fund, or to purchase an annuity from a registered insurer. In this respect the structure is similar to that of a pension (as opposed to provident) fund.

In summary then, a RA fund is characterized by direct member participation (ie there is no involvement of a participating employer), compulsory preservation of the benefit until retirement, and compulsory preservation of two thirds of the benefit in the form of a pension after retirement.

The underwritten RA fund

An underwritten fund is one whose liability to pay benefits to its members is fully underwritten (or insured) by an insurer. Underwritten funds are not restricted to RA format, and many umbrella funds, provident and pension, also utilize this form of funding. In practice what occurs is that the contributions payable by or on behalf of the member are paid directly in the form of premiums to an insurer to fund an individual life policy held in the name of the fund in respect of each member.

The underwritten model falls within the ambit of section 2(3)(a) of the Pension Funds Act 3, which applies to all pension funds (not just RA funds) that structure their investments in this manner. This section allows the Registrar of Pension Funds (“the Registrar”) to exempt funds from certain requirements contained in the Act.

The important one here is exemption from valuation in circumstances where the fund assets match the liabilities by virtue of the financial structure of the fund 4. Thus, a fund whose sole investments comprise individual insurance policies in respect of its members, and which is administered by one of the insurance companies in which it is invested, is usually given valuation exempt status, provided certain requirements are met.

One such requirement is that the fund may not operate its own bank account, and that the contributions received are paid directly over to the insurer as premiums on the policies underlying its liabilities to members. In this way, the administration, and importantly the determination of the cost of administration to be recovered from individual members, is for all practical purposes passed on to the administering insurer 5.

The implication of valuation exemption status to a pension fund is simply that it is not required to account for its funding levels or the value of its underlying investments to the Registrar.

For this reason the Registrar’s powers to oversee, and intervene in, the investment performance of the fund, and the benefits accruing to individual members, are severely circumscribed. In this regard it seems that the legislature was satisfied that the retirement investments concerned would be suitably protected by the legislative and regulatory framework relating to registered insurers.

This, as will become apparent below, was probably an over-optimistic view that has been largely responsible for the creation of the underwritten RA fund. It must be said, in view of the practices that have come to light over the past several years, that large question marks loom over the appropriateness of these vehicles to retirement funding.

An underwritten RA fund is therefore a pension fund that is funded exclusively by life policies in respect of each member.

The unit trust RA fund

In contrast, unit trust RA funds are invested directly in the market. In this respect, they resemble more closely the defined contribution model. Broadly stated, the contributions received are used to purchase units in the selected portfolio (usually ranging from conservative to aggressive investment).

The member’s fund share is credited with the contributions received together with market growth, which return can be either positive or negative. In a RA fund context, a unit trust model operates without the involvement of a participating employer, and is subject to the other requirements contained in the Income Tax Act (age of retirement, and compulsory preservation).

At the risk of stating the obvious, there is no participation of an insurer in the sense of underwriting of the investment or the issuing of individual life policies. It may be, and is often the case, that a registered insurer (in its capacity of service provider) sets up and administers the fund, but its involvement is restricted to management of the assets in the market.

A unit trust fund, because it is does not consist solely of individual life policies, is not usually valuation exempt. This means that it is accountable to the Registrar for its performance and strategies, and is obliged to report on its investments and funding levels.

Product design and cost recovery

Underwritten

The fact that underwritten funds are invested exclusively in insurance products effectively gives rise to a duplication in cost structures. The member is paying firstly for the cost of management of the underlying market assets (as in a unit trust model), and secondly for the costs incurred in designing, marketing, and administering the individual life policy that perches on top of the market investment, so to speak.

The life policies are marketed on the basis, firstly, that they are tax-incentivised, and secondly, that they offer a guaranteed minimum retirement benefit. The tax advantage is straightforward: because the product is sold through the medium of a RA fund, the member obtains tax relief (up to 15% of gross income in the present tax dispensation) on the contributions he makes to the fund, less any tax deduction he is already receiving in respect of other pension fund contributions.

The guarantee: this is usually pitched at a very conservative level, based on long-term activity of the financial markets, and the fund’s ability to outperform inflationary indexes. The guarantee, moreover, is only operative provided the member adheres to the terms of the underlying insurance policy, ie he does not cease contributions, reduce them, or retire earlier than initially indicated.

But what does the member sacrifice in exchange for these advantages? In short, he pays a substantial “guarantee” fee for the minimum benefit, and more importantly, he foots the bill for the product development, marketing, administration, and business procurement fees of the insurer in developing the product.

In order for an insurer to set up and administer a fund which operates by way of life insurance policies, the insurer incurs substantial product development and marketing fees. This includes the initial model design by actuaries and other experts, who have to satisfy themselves that the fund can pay out the retirement benefits in accordance with the minimum guarantees as and when they become due.

It also includes the administrative apparatus of the scheme, and the market capture costs of attracting membership, a substantial component of which is the commission paid to brokers or financial advisers who turn business the fund’s way. Until recently, the commission paid has been structured on the basis of upfront loading.

In other words, the entire commission payable over the life of the product (usually several decades) is paid by the insurer to the broker over the first two years of membership. The commission is based on a percentage of the total contributions (including increases), and is recovered by the insurer from the member over the term of the policy.

However, it is not just the commission structure which is effectively an up-front commitment. In addition to the commission recoverable from each member, the overall costs of the scheme described above, both developmental and ongoing, are factored into each member’s individual policy on a pro rata basis, and amortised over the life of the policy, that is until maturity (agreed retirement date).

These costs, together with the commission recoverable, are then deducted on a monthly basis in the form of administration fees, on the assumption that the policy will run to full term.

Because the insurance policies are governed by the Long Term Insurance Act 6, it is not possible to defray the overall expenses of one policy against the fund as a whole (which consists of the remaining policies), since this would entail a measure of anti-selection, or a situation where the remaining policies are subsidizing the costs of the policy that is terminated or reduced prior to full term 7.

The implications of this are that if a policy is surrendered, or contributions are reduced, or the retirement date is advanced, the overall pro rata costs outstanding in respect of the full term of the policy are accelerated and debited as a lump sum against the fund share standing to the credit of the member.

This can lead to particularly iniquitous results if alterations are made to the initially agreed terms in the early life of a policy (or fund membership) as will appear from the examples below.

Smoothed bonus products - a minor digression

Smoothed bonus investments are an additional form of “guaranteed” investment (over and above the minimum retirement “guarantee”) offered within the stable of underwritten funds.

The principle involved is that the member pays (through increased administration costs) an additional premium for the “guarantee” that should his retirement date co-incide with a downturn in the market, his benefit will be “smoothed” by being averaged over the preceding or forthcoming few years.

