New “Default” Regulations to the Pension Funds Act

IN this quarter’s Asset Manager Review, we consider the new regulations made under the Pension Funds Act, published in August 2017. (The Act gives the Minister of Finance wide powers to make regulations, provided these are “not inconsistent” with the provisions and aims of the Act.)

Although the new regulations were published in August, retirement funds have been given until 1 March 2019 to comply. This is a useful breathing space, because the regulations may have a significant impact on funds and will require close attention by trustee boards.

The new regulations will require trustee boards of Defined Contribution funds to provide members with a default investment strategy that meets prescribed standards. Trustees will also need to do more to help members to preserve their benefits, rather than taking cash, when they change employment. Trustees will also be required to offer an “annuity strategy” to retiring members – this should make it easier for members to turn their retirement savings into a pension income on a cost-effective basis.

Finally, members who change employment (and become entitled to a withdrawal benefit from their retirement fund) or retire will have to be provided with “counselling” to help them understand the options available to them – this can take the form of written material.

Usually, the articles that we publish in the Asset Manager Review are aimed mainly at trustees or Principal Officers of retirement funds. This quarter, however, we have tried to tailor our article for a more general reader – that is, for ordinary members of retirement funds. The question we are trying to answer is, what will these new regulations mean for you? Default investment strategy If you are a member of a Defined Contribution pension or provident fund that offers you a choice of investment portfolios, your fund will need to designate one (or more) of these as the Default Investment Portfolio. This is the portfolio in which your retirement savings will automatically be invested if you do not want to make your own investment choices.

Members of most funds that offer investment choice will realize that, in all probability, their fund already has a default investment strategy in place. So, what is new here?

The new requirement is that trustees will explicitly have to consider various factors when setting the default strategy, and the default strategy will have to comply with specified standards. (These will also apply to Defined Contribution funds which don’t offer any investment choices – funds like this won’t be compelled to introduce investment choice, but their investment strategy, which of course applies to all members, will have to comply with the new standards.)

The regulation allows for different defaults to apply to different categories of members – older members might be “defaulted” to a different portfolio than younger members are. (Perhaps more controversially, high earners or members with larger savings could be “defaulted” differently to those with lower salaries or savings – if the trustees felt that this was appropriate.)

Some of the new requirements are rather obvious. A default investment portfolio must be “appropriate” to the members who will be invested in it, as regards its investment objectives, asset allocation (the chosen mix of shares, bonds etc.), risk and return profile, and costs. We would hope that no funds are currently using default strategies which fail this test!

Our view is that “Life Stage” strategies, whereby members are transitioned from more aggressive portfolios to more conservative ones as they approach retirement age, can be made to fit the new standards.

Trustees will have to consider socalled “passive”, or index-tracking, investment strategies as opposed to the “active” strategies that have historically been used by most South African retirement funds. As noted by the investment managers in their responses to Question 2 on the following pages, this does not mean that trustees will be forced to choose one or the other – trustees could decide on a strategy that incorporates elements of both index-tracking and traditional active investment decision-making.

Fees and charges will have to be reasonable and competitive, and transparent. This is a new requirement – trustees will now have to assess the cost-effectiveness of their default investment strategies. (Of course, it has always been good governance to do so, but it has not been a regulatory requirement up to now.)

This will drive a greater focus on net-of-fees outcomes for members, and should lead to lower fees overall – this could also boost the use of index-tracking strategies, which are generally cheaper. As some of the managers have pointed out, however, “cost-effective” and “cheap” are not necessarily the same thing – the cheapest possible strategy may not be the one that produces the best netof-fees outcomes, over the long term.

If the fund does offer investment choice to members, switching must be permitted at least once a year, and “lock-ins” (where you are forced to remain in the default) will not be allowed.

Suitable regular communication must be made to members. This will include details of the asset allocation, net investment returns, and relevant information on fees and costs. It is possible that the form of this communication will be prescribed, but this has not been done yet. (Again, we would hope that a well-managed fund would already be communicating appropriately to its members on its investment strategy and performance.)

Encouraging preservation and portability of savings

Under the new regulations, your retirement fund will have to give you the option of leaving your retirement savings “parked” in the fund to grow with investment returns, when you change employment. In fact, if you do not make an active choice either to take a cash benefit or to transfer your savings to a different fund, this will be the default – you will become a so-called “paid-up” member of the fund.

Although the fund will be allowed to charge a reasonable ongoing fee to cover administration costs, it will not be able to charge you an initial fee when you become a paid-up member. You will pay the same investment fees as contributory members are paying.

You will not be allowed to make further contributions to the fund (after you convert to being a paid-up member) and your insured death and disability benefits will fall away, but if you die, your paid-up retirement savings will be available to provide for your family and dependants. Your savings will continue to grow with investment returns while you are a paid-up member.

