Weekend Argus (Saturday Edition)
Safe-haven status of smoothed-bonus investments called into question
RETIREMENT ANNUITY STRUCTURES
Life assurance capital-guaranteed, smoothed- or stable-bonus products, which, for decades, have provided millions of pensioners and retirement fund members with what they regarded as a safe haven for their savings, are facing a significant revision.
National Treasury has twice signalled that it has major concerns about the products in their current form.
Treasury’s first warning shot was when it excluded smoothed-bonus products from being included in tax-free savings accounts. The second came with draft regulations which, if implemented, will require retirement fund trustees to provide members with default options. The regulations exclude smoothed-bonus products in their current form from being offered either as a default investment strategy for members saving for retirement or as a vehicle to provide a pension.
Life assurers use smoothed-bonus portfolios in long-term savings products and as underlying portfolios in with-profit annuities (pensions).
The main selling point of these products is that you can have your cake and eat it, too. This is because you can invest in equities – which, historically, have provided higher average returns over the medium to long term than other asset classes – while at the same time mitigating volatility risk, particularly when your savings mature.
Smoothed-bonus products substantially reduce the volatility risk to your savings by:
◆ Guaranteeing all or part of your capital; and
◆ Smoothing the investment returns, by holding back some of the returns (in a socalled bonus stabilisation reserve) when markets are performing well, so that they can be paid out when markets are down.
Treasury is of the view that the cost of smoothed-bonus products, either as preretirement investments or as pension products, may exceed their benefits, and that members of retirement funds may be better off using other products.
In an explanatory memorandum accompanying the draft regulations, Treasury notes its concerns about the structure and costs of smoothed-bonus products and invites the industry to give feedback. Its main concerns are:
◆ High charges for poorly defined capital guarantees. If there is a major market crash, the bonus stabilisation reserve can turn negative, which can result in zero returns for policyholders until the reserve is positive.
However, zero returns are normally declared only when the reserve drops to about minus 10 percent in any year, while returns over about 15 percent are likely to be retained in the reserve to be distributed in future years.
Recovery from severe market conditions can take a few years, particularly if markets fall dramatically and stay down. Even once markets recover, returns and pension increases may not immediately reflect the more positive conditions, because the good returns are used to rebuild the bonus stabilisation reserve.
◆ Market value adjusters (MVAs). A life assurance company applies MVAs when a portfolio’s bonus stabilisation reserve is tected against market fluctuations and against a sudden fall in the markets just before you retired (see “Safe-haven status of smoothed- bonus investments negative and a policyholder wants to withdraw his or her money before the maturity date. Instead of receiving the policy’s declared value (the value you see on your statement) and the accrued bonuses, you are paid a lower amount, which reflects the market value of the underlying portfolio.
◆ The application of confiscatory penalties when policyholders stop and/or reduce their contributions. Treasury is also concerned about products that include loyalty (or terminal) bonuses, which are paid only if you remain invested for the full term of a contract.
◆ With-profit annuities in which pension increases are entirely at the discretion of the life assurance company and there are structural conflicts of interest between pensioners and shareholders (who have to make good on the pension guarantees). Treasury says that, in the past, shareholders have not acted in the interests of pensioners and their actions have not been transparent.
The two biggest providers of smoothed-bonus products and with- called into question”, above).
Most smoothed-bonus portfolios were conservatively invested to ensure that the life companies could meet the guarantees. profit annuities, Old Mutual and Sanlam, say they are not sure of the future of the products.
Braam Naude, the head of income and guaranteed solutions at Old Mutual, says that even if the products are not allowed as default investment and annuity options for retirement fund members, they can still be sold to people who want to opt out of the default options.
Lizelle Nel, the head of regulatory coordination and advanced analytics at Sanlam, says Sanlam does not want to comment on the implications, “as we are at this stage uncertain about the direction the legislation will be taking.
