HOT TOPICS - Alexander Forbes

HOT TOPICSLEADING OPINION

Investing to secure your members’ retirement

March 2014

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ALEXANDER FORBES

We would like to thank the following staff members who contributed to the drafting of this workbook:

Anne Cabot-AlletzhauserMichael PrinslooDeslin NaidooVickie LangeTrevino RamsamyDwayne Kloppers

Monica MatthewsRogerio CabanitaYouri DolyaLisa Kusters (Investment Solutions)Muitheri Wahome (Investment Solutions)

The issues surrounding Trustee duties are complex and depend entirely on the particular circumstances facing each fund. Trustees must in all cases take their own decision on issues based on their particular fund’s circumstances at the time. It is for this reason that Trustees cannot rely simply on what we have discussed here today, neither should they regard our discussions as legal advice. Trustees should get specific assistance where they are uncertain of the consequences or reasonableness of any contemplated action.

Copyright in this material is expressly reserved. This workbook may not be copied, stored, retrieved or in any way reproduced without the express written permission of Alexander Forbes Financial Services (Pty) Ltd. Breach of copyright is a serious offence and can lead to litigation.

This is not a work of final reference. While every attempt is made to ensure that the information published is accurate Alexander Forbes Financial Services (Pty) Ltd, the editors, publishers and printers take no responsibility for any loss or damage that may arise out of the reliance by any person upon any of the information contained herein.

Further details of our services may be obtained from our office in Johannesburg:

Tel: 011 269 1800 Fax: 011 269 1111 email: [email protected]

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HOT TOPICS INVESTMENTS MARCH 2014

PREFACE: Keep calm and taper on

Last year we started by asking who could blame investors for expecting double digit real returns to continue indefinitely on the back of three very solid years of growth. We pointed out that this didn’t tell the full story and cautioned that there were significant risks lurking in the system. Much of the market dynamic was and is still being manipulated by central bankers around the world. Although interest rates have started rising after being at record lows, relatively low rates are expected to persist for some time. Global growth forecasts are still weak.

Despite the challenges many markets, including the South African market, were setting new highs again in 2013. But as we have said before, the indices (or any average for that matter) can hide the truth. Within the FTSE/JSE ALSI Top 40 index – the 40 largest shares on our stock exchange - the returns on the underlying shares varied dramatically over the last year. If you were invested in the bottom performing stocks your investment more than halved over the year, whilst if you were lucky enough to have invested in the top performing stocks your investment more than doubled! This provided an opportunity for asset managers, especially active managers and certainly the bulk of active equity managers did not disappoint and finally began to outperform the indices in 2013, in contrast to their performance over the previous two years.

Short term performance can distract trustees and advisors from some of the more fundamental considerations. One such consideration is how our investment strategies have coped with the extraordinary period investors have faced over the last 5 years or so, the focus of this workbook.

In considering this problem, it is useful to first set the scene. In Section 1, we consider the main economic themes of 2013. We also look at historical market performance and the drivers thereof, considering also how these have impacted on the asset manager landscape. We will look at which strategies were winning strategies and which were not. To end off this section we consider the possible impact on the US Federal Reserve having commenced with its tapering of quantitative easing for trustees and their investment strategies.

In the second Section, we consider whether our investment strategies, and in particular life stage strategies, have worked. We also look at post retirement investment strategies and how these link to pre-retirement investment strategies. This is an aspect not always considered, but in a post Retirement Reform world where default annuity options need to be considered by trustees, this is critical. We also look once again at investment fees, and whether there is in fact a way to compare fee structures.

Finally, in Section 3 we consider Retirement Reform and will look at issues impacting retirement funds from the National Budget speech.

We hope that this Hot Topics session proves to be insightful! We welcome your feedback on the sessions.

RegardsThe Hot Topics Team

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ALEXANDER FORBES

INDEX

Section 1 Economic Landscape

1What were the main themes of 2013, in the context of:

(a) our economic environment (what drove beta); and

(b) asset manager strategies (what drove alpha).

5

2Tapering of quantitative easing is one of the main economic events to play out in 2014 – what are the possible effects?

13

3 The history of asset managers 18

Section 2 Investment Strategies

4 Have life stage strategies delivered appropriate results in view of their intended objectives?

22

5 What are the criticisms of life stage investing and how might life stage models evolve?

29

6What’s an appropriate investment strategy for post-retirement and how should this be linked to pre-retirement strategies?

33

7 How can trustees practically implement a strategy which incorporates a sustainable returns approach?

46

8 Can a fair price be determined for active asset (investment) management fees?

49

Section 3 Reform

9 The 2014 National Budget Speech – what should trustees consider?

57

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Source: Bloomberg

QUESTION 1 What were the main themes of 2013, in the context of:

a) our economic environment (i.e. what drove beta), and

b) asset manager strategies (i.e. what drove alpha)?

OUR ECONOMIC ENVIRONMENT

2013 started with the local equity market indices reaching new highs and the year ended with the local equity market indices reaching another new all-time high. Yet local equity markets were not the most important element; the story of the portfolio performances lies in the details that transpired in between; with a constant swing between “risk on - risk off” investment behaviour.

The major investment themes were driven by international markets. Five years on from the 2008 financial crisis still sees the intervention policies and strategies applied to stabilize global capital markets and restore confidence remain significant drivers of investment decision making and valuation.

The Euro crisis returned to the fore in the first half of the year. In March Cyprus defaulted on their government debt requiring the Euro countries to implement a bailout plan and contain the contagion. Shortly thereafter, Greece with high unemployment, poor GDP growth and economic austerity measures, challenged the index definitions of developed and emerging nations by being the first country to be downgraded. Emerging markets throughout the world experienced a devaluation in their currencies in relation to the US$, Euro and other major developed currencies.

The second half of the year started in an equally jittery fashion when US Federal Reserve Bank Governor Ben Bernanke announced that the pace of the Fed’s bond purchases (quantitative easing) would slow, only to then make a restatement to the market as investors panicked. China also provided a momentary flutter when it announced interest rate intervention to manage the shadow banking market prevalent in their economy. The US Fed finally announced in Mid-December that it would reduce its bond purchases and this signaled the beginning of the tapering program.

Despite the perceived economic risk factors pervading developed markets, equity markets globally powered along, seemingly disconnected from fundamental issues of economic growth. The MSCI World index returned 27.4% in dollar terms, over 20% stronger than emerging markets, and the World Government Bond Index (WGBI) delivered -4.0%. The MSCI World Index for 2013 is shown below:

SECTION 1: Our economic landscape

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MXWO Index (MSCI World Index) Graph 861 Daily 06JAN2013-06JAN2014 Copyright© 2013 Bloomberg Finance L.P.| 2014

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ALEXANDER FORBES

In South Africa, many of the themes affecting interest rate policy persisted throughout the year: concerns about the weak rand, rising inflation, labour conflicts and wage increases, moderate to weak economic growth, a wider current account deficit and stubborn unemployment were all very much in evidence. And while the Reserve Bank governor stated that she “will not hesitate to take appropriate action in order to maintain the integrity of the inflation targeting framework”, the Monetary Policy Committee left the repo unchanged at 5.0% for 2013.

But the equity markets repeatedly shook off any concerns from the international “risk-on /risk-off” and “end of quantitative easing camps” to touch their new high just as the year came to a close. The 2013 performance of the FTSE/JSE All Share Index is shown in the chart below:

Source: Bloomberg

From a South African perspective perhaps the most important performance to watch was the Rand. Over the course of 2013 the Rand depreciated from R8.50 at the beginning of the year to R10.70 against the US$ by year end. As we’ll see below, the ramifications for investment performance were far from trivial.

The various asset classes performed as follows in Rands over periods to 31 December 2013:

Asset Classes Index 1 Year 3 Years 5 Years

Local Equities FTSE/JSE All Share Index 21.43% 16.42% 19.93%

Local Bonds BESA All Bond Index 0.64% 8.29% 7.65%

Local Cash SteFi Index 5.18% 5.48% 6.49%

Global Equities MSCI World Index 57.23% 30.69% 18.60%

Global Bonds Citi WGBI 18.51% 18.00% 4.87%

Global Cash US 3month TBill 23.51% 16.63% 2.63%

Source: Bloomberg

JALSH Index – Last Price 46337.87 +131.78

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JALSH Index (FTSE/JSE Africa All Share Index) Graph 861 Daily 06JAN2013-06JAN2014 Copyright© 2013 Bloomberg Finance L.P.| 2014

06-Dec-2013 09:37:192013

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SOURCES OF PERFORMANCE FOR VARIOUS MANDATE TYPES

Balanced funds

While multi-asset class portfolios use a myriad of investment strategies in structuring their portfolios, the primary drivers of performance are typically (in order of magnitude):

• Asset allocation – Global vs. local – Asset classes within global and local• Asset strategy – Value/momentum, market cap, low volatility etc. for equities – Duration, credit, market timing and trading etc. for fixed income• Sector allocation in each asset class• Security selection

Given the rapid collapse of the Rand, there should be little surprise to learn that the most critical factors influencing performance on multi-asset global mandates over the course of 2013 were:

• The allocation to global assets, and specifically,• The allocation to global equities

Most fund managers remained at the offshore limits allowed by Regulation 28 of the Pension Funds Act. Further to this, many managers had 90% of their global exposure in developed market equities, which was the largest single contributing factor to outperformance between managers and strategic asset allocation benchmarks.

Coronation Fund Managers is a case in point, as their global exposure helped them power into the lead for the year. Exposures to Coronation, by multi-managers Symmetry and Investment Solutions also helped facilitate their securing of third and fourth place positions. And while Allan Gray’s local only portfolio lagged the peer group enough to drop its ranking to the third quartile, the performance in its international fund, Orbis, pushed its global Best Investment View (BIV) portfolio up to fifth place.

By contrast, ABSA Asset Managers kept a relatively low foreign exposure over most of the year resulting in significant underperformance in comparison to both its asset class benchmark and peers.

Domestically, equities delivered 21.4% (JSE All Share Index), property 8.4%; bonds barely made a positive return for the year (All Bond Index returning 0.6%) and cash returned just over 5% over the same period. A high exposure to local equities would have been another important performance driver. But, with many managers highly exposed to international equities, the average manager tended to be underweight to that segment of the domestic market where it mattered most: equities. Here is where managers such as Foord, Investec and Prudential benefited by having significant equity positions relative to other asset classes.

The greatest challenge for managers was determining when economic risk factors, still looming large, would come home to roost. It was a decision that would create a significant divide in manager performance. With many pension funds targeting around CPI+5% some managers took the stance that it was unnecessary to expose funds to downside risks for additional performance where the fund was already capturing strong positive performance. Prescient and Re.CM held this view for more than a year. It was a view that would place them at the bottom of the peer group managers domestically. Re.CM’s performance in their international segment redeemed them in the last quarter within their global BIV portfolio.

The other factor accounting for differential returns in balanced mandates was the persistent differential performance in their domestic portfolios between the resource sector of the equity markets and the industrials (and to a lesser extent, financials). Seasoned, competent managers had been brought to their knees over the last two years, when they mis-timed the reversal here. Some of the better performing managers for the year, such as Foord, Investec and Allan Gray were all overweight Industrial shares relative to their peers for most of the year.

“The greatest challenge for managers was determining when economic risk factors, still looming large, would come home to roost.”

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ALEXANDER FORBES

By contrast, the interest rate environment resulted in a negative real yield on all fixed income asset classes. With concerns about downside risk and volatility in interest rate markets mounting, more and more managers increased their exposure to cash. PSG’s strong performance for the year was in part due to avoiding government bonds, inflation linkers and property shares, preferring cash in their strategy.

The key point for long term investors, is that regardless of what managers’ views were on the domestic vs. international, risk on/ risk off, or resources vs. industrial debates, all of the global balanced managers (whose performances appear in the AF Manager Surveys for those periods) managed to deliver CPI+5% performance over the one, three, five and ten year periods on a per annum basis.

Equity funds

The main sources of performance in equity funds are:

• Manager style / strategy (value / growth / momentum / high beta / low beta) • Sector allocation• Market risk• Stock selection

During 2012 the significant performance differentials between the Industrial and Resources sectors tempted many managers into anticipating a convergence in these valuations. The impulse left the average active manager underperforming the benchmark by as much as 3%. By 2013, softer commodity prices; a reduction in global demand and difficult labour issues in the South African market meant the reversal would still be some time off. The local markets ended the year with the Industrials sector being the best sector for 2013 returning around 35% for the year followed by Financials at 19.1% with Resources having a tough 2013 returning 1.4% for the year.

A size bias theme also prevailed over the year with strong performances coming from Large Caps and Small Caps; but Mid-Caps lagging. Small Caps were the strongest performer over the year (+26.3%) with Large cap stocks also holding up well (+22.8%). Mid Caps, however, only delivered +13.0% for the year.

Fortunately by now, active managers had either capitulated from the valuation bet, chosen their market cap segment correctly, or had been extremely adept at selecting those shares in the resource sector that provided some promise. By whichever route, by mid-year, the fortunes of active managers began to change.

In contrast to 2012, when only 15 managers out of 53 were able to outperform SWIX, in 2013 that number grew to 29. The winning strategies continued to be momentum, specifically Earnings Momentum and Price Momentum. By contrast, managers who favoured Value and Dividend Yield tilts would have battled. For a brief moment it appeared as though we might see a reversal in Value strategies but it was short lived as the macro-economic environment settled itself. By contrast, Value was one of the better-performing strategies in the global markets.

As much as the overall domestic equity markets demonstrated low realised volatility (a traditional measure of risk); the volatility between subsectors and stocks (cross-sectional volatility) remained high. The subsectors of Oil and Gas returned almost 48%, and Consumer Goods and Health also delivered returns in excess of 40% over

“A size bias theme also prevailed over the year with strong performances coming from Large Caps and Small Caps; but Mid-Caps lagging.”