This, of course, is a form of cross-subsidisation within the fund, and simply means that a portion of actual investment returns in years of healthy market performance is withheld in order to meet the guarantees of the fund in respect of exits in years of poor or negative return. However, once again, this only applies if the member adheres to all the initially agreed terms.

Should he exit earlier than initially agreed (having already paid the premium for the “guarantee”), the guarantee is voided, and a so-called “Market Value Adjuster” (“MVA”) is applied, meaning that his benefit is adjusted downwards (never upwards) to the actual underlying market value of the investments at the time of exit 8.

The aspirant investor in an underwritten fund needs to weigh up from the aforegoing whether the “guarantees” offered are worth the cost of substantially increased administrative and management costs, as well as the very real risk that all the advantages offered only apply in the event that he can continue to sustain the contributions over a protracted period.

Should he lapse, so will the guarantees ...But the cost of them, calculated over the full term of the policy, will remain, and be debited to his retirement investment.

Unit trust

The unit trust model is much more briefly described. The tax advantage is precisely the same as that in an underwritten RA fund, ie up to 15% of gross income. However, there is no “perching structure” of insurance products and the “guarantees” that they offer.

It is a straightforward market investment, with all the attendant risks of investment performance that such a product entails. But it is also much less expensive in terms of costs. Unit trust RA funds usually permit direct member participation without requiring the involvement of a financial adviser or broker, thereby cutting down on what is effectively a direct marketing cost of its underwritten counterpart.

Administrative costs in a unit trust model are based on an ongoing management fee for as long as the membership subsists. The asset management fee is usually calculated as a percentage of annual fund value, and is often performance based in relation to a benchmark.

This in itself incentivises the asset managers to take an active role in maximizing returns. Upfront costs are seldom charged, but when they are, it is usually in the form of a nominal levy on contributions received.

Administration costs are recovered through the management fee, although sometimes an additional charge is levied, usually when the member is invested in funds not directly managed by the financial institution which established the RA fund. This is because the funds themselves are charged a platform fee for participating in other funds.

The upfront costs are therefore non-existent or substantially less than those of the underwritten fund, and are paid as and when contributions are received. There is no further deduction of ongoing “start-up” costs over the life of the membership, and the costs are therefore significantly lower. For the same reason there is no precipitous debiting against fund share should contributions cease or reduce, or membership terminate prematurely.

Areas of comparison between the two models

The following comparisons flow directly from the differing nature of the product design.

What percentage of your retirement savings is being channeled to costs?

The table below is reproduced from a paper by a consulting actuary, Rob Rusconi 9. Unfortunately more recent data is not presently available, but the comparison is still instructive from the point of view of the patterns it demonstrates. It should be mentioned that many underwritten funds have made efforts over the past few years to improve their costing structures, although these are largely only reflected in the so-called “new generation” products.

“Table 15: Summary comparison of South African savings channels

Charge ratio

Reduction in yield

Channel

Low

High

Low

High

Retirement funds
(narrow range)

Retirement funds
(wide range)

Individual policies

26.7%

43.2%

1.50%

2.80%

Unit trust products

22.3%

32.5%

1.20%

1.95%

Note: These are not designed to be directly comparable. Definitions of ranges, in particular, have been determined in different ways and are intended to give a reasonable impression of the spread of results.

Source: Various sources as disclosed in sections 6.1, 6.2 and 6.3.”

Mr Rusconi also makes it clear that in calculating the costs associated with individual policies, he did not include the guarantee charges incurred in smoothed bonus arrangements 10.

These, he states, are typically provided at an additional annual charge of a little over 1% of assets 11. If one adds this to the costs in the underwritten fund (since they are not offered in the unit trust model), the following corresponding charge ratios are obtained 12:

Charge ratio

Reduction in yield

Channel

Low

High

Low

High

Smoothed bonus
Individual policies

39.8%

52.7%

2.50%

3.80%

From the above it is apparent that the average reduction in yield (the percentage deducted annually from the member’s full fund value in respect of costs) to a member in a unit trust fund is only 70 – 80% of that of his counterpart in an underwritten fund. It is even less compared with a smoothed bonus underwritten fund.

In this case costs in a unit trust fund would amount to a little over half of the equivalent costs in the underwritten fund. Looked at from another perspective, the costs in a unit trust fund consume from 22 to 33% of the gross value of savings over term, compared with the underwritten RA fund at 27 to 43%.

In a smoothed bonus underwritten fund this ratio is still higher and can lead to an alarming erosion through costs of 40 to 53% of savings.

The following factors determine the end value of the member’s fund share: investment returns, the percentage of return that is diverted to costs, and (in the case of smoothed bonus underwritten funds) the portion of fund return held back by the insurer in order to service its guarantees to exiting members.

The escalation in management fees in the underwritten fund is directly attributable to the need to re-imburse all the middlemen: the broker, the insurer, its shareholders, and its actuaries and product development team, as well as the premium paid to compensate the insurer for providing protection against investment risk.

The question to be asked here is how much value does all of this add?

Considering that both funds, underwritten and unit trust, are ultimately invested in substantially the same market, and very often use the same asset management teams, there is probably not much difference in the performance of the underlying investment.

This is particularly so when the investment is long-term, as is usually the case with retirement funding, since the market has plenty of time to correct itself. The member also has the option of switching underlying investments as the retirement date approaches, in order to take advantage of the reduced risk of a more conservative portfolio.

What happens when the member ceases contributions, reduces contributions, advances his retirement date or increases contributions?

In the event of contribution cessation, reduction, or early retirement in an underwritten RA fund, the fund share is immediately debited with the outstanding start-up costs in respect of the underlying life policy, or a pro-rata portion thereof in the case of contribution reduction.

This is because the insurer will no longer have the opportunity of recovering those costs over the life of the policy. Examples of the devastating effect of such “recoveries” have been highlighted in many of the rulings of the Pension Funds Adjudicator (“the Adjudicator”).

See for instance De Sousa v Lifestyle Retirement Annuity Fund and Another 13, where an amount of R37 983 was contributed into the fund over a period of ten months. On premature cessation of contributions, the net investment value was reflected as R5 637. Investigation revealed that an “adjustment” of close to R31 600 had been applied to the fund value. This amounted to a retention by the insurer of 83% of the contributions paid (before adding any investment return earned on that amount).

Another illustration of this principle occurred in Du Plessis v Lifesyle Retirement Annuity Fund and Another 14. In this case the member contributed R232 408 over a two year period. When he ceased contributions, his fund value stood at R236 453. The insurer then effected a deduction of R134 778 from the underlying policy in respect of unrecovered costs, leaving the member with R101 674 as a retirement investment.

Should a member elect to increase his contribution level (over and above increases provided for in terms of the policy), the overall costs to be recovered from that member will be increased in proportion to the increase in contributions. This includes a percentage increase in the commission payable and recoverable, whether or not the financial adviser is still servicing the member.

