Trustees must focus on retirement fund liabilities
The revised Regulation 28 has many implications for pension fund trustees. Aside from expanding on various retirement industry definitions this rules-based regulation introduces important fund governance principles. “By understanding and implementing thes
“This is the first time the regulators have stipulated that trustees must consider the fund liabilities when investing,” Anderson says. Matching of assets to liabilities is not a new concept. When the retirement fund industry was predominantly defined benefit (DB) employers focused intensely on their funds’ obligation to members due to their financial liability in meeting these liabilities. The advent of defined contribution (DC) funds meant that the risk in retirement provisioning passed from employer to employee. In the years since it seems trustees (and members) have forgotten about fund liabilities in favour of return. “How many of your funds – at member level – know their number?” asked Anderson. “And do they have a plan to deliver it?”
Know your number
A member’s “number” is the amount of capital required at retirement to sustain the expected lifestyle. And a fund’s number is simply the sum of its member numbers. A typical retirement fund aims for this number by investing in balanced or CPI +5 funds… But Anderson says this strategy, when viewed in isolation, no longer meets the requirement of Regulation 28. Under the new regulation trustees should select investment vehicles “within a liability driven investment framework”. Many investment professionals are sceptical about a liability focus. They argue that CPI +5 has been historically achievable in South Africa thanks to reasonable equity weightings in funds and a solid long-term stock market performance.
The flaw in the return-based investment focus is clearly illustrated in the domestic market. Anderson used data from Alexander Forbes retirement fund member surveys – based on their universe of some 700, 000 savers – to paint a rather frightening picture. First – he reminded the audience of the staggering inflation-plus performance in many retirement fund investments. Over the past decade South African balanced funds have achieved 8% real return. But despite this return the bulk of the country’s savers were worse off at 31 December 2011 than at 1 June 2001. At the earlier date the survey reveals that most funds (for most members) were on track for a 75% replacement ratio. By the beginning of 2012 the expected replacement ratio had slipped to 63% (for 30-year olds), 69% (40-year olds) and 67% (50-year olds). Why? How can we be going backwards when investment returns have been so impressive?
“The reason is that fund liabilities are moving at a higher pace than people expected in 2001,” answers Anderson. “The cost of retiring is increasing, people are living longer. Salary increases have outstripped inflation and real yields are lower than expected – with the result the amount of capital required to buy an annuity income has increased significantly!” Trustees have to change their approach by looking at the target (or fund liability) and then managing fund assets to that target. To achieve this goal trustees may have to adjust benefit structures as well as the asset mix in the fund.
Measuring fund liabilities
Regulation 28 reveals flaws in retirement funds’ traditional approaches to liability management. It is incorrect to assume assets and liabilities are “matched” simply because the fund’s ring-fenced assets equal the liabilities recorded on the system. Anderson says this practice takes care of accounting risk only, and needs to change to assess liability from the member’s perspective. Retirement fund members do not care if their fund hits CPI +5 – and they do not care if assets match liabilities in the fund accounts – what they care about is the pension they get at retirement. After all, retirement funds exist to provide a good income (relative to final salary) in retirement.
Life-stage portfolios – already utilised by around two thirds of South Africa’s retirement savers – approximate a liability-based focus. Anderson showed the performance of back-tested life-stage portfolios, genuine liability driven strategies and strategies optimised to achieve pre-determined net replacement ratios to further illustrate the principle. Liability driven strategies (including life-state portfolio) offer a more certain outcome. They are more likely to meet a retirement fund’s liability target!
The future of retirement fund administration
The principles in the new regulation could force a rethink of the net replacement ratio. Is 75% still acceptable? If it is – is it sensible for each and every fund member? Certain members may require a replacement ratio in excess of the current “norm”. Focusing on outperforming inflation, benchmarks or peer groups is the old way of managing retirement funds. Today’s trustee should look at how to meet their liabilities. One suggestion is for fund trustees to appoint a liability manager – someone who keeps a close watch on annuity rates, interest rate changes and wage inflation, among other factors.
“Trustees must be aware that the outcome the member achieves is dependent on the strategy they put in place. Make sure you focus on the liabilities – with appropriate modelling to the required net replacement ratio – and consider each of the fund building blocks to determine whether they are adding value,” concludes Anderson.
Editor’s thoughts: It is possible to compare retirement to a road trip. You need to know where the journey begins, where it ends and both the route and vehicle you intend to complete it with. Would you agree that retirement funds are too focused on the target (the net replacement ratio) than the appropriateness of the target (what the ratio should be)? Add your comment below, or send it to [email protected]
