Smoothed bonus and recession
If you’d invested a million rand in South African equities (tracking the JSE All Share index) on 1 January 2008, your nest egg would have been worth R625 768 just 15-months later. Would you have been able to sit back and do nothing as your portfolio plumm
How do investors protect themselves from market volatility? One option, touted by many of the country’s life insurers, is the so-called smooth bonus fund (or policy). To find out whether this financial instrument really protects investors through recession we need to gain a better understanding of it. According to Metropolitan Life, smooth bonus funds are investment products with assets under management typically committed to equities, property, bonds and cash. They employ diversification strategies to mitigate investment risk and ‘smoothing’ strategies to minimise return volatility. Alex Ollewagen, Head of Investment Products at Metropolitan Life says: “Smooth bonus funds are specifically designed to protect capital, while providing reasonable and stable returns.”
How ‘smoothing’ works
The long-term objective of a smooth bonus fund is to emulate the return on an underlying index (its benchmark) without excessive volatility. Smooth bonus funds are traditionally offered as retirement annuities, endowment policies or other contractual savings products. If you invest in the product for a period of 10 years your capital should grow smoothly and consistently, without the massive dips and spikes evident on the JSE All Share index, for example. Old Mutual does this as follows: “During periods of relatively strong investment performance a portion of investment growth is not declared as a bonus. It is held back, so that in times of relatively poor investment performance, there are funds available to declare a higher bonus than would otherwise have been the case.”
The funds held back during strong investment years “are kept entirely for the future benefit of policies invested in the fund.” Old Mutual’s product brochure stresses this point a number of times. They say the benefits of a smoothed bonus policy include reduced exposure to extreme short-term ups and downs and reduced risk of market timing. Certain smoothed bonus products also offer capital guarantees. Potential investors should assess these guarantees on a product by product basis, and make sure they understand the return-limitations or other sacrifices the guarantee implies.
Does it work?
The ‘bonus’ on a smooth bonus fund is paid to investors annually and comprises of a vesting bonus and a non-vesting bonus. These bonuses are manipulated to ensure the smooth investment return the product promises. “A vesting bonus is a guaranteed return that’s effectively locked in, while a non-vesting bonus may be withdrawn if the fund performance deteriorates to unacceptably low levels,” says Ollewagen. The insurer (through its fund managers) withdraws non-vesting bonuses when applicable to protect the funding level of the fund, ensure future bonus payments and preserve capital. Investors have often treated smooth bonus funds with suspicion. But Metropolitan says its products offer improved management transparency, with each fund overseen by a Discretionary Participation Committee.
Have Metropolitan’s smooth bonus fund lived up to expectations? For some ‘real life’ experience we turned to a recent smooth bonus funds research update presented by Ollewagen. He observes that through three market crashes since 1998 there’s never been a case when Metropolitan’s smooth bonus funds failed to protect investors’ capital. He points to the group’s smooth bonus declarations in 1998 (+7.14%), 2002 (+3.5%) and 2008 (0%) compared to the JSE All Share return of -6.5%, -8.2% and -26% respectively! One side of the equation seems to work. The question is whether these products ‘pay’ acceptable returns when markets are climbing.
In the five years beginning January 2003 local equities provided unprecedented annual returns. The JSE All share was up 11% in 2003, and 22%, 38% and 16% over the next four periods. Metropolitan’s bonus declaration was 6%, 12%, 19%, 25% and 19%. It’s really in the insurers hands to determine how much of each year’s return is held for future lean years, and how much is declared as bonus. Your average return on the smooth bonus investment over the five ‘good’ years is 16.2% per annum versus the 25.97% annual average on the JSE All share. And when you include 2008 (-26% index return versus 0% bonus) the smooth bonus fund achieves 13.5% per annum, versus 17.3% on the index. This ‘gap’ narrows over time. So the question becomes how much annual return an investor is prepared to sacrifice for the benefit of long-term smoothing.
What about costs?
Are you paying for capital guarantees and the benefits of smoothing? The cost of the smooth bonus fund is incorporated in to the costs of the investment vehicle. Investors considering retirement annuities, endowment policies and the like should look out for the “reduction in yield” on quotations, which illustrate the effect of all charges on the annual return.
Editor’s thoughts: Unit trusts and exchange traded funds offer minimal protection against short-term market volatility. If you’re going to jump in and out of the market then a smooth bonus fund makes sense. But if you’re talking about a 30-year retirement annuity we get the feeling ‘time in the market’ should take care of the smoothing in itself… Are smooth bonus funds an answer – or does their attraction lessen when markets enter protracted periods of below average growth? Add your comments below, or send them to [email protected]