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1 year; while Construction and Basic Materials ended the year negatively. The range of performance of shares (JSE All Share Top 40) was large, with some shares delivering returns in excess of 100% for the year, whilst others more than halved in value. The chart below demonstrates the point:

This allowed some managers who got the super-sector selection incorrect to recoup performance through sub-sectors and security selection. A good example of this phenomenon would be Coronation who delivered exceptionally strong stock selection performance (avoiding the gold shares) in spite being generally overweight Resources. Coronation achieved an outperformance of 11.8% during 2013, by favouring the quality, global stocks that happened to be domiciled in South Africa.

While the active performance differentials between the best and worst funds narrowed over the year, it was alarming to see that the active return difference of benchmark-cognisant funds was as much was 16.4% over a 1 year period which is at the upper limits of statistical significance. Additionally, because of the high level of intra-sector variability security selection offered sufficiently diverse opportunities such that even managers with similar styles showed different performance outcomes.

Finally, it’s worth noting that active quant funds using momentum biases continued to outperform through the period, whilst those utilising more valuation driven factors that targeted resource shares, lagged. Volatility products would have also picked losers as downward trending shares had low implied volatility and provided diversification but the market rewarded momentum rather than low volatility. Due to the persistence and continuation of the earnings and price momentum factors, most quant models would have been deceived by historic calibrations.

Source: Investment Solutions

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ALEXANDER FORBES

Bond funds

The main sources of performance for bond funds are:

• Portfolio positioning: Choosing the term structures across the yield curve that you wish to be exposed to, based on the expected changes to the shape of the yield curve. You would want to be exposed more to parts of the curve that are expected to have declining yields and less to rising yields.

• Credit yield pick-up: Purchasing instruments issued by parties with a credit spread over government based issuance. Issuers with lower credit ratings offer similar term instruments at better interest rates to offset the higher risk of default.

• Managing the portfolio term (duration): Adjusting the overall portfolio term (duration) to be longer or shorter than the ALBI benchmark based on interest rate forecasts. Usually longer term instruments provide additional return for the term risk.

• Trading: Taking advantage of short term mispricing; or using alternate instruments such as derivatives, FRA’s and swaps for yield enhancement.

• Other: Other sources include convexity optimisation, carry trades, convertible bonds. Taking advantage of arbitrage between markets, fixed versus floating rates, nominal versus real rates.

The South African yield curve moved 100-150 basis points (bps) across the different key rates over the past year and the Rand Swap curve over 150 bps for durations longer than 4 years. Similarly real yields shifted on average 50 bps across the curve. This resulted in the All Bond Index delivering its lowest positive return (0.64%) in 30 years (shown below) and Inflation linked bonds struggling at 0.79% for the year.

Source: Bloomberg

When the MPC left the repo rate unchanged at 5.0% over the course of 2013, it did not preclude the market from anticipating future rate changes and therefore the structure of the yield curves used to price interest rate instruments moved upward in an uncharacteristically volatile manner.

Although inflation peaked at over 6% during the course of the third quarter, CPI was 5.3% for the year. Like cash, the bond markets in general delivered negative real rates for investors. The deteriorating domestic inflation outlook continued to place the market in the fragile position of sustained negative real rates. With the deteriorating economic framework, South Africa was under threat of a credit downgrade. The medium term budget speech by the Minister of Finance was prudent and stabilized market expectations. However, for the year credit spreads widened with the credit index down -2.3%.

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ALBTR Index (ALBI Total Return Index) Graph 865 Daily 06JAN2013-06JAN2014 Copyright© 2013 Bloomberg Finance L.P.

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South Africa together with Turkey, Indonesia, Brazil and India have been labeled the “fragile five” and are expected to be impacted significantly by the US tapering program due to weak economic fundamentals. Outflows from bond markets by foreigners have been at its highest levels since the 2008 crisis.

The upward shift of the yield curve translated into all debt instruments losing capital value. Throughout the year almost all managers had lowered their overall duration to the ALBI, commonly moving their exposure to maturities less than 5 years. This was the correct tactical position as 1-3 year term structure of the yield curve was the best performing component of the ALBI index which systematically deteriorated as maturities increased. This tactical positioning allowed all Specialist bond funds to outperform the ALBI index, albeit it with low returns in nominal terms.

Duration positioning, portfolio adjustments and trading were large drivers of performance with credit playing a lesser role relative to previous quarters.

Money market funds

The main sources of performance for money market funds are:

• Credit yield pick-up: Purchasing instruments issued by parties with a credit spread over government based issuance or the “Big 4” banks. Issuers with lower credit ratings offer similar term instruments at better interest rates to offset the possible risk of default.

• Managing the portfolio term (duration): Adjusting the overall portfolio term (duration) to be longer or shorter than the STeFI benchmark based on interest rate forecasts. Usually longer term instruments provide additional return for the term risk.

• Trading: Taking advantage of short term mispricing or using alternate instruments such as FRA’s and swaps for yield enhancement

Although the Money Markets were fairly robust over the past year, longer dated instruments were materially impacted by global developments around the QE programs in Europe, Japan and most relevantly the United States. This resulted in interest rates steepening on longer dated maturities.

The short end of the yield curve remained subdued with the STeFI Call deposit index delivering 4.67% effective (per annum) down 40 basis points from 2012. There remains a yield pickup of almost 1% being paid for term – i.e. the difference on Overnight to 12 month rates which has remained consistent for 2013. Funds with a portfolio duration of greater than 91 days and up to 180 days performs on average better by 50bps due to taking advantage of the 1% differential in term performance. Its dispersion over 1 year has increased to 108 bps per annum from 85bps per annum last year.

Unlike other asset classes, cash instruments constantly mature and investment decision making is continual.

Those funds with mandates allowing investment into terms greater than 12 months will have access to better rates due to term and more issuers providing additional return (via credit). Access to credit and other limited supply of debt instruments will also be key features for funds to add additional performance. Managers would need to be careful to balance their flexibility to adjust to changing conditions. Being locked into better long term fixed rates can be counter-productive in a rising interest environment.

Absolute return funds

• Absolute Return Funds focus on multi-asset class mandates that target performance above the SA headline inflation rate (CPI), while simultaneously seeking to protect capital over a 12 month period.

• These portfolios usually build and implement their investment strategies such that the portfolio is resilient to strong negative equity market moves and able to capture (a reasonable amount of) the risk premia of the invested asset classes to deliver returns above inflation.

“South Africa together with Turkey, Indonesia, Brazil and India have been labeled the “fragile five” and are expected to be impacted significantly by the US tapering program due to weak economic fundamentals.”

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ALEXANDER FORBES

Fund managers would have had the arduous task of balancing risk and return for there clients. Being highly exposed to equities and foreign assets while simultaneously protecting the portfolio from capital loss, although proven correct by market returns, was not necessarily the prudent decision.

Funds across all categories of the survey protected capital during 2013 and all but two funds protected the investor from inflationary erosion. Funds with global asset exposure had a distinct performance advantage over domestic only product offerings.

Managers applying more traditional balanced type of strategies utilising asset allocation techniques would have also performed better than the peer group as it would have allowed them higher exposures to equities which had been the best performing asset.This would also include strategies that use derivatives to hedge out equity risk.

The Foord Absolute Return fund in the CPI+5% category is a statistical outlier by almost 4 standard deviations over 3 years - its performance would have made it a better offering than its own global balanced fund over one year. This seems inconsistent with a fund managed to a CPI+5% target, which one may have expected to pare back risk once having achieved the benchmarks. Its performance seems to closely track that of the balanced offering.

Interestingly, the performance across the categories are not linear as suggested by their performance targets, reflecting that the strategies may change significantly as higher real returns are targeted.

Absolute return category CPI+3% CPI+4% CPI+5% CPI+6%

1 year median return 9.2% 9.7% 11.94% 14.78%

Conclusion and message to trustees

The purpose of this article is not merely to update Trustees on markets during 2013 – there will be plenty of investment report-backs which do that - but rather to highlight that it is important that Trustees understand the drivers of performance over the period and the environment in which it was achieved, in order to evaluate their managers appropriately. Performance (short-term) can depend to some degree on market cycles and certain styles would be rewarded and others punished, not making any one of them wrong or right. It is therefore more important for trustees to understand what performance their chosen strategy could have been expected to deliver over the period, and then what it actually delivered and why.

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Christine Romans, Chief Business Correspondent for CNN, recently described “tapering” as the most important driver of US defined contribution (“DC”) pension plans right now.

“Tapering” refers to the gradual elimination (or tapering off) of quantitative easing (“QE”). After the 2008 financial crisis, the US Federal Reserve (“the Fed”) started using QE in an attempt to jump start the US economy. QE aimed to increase monetary supply and keep interest rates low, hopefully stimulating economic growth.

The scale of the US QE program is unprecedented, with the Fed expanding its balance sheet from around $800 billion to about $4 trillion in just over five years. To put this into context, this equates to adding debt of between three and four South African economies.

This leads to the question of what the possible effects would be of removing this stimulus and whether the pension fund is well positioned. How should trustees prepare their fund and its members for tapering? Trustees could consider some or all of the following points:

Anticipate a period of volatility and uncertainty

QE has been controversial since its onset, with economists polarized about its longer term merits. The simple truth is that no one knows exactly what will happen to financial markets during and after the taper – even now as it has just begun. It is important Trustees understand that markets are likely to be volatile as traders try to understand how tapering will play out. Below we consider two extreme views.

1. Negative views

David Stockman, a former Reagan administration Office of Management and Budget Director described QE as “high grade monetary heroin”. Stockman suggested that like heroin, QE is dependence forming and that ending it will be a difficult and painful process. QE sceptics believe that the program merely “kicked the can down the road” without fixing the fundamental economic problems that triggered the financial crisis. A pessimist might argue that tapering will lead to:

• Large declines in equity markets, which have been artificially propped up by the expanded money supply of QE and cheap credit.

• Large losses on bond portfolios as interest rates increase and normalise.

• Large losses in emerging markets (such as South Africa) as global investors move assets back to lower risk countries such as the USA.

If these negative factors materialise, the Fed would have exhausted all policy measures available to it. It may hence be difficult to contain and manage any further declines in economic activity.

These negative factors could compound with global economic risks such as the current slowdown in the economic growth in China, the struggling European economy, or a failure of Japan’s aggressive expansionary policy (known as ‘Abenomics’).

Source: http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

QUESTION 2 Tapering of quantitative easing is one of the main economic events to play out in 2014 – what are the possible effects?

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ALEXANDER FORBES

2. Positive views

Proponents of QE argue that the strategy has stabilized the US economy, managed unemployment and galvanized economic growth. Optimistic analysts argue that market participants know that QE must end and that any negative effects of tapering are already priced in. They point to the fact that the Fed carefully communicated this message for over six months before starting to taper. These analysts argue that the sharp increase in interest rates during 2013 (which resulted in losses on bond portfolios) demonstrate that the market has already priced the effects of an increase in expected interest rates. This outlook suggests that the Fed has managed QE and the announcement of tapering well and that any losses associated with tapering have already been processed by markets. Consequently, equity markets will deliver moderate but positive growth while bond prices remain stable.

The reality is likely to lie somewhere between these two extremes. It is however unclear where markets will settle and this uncertainty is likely to drive volatility. Anticipate volatility in overall market returns and volatility in the outperformance your managers can deliver.

Prepare your fund and members for this volatility

Following on from the above discussion, Trustees can reasonably expect a lot of news flow with competing theories and differing opinions. Recognize that markets may vacillate as traders scramble to predict the Fed’s next move and the consequences this will have. Volatility is not just a US problem. The South African Reserve Bank raised rates 50 basis points in a surprise move in January – ahead of their decision all of the “experts” surveyed did not expect a change. A well prepared board might consider:

• Determining how the pension fund will be invested and sticking to that decision. This includes the style of investment to be used and the managers to be used. It is often easier to make a measured, well thought out decision before market volatility increases and a sense of urgency enters the decision making dynamic. This need not be a single strategy - the board might pre-define events that would result in a change of manager or strategy now.

• Communicating this potential volatility to members and encouraging them not to make rash investment decisions. Research by Alexander Forbes shows that most member investment choices made during periods of market volatility are value destructive. Emotion and a lack of adequate investment expertise often results in members disinvesting from equity markets after large falls and reinvesting after subsequent recoveries, resulting in large losses.

• Alerting the fund’s sponsoring employer about potential volatility and its effects. This is especially relevant in defined benefit funds.

• When market volatility begins to materialise, don’t panic; rely on decisions made in preparation for this.

“Optimistic analysts argue that market participants know that QE must end and that any negative effects of tapering are already priced in.”

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Retain a well diversified strategy

It may be tempting to time markets and try to benefit from the consequences of tapering. Should a board reduce bond exposure or sell out of equities? Is it wise to liquidate exposure to emerging markets and ramp up exposure to the US dollar?

Given the large uncertainty regarding the market implications of tapering or even if tapering will continue, we would advise against heavily concentrated strategies designed to take advantage from single possible outcomes to tapering in favour of retaining a well diversified portfolio. An approach which incorporates some flexibility (such as a balanced approach, tactical asset allocation overlay, or flexible mandates) would leave the fund’s professional asset managers with scope to try to react to market movements during tapering.

Some boards do not believe managers are able to add sufficient value through asset allocation to offset the additional risk and cost of this approach or are trying to target a specific objective. In such cases, the board might be using a specialist mandate approach. Arguably there is no reason to believe asset allocators are likely to get a larger proportion of their calls right during tapering than at any other time. We hence do not believe boards using a specialist approach need to review this specifically for tapering. In all cases we do believe trustees should not try to time tapering through asset allocation or manager selection themselves.