Any reduction in contributions thereafter (even back to the initial level) will result in a debiting of the member’s fund value (or underlying policy value) with an amount representing the unrecovered “costs” in respect of the increase.

In a unit trust RA fund there are no penalties associated with contribution cessation or reduction, or on early retirement. Because the costs are structured on a pay-as-you-go system, and the member is only paying for funds under management without the questionable guarantees and risk hedging offered by the insurance policy, there are no outstanding costs that need to be recovered.

The investment then remains in the fund until accessed at retirement or disability, and participates in fund performance after deduction of the ongoing monthly administration fee. Similarly, in the case of advancement of retirement date, the member is entitled to the full fund value standing to his credit.

Once again there are no outstanding costs to recover. In the case of increase in contributions, if the administration fee is based on a percentage of assets under management, the costs will increase proportionately. However, unlike the underwritten fund, if the member should reduce contributions again, his administration fee will similarly be reduced.

Transparency of costs

The costing structures in underwritten funds have been opaque at best, and characterized by a marked lack of disclosure and frankness. Most members were not apprised of the fact that they would be paying directly for the commission incurred in selling them the product, or that they would be liable for a pro-rata allocation of the development and start-up costs of the fund.

One looked in vain in the rules of most underwritten funds for any meaningful indication to the member that in the event of cessation of contributions, all future expenses of the underlying policy would be accelerated and deducted from his investment, often resulting in a negative figure within the first two years.

The transparency in costing structures has improved dramatically over the past several years, owing partly to the introduction of the Financial Advisory and Intermediary Services Act (“the FAIS Act”) 15, and partly to the intense public focus that has been brought to bear on these products in recent years.

The FAIS Act specifically requires disclosure of the costs of a financial product in a manner in which the investor can understand them. In particular the member must now be informed of the amount of any commission payable.

However, the costing structures in the underwritten fund are still hard to understand for the average member, because in addition to the monthly charges that are levied, the insurer is running a parallel accounting exercise to make provision for the “debt” still owed by the member in respect of the start-up costs.

This means that in the event of any alteration to the underlying policy (for instance reduction in contributions) the costs are recalculated, and a lump sum amount is deducted from the member’s fund value. The full cost implications therefore only become apparent to a member on the happening of that event, as it requires the application of an intricate formula to recalculate the new fund value.

It follows from the above that it is difficult to quantify the costs in an underwritten RA fund, since the overall impact on a member’s benefit is completely variable, dependant on whether or not he alters the underlying policy, and if so to what extent. The quoted rates expressed as monthly fees are meaningless in the context of a member who has to make his benefit paid up (cease contributions) or retire early.

Unit trust RA funds on the other hand are fully transparent in their costing structures. As stated, there are no “hidden” costs, or costs that will be recovered on cessation or reduction of contributions. It is a much simpler model, based on a pay-as-you-go system.

The following comparison is offered of the costing structure of three different unit trust retirement annuity funds. Upfront costs are expressed as a percentage of contributions received. The asset management fee ranges from 0 to 3 % of total fund value annually, depending on which portfolio of unit trust the member is invested in.

In some funds it is performance linked, dependant on out-performance of the benchmarks. The administration fee is also deducted annually from fund value. Financial adviser fees are negotiated separately between the member and the adviser concerned.

Fund

Upfront costs

Asset Management Fee

Admin Fee

Equity Linked R A Fund

3%

1 to 1,5%

0%

Coronation R A Fund

0%

1 to 1,5%

0,2%

Allan Gray RA Fund

0%

0 to 3%

0%

In summary then, not only are the costs in a unit trust RA fund significantly lower than those in an underwritten RA fund, but the product allows for flexibility in relation to financial commitment. An underwritten fund is a little like a marriage – it requires a commitment for life. If this cannot be maintained, the member will pay dearly for the broken promise.

What happens if you want to transfer your investment?

In terms of section 1(b)(xii)(bb) of the Income Tax Act, a RA fund may permit transfer of a member’s accrued value in the fund to another RA fund prior to retirement. This provision is permissive not peremptory. In other words it allows but does not force funds to have rules providing for transfers into or out of the fund.

Traditionally the underwritten RA funds have actively prevented transfers out of their funds prior to retirement. They have done this through the simple expedient of not having transfer rules. If the fund rules do not specifically authorize a particular action, it may not be performed. The fund, through its trustees, may only do what is set forth in the rules 20.

In this regard the following of the largest RA underwritten funds do not have transfer rules: Central Retirement Annuity Fund 21, Professional Provident Society Retirement Annuity Fund 22, and South African Retirement Annuity Fund 23. The two underwritten funds which do have rules permitting transfer prior to retirement are Lifestyle Retirement Annuity Fund 24 and Momentum Retirement Annuity Fund.

However, in the case of both of these funds the right to transfer is not automatic, but requires the permission of the trustees. In addition, the transfer value is defined as the amount determined by the insurer. One can assume that, in line with all the principles set out above, this will incorporate the cost recoveries incurred in the early surrender of an underlying policy in the ordinary way.

The reason that transfers have historically been discouraged in underwritten RA funds, apart from the obvious advantage of farming a captive market, is presumably to protect the member from the financial penalties he would incur following what amounts to premature contribution cessation.

In contrast, the unit trust RA funds are not subject to the same financial restrictions imposed by the underwritten model. Since they operate on a pay-as-you-go system, there are no future cost recoveries to be debited against an accrued fund value on transfer prior to retirement. The three unit trust RA funds referred to above all permit transfer prior to retirement.

This issue recently received attention in a ruling by the Adjudicator, Browne v South African Retirement Annuity Fund and Another 25. The Adjudicator concluded that the effect of not permitting members to transfer amounted to a “lock-in” situation, which could not be in the interests of fund members, particularly if they were trapped in a long-term acrimonious relationship with the fund/service provider in whose investment strategies they had lost faith.

On the contrary, he held that it served, instead, the interests of the insurer, and that the trustees of the fund had a fiduciary duty to act in the members’ interests, especially in the situation of a conflict of interest between members and other parties. He therefore directed the trustees to effect a rule amendment permitting transfer prior to retirement, and to submit it to the Registrar for approval.

Independence of the Board of Management (trustees)

The above case also touched on a final area of comparison between the two types of RA fund, that is the role of trustees, and the necessity for their independence from financial institutions having an interest in the fund. Section 7C of the Pension Funds Act codifies the common law fiduciary duty of a trustee who is charged with the oversight of funds belonging to another.

It is an onerous relationship in which the trustee must avoid conflicts of interest and remain impartial at all times, in order best to serve the interests of members in a most objective manner. RA funds are entitled to an exemption in terms of the Pension Funds Act 26 in terms of which they are not obliged to include member elected trustees on their boards of management.

