Choice increases risk
INCREASED MEMBER CHOICE was one of the inherent appeals when the drive from defined benefit to defined contribution retirement funds started about 15 years ago.
Choice is good. But it needs to be accompanied by far higher levels of understanding among members and trustees, otherwise the flexibility offered by member choice becomes a minefield.
This applies not only to member choice of investment options but also to the allocation of contributions to retirement savings versus death and risk benefits.
Proposed changes to legislation are going to make these areas increasingly “dangerous” for trustees, who face personal liability and possibly even legal action from fund members.
Though the performance of the local stock market has been far from “normal” over the past three years, it could provide ammunition for fund members who feel trustees placed them in overly conservative investment portfolios.
The Pension Funds Adjudicator has been scrutinising inappropriate decision making by trustees, particularly decisions regarding investments, notes James Louw, head of implemented consulting at acsis, an independent asset consulting and financial planning company.
“The inherent volatility of investment markets coupled with potential financial losses have left retirement fund trustees searching for structures to guide their investment decision-making processes. They have thus adopted what is referred to as the age-based or life-stage banding approach to provide such guidance.”
Louw says this is largely due to the current Regulation 28 of the Pension Funds Act being “innocuous and vague”, resulting in a one-size-fits-all approach with little attention to members’ actual objectives and needs.
Louw’s problem with this approach is that it determines a risk profile for a fund or its members based on the individual’s time to retirement. “The focus is therefore on the risk profile input and not on whether the amount will actually be enough to sustain the member throughout retirement.”
A big concern with age-based strategies, he says, is that members’ individual needs are not taken into account. Investment decisions are based purely on time and investment risk, and members banded into a particular investment may not understand the consequences or implications that the trustee’s decision has on their retirement needs.
“It is therefore critical for members’ choices to be made holistically, taking into account their personal pre- and post-retirement investment and expenditure patterns, as well as their specific needs.”
There’s even more concern with the age-based approach in funds where members don’t have investment choice. Traditionally, members are moved into a low-risk portfolio, such as a money market fund, about five to 10 years before retirement. But Louw says that while it may be preferable to move into safer investment options at times, the band approach could see members “sacrificing significant potential investment growth that could be vital for their financial well-being during retirement”.
The outcome could be a “situation where a member challenges and potentially tries to sue the trustee board for lost growth due to the board defaulting that member’s investment into a particular investment portfolio”.
Louw says irrespective of whether a fund offers member investment choice, members should be encouraged to look past retirement. “Retirement should be viewed as a single point in time and members selecting low-risk portfolios before and during retirement may exhaust their savings before death.”
Further complications around member choice relate to the increasing cost of risk benefits. In defined contribution funds, the amount allocated to retirement funding has often decreased accordingly, affecting members’ final retirement benefits.
“Greater flexibility and choice in the allocation of contributions is therefore the clarion call: basically how much goes to retirement savings, versus the cost of death and other risk benefits?” asks Wayne van Rensburg, principal consultant at Glenrand MIB Benefit Services.
“Some trustees are allowing members to choose the level of death benefits they would like to enjoy, thereby allowing them to choose what portion is allocated to their retirement savings, and what portion is allocated to costs.”
Van Rensburg says “choice” has to be premised on appropriate information and an understanding of potential consequences. “Experience shows that members often make emotional decisions if allowed wide latitude in this respect, particularly when those decisions are based on lack of knowledge and sophistication.”
Members should be encouraged to look past retirement. James Louw