“We believe that smoothed-bonus [products] might still be sold, but we are uncertain whether they will be allowed to be sold as part of the default strategy. In our view, the current regulations are not 100percent clear on this.”
Nel says that more engagement with Treasury is required and more detail is required, particularly with regard to the default annuities.
Naude says the proposed regulations do There are three main retirement annuity (RA) structures. They are:
◆ Life assurance RAs. Your money is invested in a policy issued under the Long Term Insurance Act. A risk life assurance policy is usually linked to the investment policy. This is known as an underwritten RA fund.
You contract with the life assurer to pay contributions for a predetermined number of years. If you stop paying, or reduce your contributions before the policy matures, you will, in most cases, have to pay a penalty, which can reduce the value of your accumulated savings by up to 15 percent on RAs sold after January 1, 2009. Some life companies offer products that allow you to alter your contributions without incurring a penalty, but you will pay higher ongoing costs.
In 2004, a study by independent actuary Rob Rusconi found that life assurance RAs were the most expensive retirement-savings products in South Africa.
◆ Linked-investment services provider (Lisp) RAs. Lisps are essentially administration platforms that enable you to invest in a range of investments offered by
Life assurers have adjusted smoothedbonus products over the years in an attempt to retain market share. They still attract considerable amounts of money, because they significantly reduce the impact of market volatility on savings, but at a cost that concerns National Treasury.
The next generation of life assurance RAs, which were introduced by Liberty almost 50 years ago, gave you greater exposure to equity markets, but the value of your investment was directly linked to the market value of the underlying investment portfolio. You had no say in the underlying investments; at best, you had the choice of a high-equity or a low-equity portfolio.
The cost of life assurance RAs was, and often still is, high, and these RAs have penalties if you reduce, or stop paying, the contributions. not specifically exclude smoothed-bonus portfolios as default investments.
“The requirement that the default investment portfolio should be appropriate for members, and, in particular, their preferences for balancing risk and returns, in our view supports the consideration of smoothed-bonus funds as a possible default investment portfolio. However, some aspects of the proposed default regulations (for example, if MVAs are not allowed for voluntary bulk disinvestments) may effectively limit the extent to which investment returns can be smoothed.”
Some changes may have to be made to smoothed-bonus funds before they can be used as a default investment portfolio for occupational retirement funds and RA funds, Naude says.
He says with-profit annuities will not meet the requirements of the proposed default regulations, and therefore retirement funds will not be allowed to offer them as a default pension from a life assurer. However, they can still be offered to members of funds who select in writing to opt out of the default option. different companies and to switch between those investments. Lisps hold these units in bulk accounts.
For your protection, the bulk accounts must be held in the name of the life assurer, the retirement fund, or an independent custodian on your behalf, depending on the product.
A Lisp RA is completely flexible – you can increase, decrease or stop your contributions at any time without incurring a penalty.
◆ Collective investment scheme (CIS) RAs. The CIS management company offers its own funds (mainly unit trust and exchange traded funds) as underlying investments. You can switch between these funds free of charge.
A unit trust RA is completely flexible – you can increase, decrease or stop your payments at any time without incurring a penalty.
An RA (any of these types) does not have a mandatory retirement age, but you cannot mature your investment before the age of 55, except on the grounds of ill health or if you emigrate. This means you can keep your accumulated savings in an RA fund after you retire.
The pressure for more flexible RA investment portfolios resulted in the launch of “unit trust RAs” in the 1990s. These products offer you a choice of underlying investments from the unit trust funds of a collective investment scheme (CIS) management company, or from a range of funds from different CIS management companies through an investment platform provided by a linked-investment services provider.
The disadvantage of “unit trust RAs” is that you will undermine the likelihood of retiring financially secure if you choose inappropriate underlying investments.
RA members, like members of definedcontribution retirement funds, have to buy a pension with at least two-thirds of their savings. But, unlike employer-sponsored defined-contribution funds, very few RA funds have investment strategies linked to pension strategies.