This diversification could include making use of the Fund’s offshore allocation. QE drove interest rates to record low levels across many developed nations. This triggered a ‘search for yield’, with offshore investors attracted to the (relatively) high yields available in countries such as South Africa. Throughout the QE era, South Africa’s currency and bond market has been influenced significantly by these ‘risk on’ (and ‘risk off’) flows into and out of developing markets. This has led many analysts to believe that developing and emerging markets could suffer significant capital outflows as yields in developed nations normalise. During December 2013 and January 2014, emerging market currencies already weakened significantly, partly due to this effect.

Understand the importance / limits of the fund’s long term strategic asset allocation strategy and how that strategy was derived

As always, the longer term strategic asset allocation used should be derived using a risk budgeted approach to a suitable objective such as a replacement ratio (for defined contribution funds) or a funding level (for defined benefit funds). This is typically achieved using stochastic asset liability modeling and an appropriately worded set of investment guidelines and investment mandate for the fund’s asset managers. The strategic asset allocation chosen by the trustees and the limits derived using this modeling will not need to be reviewed frequently during tapering. These allocations and limits are designed to provide the necessary growth within acceptable risk levels across long investment horizons – and thus protect the principle objectives of the fund.

The outlook for longer term returns is less volatile than the outlook in the very short term. Trustees need to recognize that even professional asset managers may find it difficult to effectively implement a view to take advantage of tapering. If QE is still sustaining inflated asset prices, both bonds and equities are likely to be affected. Unexpected announcements regarding tapering are likely to adversely affect bond prices and the prices of risky assets such as equity and property. Cash might at first seem like an appropriate safe haven from capital volatility. Real rates of return (or returns after inflation) are however negative for cash. It is also unclear how long the Fed will take to unwind QE. The risk of a major correction could persist for many years to come. As such, it would be imprudent to switch a pension fund to cash for the duration of this uncertainty.

“The risk of a major correction could persist for many years to come. As such, it would be imprudent to switch a pension fund to cash for the duration of this uncertainty.”

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ALEXANDER FORBES

Keep a close eye on your asset managers

Regulation 28 dictates that boards of trustees should:

“understand the changing risk profile of assets of the fund over time, taking into account comprehensive risk analysis”

Regulation 28 makes it clear that trustees remain responsible for compliance, even when functions such as asset management are outsourced. Trustees should discuss tapering with their asset managers, and ask whether they are including any bets targeted at benefiting from tapering or any positions designed to act as a hedge in your portfolio. Trustees should satisfy themselves that these positions are prudent and offer sufficient upside potential and downside limited to levels tolerable by the fund and its members. Factors such as performance fees imply that a manager may have a larger tolerance for higher risks within a portfolio than the trustees. Managers need to be able explain any significant portfolio tilts they have implemented and what the potential profits and losses on these positions are.

Interest rate risks and the value of tailored advice

Unfortunately history does not provide any examples of quantitative easing on the scale used by the Fed during the last five years. There is very little certainty regarding how yields (or interest rates) will react during and after tapering. As the Fed reduces its bond purchases, bond prices may weaken (which implies increased yields). Arguably the market is fully aware of the Fed’s intention to taper and some of this may already be priced in (at least for longer term yields). It is impossible to say how much further yields might increase and when this might occur. As the market grapples with the implications of tapering, we expect rates to be volatile. Despite a significant increase during 2013, real interest rates remain low relative to longer term averages.

Defined contribution pension funds

Members need to be encouraged to focus on the income they can afford during retirement rather than the capital they have accumulated. Volatile rates imply volatile annuity prices – an example of this is shown in a later question. Expect that the members’ income stream purchasing power will be highly variable and encourage members closing in on retirement to consider strategies that could minimize that variability. Here is where the introduction of a good financial advisor can be of particular value. They can:

• Help the member to evaluate their income needs;

• Assist the member to understand what sort of income their current savings can buy them; and

• Explain how the income they can buy might vary as interest rates vary during the Fed’s taper.

Based on this information, the advisor will be able to assist the member in deciding whether they can afford to annuitize now or whether to defer this decision to a future date. This approach will ensure that members crystallize any opportunities to retire at a comfortable level of income rather than simply focusing on controlling the volatility of their capital.

Trustees can play a valuable role here by selecting reputable advisors and ensuring members are made aware of the importance of advice and how to access it.

Defined benefit pension funds

As interest rates fell on the back of QE, the value of defined benefit pension fund liabilities increased significantly. Many local defined benefit pension funds already made use of liability driven investment (“LDI”) techniques to hedge against this risk. Funds with no rates hedges in place suffered significant declines in funding levels due to these rates increases. UBS strategist Boris Rjavinski writes:

“In a perfect world we could separate the effects of the economy and QE, but this simply is not feasible. Still, we think that QE at a minimum has accelerated the demise of some pensions… Unfortunately, things got so bad for some pension funds that they never had a chance to stick around to see the “long run”.”

“Volatile rates imply volatile annuity prices.”

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The effects of QE again highlighted the sensitivity of defined benefit funds to interest rates. As tapering occurs, rates may rise, which would in turn make LDI strategies more affordable. Trustees who have not yet made use of LDI could investigate the benefits and consider preparing market triggers for implementation through the rising rates cycle.

Should funds with existing LDI strategies consider reducing their hedge exposure during tapering? Any losses due to increasing interest rates incurred on LDI bond portfolios would be reflected in reduced liability values, implying no impact on the financial health of the fund. Removing these hedges would expose the fund to funding level volatility as markets settle during tapering. It is unclear how long this would take and how one would identify when the market has fully reacted. A fund might hence need to remain unhedged for a significant time period, possibly years. Given this lack of certainty of both upside and downside, all else being equal LDI strategies already in place should probably be retained through tapering.

Conclusions

Given the unprecedented scale of the Fed’s QE program it is impossible to reliably predict exactly how markets will react to tapering. Alexander Forbes’ view is that there are no free ‘free lunches’ attributable to tapering without at least some risk for investors. Previous advice remains - pension funds should retain well diversified portfolios designed to target suitable liability related objectives such as replacement ratios in DC funds and funding level in DB funds. Trustees should engage with their managers regarding how they have positioned their portfolios for tapering. Trustees might also consider informing members and the fund’s sponsor about potential market volatility during tapering and should encourage members retiring to seek advice regarding when to annuitize. During periods of high market and annuity price volatility, individual advice for members near retirement is particularly valuable. Trustees could help members feel confident about where to access quality advice by doing some of the vetting on their behalf.

“Given the unprecedented scale of the Fed’s QE program it is impossible to reliably predict exactly how markets will react to tapering.”

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ALEXANDER FORBES

How does the South African asset management industry fare globally?

South Africa accounts for just under a fifth of Africa’s GDP, 0.7% of world GDP and less than 2% of global assets under management. Yet despite its modest global standing, SA has a highly developed financial services industry, when set against global benchmarks. SA ranks 53rd out of 148 countries in the global competitiveness landscape according to the World Economic Forum’s Global Competitiveness Report 2012/2013. However, its financial services industry is ranked third out of 148 countries for financial market development. Indeed, according to the Towers Watson Top 500 list of global asset managers, in 2012 there were ten SA firms compared with six from Brazil, 25 from China and six from India. This is a stand-out performance compared with the BRIC countries, which together contribute 26% of world GDP.

A number of critical developments have allowed the asset-management industry to grow into a globally competitive business and thrive. SA has a long history of institutional pension fund and unit trust investing. Indeed, according to The Pension Funds Act: A Commentary by R Hunter et al the first occupational pension fund is thought to have been established in the Transvaal Republic in 1882. By the time, the Pension Funds Act was enacted in 1956, there were 1 200 pension funds. In 1989, the abolition of prescribed assets and the introduction of Regulation 28 prudential investment limits would further foster a strong culture of active equity investment in SA. The first unit trusts arrived in 1965 and by 2012 the industry had R1 trillion in assets. In 2012, pension assets represented 64% of GDP (compared with 101% in Australia, 14% in Brazil, 110% in the UK and 108% in the US), according to the Towers Watson Global Pensions Asset Study. Extraordinary real returns across most assets through the decades have underpinned the industry’s growth. In the five-year period ending 2012, unit trusts were the fastest-growing pool of assets (14% p.a.), followed by the Public Investment Corporation (PIC) (12% p.a.), public and official pension funds (11% p.a.) and then private pension funds (8% p.a.), according to the SA Reserve Bank Quarterly Bulletin.

Size of the industry

Total assets managed by SA investment managers grew from just under R1.1 trillion in 2000 to more than R3.8 trillion in 2012, according to an Alexander Forbes survey. This increase represented a compound annual growth rate (CAGR) of 10.2% a year in a period when local financial markets returned a total 17.4% a year in equities, 11.7% in bonds and 8.3% in cash. These returns accounted for most of the growth in the assets managed by investment managers.

The SA asset-management industry is highly concentrated compared to countries such as the US (30%), Australia (43%), Japan (40%) and China (25%) as illustrated by graph 1 below. These percentages indicate the market share of the biggest five asset managers in their respective countries.

Graph 1: Asset management industry concentration in different regions

Source: World Bank, BlackRock

QUESTION 3 The history of asset managers.

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Table 1 below further illustrates the concentration in the industry and how it has changed over the twelve year period. As at the end of December 2012, the five largest asset managers accounted for 61% of industry assets, while the ten largest managed 87%. Nevertheless, the top five managers’ share of market declined from 65% to 61%, as independent firms gained share from the life-owned asset management firms.

Table 1: Market share concentration

As a group, life insurance companies lost out significantly over the period. Indeed, life insurance companies began the decade with 67% of total industry assets, but accounted for only 42% of market share as at the end of 2012 as shown by graph 2 below.

Graph 2: Life insurance companies vs. the rest

The declining market share prompted some of the life insurance companies to restructure their business models to better compete with smaller specialist boutiques. As an example in 2004, Old Mutual Asset Management transformed its business with the creation of 14 different investment boutiques.

Strong performance, the emergence of new distribution channels such as asset consultants, multi-managers, and linked investment platforms, as well as product innovation and the ability to outsource administration functions, allowing firms to focus on functions central to investment management, have all boosted growth in independent firms to the detriment of the rest.

How have dominant players in the industry changed over time?

OMIGSA (Old Mutual Investment Group South Africa) has been the largest firm throughout the period since December 2000 to December 2012. This period saw newcomers including Allan Gray, Prudential, Prescient, Futuregrowth and Absa enter the top 10 in the list of largest managers. A number of managers disappeared over the period. Stanlib was formed following the merger of SCMB (Standard Corporate Merchant Bank) and LIBAM (Liberty Asset Management) in 2002. Investec acquired

Source: Investment Solutions/ Alexander Forbes


Top 5 Next 5 The rest

December 2000 64.8% 17.3% 17.9%

December 2012 60.5% 26.7% 12.8%

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ALEXANDER FORBES

Fedsure in 2001. RMBAM and Metropolitan, who merged in 2010 to form MMI, lost significant ground. Table 2 below lists the top 10 investment managers in 2000, 2005, 2010 and 2012. Life-company owned companies have been highlighted to show a decrease in their dominance in the industry.

Table 2: Largest managers over time

As at 31 December 2012, independent and bank-owned managers accounted for three of the top five places in the rankings by assets under management, reducing the historical dominance of insurer-owned asset managers. In 2006, Allan Gray would become the first independent firm to break the dominance of the insurer-owned firms - a feat achieved 32 years after it opened its doors. While Old Mutual remains the largest manager in SA, rapid growth at Coronation, which turned 20 in the year 2013, has seen the firm rise steadily up the league table. After nearly a R100 billion increase in assets in less than a year, the firm is now hot on Sanlam’s heels.

Although the industry success has attracted lots of players, foreign firms have found it difficult to break into the market, which remains firmly in the grip of local firms, thanks to strong investor home-market bias. Graph 3 below illustrates the growth rates of the largest ten firms as at 31 December 2012 over the last 10 years.

Graph 3: Top ten asset managers as at December 2012 and their growth rates over the past ten years


Rank 2000 2005 2010 2012

1 OMIGSA OMIGSA OMIGSA OMIGSA

2 SIM SIM SIM Investec

3 LIBAM STANLIB STANLIB SIM

4 RMBAM RMBAM Allan Gray Coronation

5 Investec Investec Investec Allan Gray

6 Coronation Allan Gray Coronation STANLIB

7 Fedsure Investment Solutions Investment Solutions Investment Solutions

8 SCMB Coronation RMBAM Momentum

9 Investment Solutions Metropolitan ABSA Prescient

10 Metropolitan ABSA Prudential Futuregrowth

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Over time, the big firms have also sought to establish a footprint overseas through acquisitions and gathering assets to fulfil their strategic ambitions to have a global asset-management capability and meet the growing needs of local investors. With retirement funds’ offshore allowance growing from 5% in 1995 to the current 25% plus an additional 5% in Africa, South African firms have leading positions in Namibia, Botswana and Swaziland. With the increasing interest in the African growth story, managers could expand further afield. For example, Allan Gray recently opened a business in Nigeria.

After an inauspicious start to the new millennium, marked by the dot.com crisis, there would be a significant wave of consolidation that would mark the end of many firms. After 2003, there was a wave of new start-ups and boutiques that would result in a proliferation of firms and products. To put it in perspective, at the beginning of 2000, 12 managers and 72 products were tracked by the Investment Solutions investment team. By the end of the decade, the number of managers and products had grown about eight-fold.

The Financial Sector charter would be signed in 2004, marking the onset of a flurry of empowerment deals and the emergence of new leadership within the industry, although it would take longer for transformation to take root across the businesses. In 2008, many young firms won first-time mandates from the PIC, which, with over R1 trillion in assets and growing, continues to play an influential role in supporting transformation in the asset-management industry. Particularly pleasing is that some of the fledglings the PIC supported are now established firms, adding to the universe of local asset managers.