Typically, there is therefore no member representation on RA management boards. In an underwritten RA fund, the board of trustees is invariably appointed from the ranks of employees of the insurer, usually with one independent trustee. Although these board members are selected for their skill and expertise in a particular field, there can be no real contest when there is a conflict between the interests of the members and the interests of the insurer.

Such conflicts are ever-present, and inherent in the nature of the underwritten fund, where the insurer administers the fund and markets its products through the fund to generate profit for its shareholders. In many cases, sadly, the fund itself is regarded as a mere collection agent for premiums for the insurer, and the trustees, other than performing a mundane administrative function, defer all important decisions to the insurer, which effectively runs the fund.

The position of trustees in an underwritten fund was considered in Central Retirement Annuity Fund v Pension Funds Adjudicator and Another27 in which Davis, J commented as follows:

“It follows that the reasonableness of the total charges levied by the insurers from time to time in respect of the administration of the fund and the apportionment thereof among beneficiaries are considerations of which account must be taken by Applicant’s management committee. Similarly, the reasonableness of investments effected and maintained by the insurer for the fund from time to time should be examined by the management committee, if the latter is to fulfill its fiduciary responsibilities to members. In addition, the adequacy of disclosure of information which is critical to the interests of members, such as an adequate and fair explanation as to the meaning of documents which provide illustrative values at the inception of the contract as well as the adequacy of disclosure by the insurer to members from time to time, must, in the light of the analysis advanced, comprise part of the responsibilities of the management committee of applicant.”

No such conflicts exist in the unit trust RA fund. The trustees in such funds are not hamstrung by having to consider the interests of the markets or financial institutions in which they have invested the fund’s assets. The fund does not exist in a symbiotic relationship with a sponsoring insurer, and the boards of these funds therefore enjoy an independence not attainable by boards (as presently constituted) in the underwritten RA fund.

Conclusion

If one identifies the requirements of a retirement savings vehicle against the background of altered employment patterns over the past few decades, it is evident that a crucial requirement is flexibility of rate of saving.

This reflects the variable financial circumstances most people experience during their working life. However, when this change in saving rate is accompanied by penalties, or financial disincentives, the product ceases to be “flexible”.

Further requirements from the member’s point of view are portability (transferability) of the investment, and choice in the underlying investment portfolios. The right to transfer allows a member to consolidate his retirement savings, should he wish to, in order to reduce costs, and also permits him to shop around for the most competitive products.

The right to transfer is considerably watered down if the member is mulcted in unrecovered costs if he removes his savings from the fund. As far as investment choice goes, both models, underwritten and unit trust RA funds, offer a considerable variety of investment options.

These can be categorized according to the type of assets, or the investment strategy (conservative to aggressive), and in many RA funds the member has the option of participating in a wide selection of funds set up by the major financial institutions.

The major drawback to the underwritten funds in this regard is the costing structures set out above, because the fund participation is sold through life policies.

For example, a member can elect to participate in a particular portfolio with a particular financial institution or asset manager through a unit trust RA fund. In the same circumstances, he could, through an underwritten RA fund, be invested in exactly the same portfolio, with the same institution, but might be paying up to twice as much in costs because it is structured through an insurance policy.

The cost of this policy could translate to as much as an additional 25% reduction in the maturity value of the investment (up to 52,3% reduction altogether in maturity value through cost erosion over the investment term). This is a considerable price to pay for a limitation of investment risk over so long a period.

As a retirement investment option, then, it appears that the unit trust RA funds are far more suitable as savings vehicles.

There is of course a place for insurance and protection against risk, but the perennial caveat remains: do not confuse risk insurance and investment.

1. 58 of 1962

2. The funds usually also become available to the beneficiaries of the member on his death.

3. 24 of 1956

4. Regulation 2 promulgated in terms of section 2(3)(a) of the Pension Funds Act

5. The legal, as opposed to the de facto, position in this regard is beyond the scope of this paper, but the reader is referred to the comments under “Independence of the Board of Management (trustees)”.

6. 52 of 1998

7. See Old Mutual Life Assurance Company (South Africa) Ltd v the Pension Funds Adjudicator and Others Cape Provincial Division, judgment delivered on 26 October 2006 under case no 7492/2006, as yet unreported.

8. See Mungal v Protektor Preservation Provident Fund and Another [2006] 2 BPLR 149 (PFA). The ruling is presently being appealed before the High Court in the Durban and Coast Local Division.

9. “Costs of Saving for Retirement” (Presented at the 2004 Convention of the Actuarial Society of South Africa, October 2004, Cape Town), at page 105

10. page 89

11. page 89, footnote 132

12. I am indebted to Rob Rusconi for furnishing the recalculated charge ratio in this table

13. [2005] 3 BPLR 267 (PFA)

14. [2005] 5 BPLR 383 (PFA)

15. 37 of 2002

16. administered by Old Mutual Life Assurance Company South Africa Ltd

17. administered by Coronation Fund Managers

18. administered by Allan Gray Ltd

19. if it is invested in an Allan Gray fund, otherwise an administration charge is levied dependant on the costing structure of the Collective Investment Scheme chosen by the member.

20. see Tek Corporation Provident Fund and Others v Lorentz [2000] 3 BPLR 227 (SCA) at 239D

21. underwritten and administered by Sanlam Life Insurance Ltd

22. underwritten and administered by Sanlam Life Insurance Ltd

23. underwritten and administered by Old Mutual Life Assurance Company South Africa Ltd

24. underwritten and administered by Liberty Group Ltd

25. a determination of the Pension Funds Adjudicator handed down on 19 October 2006 under case no PFA/FS/5271/05, as yet unreported.

26. Section 7B

27. [2005] 8 BPLR 655 (C) at 663E-G

The different manner in which these respective types of fund are structured determines the method by which administrative and other costs are recovered from members, and consequently also the extent of the associated costs. Historically it has also impacted on the question of freedom of transferability between funds.

The description that follows is not intended as an exhaustive definition of either type of fund, but simply a brief sketch of the main features of each. Firstly, though, it may be helpful to distinguish a RA fund from other types of pension fund.

RA funds and the Income Tax Act

The concept of a RA fund was introduced into the Income Tax Act 1 by an amendment whose purpose was to incentivise savings for retirement funding outside of the traditional occupational pension funds, through tax concessions.

This was to afford people who were not members of pension funds through their employment circumstances the opportunity of saving for retirement in a tax-effective manner. Such groups include the self-employed, and employees whose service conditions do not include membership of a pension fund. In addition, persons who wish to supplement their occupational retirement funding can also use RA funds as vehicles.

