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The trouble with smoothed bonus funds

22 June 2007 Gareth Stokes

Old Mutual recently launched its new generation of real return investment portfolios. The Absolute Growth Portfolios will provide institutional investors with a better option than the existing smoothed bonus funds on offer. (Click on the heading to rea

Old Mutual believes that these funds address most of the negatives currently associated with products in the smoothed bonus market. According to Tim Cumming, Managing Director of Old Mutual Corporate: "This approach, along with a significantly higher exposure to equities and alternative investments than traditional smoothed bonus funds, will enable the portfolios to compete strongly with market-related funds, while still offering investors protection from short-term market volatility."

One of the main reasons for a real return fund is to smooth out market volatility by aggregating performance over a number of periods. Fanews Online took some time to talk to Trevor Pascoe, Head of Investment Services at Old Mutual Corporate, to find out more.

The house view

Pascoe mentioned that Old Mutual had been active in the corporate retirement fund space (guaranteed funds) for around 40 years. The group introduced a fully vested option called Core Growth in 1997 before migrating to a more direct contribution valued option called Genesis.

Pascoe acknowledged that smoothed bonus products "had been in decline, basically since the late 1990s." Part of the reason was a belief that the administration of smoothed bonus portfolios was a black box. "We didn't know what was happening under the hood and what was happening with charges." Most of these concerns would, Pascoe believed, be addressed by the new product.

The Absolute Growth Portfolios offered better returns and more efficient fee structures than the Genesis products and would assist in reversing the decline in this type of retirement investment. The three options, said Pascoe, included the Absolute Smooth Growth with a 50% capital guarantee, the Absolute Stable Growth with an 80% capital guarantee and the Absolute Secure Growth with a 100% capital guarantee. The protected capital in these products was equal to the capital invested plus bonuses declared.

Smoothing the peaks and filling the troughs for a stable return

A smoothed bonus product is designed to "take out the troughs and smooth out the peaks," in an often volatile market environment. Pascoe believes that smoothing strategies do not impair returns as significantly as other strategies employed to deal with volatility. Funds which counter volatility through large cash and bond exposure will end up with impaired performance.

"The risk of short-term market volatility is significantly reduced through the use of a smoothing philosophy. The portfolios use a reserving mechanism to absorb the impact of the peaks and troughs associated with investing in balanced portfolios, whilst in the longer term delivering net real returns to investors in line with such exposure," said Pascoe.

He expects the Absolute Growth Portfolios to outperform the existing product range by about half a percent per annum, mostly because of the increase in equity as a percentage of the total asset mix.

Addressing transparency in smoothed bonus products

As mentioned earlier, one of the reasons for the Old Mutual product launch was to address industry concerns that existed in the smoothed bonus fund environment. These concerns included a conservative investment mandate, difficulties in understanding the product, transparency in bonus application and excessive fees.

Many analysts feared that smoothed bonus funds were operated too conservatively and that returns on such funds lagged balanced portfolios by some margin. Decision makers were unhappy with the calculations applied to smoothed bonus funds and unsure of how bonuses were applied to the fund.

Pascoe noted that Old Mutual had attempted to address these issues though "a complete review of the mandate, to be more aggressive and target explicit CPI plus targets, so that funds have investment policy statements for targets over three year rolling periods." The new funds have an explicit target linked to a transparent bonus formula.

Fees remain an issue

The greater transparency reveals that fees quickly mount up on these products. The 100% guarantee option incurs a capital charge of 2.7%. There are presently no other product offerings with similar terms to compare on a cost basis.

Pascoe revealed that Old Mutual currently has R60 billion placed with these funds. He believed the CPI plus targets were realistic in light of historic market returns. A 'back test' of the new product performances revealed promising results.

In summary, Pascoe said that absolute return funds should be able to meet their performance targets. "Equities should over the long term earn you 7% plus inflation and bonds are going to give us CPI plus 3.5% over the long term."

Editor's thoughts:
My first encounter with smoothed bonus funds left me confused about how the insurance company calculated their share of the profits. In my experience, the more confusing a product is, the more difficult it is to evaluate it and compare it to other products providing
similar outcomes. Do companies in the life industry still use complicated formulas to hide the true cost of their products? Send your comments to

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