The revised Regulation 28 requires trustees to consider transformation when appointing service providers, which could see the market share of these firms grow from its current low base, and further foster competition. Black-owned and managed firms have a market share below 10% of total industry assets despite recent strong growth in assets under management. Black-owned or controlled investment-management firms (those with more than 50% black ownership) have experienced rapid growth in assets, albeit off a low base. One reason for the low market share is that most of these firms were set up in recent years so they have shorter track records. Another is that because of their boutique nature, they do not have a wide range of investment portfolios. Graph 4 below illustrates market share of black-owned and managed firms since 2005.

Graph 4: Market share of black-owned and managed firms over time

Current challenges facing firms

Growing demands, including National Treasury’s call for a transition to lower fees, the increasing cost of regulatory compliance, market volatility and shrinking of funds will keep the industry under pressure. To meet the challenges ahead and run a sustainable business, firm size and strategy will be vital and the consolidation of smaller players in the industry seems inevitable. Skill, luck and patient investors and shareholders will be key to the longevity of firms. A challenge for investors will be to continue to refine a rigorous and robust manager selection process, that takes account the changing landscape, in order to maximise the chances of identifying investment managers that will be successful in the future.

Source: Investment Solutions

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ALEXANDER FORBES

History of and rationale behind life stage investing

The South African retirement fund landscape underwent a dramatic change in the early 1990’s with the industry trending away from defined benefit in favour of defined contribution funds. Over the next decade, the vast majority of members’ retirement benefits were converted from a defined benefit (DB) funding mechanism to a defined contribution (DC) approach. A discussion of the relative merits of these two options for retirement funding can easily fill an entire booklet - particularly with the benefit of 20 plus years’ experience as we now enter 2014 - but in answering the above question we will be focusing on certain aspects of the subsequent evolution of retirement fund investment strategies.

At the time of conversion to DC, members and trustees were mostly of the view that, while the target income objective after retirement remained the same for both DB and DC funds, the primary difference was that the investment risk would be transferred from the plan sponsor to the individual fund members. These fairly innocuous sounding words have had enormous implications for members over the past 20 years and will continue to do so.

There were also other, less obvious risks that were passed from funds/employers to individual members. These risks include longevity risk, planning risk and modeling risk. Planning for retirement is a very complex problem. One might argue that most members do not need to plan - the trustees of their pension fund and their employer will typically set their investment strategy, contribution rate, retirement age and other key variables. Unfortunately, very few members will stay with a single employer (and hence a single pension fund) across their entire working life. Therefore individual members are left with the ultimate responsibility of ensuring their aggregate saving across various funds and various fund rules will be adequate.

A critical question for trustees is what kind of income will members be able to purchase on retirement when one considers various combinations of contribution rates, retirement ages, investment strategies, and annuity costs? This answer is typically derived from modeling - modeling which requires assumptions about such inputs as a reasonable equity return for the next few decades, or which mortality rates will prevail over the next few decades, to estimate what annuities will cost when members retire. These assumptions are notoriously difficult to set. The extents to which the assumptions play out in practice over the long term represent a risk in the benefit design phase.

These risks need to be considered when designing the benefit structures, including the investment strategy.

QUESTION 4 Have life stage strategies delivered appropriate results in view of their intended objectives?

SECTION 2: Investment strategies

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Let’s have a look at how the investment risks could impact. The graph below shows the value of R100 invested in each of the primary asset classes 20 years ago.

Members who contributed to a defined contribution retirement fund over this period should have benefited from very strong real investment returns. South African equity markets have experienced two significant long term bull runs with the ALSI delivering an overall annualized return of around 16% over the last two decades while bonds (ALBI) delivered 12% p.a. over the same period. These returns compare favourably with the assumptions used to initially determine many DC fund benefits and objectives, as inflation over the same period averaged just over 6% p.a. It would therefore appear that individuals saving for retirement within a DC environment over the last two decades should be in a strong financial position and be well on track to a comfortable retirement. However individual member behavior (e.g. non-preservation) and a lack of financial awareness, coupled with market volatility amongst other things, has unfortunately meant that many members have not fully captured the benefit of these strong returns.

For now we will focus on the development of DC investment strategies – in particular the life stage strategy – in response to this market volatility and detrimental member behaviour.

Value of R100 invested 20 years ago

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ALEXANDER FORBES

The performance of the last two decades was delivered with a certain degree of volatility in returns which became the short term primary focus of many members and trustees. The volatility can be quite significant over the shorter term. The graph below shows the monthly progression of the actual value of the R100 invested 20 years ago, versus a notional “smoothed” investment vehicle which delivers the same overall result at the end of the 20 years but in the absence of any volatility (please note the latter could, of course, not exist in reality but is merely illustrative).

Volatility of equities vs. notional smoothed investment portfolio

While one can argue that DB and DC funds are not that different in their objectives (since they ultimately aim to achieve an adequate replacement of a member’s income at retirement) the “transfer of (investment) risk” together with market volatility has had a significant impact on member and trustee behavior, and on the evolution of the investment strategies for DC funds.

Under the DB approach, short term volatility of investment returns had no direct impact on members’ accrued benefits (nor behaviour), and even presented little concern to trustees at their quarterly meetings since the actuarial valuation methodology inevitably “smoothed out” these market fluctuations by applying long-term assumptions to the valuation of the fund’s assets (creating an effect similar to the smoothed line we see in the graph above). Under a DC approach, members’ benefits/fund credits move directly in line with market returns and the benefits of smoothing and pooling of risk is no longer typically available to absorb the short term market volatility to the same extent. It is possible to partially smooth investment returns, usually at some extra cost, but the challenge of equity between generations of members needs careful consideration.

This feature, coupled with the growth in the number of DC funds, naturally led to an increased focus on the investment strategy for member’s fund credits and in response a “life stage” approach was often adopted as the default strategy for many South African DC retirement funds. This approach aims to address the impact of volatility at the appropriate stages of a member’s working lifetime, while also offering a default, one-size fits all, approach or option for members who are not in a position to determine their own unique investment strategy against the backdrop of an ever-changing market and economic climate as well as variety of retirement options.

What do we mean by “life stage strategy”?

The thesis behind a typical life stage approach is that the investment lifetime of a typical employed individual can be split into distinct phases. This is usually represented by three broad phases as illustrated below:

Accumulation Stage Pre-retirementStage Post-retirement Stage

Start working Retire

Ran

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The investment objective and strategy for each of these three stages is different. During the Accumulation Stage individuals are accumulating the bulk of their wealth in order to provide an income during the post-retirement stage. This stage is usually the longest of the three stages, and can typically extend to as long as 30-35 years. During this accumulation phase, investors should be seeking higher investment returns, and due to the long time horizon here, investors are usually willing and able to tolerate a relatively high degree of investment risk and should be able to ride out volatility in favour of their long term strategic asset allocations.

During the pre-retirement stage, which can be anything from 5 to 10 years prior to retirement, individuals start planning for their retirement and should, hopefully, be considering the annuity options they wish to exercise when they retire. Investors are thought to require more certainty of investment returns over this period, especially in the last few years leading up to retirement. Pre-retirement stage investors should therefore be more risk averse, but given that this stage can commence up to ten years before retirement, it is generally accepted that an appropriate level of investment risk should be maintained during the earlier years of this stage. The pre-retirement stage can be divided into any reasonable number of steps which smooth the transition from the accumulation strategy to the strategy in the years immediately prior to retirement.

The investment strategy for a typical life stage model typically involves a combination of the primary asset classes – equities, bonds and cash – with diversification into international asset classes and alternative asset classes in order to diversify the portfolio returns and risk exposures. The allocation to the more volatile/growth assets is naturally higher during the accumulation phase, and gradually reduces according to a pre-determined schedule in favour of the less volatile asset classes – usually bonds and cash. Pre-retirement portfolios usually target at least one-third cash at retirement.

This strategy has largely been implemented via active specialist mandates into the above asset classes, but we have also seen the strategy applied with balanced mandates and more recently passive specialist mandates.

As an example, the diagram below shows the look-through asset class exposure for the Alexander Forbes Specialist LifeStage portfolio as at December 2013.

Once an individual enters the post-retirement stage he/she begins to draw an income from the assets accumulated up to that point. At the start of this stage, a member retiring from a pension fund will need to purchase some sort of annuity with part of their fund credit. Note that this requirement will apply to provident funds in respect of contributions and growth on these from 1 March 2015 onwards.

Retirees are faced with many different options available in the market – each with differing levels of affordability, guarantees and risks. Members will also often elect to receive a portion (up to 1/3rd) of their accumulated fund credit as cash. The investment strategy during the retirement years is still critical as people are typically living for up to 20 or 30 years after retirement. Exposure to real assets (which earn a return in excess of inflation) is essential if living standards are to be maintained throughout the post-retirement stage.

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ALEXANDER FORBES

A typical retirement fund life stage model encountered today is usually designed to adequately address the different investment needs of the typical fund member throughout the first two of the above stages. In certain cases the pre-retirement portfolios may, to some degree, take into account the strategy to be adopted during the retirement stage.

The following have to date been considered the primary objectives of successful life stage models or strategies:

• Achieving investment returns in line with the stated objectives (usually linked to replacement ratios)

• Exposure to growth assets – for long enough• Diversification of returns• Limited volatility (preservation of capital) close to retirement• Limited (negative) impact of member behaviour - offering an embedded advice model• Simple enough for members to understand and to be administered in a

cost-effective manner

Now to answer the question…

Given the limited time period that many life stage strategies have been in place, when compared to an entire working lifetime, as well as the nature of some of the objectives listed above, it would be impossible to categorically determine at this stage (or perhaps ever) whether life stage strategies have indeed “delivered appropriate results in terms of (all of) their objectives”. Indeed many existing life stage strategies are quite different to each other in terms of complexity and portfolio construction and while some have been more “successful” others have been less so – again depending on which objective we are actually measuring success against and how we define success. In addition we have learned along the way that some of these objectives need to be refined or improved on in order to achieve an optimal retirement outcome with a higher degree of likelihood. So success in hindsight may not translate into a successful result going forward as objectives and strategies are respectively restated and refined.

What we can say is that in a risk cognisant world, developing our investment strategy in such a way that it is at inception optimized to deliver our key objective (such as a replacement ratio) with as high a probability as we can, and then refining this over time to improved techniques, is more than intuitively correct – it is, based on the modeling and the inputs at the time, the most appropriate strategy for that objective because it is optimal. This does not guarantee that in hindsight, a slightly different structure could not have delivered a marginally better result. It is all about maximizing the probability of success.

We can, to a limited degree, examine certain of the above objectives in more detail to ascertain how we have done so far. We will begin with an examination of the investment returns of several different life stage strategies adopted by different retirement funds (one of which uses the AF Specialist LifeStage product). Each of these life stage strategies offers significant exposure to growth assets during the accumulation phase with a step-down approach to a more conservative portfolio during the pre-retirement stage. Members all end up with about 30% in cash immediately before retirement, with the balance invested in bonds and a smaller allocation to growth assets such as equities. In all cases, exposure to offshore assets is set at a higher level during the accumulation phase, decreasing in favour of local assets as members approach retirement. The funds employ alternative investments to a greater or lesser degree - for diversification and return enhancement. All follow active investment strategies.

Firstly, we examine the net investment returns during the accumulation phase for each of these funds. Remember the returns are NOT directly comparable to each other given the different strategies adopted and the different measurement periods for each fund. The returns can, however, be compared to inflation over the same measurement period in order to assess whether the investment strategy during the accumulation phase has had sufficient exposure to growth assets in order to deliver sufficient returns in excess of inflation to set members on the path to an acceptable replacement ratio.

In addition we have learned along the way that some of these objectives need to be refined or improved on in order to achieve an optimal retirement outcome with a higher degree of likelihood.

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A further objective of the traditional life stage approach is the limitation of volatility or preservation of capital as members approach retirement. Fortunately (or unfortunately) we experienced one of the most significant financial crises and market crashes of the last century during the measurement period. This provides an opportunity to measure how successful these funds were at preserving member’s capital during this period of market turmoil and extreme volatility.

The graph below shows the performance of R100 invested in the pre-retirement portfolio in July 2007. The performance of R100 invested in the ALSI is also shown by way of comparison and to provide some context to market conditions during the period in question. The graph clearly illustrates how these portfolios have protected investors from equity market volatility, while still providing a respectable return. In fact each of these portfolios delivered returns at least 2% in excess of inflation over the period. This performance can, in part, be attributed to the performance of domestic bonds (which form the cornerstone of many pre-retirement strategies) over the measurement period.

Date of commencementAccumulation portfolio

performance since commencement

Inflation Real Return since commencement

Fund A Mar-06 13.3% 6.5% 6.8%

Fund B Oct-06 12.9% 6.5% 6.3%

Fund C Jul-07 11.1% 6.4% 4.7%

Fund D Dec-00 15.3% 5.8% 9.5%

The largest capital drawdown over rolling three month measurement periods for any of the four portfolios was -3.8%, while none of the portfolios experienced capital losses over 12 month rolling measurement periods. In contrast, the ALSI (as a rough proxy for growth orientated portfolios) suffered fairly large quarterly drawdowns and had periods where capital losses occurred over several rolling 12 month periods.

We can therefore say this sample of pre-retirement life stage style portfolios appears to have met the objective of capital protection close to retirement, and still provided some capital appreciation.

Ran

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ALEXANDER FORBES

An important takeaway here

is that we are not determining

success by comparing the

various funds’ returns against

each other, nor against market

related benchmarks or other

unrelated strategies such as

balanced portfolios. Instead we

are determining the success

of the strategy by comparing

the experience to the stated

objectives – an inflation plus

return or preservation of capital

– over a sufficiently long period

of time.