The fund will have to provide you with a certificate, within two months of your leaving employment, setting out your benefit entitlements as a paid-up member. The fund will also have to provide you with “benefits counselling”, which explains your options in clear and simple language – this can be in written form.

It is likely that, even after you have become a paid-up member, you will still have the right to ask your fund to pay out a cash benefit to you at a later stage (or to transfer your savings to another fund) – this will be covered in the fund’s rules, but we would expect funds to permit this.

If you join a new employer’s fund, the rules of that fund will have to allow for amounts that you choose to transfer from previous funds. Ideally, you should keep your benefits in the retirement system as savings for your old age – taking cash has negative tax implications and it is difficult to get the cash back into the retirement system.

In fact, your new fund must ask you if you have any paid-up benefits in previous funds that you might have belonged to, and whether you want to transfer these to your new fund. There will be no transfer fees associated with such transfers, if you choose this option.

(Obviously there could be advantages to you from having your retirement savings consolidated in one fund. You should be given information on the costs and investment strategy of your new fund, so that you can see if it makes sense to transfer your paid-up benefits to the new fund.)

One thing to keep in mind, if you do leave money “paid-up” in your old fund, is that the fund will only be able to stay in touch with you if you update your contact details whenever they change. This does put some responsibility on you.

Of course, even if the fund does lose touch with you, your money will still be safe – the fund will be obliged to keep a record of you as a paid-up member, and will probably make an effort to trace you when you reach retirement age. But make sure you keep all your documentation and stay in touch with your previous funds! Pension options at retirement In the days of Defined Benefit funds, when you retired your fund would pay you a lifetime pension, with a pension to your spouse if you died before they did. The pension was formula-driven and no decisions were needed, except whether you wanted to trade some of your pension (up to a third) for a cash lump sum when you retired.

In the Defined Contribution era, many funds offer no support to members who retire. If your fund is a provident fund, you can take the whole benefit as a cash lump sum, but usually you also have the option to use part of it to buy a pension – but the choice of pension and provider is normally left entirely up to you. If your fund is a pension fund, you must use at least two-thirds of the benefit to buy a pension – but again, the choice of pension and provider is usually yours alone.

The new regulations will change that. Funds will be obliged to develop an “annuity strategy” – they will have to assist you by offering you some method of providing yourself with a pension, which meets specified standards.

You will not be forced to take this default pension option offered by your fund. If your fund currently allows you to make your own choice of pension – as most Defined Contribution funds do - you will still be allowed to choose your own pension provider and the type of pension that suits you best.

Any pension offered by your fund will have to be appropriate to your needs, at a reasonable and competitive cost, and with suitable communication (including “retirement benefits counselling” to explain this option, at least three months before your normal retirement date – noting that this may be in written form).

The pension offered by the fund may be in the form of a so-called “living annuity”, where your retirement savings stay invested, earning a return, and you choose each year how much pension to draw from it (within certain parameters). Just remember that if you use up all your savings, your pension stops!

Your “living annuity” may be paid from the fund itself, or the trustees may choose an insurer as their preferred provider, in which case the pension will be paid by the insurer. (For this purpose, many investment managers or multi-managers can also act as the insurer.)

The living annuity provider – the fund or the insurer chosen by the trustees – will have the responsibility for monitoring the income you are drawing from the living annuity, and warning you if you are running the risk of exhausting your savings before you die.

Currently, you will be allowed to draw an income of between 2.5% and 17.5% of your savings, per year, although restrictions may be placed on the maximum draw-down percentage at some future date. (The truth is that a yearly income of anywhere close to 17.5% of the capital is far too high for almost all members invested in living annuities, so these restrictions would be for your own good. In fact it is sensible to aim for a pension draw-down rate of 5% or less, when you retire!)

If your trustees offer you a living annuity as the default retirement option, you will be restricted to a choice of no more than four investment portfolios.

As an alternative, your fund could offer you a so-called “life annuity” pension. This is similar to the fixed lifetime pensions offered by the old Defined Benefit funds – the starting pension would typically be guaranteed for life, with increases on some contractual basis, and with a specified level of provision for your spouse and dependants if you die. The pension could be paid by the fund itself, but it is more likely that the trustees will choose an insurance company as their preferred pension provider.

Importantly, however, any options that you have at present will not be taken away – you will still have to make your own decision. But in future you will have a cost-effective alternative, which is clearly explained to you, and which your trustees have considered. And more information is always a good thing.

In the following pages, we put various questions to the investment managers, asking how they believe that key aspects of the new regulations should best be implemented, for the benefit of retirement fund members.

Erich Potgieter and Joanna Combrink, Willis Towers Watson