It is important to note in this regard that non-compliance with the provisions of the Income Tax Act by a RA fund does not deprive it of the status of a pension fund, but it could negate its preferential tax status to the detriment of its members. Accordingly, in order to preserve this financial advantage, RA funds are structured in a way that align them with the requirements of the Income Tax Act, and this is reflected in the obligations and entitlements set out in the rules of the fund concerned.

In broad summary, the most important requirements of RA funds in terms of the Income Tax Act are that they undertake to provide for retirement benefits between the ages of 55 and 70, and that a member may not access the savings prior to age 55, unless he becomes permanently disabled 2. The fund investment may however be transferred to another pension fund. There is therefore no provision for a withdrawal benefit, unlike most occupational funds, which is in line with the policy of incentivising preservation of savings until retirement.

In addition, unlike provident pension funds, a RA fund is precluded from paying out the whole benefit at retirement. The member may only take up to one third of it in cash, and the remainder must be utilised to fund an annuity from the fund, or to purchase an annuity from a registered insurer. In this respect the structure is similar to that of a pension (as opposed to provident) fund.

In summary then, a RA fund is characterized by direct member participation (ie there is no involvement of a participating employer), compulsory preservation of the benefit until retirement, and compulsory preservation of two thirds of the benefit in the form of a pension after retirement.

The underwritten RA fund

An underwritten fund is one whose liability to pay benefits to its members is fully underwritten (or insured) by an insurer. Underwritten funds are not restricted to RA format, and many umbrella funds, provident and pension, also utilize this form of funding. In practice what occurs is that the contributions payable by or on behalf of the member are paid directly in the form of premiums to an insurer to fund an individual life policy held in the name of the fund in respect of each member.

The underwritten model falls within the ambit of section 2(3)(a) of the Pension Funds Act 3, which applies to all pension funds (not just RA funds) that structure their investments in this manner. This section allows the Registrar of Pension Funds (“the Registrar”) to exempt funds from certain requirements contained in the Act.

The important one here is exemption from valuation in circumstances where the fund assets match the liabilities by virtue of the financial structure of the fund 4. Thus, a fund whose sole investments comprise individual insurance policies in respect of its members, and which is administered by one of the insurance companies in which it is invested, is usually given valuation exempt status, provided certain requirements are met.

One such requirement is that the fund may not operate its own bank account, and that the contributions received are paid directly over to the insurer as premiums on the policies underlying its liabilities to members. In this way, the administration, and importantly the determination of the cost of administration to be recovered from individual members, is for all practical purposes passed on to the administering insurer 5.

The implication of valuation exemption status to a pension fund is simply that it is not required to account for its funding levels or the value of its underlying investments to the Registrar.

For this reason the Registrar’s powers to oversee, and intervene in, the investment performance of the fund, and the benefits accruing to individual members, are severely circumscribed. In this regard it seems that the legislature was satisfied that the retirement investments concerned would be suitably protected by the legislative and regulatory framework relating to registered insurers.

This, as will become apparent below, was probably an over-optimistic view that has been largely responsible for the creation of the underwritten RA fund. It must be said, in view of the practices that have come to light over the past several years, that large question marks loom over the appropriateness of these vehicles to retirement funding.

An underwritten RA fund is therefore a pension fund that is funded exclusively by life policies in respect of each member.

The unit trust RA fund

In contrast, unit trust RA funds are invested directly in the market. In this respect, they resemble more closely the defined contribution model. Broadly stated, the contributions received are used to purchase units in the selected portfolio (usually ranging from conservative to aggressive investment).

The member’s fund share is credited with the contributions received together with market growth, which return can be either positive or negative. In a RA fund context, a unit trust model operates without the involvement of a participating employer, and is subject to the other requirements contained in the Income Tax Act (age of retirement, and compulsory preservation).

At the risk of stating the obvious, there is no participation of an insurer in the sense of underwriting of the investment or the issuing of individual life policies. It may be, and is often the case, that a registered insurer (in its capacity of service provider) sets up and administers the fund, but its involvement is restricted to management of the assets in the market.

A unit trust fund, because it is does not consist solely of individual life policies, is not usually valuation exempt. This means that it is accountable to the Registrar for its performance and strategies, and is obliged to report on its investments and funding levels.

Product design and cost recovery

Underwritten

The fact that underwritten funds are invested exclusively in insurance products effectively gives rise to a duplication in cost structures. The member is paying firstly for the cost of management of the underlying market assets (as in a unit trust model), and secondly for the costs incurred in designing, marketing, and administering the individual life policy that perches on top of the market investment, so to speak.

The life policies are marketed on the basis, firstly, that they are tax-incentivised, and secondly, that they offer a guaranteed minimum retirement benefit. The tax advantage is straightforward: because the product is sold through the medium of a RA fund, the member obtains tax relief (up to 15% of gross income in the present tax dispensation) on the contributions he makes to the fund, less any tax deduction he is already receiving in respect of other pension fund contributions.

The guarantee: this is usually pitched at a very conservative level, based on long-term activity of the financial markets, and the fund’s ability to outperform inflationary indexes. The guarantee, moreover, is only operative provided the member adheres to the terms of the underlying insurance policy, ie he does not cease contributions, reduce them, or retire earlier than initially indicated.

But what does the member sacrifice in exchange for these advantages? In short, he pays a substantial “guarantee” fee for the minimum benefit, and more importantly, he foots the bill for the product development, marketing, administration, and business procurement fees of the insurer in developing the product.

In order for an insurer to set up and administer a fund which operates by way of life insurance policies, the insurer incurs substantial product development and marketing fees. This includes the initial model design by actuaries and other experts, who have to satisfy themselves that the fund can pay out the retirement benefits in accordance with the minimum guarantees as and when they become due.

It also includes the administrative apparatus of the scheme, and the market capture costs of attracting membership, a substantial component of which is the commission paid to brokers or financial advisers who turn business the fund’s way. Until recently, the commission paid has been structured on the basis of upfront loading.

In other words, the entire commission payable over the life of the product (usually several decades) is paid by the insurer to the broker over the first two years of membership. The commission is based on a percentage of the total contributions (including increases), and is recovered by the insurer from the member over the term of the policy.

However, it is not just the commission structure which is effectively an up-front commitment. In addition to the commission recoverable from each member, the overall costs of the scheme described above, both developmental and ongoing, are factored into each member’s individual policy on a pro rata basis, and amortised over the life of the policy, that is until maturity (agreed retirement date).

These costs, together with the commission recoverable, are then deducted on a monthly basis in the form of administration fees, on the assumption that the policy will run to full term.

Because the insurance policies are governed by the Long Term Insurance Act 6, it is not possible to defray the overall expenses of one policy against the fund as a whole (which consists of the remaining policies), since this would entail a measure of anti-selection, or a situation where the remaining policies are subsidizing the costs of the policy that is terminated or reduced prior to full term 7.