An important takeaway here is that we are not determining success by comparing the various funds’ returns against each other, nor against market related benchmarks or other unrelated strategies such as balanced portfolios. Instead we are determining the success of the strategy by comparing the experience to the stated objectives – an inflation plus return or preservation of capital – over a sufficiently long period of time.

Another of the objectives stated above is to limit the negative impact of member behavior on retirement outcome in a DC environment - through the embedded advice model when life stage is implemented as a default strategy. By negative member behavior we are, in this case, referring to the inappropriate short term decisions taken by members when offered individual investment choice, often in response to market volatility amongst other things. We are also referring to the potential apathy of members in changing a strategy once implemented for their particular lifecycle i.e. implementing a strategy with good intentions but never reviewing this even if their circumstances change.

It is perhaps not possible to empirically measure how successful a default life stage strategy has been in this case, as we do not know what decisions members may have taken in the absence of the default strategy or if they had to implement their own appropriate pre-retirement strategy from available portfolios on offer. It is accepted, however, that members close to retirement generally seem to be more risk-averse than is appropriate and tend to switch into more conservative assets to early and/or to a greater degree than is appropriate (for example switching 100% into cash). We also know from our Member Watch surveys that there are a fair proportion of members making switches who are risk averse at the younger ages. It is possible that they do not recognize the impact of this decision on their ability to grow capital for retirement.

This is just one example of member behavior which can negatively affect their retirement outcome. Attempts to “time” markets or panic-driven switching into cash following a market correction during the accumulation phase are both common examples of detrimental member behavior when individual investment flexibility or choice is offered. A default strategy which is appropriate to the typical member and is constantly reviewed and assessed by board of trustees together with professional investment advisors should offer some protection against the potentially devastating effect of this member behaviour1.

And in conclusion

Given that

• life stage investing has been and will continue to be a continually evolving framework,

• the timeframe for this strategy to be fully employed is extremely long (effectively an individual working lifetime),

• individual life stage strategies can be very different in design (for example passive versus active, targeting different sources of retirement income etc),

it will always be nearly impossible to measure the success or performance of one particular life stage strategy against another or against other popular DC retirement portfolios or strategies. The changing nature and evolution of the framework in response to regulation changes and product/ investment market development and innovation also means that it is very hard to ever categorically state that a particular application of the strategy or the broader life stage framework has been successful in achieving stated objectives. At this stage we can say that this framework represents an intuitive solution to the retirement problem, and given its “building-block” substructure part of its strength lies in the fact that it is a flexible framework which can be easily tailored to incorporate fund-specific circumstances or industry developments. Certainly the limited evidence provided above seems to suggest that, to date, the strategy or framework does appear to be achieving the objectives where measureable.

We therefore believe that a life stage framework is the appropriate default strategy for the majority of South African defined contribution funds.

1 In the institutional market the cost of chopping and changing asset managers and/or asset consultants when combined with performance short-termism has been estimated to create as much as 3% of value erosion per annum.

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Criticisms and Shortcomings of life stage

We have demonstrated in the previous question (to at least a limited degree) that a life stage approach to retirement funding is based on sound financial reasoning and appears to have delivered on its basic objectives since first becoming popular in South Africa. The reason our evidence is limited is the same as for many investment hypotheses – not enough (homogenous) data, and not enough time.

But we must acknowledge that there are critics of the life stage approach. Their criticism covers a range of features of the strategy - some of the more common ones are listed below. It is worth noting, as you read through the list, that many of the criticisms are leveled against the earlier and arguably less sophisticated forms of the life stage investment strategies. Life stage strategies have evolved since they were first introduced and much of this evolution addresses the criticisms leveled against them in general.

Common criticisms of life stage strategies include:

• The strategy is too conservative at retirement and does not recognize that the investment horizon can still be as long as 30 plus years.

• The strategy does not cater to a smooth transition into retirement given the range of choices available to members at retirement.

• The strategy focuses on preservation of capital and not preservation of income.

• Most members access all their savings in cash if they can.

We group these points together because they stem from a common criticism of many current life stage strategies and DC funds in general: that the investment strategy only caters to members’ liabilities up to the point of retirement. Little or no cognizance is taken of the diverse range of choices available to a member at retirement and the pricing of or post-retirement strategies associated with these choices. The pre-retirement strategy usually does not seamlessly transfer into post-retirement strategies which, in turn will depend on the choices available to members. As will be seen in our discussion below on the evolution of life stage strategies, this is the area which has received the most attention in terms of research and product development over the last few years and many products or strategies currently exist which address these concerns to a certain degree. It is also clear that this is still an area which requires significant further refinement to optimize the overall outcome in terms of maximization and preservation of retirement income. This is also discussed further in the next question.

The strategy adopts a “one-size fits all” approach – for example increasing exposure to cash to one-third at retirement.

The life stage strategy is generally designed as a default investment strategy for a typical fund member. It is therefore, by design, a “one-size-fits-all” approach. Trustees recognize that particular members may have individual circumstances different from the “typical” member’s and may wish to formulate their own investment strategy. This is generally catered for by offering members the choice to opt-out of the life stage framework in favour of one of the life stage portfolios or even in favour of a different strategy altogether.

One feature of many life stage strategies which does warrant further attention and development is the assumption that typical members will elect to take one-third in cash at retirement. Tax incentives have, in some part, played a role here, effectively incentivizing retirees to access at least some of their benefit in cash. Whatever the reasons for accessing cash, evidence suggests that many South African retirees are not achieving an acceptable replacement ratio and in order to boost their income should aim to annuitise their full fund credit. The current practice of placing at least one-third of the fund credit in cash reinforces the behavior of taking these funds as a lump sum, which may subsequently be dissipated. Given the current investment landscape, with negative real returns being earned on cash, and the potential long term horizon for this one-third component if it is converted into an income, it may be appropriate to consider offering members some degree of choice around the cash allocation of their pre-retirement portfolios.

QUESTION 5 What are the criticisms of life stage investing and how might life stage models evolve?

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ALEXANDER FORBES

The pre-retirement portfolio is still fairly volatile – members can still lose money

The focus and development of life stage strategies over the years has been away from preservation of capital leading up to retirement toward the preservation of the (real) amount of income that can be secured at retirement. These objectives can conflict somewhat – depending on the choices made at retirement. This is discussed further in the next question. For now it is important to note that strategies that target preservation of income may result in some capital volatility close to retirement – but as long as the strategy delivers returns which can immunize the investor against changes in the cost of an annuity or a fall in the amount of income they can secure in retirement with their fund credit they are appropriate and should still be seen as achieving their objectives. We consider this in the next question.

The pre-retirement strategies with the highest probability of preserving capital entail having a high allocation to cash. Current investment conditions with very low interest rates means that while the assets invested in cash have almost no volatility, members fund credits invested in such a portfolio would be earning negative real returns thereby diminishing the purchasing power of their fund credit (all else being equal). Even under more normal capital market circumstances cash is only expected to deliver slightly positive real returns. Consider the member who wishes to invest in a living annuity at retirement. The long term time horizon of such a vehicle will imply that some exposure to growth assets is still required. The impact of spending up to 3-5 years “out of the market” in cash prior to retirement creates a significant and unnecessary disjoint between the pre- and post-retirement strategies as well as introduces the opportunity cost of earning growth asset returns over the period.

The strategy has underperformed other (more discretionary) investment strategies (eg balanced portfolios)

Members or trustees often compare the performance of the life stage portfolios (particularly for the accumulation phase) to alternative portfolios which may be offered by the fund – such as discretionary balanced portfolios or other more aggressive strategies which cater to individuals with a higher risk appetite. Given the very different hypotheses and objectives behind these distinct strategies, such comparisons should not be undertaken and can lead to spurious results and inappropriate behavior. Portfolios which are more aggressive or have shorter term return focused objectives and form part of a broader homogenous peer group naturally follow a different strategy to a typical life stage portfolio which is focused on achieving a certain set of objectives over the working lifetime of a member. These objectives are usually related to securing a reasonable retirement income rather than beating a peer group or market-oriented benchmark over a shorter measurement period.

This does not make any particular strategy superior to the other – either in terms of performance or design. The appropriate choices will depend on the individual circumstances of each member. Consider a member who has secured an external passive source of retirement income outside of their retirement fund. It would not be unwise for such a member to opt out of the life stage framework in favour of a more aggressive investment strategy for his/her fund credit. Suffice to say that the “typical” employee in South Africa does not have significant discretionary external savings outside of their retirement fund to generate an income in retirement and hence the life stage strategy remains appropriate as a default choice for almost all funds.

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The evolution of DC and life stage investment strategies

As we have discussed, since their early beginnings, DC fund strategies have evolved over time to become more sophisticated, and continue to do so. The diagram below shows the development and evolution of DC funds and life stage strategies since these funds first gained popularity, up to and including the latest developments currently being considered by providers.

The first life stage strategies focused primarily on protection of capital close to retirement and in many cases phased investments towards a 100% cash portfolio at retirement. Since then, these strategies have evolved to take cognisance of the choices members are offered at retirement and to facilitate a smoother translation of the members’ fund credit into an income after retirement. For some “off the shelf” products, this has led to the development of different pre-retirement portfolios within a particular product offering, each designed to target a particular form of income at retirement such as a fixed annuity, an inflation linked annuity, a with profit annuity or a living annuity. Members must then select the appropriate pre-retirement portfolio depending on what form of retirement income they intend to secure at retirement date. An example of this is the Alexander Forbes Lifestage Annuity range.

While such a strategy represents a significant improvement as it recognises that different pre-retirement strategies are appropriate and depend on the type of annuity to be secured at retirement, this strategy sometimes involves offering members a range of pre-retirement portfolios from which to choose up to 10 years prior to retirement. This means that members must be in a position to consider the various annuity and portfolio choices at this stage of their careers. This is very difficult for most members, particularly in the absence of professional financial counselling. This, together with the administrative and cost burden of offering numerous investment channels to members close to retirement means that despite this approach offering a neat solution to smoothing the transition from fund credit to retirement income by better protecting the level of income that can be purchased, it is not always practical to all but the largest funds, and/ or to umbrella funds offering “off the shelf” life stage solutions.

Source: Principle Global Investors / CREATE-Research Survey 2013

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ALEXANDER FORBES

Even where this choice of pre-retirement portfolio is offered, industry is developing more refined solutions which aim to further align the pre-retirement investment strategy to that backing the cost of securing an income or the strategy after retirement. As discussed earlier, the extension of the concept of Liability Driven Investing (LDI) to active members is one such example. This fits naturally within the bond component of the pre-retirement portfolio and the concept can further be extended to the other asset classes.

In 2013 National Treasury issued several discussion papers which covered proposals on retirement reform in South Africa. One of the proposals, in particular, addresses the choices members are offered at retirement. In particular, it has been proposed that trustees should consider the post-retirement options available to members, and must select a default annuity into which member credits are automatically switched at retirement in the absence of the member indicating an alternative preference. This default annuity can be administered either outside or inside the fund. This will mean that boards of trustees will need to apply their minds to the appropriate default annuity they wish their fund to offer members at retirement. Once this has been established they should ensure that their default pre-retirement investment strategy is appropriate given the (investment) strategy for the post-retirement annuity option.

Further developments in life stage portfolios involve optimising the timing and implementation of the phase-down or de-risking period until the member is in the final pre-retirement portfolio. Further attention is also being paid to options for return maximisation within the accumulation stage – either through the introduction of more discretionary portfolios (for example where tactical asset allocation alpha can also be sought) or through the introduction of alternative asset classes which aim to improve both returns as well risk profile of the portfolio through diversification.

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In the last question we considered briefly how pre-retirement life stage portfolios have been and will continue to evolve to take cognisance of the annuity choices facing retirees.

There has been little change in overall contribution rates over the years, or other design inputs into replacement ratios. The problem with this static structure is that the cost of retirement has not been static at all – at Hot Topics 2013 we considered what the record low bond yields implied for retirees and the effect was dramatic – annuities were far more expensive. The Alexander Forbes Pensions Index highlights this and that although expected outcomes improved in the last six months of last year, over the long term pension expectations have reduced.

A paper entitled, “A Pension Promise to Oneself” by Stephen C.Sexauer and Laurence B.Siegel, stated that saving for retirement is not hopeless. Noting that many defined benefit funds in the past were well-run and provided income for many pensioners over many generations, the reason why more and more started to fail was because they broke the rules. These funds started to depend on stock market returns to pull them out of the sinking sand instead of spending time and effort on controlling the benefit promises that they made which caused the sand to sink in the first place. This is a topic that generates much debate.

However, what we aim to discuss is the question “what are members (who are mainly participants in DC plans) currently doing to ensure that their retirement is as they expect?”

The purpose of a retirement fund (be it DB or DC) is effectively to spread the earnings during one’s working life over one’s whole life, and achieve a comfortable retirement income whilst retaining a reasonable standard of living pre-retirement.

QUESTION 6 What’s an appropriate investment strategy for post-retirement and how should this be linked to pre-retirement strategies?

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ALEXANDER FORBES

What are the attributes of a comfortable retirement income?

In an environment with limited social security support (and often even in countries where this exists) most employed individuals will have to rely on their lifetime savings built up during their working years. The desirable attributes of a retirement income that one aspires to achieve, are:

• Sustainability of standard of living post retirement.• Stability of income in retirement.• Income for life and avoiding running into savings shortfall.

These are risks associated with retirement funding. We take a deeper look at each.

Standard of living

All of us have been exposed to the effects of inflation, just think back to how much things used to cost 5, 10 or 15 years ago and how much you are paying for them now. Take for example the price of white bread:

At the end of 2007 the price of a loaf of white bread cost approximately R5.89. The cost of this same loaf of bread was R10.50 as at 30 September 2013.

