The Evolution of Retirement Fund Benefit Provision

Retirement funds have evolved considerably in the last 20 years. Members are now afforded not only more say, but also have more responsibility in the management of their fund, and in the choices they have.

Traditionally, Defined Benefit Funds provided a retirement benefit that was directly related to the employee’s salary just prior to retirement. Funds were designed in such a way to ensure that, provided sufficient service was achieved, members were able to ensure that post retirement they would receive a reasonable pension compared to their pre-retirement salary.

Employer’s risk

Krishen Sukdev, an Employee Benefits Consulting Actuary for Aon South Africa, explains that in determining the costs of the fund, assumptions were made about salary increases and investment returns, and if the actual experience of the scheme differed from the assumptions made, the risks lay with the employer.

Risks transferred

Sukdev says that the evolution to Defined Contribution Schemes transferred the investment risks to members. "If investment returns were poor, the growth of member fund credits would be lower, and members could also benefit from favourable investment conditions. Trustees need to consider how investment returns earned in the market would be transferred to members. Traditionally, Defined Contribution Funds held an investment reserve at a fund level to smooth the returns from year to year – the investment reserve effectively acted as a buffer against poor or negative returns.

"However, this protection was mainly a short-term type of insurance against market volatility and this helped particularly those closest to retirement, whose fund credits could be a reliable indicator of the actual benefit they would eventually receive. In the long-term, however, the returns granted to members would need to correlate to the actual returns earned in the market."

Members carry poor performance risk

Sukdev says legislation now requires exiting members to receive their portion of the investment reserve. "This effectively compromises the fund’s ability to smooth investment returns from year to year and increasingly funds are now moving towards a unitised system of determining fund credits," says Sukdev. "Members own a number of units in investment portfolios and the value of these units fluctuate with market movements. When members exit they receive the market value of the units they hold and the risks of poor investment performance lie entirely with the members.”

Risks vs performance

These risks may, however, be mitigated by choosing a more conservative investment portfolio – although Sukdev warns that the choice of a more conservative investment portfolio may cost the member in terms of investment underperformance in the long term. "There is thus a delicate balance between choosing options providing higher capital security with the risk of underperformance, and opting for a higher equity exposure with the risk of greater market volatility."

More choice

These unitised portfolios could include individual investment choice, permitting members to choose their own portfolios. This can be a very intimidating prospect for them though, and it is important for Trustees to provide sufficient quantity and quality information for these choices to be made.

"Choices, however, are not limited to investment portfolios alone – members may also be required to choose their desired level of risk benefits," says Sukdev. "In a typical flexi-benefit arrangement the fund would provide a core level of risk benefits and members could buy up additional benefits if required. Members may also be able to increase their contributions to the fund to improve their retirement benefits."