The implications of this are that if a policy is surrendered, or contributions are reduced, or the retirement date is advanced, the overall pro rata costs outstanding in respect of the full term of the policy are accelerated and debited as a lump sum against the fund share standing to the credit of the member.

This can lead to particularly iniquitous results if alterations are made to the initially agreed terms in the early life of a policy (or fund membership) as will appear from the examples below.

Smoothed bonus products - a minor digression

Smoothed bonus investments are an additional form of “guaranteed” investment (over and above the minimum retirement “guarantee”) offered within the stable of underwritten funds.

The principle involved is that the member pays (through increased administration costs) an additional premium for the “guarantee” that should his retirement date co-incide with a downturn in the market, his benefit will be “smoothed” by being averaged over the preceding or forthcoming few years.

This, of course, is a form of cross-subsidisation within the fund, and simply means that a portion of actual investment returns in years of healthy market performance is withheld in order to meet the guarantees of the fund in respect of exits in years of poor or negative return. However, once again, this only applies if the member adheres to all the initially agreed terms.

Should he exit earlier than initially agreed (having already paid the premium for the “guarantee”), the guarantee is voided, and a so-called “Market Value Adjuster” (“MVA”) is applied, meaning that his benefit is adjusted downwards (never upwards) to the actual underlying market value of the investments at the time of exit 8.

The aspirant investor in an underwritten fund needs to weigh up from the aforegoing whether the “guarantees” offered are worth the cost of substantially increased administrative and management costs, as well as the very real risk that all the advantages offered only apply in the event that he can continue to sustain the contributions over a protracted period.

Should he lapse, so will the guarantees ...But the cost of them, calculated over the full term of the policy, will remain, and be debited to his retirement investment.

Unit trust

The unit trust model is much more briefly described. The tax advantage is precisely the same as that in an underwritten RA fund, ie up to 15% of gross income. However, there is no “perching structure” of insurance products and the “guarantees” that they offer.

It is a straightforward market investment, with all the attendant risks of investment performance that such a product entails. But it is also much less expensive in terms of costs. Unit trust RA funds usually permit direct member participation without requiring the involvement of a financial adviser or broker, thereby cutting down on what is effectively a direct marketing cost of its underwritten counterpart.

Administrative costs in a unit trust model are based on an ongoing management fee for as long as the membership subsists. The asset management fee is usually calculated as a percentage of annual fund value, and is often performance based in relation to a benchmark.

This in itself incentivises the asset managers to take an active role in maximizing returns. Upfront costs are seldom charged, but when they are, it is usually in the form of a nominal levy on contributions received.

Administration costs are recovered through the management fee, although sometimes an additional charge is levied, usually when the member is invested in funds not directly managed by the financial institution which established the RA fund. This is because the funds themselves are charged a platform fee for participating in other funds.

The upfront costs are therefore non-existent or substantially less than those of the underwritten fund, and are paid as and when contributions are received. There is no further deduction of ongoing “start-up” costs over the life of the membership, and the costs are therefore significantly lower. For the same reason there is no precipitous debiting against fund share should contributions cease or reduce, or membership terminate prematurely.

Areas of comparison between the two models

The following comparisons flow directly from the differing nature of the product design.

What percentage of your retirement savings is being channeled to costs?

The table below is reproduced from a paper by a consulting actuary, Rob Rusconi 9. Unfortunately more recent data is not presently available, but the comparison is still instructive from the point of view of the patterns it demonstrates. It should be mentioned that many underwritten funds have made efforts over the past few years to improve their costing structures, although these are largely only reflected in the so-called “new generation” products.

“Table 15: Summary comparison of South African savings channels

Charge ratio

Reduction in yield

Channel

Low

High

Low

High

Retirement funds
(narrow range)

Retirement funds
(wide range)

Individual policies

26.7%

43.2%

1.50%

2.80%

Unit trust products

22.3%

32.5%

1.20%

1.95%

Note: These are not designed to be directly comparable. Definitions of ranges, in particular, have been determined in different ways and are intended to give a reasonable impression of the spread of results.

Source: Various sources as disclosed in sections 6.1, 6.2 and 6.3.”

Mr Rusconi also makes it clear that in calculating the costs associated with individual policies, he did not include the guarantee charges incurred in smoothed bonus arrangements 10.

These, he states, are typically provided at an additional annual charge of a little over 1% of assets 11. If one adds this to the costs in the underwritten fund (since they are not offered in the unit trust model), the following corresponding charge ratios are obtained 12:

Charge ratio

Reduction in yield

Channel

Low

High

Low

High

Smoothed bonus
Individual policies

39.8%

52.7%

2.50%

3.80%

From the above it is apparent that the average reduction in yield (the percentage deducted annually from the member’s full fund value in respect of costs) to a member in a unit trust fund is only 70 – 80% of that of his counterpart in an underwritten fund. It is even less compared with a smoothed bonus underwritten fund.

In this case costs in a unit trust fund would amount to a little over half of the equivalent costs in the underwritten fund. Looked at from another perspective, the costs in a unit trust fund consume from 22 to 33% of the gross value of savings over term, compared with the underwritten RA fund at 27 to 43%.

In a smoothed bonus underwritten fund this ratio is still higher and can lead to an alarming erosion through costs of 40 to 53% of savings.

The following factors determine the end value of the member’s fund share: investment returns, the percentage of return that is diverted to costs, and (in the case of smoothed bonus underwritten funds) the portion of fund return held back by the insurer in order to service its guarantees to exiting members.

The escalation in management fees in the underwritten fund is directly attributable to the need to re-imburse all the middlemen: the broker, the insurer, its shareholders, and its actuaries and product development team, as well as the premium paid to compensate the insurer for providing protection against investment risk.

The question to be asked here is how much value does all of this add?

Considering that both funds, underwritten and unit trust, are ultimately invested in substantially the same market, and very often use the same asset management teams, there is probably not much difference in the performance of the underlying investment.

This is particularly so when the investment is long-term, as is usually the case with retirement funding, since the market has plenty of time to correct itself. The member also has the option of switching underlying investments as the retirement date approaches, in order to take advantage of the reduced risk of a more conservative portfolio.

What happens when the member ceases contributions, reduces contributions, advances his retirement date or increases contributions?

In the event of contribution cessation, reduction, or early retirement in an underwritten RA fund, the fund share is immediately debited with the outstanding start-up costs in respect of the underlying life policy, or a pro-rata portion thereof in the case of contribution reduction.

This is because the insurer will no longer have the opportunity of recovering those costs over the life of the policy. Examples of the devastating effect of such “recoveries” have been highlighted in many of the rulings of the Pension Funds Adjudicator (“the Adjudicator”).