This is an increase of 78% over just under 6 years. The point here is not that the price increased, it is that someone receiving a pension over this period would have had to buy this loaf of bread from time to time over this period. If the portion of their income they used to buy bread was not increasing at the same rate, they would not have been able to afford to buy the same quantity of bread.

Source: Bloomberg

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Therefore an individual needs their retirement income to minimize or counter the effects of inflation (increases in prices over time). Ideally, your income needs to grow in-line with inflation every year – if not you get the following picture:

Stability of income

Uncertainty of the monthly income you are going to receive each month makes it very difficult to budget and live within that budget. This is especially so when you do not have the ability to supplement those earnings. The income stream should be reliable and predictable, preferably in real terms, throughout your retirement.

Income for life

In a living annuity the income is not guaranteed for life and careful consideration should be given to the level of income drawn each year. One has to strike a balance between maximizing income drawn each year and having high conviction that this level of income can be sustained for life.

Now that we know how we want our retirement income to behave, we consider the vehicles that will help us ensure that our retirement income has these attributes embedded in it. These vehicles should be divided into two categories:

1 Pre-retirement vehicles (this speaks to the typical member of a DC fund or who participates in a retirement annuity).

2 Post-retirement vehicles (this speaks to annuities).

The main purpose of this article is to consider how these vehicles or strategies should be linked together. The previous article considered the pre-retirement vehicles. We begin by talking about the objectives of an individual at retirement and the post-retirement vehicles at their disposal.

Not Desirable

Time

Reducing Lifestyle

Pur

chas

ing

Pow

er

eNot Desirabl

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ALEXANDER FORBES

RETIRMENT INCOME OPTIONS

Assuming a member has contributed and preserved diligently throughout their life time and has a healthy retirement savings asset, what post-retirement vehicles can they utilise to convert their hard earned savings into a comfortable retirement income stream? The following options are available to them:

1. Inflation-linked Annuity2. With-profit Annuity3. Fixed increase annuities (including level annuities)4. Living Annuity

Let’s discuss each of these in turn2.

Inflation-linked annuity – the “Holy Grail”

The provider of an inflation-linked annuity guarantees the monthly income for life and the level of income is increased in line with inflation each year. This vehicle therefore meets all the desired characteristics of a comfortable retirement income (maintains the standard of living, guarantees income stability as well as income for life) - the “holy grail’ of retirement income provision.

However, it comes at a cost. In the case of annuities “cost” means the amount of capital needed to provide a certain level of income as the provider needs to be compensated for taking on all or some of your retirement income risks. The table below demonstrates the amount of retirement savings needed to secure a certain income level by a way of an inflation linked annuity.

Monthly Income (net of income taxes) Capital Needed

R5 000 R1 360 000

R15 000 R4 505 000

R25 000 R8 300 000

As you can see, the cost (i.e. capital needed) is quite high. Should a retiree not be in a position to afford this then in order to reduce this cost of conversion of retirement savings into income they need to take on some of the risks instead of the insurer. This takes us to our next option, a with-profit annuity.

With-Profit annuity

The income from a with-profit annuity is guaranteed for life and is guaranteed not to decrease in nominal terms. However, the future income increases are not certain and are not directly linked to inflation each year. They are largely based on the investment performance of the bonus portfolio of the provider. They may also partially be based on the mortality experience of the underlying pool. Hence, an individual is left with a risk of not being able to maintain their lifestyle in retirement if increases do not keep pace with inflation. Taking on this risk yourself allows one to reduce the cost of the conversion by approximately 30% as can be seen in the table below i.e. the capital required to secure the same initial income from a with-profit annuity when compared to the inflation-linked annuity is approximately 30% lower.

Monthly Income (net of income taxes)

Capital Needed

R5 000 R1 005 000

R15 000 R3 310 000

R25 000 R6 110 000

2 Please notes that all annuity quotes shown are estimates that are based on the Alexander Forbes Annuity Bureau for a joint life married male aged 65 (100% spouse reversion and spouse assumed to be 4 years younger) with a guarantee period of 10 years as at 18 February 2014.

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Fixed annuities (including level annuities)

The income from a fixed annuity is guaranteed for life and is guaranteed not to decrease in nominal terms. This type of annuity is not typically recommended unless clients need a guaranteed income for life but can’t afford an inflation-linked annuity or with-profit annuity. There are two main versions of fixed annuities. We have listed these below with a brief description of each:

• Fixed Level Annuity – this annuity provides an income that is fixed for the rest of a person’s life. It does not increase or decrease. For example: R5000 per month for the rest of an individual’s life. This means that the pensioner’s buying power (remember the bread example) will halve in about 12 years at 6% inflation.

• Fixed Escalating Annuity - this annuity provides an income that is guaranteed to increase by a fixed amount (or percentage) for the rest of a person’s life. What is important to understand is that these annuity payment increases are not linked to inflation. Though it is better than a Level Annuity, it is not guaranteed to increase with inflation. For example: R5000 per month that will increase by 5% on an annual basis for the rest of an individual’s life.

These annuities are generally cheaper than inflation-linked annuities and decent with-profit annuities.

Monthly Income (net of income taxes)

Capital Needed for Level Annuity*

Capital Needed for 5% Escalating Annuity*

R5 000 R630 000 R1 000 000

R15 000 R2 100 000 R3 310 000

R25 000 R3 850 000 R6 100 000

Living Annuity

Then finally we get to the living annuity. This is the cheapest (in the sense of capital required to provide a certain level of income) annuity since the only person taking on risk is the living annuity holder.

Typically we recommend that only people who have at least R1,000,000 can invest in living annuities. The reason for this is that if an individual has less than this, it is almost guaranteed that he or she will run out of money prior to passing away irrespective of what returns could be earned. So what should these people do? There are not many options but they could purchase a fixed annuity so that they at least have a base income for the rest of their lives. It is far from the holy grail but at least the longevity risk is taken care of.

In a living annuity there are no guarantees provided - individuals need to manage all of the retirement income risks. In particular, they would need to choose:

• the “correct” or “affordable” level of income to take each year. In terms of legislation, a living annuity holder may withdraw an annual income of between 2.5% and 17.5% of the residual capital each year. This is a vital decision as it affects all three attributes of a comfortable retirement income.

• an appropriate investment strategy that will ensure that your retirement income

a. grows in line with inflation and b. does not fluctuate from one year to the next.

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ALEXANDER FORBES

Correct level of income

The task might sound simple – but how does one determine a reasonable amount of income to draw?

In one methodology, the first step is to determine levels of income, both those desired for comfort and that of necessity. The help and input of an advisor and the setting of a budget are key. Then the advisor’s toolkit comes into play, and they would look to stochastically model the potential returns for a chosen investment strategy, and given a drawdown rate determine the likelihood of falling short of the chosen income levels on a real basis. This can be re-run under various scenarios to test the sensitivity to chosen inputs.

A simplistic way to test the reasonableness of a particular drawdown once chosen is to look at a possible range of “affordable” levels of income by using the annuity markets as a proxy (this is only a proxy and not a substitute for the process described above). The income levels of an inflation-linked and a with-profit annuity would give you an acceptable range.

We have used a with-profit annuity (at a discount rate of 3,5%) which (under a given set of assumptions) could provide increases that are in line with 65%-70% of inflation. It must be stressed that this is not guaranteed as increases are based on investment returns and mortality experience and not directly related to inflation.

The table below compares the income levels from an inflation-linked annuity and a with-profit annuity for a given level of retirement savings.

Capital Inflation-linked annuity pm

3.5% With-profit annuity pm

R1 million R3 674 R4 990

R5 million R14 784 R21 164

However, most people in South Africa retire with insufficient retirement savings. That is, when their savings are converted into retirement income it is not enough to cover their living expenses. This leads to living annuitants drawing an income that is greater than the income from the with-profit annuity early on which jeopardises their retirement income in their later years. The income for life attribute would most probably cease to exist. Striking a balance between the amount of income drawn each year and the sustainability of that income level in retirement becomes crucial.

On the other hand, setting the income draw too conservatively might mean that your standard of living could have been better without putting your retirement savings in strain. This task of setting the correct draw is not as simple as first thought.

Appropriate Investment Strategy

The boundaries can be pushed further with an appropriate investment strategy. The savings invested in a living annuity are there to provide a retirement income and the investment strategy adopted should reflect that. If we go back to the “holy grail” of retirement income (the inflation-linked annuity) we can work out how much capital is needed to secure a certain level of income that is inflation-linked for life.

In particular, in order to have a lifestyle in retirement equivalent to R5 000 p.m. you would need to have retirement savings or a living annuity investment of R1 360 000 (from the table above). However, as your income requirements change over time so does the capital needed. The investment strategy needs to be aligned to the changing cost of an inflation linked income and your income requirements over time. Having such a strategy in place would give you the best chance of having a stable inflation linked income in retirement.

If your income requirements are just too aggressive then an adjustment/compromise needs to be made. Sexauer and Siegel named this adjustment the Personal Fiscal Adjustment (“PFA”). These adjustments are decisions that need to be made by the individual to help bridge the gap between his accumulated savings and his retirement income requirements. The individual could decide to increase his income by retiring later or get a side job to help alleviate the pressure from his living annuity

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drawdown rate. Alternatively he could make decisions to lower his consumption. These are just some of the adjustments that could be made. Let’s assume the individual has made all the reasonable PFA’s that he possibly could and now needs to concentrate on setting his investment strategy.

Investment strategy underlying the “holy grail”

The two distinct features of an inflation-linked annuity are the income for life guarantee and perfect alignment to headline inflation. Investment strategies that match these characteristics consist mainly of Inflation-linked bonds. These are the main financial instruments that back all insurance companies’ inflation-linked annuities. So what exactly is an inflation-linked bond?

Inflation-linked bonds (“ILB’s”) are simply government or corporate borrowings where the interest payments and the final repayment are tied to headline inflation. This makes them a perfect investment instrument to match/counter the provider’s promises under the inflation-linked annuity.

Looking at the graph below we can see how closely the value of Inflation-linked bonds follows or tracks the changing cost of converting retirement savings into an inflation-linked income i.e. an annuity price. This matching is not perfect nor is it guaranteed but it is reasonably well correlated. As mentioned before the conversion “cost” is represented by the amount of retirement savings needed to secure a particular level of retirement income by purchasing an inflation-linked annuity.

Importantly, most of the time changes in the cost of conversion can be explained by changes in the value of inflation-linked bonds in the market. And it is this cost of conversion (annuity price) that represents an income stream that is inflation-linked. What we are trying to emphasise is that a person does not have to annuitise to make this strategy work.

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ALEXANDER FORBES

If you are drawing an inflation-linked income from a living annuity and your residual capital (or “fund credit or savings” if you may) value tracks the price of an inflation-linked annuity well then you are effectively tracking an inflation-linked income draw that should last you for the rest of your life.

As mentioned above it is not guaranteed as either the annuity price or savings value may change for other unexpected reasons. Should this happen, it is important that the investor, with the aid of his/her advisor, makes the relevant decisions to combat this unexpected mismatch. Either the investor draws less from their living annuity or the investor takes on extra risk in their investment strategy to try make up for the shortfall. These are the type of decisions that advisors should be able to assist investors with. This is because each decision has consequences and investors need to be made aware of the range of outcomes that could occur based on each decision.

Replicating the “Holy Grail”

It is possible in a living annuity to replicate the investment strategy underlying an inflation-linked annuity by investing in a pure ILB portfolio. It should be noted that the income in a living annuity is not guaranteed for life and that there is a chance that you might run out of capital later on in retirement. However, the initial investment amount would need to be the same as the amount required to purchase an inflation-linked annuity. If this is not the case, some personal fiscal adjustments (PFA’s) may need to be made. In addition to this, the income drawn would need to be inflation-linked. Going back to our example, for a monthly income of R5 000 you would need to invest R1 360 000 in a living annuity.

As mentioned earlier, most retirees in South Africa have not saved enough for their retirement and hence would not be able to replicate the “holy grail” within a living annuity. So how does one in this specific scenario go about choosing an appropriate investment strategy for a living annuity?

Taking a calculated investment risk

In order to increase the level of retirement income an individual can take on some of the retirement income risks. One way to do this is to deviate from the “holy grail” investment strategy slightly but not completely, as you would want to minimize the chance of an undesirable outcome. Two examples of an undesirable outcome could be:

a. substantial loss of capital or b. an overly conservative investment strategy.

A substantial loss of capital would result in a potential reduction of retirement income that you can take in a given year or two or three or maybe even for your whole retirement. Alternatively, an overly conservative investment strategy does not allow your living annuity capital to grow enough to continuously provide income throughout your retirement.

To summarise, an appropriate living annuity strategy has to in part align to the “holy grail” but at the same time should not be too conservative to ensure that your living annuity’s ability to provide income over the long-term is not compromised. Does such an investment strategy exist?

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Alexander Forbes’ Purchasing Power Portfolios

An example of such a portfolio is discussed below. This is not intended to promote this portfolio, but rather to discuss the principles at play – which are extremely important. Alexander Forbes constructed a range of portfolios that gives living annuitants the opportunity to improve their retirement income and reduce the chance of an undesirable outcome (so called Alexander Forbes Purchasing Power Portfolio Range which includes: the Preserver, Moderator and Enhancer portfolios.)

Retirement funding position is a measure that compares your retirement savings (living annuity capital) to the amount needed to secure a specific retirement income. It can be seen as an indication of how affordable a certain level of inflation-linked income is in retirement.

The foundation of the Purchasing Power Portfolios is the investment into ILB’s which counter some of the retirement income risks. In addition to this each portfolio is designed to provide a certain amount of risk to improve your retirement funding level relative to purchasing an inflation linked annuity.

