Retirement Investors warned of tough times ahead

With volatile economic conditions expected to prevail for the next 12 – 24 months, it is crucial that trustees and members of retirement funds proactively manage their investment risk by making use of the various protection mechanisms that are available.

This is the recent outlook released by Windall Bekker, Head of Investment Consulting at OMAC Actuaries & Consultants. He says that South African investors should prepare themselves for the knock-on effects of a potential recession in Europe and possibly even a global recession in the next 12 months.

“In a recent Bloomberg Poll, 75% of investors expected a recession in Europe with 43% expecting a global recession in the next 12 months. Our expectations are broadly in line with this poll result, however, we do not expect a full-blown recession to occur in South Africa,” he says.

Bekker also predicts that a lack of fiscal discipline, as a result of political pressure, with a corresponding increase in inflation, will continue in the near term.

Furthermore, he says increased tax rates and austerity packages especially in the US and Euro zone, with a knock-on effect on demand for resources, will impact the domestic economy negatively. “Locally, consumers can expect an increase in taxation in the form of toll roads, higher utility charges and so on to continue, with the effective tax burden on the employed rising over time,” he says.

Bekker says difficult market conditions leading to high unemployment and increased taxes will significantly reduce consumer demand for goods and services during this period.

“There will also be increasing pressure on the government to be seen to be rectifying the historical imbalances, with the nationalisation debate and unilateral land reforms affecting local and international investors’ concerns over long term property rights,’ says Bekker.

In light of this outlook, Bekker states that members’ income replacement ratios at retirement could fall, should their retirement funds be unable to meet their investment objectives. “We believe that there is a potential for stagflation (low growth combined with inflation) in the local economy, which will adversely affect replacement ratios. This will be especially relevant to the growth retirement portfolios which target high investment objectives, for example, inflation + 7% p.a. target,” he explains.

Bekker advises investors to ensure that they protect against the downside while participating in the upside. He says although the short to medium term economic outlook is negative, trustees can consider a number of strategies to proactively manage their retirement fund risk during this period of uncertainty. He recommends asset allocation, derivative overlay strategies and smoothing tools as some of the protection mechanisms trustees should consider.

Bekker explains that downside protection using active asset allocation means that the fund manager takes an overweight position in asset classes such as cash and money market that protect against losses during negative periods. Conversely, the manager takes an underweight position in asset classes that experience losses during negative periods, such as equities. “The challenge is that it usually takes the fund manager time to implement the strategy and trading costs and imperfect market timing can negatively affect the fund’s performance,” says Bekker.

He explains that a derivative overlay strategy is when the fund manager uses derivative instruments to protect against losses during negative periods. “The advantage is that the derivative structures can be implemented relatively quickly, but the challenge is that the derivative structures can be expensive during times of market volatility and are more complex to manage,” he says.

By using smoothing and guarantees, the fund manager reduces volatility risk from the fund’s returns and uses guarantees to protect the fund from capital losses. According to Bekker, the advantage of this strategy is that the fund manager can provide stable returns at very low risk with any guarantees backed by the balance sheet of a large insurance company. This allows the fund manager to target a level of growth (after costs) that could be more challenging for other strategies that are forced to move out of equities to reduce risk.

However, the disadvantage is that the smoothing strategies and guarantees can be complex to understand and an additional layer of costs is introduced. .