See for instance De Sousa v Lifestyle Retirement Annuity Fund and Another 13, where an amount of R37 983 was contributed into the fund over a period of ten months. On premature cessation of contributions, the net investment value was reflected as R5 637. Investigation revealed that an “adjustment” of close to R31 600 had been applied to the fund value. This amounted to a retention by the insurer of 83% of the contributions paid (before adding any investment return earned on that amount).

Another illustration of this principle occurred in Du Plessis v Lifesyle Retirement Annuity Fund and Another 14. In this case the member contributed R232 408 over a two year period. When he ceased contributions, his fund value stood at R236 453. The insurer then effected a deduction of R134 778 from the underlying policy in respect of unrecovered costs, leaving the member with R101 674 as a retirement investment.

Should a member elect to increase his contribution level (over and above increases provided for in terms of the policy), the overall costs to be recovered from that member will be increased in proportion to the increase in contributions. This includes a percentage increase in the commission payable and recoverable, whether or not the financial adviser is still servicing the member.

Any reduction in contributions thereafter (even back to the initial level) will result in a debiting of the member’s fund value (or underlying policy value) with an amount representing the unrecovered “costs” in respect of the increase.

In a unit trust RA fund there are no penalties associated with contribution cessation or reduction, or on early retirement. Because the costs are structured on a pay-as-you-go system, and the member is only paying for funds under management without the questionable guarantees and risk hedging offered by the insurance policy, there are no outstanding costs that need to be recovered.

The investment then remains in the fund until accessed at retirement or disability, and participates in fund performance after deduction of the ongoing monthly administration fee. Similarly, in the case of advancement of retirement date, the member is entitled to the full fund value standing to his credit.

Once again there are no outstanding costs to recover. In the case of increase in contributions, if the administration fee is based on a percentage of assets under management, the costs will increase proportionately. However, unlike the underwritten fund, if the member should reduce contributions again, his administration fee will similarly be reduced.

Transparency of costs

The costing structures in underwritten funds have been opaque at best, and characterized by a marked lack of disclosure and frankness. Most members were not apprised of the fact that they would be paying directly for the commission incurred in selling them the product, or that they would be liable for a pro-rata allocation of the development and start-up costs of the fund.

One looked in vain in the rules of most underwritten funds for any meaningful indication to the member that in the event of cessation of contributions, all future expenses of the underlying policy would be accelerated and deducted from his investment, often resulting in a negative figure within the first two years.

The transparency in costing structures has improved dramatically over the past several years, owing partly to the introduction of the Financial Advisory and Intermediary Services Act (“the FAIS Act”) 15, and partly to the intense public focus that has been brought to bear on these products in recent years.

The FAIS Act specifically requires disclosure of the costs of a financial product in a manner in which the investor can understand them. In particular the member must now be informed of the amount of any commission payable.

However, the costing structures in the underwritten fund are still hard to understand for the average member, because in addition to the monthly charges that are levied, the insurer is running a parallel accounting exercise to make provision for the “debt” still owed by the member in respect of the start-up costs.

This means that in the event of any alteration to the underlying policy (for instance reduction in contributions) the costs are recalculated, and a lump sum amount is deducted from the member’s fund value. The full cost implications therefore only become apparent to a member on the happening of that event, as it requires the application of an intricate formula to recalculate the new fund value.

It follows from the above that it is difficult to quantify the costs in an underwritten RA fund, since the overall impact on a member’s benefit is completely variable, dependant on whether or not he alters the underlying policy, and if so to what extent. The quoted rates expressed as monthly fees are meaningless in the context of a member who has to make his benefit paid up (cease contributions) or retire early.

Unit trust RA funds on the other hand are fully transparent in their costing structures. As stated, there are no “hidden” costs, or costs that will be recovered on cessation or reduction of contributions. It is a much simpler model, based on a pay-as-you-go system.

The following comparison is offered of the costing structure of three different unit trust retirement annuity funds. Upfront costs are expressed as a percentage of contributions received. The asset management fee ranges from 0 to 3 % of total fund value annually, depending on which portfolio of unit trust the member is invested in.

In some funds it is performance linked, dependant on out-performance of the benchmarks. The administration fee is also deducted annually from fund value. Financial adviser fees are negotiated separately between the member and the adviser concerned.

Fund

Upfront costs

Asset Management Fee

Admin Fee

Equity Linked R A Fund

3%

1 to 1,5%

0%

Coronation R A Fund

0%

1 to 1,5%

0,2%

Allan Gray RA Fund

0%

0 to 3%

0%

In summary then, not only are the costs in a unit trust RA fund significantly lower than those in an underwritten RA fund, but the product allows for flexibility in relation to financial commitment. An underwritten fund is a little like a marriage – it requires a commitment for life. If this cannot be maintained, the member will pay dearly for the broken promise.

What happens if you want to transfer your investment?

In terms of section 1(b)(xii)(bb) of the Income Tax Act, a RA fund may permit transfer of a member’s accrued value in the fund to another RA fund prior to retirement. This provision is permissive not peremptory. In other words it allows but does not force funds to have rules providing for transfers into or out of the fund.

Traditionally the underwritten RA funds have actively prevented transfers out of their funds prior to retirement. They have done this through the simple expedient of not having transfer rules. If the fund rules do not specifically authorize a particular action, it may not be performed. The fund, through its trustees, may only do what is set forth in the rules 20.

In this regard the following of the largest RA underwritten funds do not have transfer rules: Central Retirement Annuity Fund 21, Professional Provident Society Retirement Annuity Fund 22, and South African Retirement Annuity Fund 23. The two underwritten funds which do have rules permitting transfer prior to retirement are Lifestyle Retirement Annuity Fund 24 and Momentum Retirement Annuity Fund.

However, in the case of both of these funds the right to transfer is not automatic, but requires the permission of the trustees. In addition, the transfer value is defined as the amount determined by the insurer. One can assume that, in line with all the principles set out above, this will incorporate the cost recoveries incurred in the early surrender of an underlying policy in the ordinary way.

The reason that transfers have historically been discouraged in underwritten RA funds, apart from the obvious advantage of farming a captive market, is presumably to protect the member from the financial penalties he would incur following what amounts to premature contribution cessation.

In contrast, the unit trust RA funds are not subject to the same financial restrictions imposed by the underwritten model. Since they operate on a pay-as-you-go system, there are no future cost recoveries to be debited against an accrued fund value on transfer prior to retirement. The three unit trust RA funds referred to above all permit transfer prior to retirement.

This issue recently received attention in a ruling by the Adjudicator, Browne v South African Retirement Annuity Fund and Another 25. The Adjudicator concluded that the effect of not permitting members to transfer amounted to a “lock-in” situation, which could not be in the interests of fund members, particularly if they were trapped in a long-term acrimonious relationship with the fund/service provider in whose investment strategies they had lost faith.