Back to our example where R1 360 000 could secure an inflation-linked income of R5 000 p.m. Let’s say that you have an investment amount of only R1 000 000 which means that you are underfunded or put simply don’t have enough to secure monthly inflation-linked income of R5 000. Alternatively having more than R1 360 000 would make you overfunded for that income level.

Your retirement income funding position dictates the amount of risk that you need to be taking. In particular, having enough capital (overfunded) means that you don’t need to be exposed to too much investment risk since you can already afford an inflation-linked annuity at your required income level.

On the other hand, not having enough retirement savings or being underfunded (within an acceptable range) would require you to take on some investment risk. This would give you the ability to try improve your retirement funding position which in turn will help you obtain your desired level of income in retirement.

Note that no amount of risk taken can improve retirement funding if you have wholly insufficient retirement savings. Therefore individuals need to be constantly reminded of the importance of retirement contributions and preservation.

The Purchasing Power Moderator portfolio (Enhancer is more aggressive, the Preserver less so) has been constructed with enough risk that should close small gaps in retirement income funding levels over time. The amount of investment risk that one would need to take together with the sustainable level of income that can be drawn is calculated with the help of sophisticated modelling techniques that assess your living annuity capital’s ability to provide for your desired level of income over the long term. This is the reason decent financial advice is a crucial element of a living annuity strategy.

When trustees are considering their advice offerings in the context of default annuities it will be important for them to ascertain their prospective providers’ abilities in this regard.

Note that no amount of risk taken can improve retirement funding if you have wholly insufficient retirement savings. Therefore individuals need to be constantly reminded of the importance of retirement contributions and preservation.

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ALEXANDER FORBES

Measuring success

After choosing an appropriate living annuity portfolio it is important to measure and monitor its success. This can be done by tracking your funding/affordability level over time. That is, comparing portfolio performance to the change in the cost of the conversion of retirement savings into income.

The graph below demonstrates that the Purchasing Power Moderator portfolio over time comfortably outperformed this cost and hence improved the funding/affordability level. This would mean that the living annuity capital’s ability to provide retirement income has been marginally boosted.

What would happen if annuities were to suddenly get very expensive and unaffordable? This happened during the month of June 2013.

June 2013 Annual

ALSI -5.7% 21.0%

ALBI -1.5% 6.2%

SAPY 4.4% 24.0%

STEFI 0.4% 4.7%

Purchasing Power Moderator -3.91% 14.36%

Although the portfolio’s absolute return was negative in this month, the portfolio managed to improve a living annuity investor’s affordability level over this month. Looking at a real-life example of a 60 year old couple with the husband being the principal investor the following happened:

1. Living annuity investment capital values decreased slightly2. The cost of conversion to income reduced substantially3. Overall affordability position improved within one month

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This is laid out in the following table which is really the crux of why an investment strategy which is cogniscnt of liabilities is so powerful, and why it is different to an absolute return objective.

Monthly Income Needed

Capital needed for income

Investment Value

Affordability Level

1 June 2013 R5 500 1 864 818 1 500 000 80.44%

1 July 2013 R5 500 1 659 085 1 441 393 86.88%

Improvement 12.04% -3.91% 6.44%

Having looked at the anecdotal evidence we need to ensure that the investment strategy can deliver predictable/desirable outcomes consistently. The actual historical returns that the portfolio delivered over the last five years confirm that it is coping with its task of:

• Improving affordability level by providing stable growth, and• Reducing unfavorable outcomes by minimizing the chance of a negative return.

The picture is similar when we take into account an individual invested in a living annuity drawing an inflation-linked income. This individual’s affordability level is looked after by the purchasing power investment strategy.

As can be seen above, the Moderator portfolio offers much lower downside risk and volatility risk when compared to the Performer portfolio as an example. This comes at a cost albeit a very reasonable cost – reduced upside.

Purchasing Power Moderator Performer

Period of Analysis 1 Year 3 Year 1 Year 3 Year

Average return 12.8% 12.9% 14.3% 15.0%

Risk (Volatility) 4.4% 1.4% 11.6% 3.8%

Minimum 0.5% 10.0% -17.3% 7.5%

Maximum 22.4% 15.6% 30.8% 19.8%

Probability of a –ve 0% 0% 12.9% 0%

Average –ve return when it occurs N/A N/A -10.8% N/A

Purchasing Power Moderator Performer

Period of Analysis 1 Year 3 Year 1 Year 3 Year

Average Capital Remaining R2 130 759 R2 447 408 R2 127 877 R2 593 496

Risk (Variability of Capital) 23 804 26 448 61 125 68 298

Minimum Capital R1 902 717 R2 268 980 R1 568 857 R2 164 366

Maximum Capital R2 295 812 R2 612 846 R2 551 214 R3 101 495

Ave Draw rate required next year 5.64% 5.16% 5.67% 4.88%

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ALEXANDER FORBES

Below you will find a graph which shows the affordability level of an individual who is drawing R5000 per month which is increased by inflation. This assumes the living annuity holder is invested in the Purchasing Power Moderator portfolio. You will then notice how the affordability level improved from just over 80% to 88% despite the individual drawing R5000 per month (increasing with inflation on annual basis) and despite going through the credit crisis.

LINKING THE PRE-RETIREMENT STRATEGY TO THE POST-RETIREMENT STRATEGY

In the preceding section we discussed what investment strategy one would need to adopt within the living annuity space i.e. the purchasing power investment strategy. This does indeed seem to work but to get to that point, an individual must have grown his capital in the pre-retirement stage. In addition to this one has to ensure that there is consistency between the pre-retirement investment strategy and post-retirement strategy.

This is key in an individual’s retirement savings journey and it all depends on what post-retirement investment strategy each individual follows. The holy grail should be the aim but depending on how much the individual has contributed and preserved, in his accumulation phase, this may not always be achievable.

We can divide the whole period before retirement into two segments, namely:

1. The capital build-up (or accumulation) segment

2. The pre-retirement matching segment

The capital build-up segment would make up a significant portion of the 40 year working period. This is where the individual will need to make certain cashflow sacrifices and save significantly for retirement. These savings would then need to be invested in a reasonably aggressive investment strategy in order to grow accumulated savings as much as possible so that ideally they can afford to purchase the inflation linked annuity upon retirement. They can afford to be invested in risky growth assets such as equity and property since the investment horizon is long term and can ride out the short term volatility in order to chase those higher expected returns actually needed to fund a decent retirement.

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When an individual is 5 or so years from retirement, they can assess whether they are on target for the holy grail. With the assistance of an advisor and certain financial tools, a call can be made on an appropriate post-retirement strategy to be targeted and on what can likely be afforded. The individual may need make some PFA’s. Once this is done then the appropriate retirement matching strategy can be slowly adopted. This is what we also call the life stage approach.

A life stage approach that slowly converts into a 100% cash portfolio is not the type of strategy that we want. The reason for this is that an investor coming out of the market (pre-retirement) and then going back into the market (post-retirement) just does not make any investment and economic sense. What are the different retirement matching strategies for each post-retirement vehicle? The answer can be found in the table below:

Post-Retirement Vehicle Asset Backing this Vehicle

Retirement Matching Strategy

Inflation-linked annuity Inflation-linked bonds Inflation-linked bonds

With-profit annuity Multi-asset class investment strategy

Multi-asset class investment strategy

Living annuity Whatever was the chosen investment strategy but to target inflationary increases a significant portion of ILB’s needs to be purchased.

Purchasing power strategy

As you would have noticed, the retirement matching strategy is effectively the strategy that the annuity providers follow in order to offer these annuity products. So the individual would slowly phase into the appropriate retirement matching strategy (from the aggressive capital build-up investment strategy) over the last 5 or so years prior to retirement. In this way it smoothens out any potential market effects from pre-retirement into post-retirement. The two strategies are then consistent allowing the individual the opportunity, without unnecessary mismatch risk, to obtain a retirement with all the required attributes. This change of thinking is effectively a mindshift from return maximization to income maximization.

To sum up here is a retirement recipe so that all links are taken into account for a comfortable retirement:

Receive education from the beginning Ensure that members understand what is required to ensure a comfortable retirement.

Embrace sacrifice (PFA’s) and save Save more, lower consumption and prolong income.

Take on advice Advice does indeed add value.

Initiate an aggressive Capital Build-up High allocation to growth asset classes.

Retirement matching strategy Obtain advice on what post-retirement vehicle you can utilise and match to this vehicle.

Effective post-retirement vehicle Aim for the holy grail.

Then enjoy the fruits of your hard work and RETIRE comfortably.

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ALEXANDER FORBES

Seeking long-term returns entails investing in sustainable and attractive investments, avoiding any negative shocks resulting from risks that could have been avoided, such as unsavoury corporate behaviour. This type of investing requires a shift from chasing short-term gains to focusing on achieving benchmark-beating returns over time. This can only be done by actively ensuring those companies in which a fund invests are held accountable and expected to behave morally and ethically, protecting the company and its stakeholders into the future. With about R3 trillion invested in retirement funds on behalf of working SA, trustee boards have an extremely important role in ensuring effective and sustainable long-term decisions are made on behalf of the ultimate beneficiaries. It also requires a change in the way the risk of an investment is assessed as there are financial risks and non-financial risks to consider.

Active Owners

A core objective of responsible investing (RI) is to act in the best interests of pension fund members by considering the risks and opportunities evident in environmental, social and governance (ESG) factors. It emphasises the importance of active ownership of pension funds and that pension funds should not and need not be “absentee landlords” regarding the companies and other assets they own. Rather, they must be committed, responsible owners able to understand, quantify and influence behaviour in accordance with the ESG risks presented in their portfolios.

Regulation

The obligation to take ESG into account has been embedded in pension fund law (Regulation 28) since 2011. Regulation requires trustees to consider any factor that may affect the sustainable long-term performance of investments, including those of an ESG nature. This is further supported by the Code for Responsible Investing in South Africa (CRISA), which provides guidance through a number of principles on how the institutional investor should promote responsible investing and ownership practices. Although being “responsible investors” is a new challenge for trustee boards, they are ultimately accountable for the strategy they adopt. As a result, boards need some guidance relating to interpretation, measurement, implementation, monitoring and reporting, to name a few.

The Responsible Investment and Ownership Guide

The Responsible Investment and Ownership Guide, led by the Sustainable Returns steering committee, was launched in September 2013 and addresses many challenges trustees face. The Sustainable Returns project, convened by the Principal Officers Association (POA), the International Finance Corporation (IFC), the Government Employees Pension Fund (GEPF) and the Association for Savings & Investment SA (ASISA), is an industry-led initiative that assists in incorporating ESG factors into retirement industry-led practices. The guide is specifically geared to assist principal officers and trustees who are new to RI. It provides a much-needed toolkit to assist trustees in practically implementing RI practices, including how to define the concept, develop policies and implement and report on RI investing activities. It also suggests a four-year timeline trustees can work towards, ending December 2016. Initially, the task may seem onerous to trustees, but the guide provides a step-by-step strategy to assist in implementation, starting with developing an RI policy.

Developing an RI policy

The starting point for the board is to ascertain whether an ESG strategy is being implemented and if so, whether it addresses all the important outcomes such as investment approach, engagement on ESG issues, active ownership and reporting. One of the most challenging tasks is to test if the current strategy is being implemented effectively or if a tick-box approach is being followed.

If a strategy doesn’t exist, boards may simply update their investment policy statements to include one that broadly and generally acknowledges and considers ESG issues. However, one could argue that this is a short-term solution and not in the true spirit of RI and CRISA. This approach leaves many unanswered questions and ultimately boards will continue to struggle to understand the concept and keep up with regulatory and other requirements.

QUESTION 7 How can trustees practically implement a strategy which incorporates a sustainable returns approach?

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A detailed and comprehensive RI policy should address some of the following aspects:

• How RI is interpreted and how it is aligned with the overall philosophy and objectives of the fund

• Which individual/s on the board are responsible for implementation and monitoring

• The scope of application, for example, which asset classes it will apply to and whether it applies to local and global mandates. According to the guide, the most logical starting point is to focus on the listed equities asset class for the first two to three years of implementation

• The key ESG issues applicable to the fund

• The fund’s position on voting and engagement

• How conflicts of interest are handled

• What investment approach is being adopted (for example, integration in the investment process or positive/negative screening)

• How the fund will report on ESG activities

Although boards may rely heavily on their service providers to tackle the above, the trustees need to ensure the approaches are aligned. As per the requirements of CRISA, these policies should be available to the public in the spirit of transparency.

Implementation

According to the guide, the most logical starting point is to focus on the listed equities asset class for the first two to three years of implementation. At this stage, a great deal of time should be spent in understanding how investment managers apply RI principles within their investment process.

• There are a number of issues to address here, including:

• How does it align with the board’s policies?

• What skills are in place to address these issues?

• What is their voting policy?

• How do they measure ESG performance and how do they report on ESG activities?

• How will the board measure asset managers’ ESG performance? The guide suggests setting ESG performance criteria or targets and then monitoring performance against these measures.

Key at this stage is to ensure investment managers can provide evidence of the above. The starting point is to scrutinise their policies – reviewing their voting activity and assessing their investment approach to determine how ESG factors are incorporated into their investment decisions. There is a risk that they have policies in place but are unable to provide evidence of application.

An important part of implementation is having a clear policy on the fund’s goals, objectives and commitments regarding active ownership. The fund should stipulate the timelines and milestones/goals it expects to reach over a pre-defined period, which could be as long as three to four years. This should be documented in the fund’s investment policy statement. (See the proposed timelines suggested by the Sustainable Returns guide later in the document).