On the contrary, he held that it served, instead, the interests of the insurer, and that the trustees of the fund had a fiduciary duty to act in the members’ interests, especially in the situation of a conflict of interest between members and other parties. He therefore directed the trustees to effect a rule amendment permitting transfer prior to retirement, and to submit it to the Registrar for approval.

Independence of the Board of Management (trustees)

The above case also touched on a final area of comparison between the two types of RA fund, that is the role of trustees, and the necessity for their independence from financial institutions having an interest in the fund. Section 7C of the Pension Funds Act codifies the common law fiduciary duty of a trustee who is charged with the oversight of funds belonging to another.

It is an onerous relationship in which the trustee must avoid conflicts of interest and remain impartial at all times, in order best to serve the interests of members in a most objective manner. RA funds are entitled to an exemption in terms of the Pension Funds Act 26 in terms of which they are not obliged to include member elected trustees on their boards of management.

Typically, there is therefore no member representation on RA management boards. In an underwritten RA fund, the board of trustees is invariably appointed from the ranks of employees of the insurer, usually with one independent trustee. Although these board members are selected for their skill and expertise in a particular field, there can be no real contest when there is a conflict between the interests of the members and the interests of the insurer.

Such conflicts are ever-present, and inherent in the nature of the underwritten fund, where the insurer administers the fund and markets its products through the fund to generate profit for its shareholders. In many cases, sadly, the fund itself is regarded as a mere collection agent for premiums for the insurer, and the trustees, other than performing a mundane administrative function, defer all important decisions to the insurer, which effectively runs the fund.

The position of trustees in an underwritten fund was considered in Central Retirement Annuity Fund v Pension Funds Adjudicator and Another27 in which Davis, J commented as follows:

“It follows that the reasonableness of the total charges levied by the insurers from time to time in respect of the administration of the fund and the apportionment thereof among beneficiaries are considerations of which account must be taken by Applicant’s management committee. Similarly, the reasonableness of investments effected and maintained by the insurer for the fund from time to time should be examined by the management committee, if the latter is to fulfill its fiduciary responsibilities to members. In addition, the adequacy of disclosure of information which is critical to the interests of members, such as an adequate and fair explanation as to the meaning of documents which provide illustrative values at the inception of the contract as well as the adequacy of disclosure by the insurer to members from time to time, must, in the light of the analysis advanced, comprise part of the responsibilities of the management committee of applicant.”

No such conflicts exist in the unit trust RA fund. The trustees in such funds are not hamstrung by having to consider the interests of the markets or financial institutions in which they have invested the fund’s assets. The fund does not exist in a symbiotic relationship with a sponsoring insurer, and the boards of these funds therefore enjoy an independence not attainable by boards (as presently constituted) in the underwritten RA fund.

Conclusion

If one identifies the requirements of a retirement savings vehicle against the background of altered employment patterns over the past few decades, it is evident that a crucial requirement is flexibility of rate of saving.

This reflects the variable financial circumstances most people experience during their working life. However, when this change in saving rate is accompanied by penalties, or financial disincentives, the product ceases to be “flexible”.

Further requirements from the member’s point of view are portability (transferability) of the investment, and choice in the underlying investment portfolios. The right to transfer allows a member to consolidate his retirement savings, should he wish to, in order to reduce costs, and also permits him to shop around for the most competitive products.

The right to transfer is considerably watered down if the member is mulcted in unrecovered costs if he removes his savings from the fund. As far as investment choice goes, both models, underwritten and unit trust RA funds, offer a considerable variety of investment options.

These can be categorized according to the type of assets, or the investment strategy (conservative to aggressive), and in many RA funds the member has the option of participating in a wide selection of funds set up by the major financial institutions.

The major drawback to the underwritten funds in this regard is the costing structures set out above, because the fund participation is sold through life policies.

For example, a member can elect to participate in a particular portfolio with a particular financial institution or asset manager through a unit trust RA fund. In the same circumstances, he could, through an underwritten RA fund, be invested in exactly the same portfolio, with the same institution, but might be paying up to twice as much in costs because it is structured through an insurance policy.

The cost of this policy could translate to as much as an additional 25% reduction in the maturity value of the investment (up to 52,3% reduction altogether in maturity value through cost erosion over the investment term). This is a considerable price to pay for a limitation of investment risk over so long a period.

As a retirement investment option, then, it appears that the unit trust RA funds are far more suitable as savings vehicles.

There is of course a place for insurance and protection against risk, but the perennial caveat remains: do not confuse risk insurance and investment.

1. 58 of 1962

2. The funds usually also become available to the beneficiaries of the member on his death.

3. 24 of 1956

4. Regulation 2 promulgated in terms of section 2(3)(a) of the Pension Funds Act

5. The legal, as opposed to the de facto, position in this regard is beyond the scope of this paper, but the reader is referred to the comments under “Independence of the Board of Management (trustees)”.

6. 52 of 1998

7. See Old Mutual Life Assurance Company (South Africa) Ltd v the Pension Funds Adjudicator and Others Cape Provincial Division, judgment delivered on 26 October 2006 under case no 7492/2006, as yet unreported.

8. See Mungal v Protektor Preservation Provident Fund and Another [2006] 2 BPLR 149 (PFA). The ruling is presently being appealed before the High Court in the Durban and Coast Local Division.

9. “Costs of Saving for Retirement” (Presented at the 2004 Convention of the Actuarial Society of South Africa, October 2004, Cape Town), at page 105

10. page 89

11. page 89, footnote 132

12. I am indebted to Rob Rusconi for furnishing the recalculated charge ratio in this table

13. [2005] 3 BPLR 267 (PFA)

14. [2005] 5 BPLR 383 (PFA)

15. 37 of 2002

16. administered by Old Mutual Life Assurance Company South Africa Ltd

17. administered by Coronation Fund Managers

18. administered by Allan Gray Ltd

19. if it is invested in an Allan Gray fund, otherwise an administration charge is levied dependant on the costing structure of the Collective Investment Scheme chosen by the member.

20. see Tek Corporation Provident Fund and Others v Lorentz [2000] 3 BPLR 227 (SCA) at 239D

21. underwritten and administered by Sanlam Life Insurance Ltd

22. underwritten and administered by Sanlam Life Insurance Ltd

23. underwritten and administered by Old Mutual Life Assurance Company South Africa Ltd

24. underwritten and administered by Liberty Group Ltd

25. a determination of the Pension Funds Adjudicator handed down on 19 October 2006 under case no PFA/FS/5271/05, as yet unreported.

26. Section 7B

27. [2005] 8 BPLR 655 (C) at 663E-G

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