Active ownership includes proxy voting and shareholder engagement. Voting proxies can be an onerous task for trustees who lack the resources to do so. The guide suggests various ways this may be dealt with – the responsibility may be delegated to investment managers, proxy voting service providers or the board may opt to do it in-house. Importantly, the board should draft a policy setting out guidelines to be adopted during voting. This could incorporate guidelines on remuneration, incentivisation, handling and disclosure of environmental or social issues or board composition and directorship to ensure an independent and capable board.

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ALEXANDER FORBES

Disclosure and reporting

The CRISA practice note on disclosure requires that institutional investors should fully and publicly disclose to what extent it applies the code at least once a year. This should include a general description of the approach adopted to implement CRISA, the period the disclosure covers, the extent to which the organisation has engaged stakeholders, measures adopted to ensure application and the approach to each CRISA principle.

This forms an important step towards collaboration and sharing of ideas between industry players. It also publicly documents progress and commitment to making sustainable investing a reality in SA.

Recommended timeline

The guide recommends that RI be adopted over a four-year period. It also recommended at the time of issue that pension funds should have already basically engaged and become familiar with RI by December 2013. Each stage maps out what is required from the fund regarding policies, reporting, capacity and planning.

STAGE 2 STAGE 4STAGE 1 STAGE 3

Source: Responsible Investment and Ownership: A Guide for Pension Funds in South Africa

Deadline: December 2013

• Basic engagement and familiarisation

• Training

• Planning

• Annual report


• Consideration of voting and engagement policy

• Roll out of RI policy on equities asset class

• Integration of RI into existing and new mandates

• Planning

• Annual report


• Periodic review of policies

• RI routinely incorporated into manager selection, evaluation and performance management

• Quarterly disclosure of voting records

• Planning and continuous improvement

• Annual report


• Preparation of an RI policy

• Training

• An understanding of the policy and a plan for full implementation

• Annual report

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Designing investment strategies for retirement funds relies on complex modeling of potential future liabilities and then matching them with appropriate assets based on long term growth expectations and an assumed risk tolerance for the fund.

Implementing the fund strategy usually requires a layer of fees, from administration to governance to reporting, and of course the asset management fee. All of these fees are subject to market dynamics and competitive economic pricing. The focus of this article is on the asset management fee, the fee paid to the asset manager for managing the investment.

This should not imply that the asset manager fee is not subject to competitive pricing. As anti-competitive behaviour and pricing collusion is not acceptable behaviour – we will also assume that asset management fees are competitively priced from a supply-demand perspective. But if we simply accept prices as they stand in the market, then this is a rather short and pointless article.

The perceived complexity to decompose the asset manager fee is related to the fact that we have always been made to assume that the asset manager’s argument of financial cost of manufacture is the most important consideration in determining the active management fee.

We look to review the fee conundrum through alternate lenses, from the perspective of the consumer, and the value being purchased. This article is based on an unpublished working paper: “Using option mathematics to explain active management fees” by Deslin Naidoo. It uses a model based on real option theory and principles drawn from economic theory to put forward a pricing framework for active asset management fees.

The model establishes that a strong, quantifiable relationship exists between the active management fee payable and the risk-return framework of the investment strategy. The purpose of this article is less to communicate this mathematical framework and more about the principles underlying it. However, to deconstruct the problem requires some knowledge of risk and return and an intuitive knowledge of how call and put derivative options work. We then reconstruct these elements to calculate a statistically “fair” active management fee.

This article uses a naïve framework of prices that are consistent with the overall model. “Naïve” refers to the use of a simplified set of assumptions (including normal distributions of performance) that will be used to demonstrate the argument and this term will be used throughout the article. Many technical elements are debatable when using a naïve basis, however this article is meant to introduce the principles of an innovative way of defining the active management fee; as opposed to a prescriptive mathematical methodology of defining it.

More importantly, by providing a quantitative basis for comparison of both active and passive fees, this framework should help the (potential) investor get a better grasp of what he is paying for; and better select an investment manager based on a cost benefit basis. Effectively, it should allow practitioners to compare and benchmark the value of different managers in a strategy in a more deterministic way. The higher the fee charged by the manager, the more intense the discussion and research of the manager is required to be. The interaction with the manager will revolve around pertinent questions on the investment strategies, its behaviour and expected value-add under different market conditions.

QUESTION 8 Can a fair price be determined for active asset management (investment) fees?

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ALEXANDER FORBES

Understanding what is purchased: Beta and Alpha

What are we paying the asset manager fee for? The first and simplest element of this transaction is that we are paying the manager to access an asset class, an investment strategy or both.

At the broadest level, pension funds and retirement plans use asset-based investment strategies. A strategic asset allocation is determined to provide greater certainty to achieve one’s retirement objectives; usually being able to replace your salary with an appropriately defined monthly income on retirement.

Passive investments in asset benchmark indices are usually the most cost effective manner to access broad asset classes. If the investment is passive then the expectation is that the appointed manager will replicate the structure and performance of the underlying asset benchmark index. In technical terms we call this accessing the Beta of an asset class. Beta is the degree that a portfolio is more or less volatile than its benchmark index. In passive portfolios, if this is perfectly matched or at least extremely close, the beta is said to be equal to one. By extension, we expect the return of a passive portfolio to have very little or no variation to the benchmark index. An advisor would be best positioned to determine the correct benchmark with respect to the investment strategy that has been designed.

If we can pay passive fees to access an asset class, what do we buy from an active manager? The only thing that they can sell is additional performance that can be derived from the asset, (what is commonly and sometimes mistakenly referred to as Alpha). What we pay for is the expectation that the manager will outperform the benchmark.

Principle 1: Don’t pay more than what you get

There is a simple economic truth about a rational consumer and that is they should not pay more than the expected value that is to be delivered. It would be counterintuitive to pay for something and then be told, that not only are you not going to receive what was expected, but you are going to have to pay more. Yet, this is exactly what happens with active managers.

The investment manager promises a certain type of additional performance outcome e.g. “Wonder Manager’s Equity Fund performance target is to beat the market by 2%”. It sets an expectation that the investor is purchasing a strategy that will beat the identified market benchmark by 2%.

For example, when the equity benchmark index delivers 30% and Wonder Manager’s Equity Fund underperforms and returns 28%; we lose sight of the fact that we actually lost 2% of our money. This is over and above the active management fee.

It would be myopic not to recognise that a manager will have periods of underperformance. In an ideal world, it would be convenient to simply access this additional performance being sold by the manager without having to incur the downside of poor performance. Is there then a “fair” price for this performance? Intuitively we start by suggesting that one should not pay more than the value derived.

Concept 1: The relationship of risk and return

To understand how the framework is built, it is important to understand that there is a direct relationship between the risk assumed in a fund and the return that the fund generates.

If one takes more absolute risk in the portfolio, then one should be rewarded with greater return.

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Absolute risk is the total risk that the investment portfolio is exposed to. A portfolio is made up of various underlying securities. Some securities are riskier than others. Some securities diversify risk while others increase risk. We can create portfolios with different expected return and risk characteristics by holding different securities in different quantities. Optimal portfolios are those portfolios that have the best return expectations for a given level of risk. Figure 1 below illustrates this concept.

We can use the Beta of the portfolio (defined earlier) to demonstrate a simplified relationship of the risk and return relationship.

Example 1.1.: If the Beta of your portfolio = Asset beta = 1; then the portfolio has equal risk to the asset. As a result if the asset goes up by 10% your portfolio will also go up by 10%. Similarly, if the asset goes down by 10% your portfolio will also go down by 10%.

Example 1.2.: If the Beta of your portfolio = 0.9; then the portfolio has less risk to the asset. As a result if the asset goes up by 10%, your portfolio will only go up by 9%. Similarly, if the asset goes down by 10%, your portfolio will only go down by 9%.

Example 1.3.: If the Beta of your portfolio = 1.1; then the portfolio has more risk to the asset. As a result if the asset goes up by 10%, your portfolio will go up by 11%. Similarly, if the asset goes down by 10%, your portfolio will go down by 11%.

A manager can increase or decrease the Beta of his portfolio to create additional performance.

If one takes more relative risk in the portfolio, then one will generate returns more varied than the benchmark.

Relative risk is the difference in the structure of risk in the portfolio relative to the risk in the benchmark. Relative risk is also called Active Risk. A common measure of active risk is prospective (forward looking) tracking error. A prospective tracking error of 4% per annum, implies that there is a 68% chance that the returns of the portfolio will between +4% and -4% of the benchmark return.

The concepts of absolute risk and active risk underlie most portfolio construction, risk management or risk attribution models. The difference in performance outcomes of a portfolio are governed by these measures. Therefore the additional performance from an investment manager is equally governed by these measures.

Figure 1: Illustration of risk return sourced from Investopedia

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ALEXANDER FORBES

Principle 2: Don’t be fooled by randomness – luck versus skill

All managers would like to attribute any outperformance generated by their portfolios to skill; however luck can also generate positive outcomes.

Table 1 below measures the naïve probability of outperforming a benchmark in an efficient market3.

There is a 50% probability of achieving a positive outcome (> 0%) on a random basis over one year. Further to this, approximately one in five managers (19.08%) will randomly deliver a return in excess of 3.5%. By extension, this would imply that over three years, one in 125 zero-skill managers will randomly outperform the benchmark by 18.5% or more. Basically, one should not pay extra for random outcomes.

Concept 2: Introducing option theory

To complete the understanding of the framework, we need to have an intuitive understanding of basic option contracts.

We first introduce the CALL option. The call option buyer pays a premium to the issuer of the option to hold the legal right but not the obligation to purchase a specific investment instrument at a specific time in the future at a predefined price. This mouthful is best explained by example.

Example 2.1.: A call option contract could be issued on Facebook Inc. which allows the investor to buy Facebook shares for US$62.75 in exactly 1 year. With option mathematics a fair price (the premium) can be calculated for the investor to buy this option today. After one year has passed the Facebook Inc. share price would have moved based on the various market and valuation dynamics.

If the share price is less than US$62.75, say US$60.75, it does not make sense to exercise your right and buy the shares at the price stated in the option contract. It would generate a loss of US$2 per share. One would simply lose the premium paid and let the option expire.

If the share price is more than US$62.75, say US$72.75, it makes sense to exercise your right and buy the shares at the price stated in the option contract. It would generate a profit of US$10 per share. One could immediately sell the shares on the exchange and bank the profit.

The call option is usually purchased by investors who hold the view that the underlying asset or portfolio being sold to them will increase in value, but they do not wish to be exposed to the scenario where the asset loses value. They are willing to pay a premium to lock in the price that they wish to pay. This has strong parallels to the idealistic concept of accessing the additional performance being sold by the manager without having to incur the downside of poor performance.

We introduce next the PUT option. The put option buyer pays a premium to the issuer of the option to hold the legal right but not the obligation to sell a specific investment instrument at a specific time in the future at a predetermined price. Another mouthful best explained by example.

3 To calculate this we make two assumptions: • We assume that the manager has zero-skill to generate outperformance (i.e. over the long term expected outperformance = 0 before fees) • We assume that the portfolio is exposed to a 4% prospective tracking error per annum

Table 1: Probability of randomly achieving positive outperformance outcomes with zero-skill

Potential Outperformance Outcomes

4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0%

15.87% 19.08% 22.66% 26.60% 30.85% 35.38% 40.13% 45.03% 50.00%

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Example 2.2.: A put option contract could be issued on Facebook Inc. which allows the investor to sell Facebook shares for US$62.75 in exactly 1 year. With option mathematics a fair price (the premium) can be calculated for the investor to buy this option today. After one year has passed the Facebook Inc. share price would have moved based on the various market and valuation dynamics.

If the share price is more than US$62.75, say US$64.75, it does not make sense to exercise your right and sell the shares at the price stated in the option contract. It would generate a loss of US$2 per share. One would simply lose the premium paid and let the option expire.

If the share price is less than US$62.75, say US$52.75, it makes sense to exercise your right and sell the shares at the price stated in the option contract. It would generate a profit of US$10 per share. One could buy shares on the exchange and sell them as per the contract and bank the profit.

The put option purchaser is usually seeking protection from adverse movements in the underlying asset or portfolio. The issuer will receive a premium to provide this insurance to the buyer. We draw a parallel directly to the active management process where the investment manager passes any underperformance in his strategy directly back to the investor.

When the fictitious world of performance options becomes reality

By deconstructing the active management fee problem into the parallel concepts of the call and put option; it enables us to utilize mathematical models on the deconstructed elements. When the theoretical elements are put together again we are able to establish a fair price.

Let’s go back to the assumption that we want to access the positive performance of the additional return that the manager could generate, with none of the downside. This is theoretically equivalent to the investor buying a call option on the investment manager’s relative performance on the portfolio. This means that a premium is due to the investment manager for issuing the call option.

BUT, the investment manager seeks to be protected from adverse movements in the underlying portfolio, and transfers the risk of underperformance back to the investor. This means that the investor now becomes the insurer for the underperformance. This is theoretically equivalent to the investor selling a put option on the portfolio to the investment manager. This means that a premium is due to the investor for issuing the put option.

Based on this information the fair pricing model to determine the active management fee is:

Active management fee = Passive Fee to access asset + Premium due to the manager on the Call option – Premium due to the investor for the Put option

We will use a naïve assumption set utilising a risk neutral pricing model to demonstrate the mechanism to calculate a statistically fair asset management fee4.

We will use the term “Skill” to refer to a manager’s expected level of outperformance to the benchmark that is not random. There are protagonists of all forms that will debate this definition, and even the existence (and non-existence) of skill. This article will avoid these debates and assumes that a process exists to establish the existence and measurement of skill. Applying the naïve model, table 2 below demonstrates that the Active Fee (premium payable) would be the same as the expected value of the manager’s outperformance target. Clearly, this represents the maximum fee that a rational investor would contemplate paying.

Skill (Expected Non-random outcome)

0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00%

Call Option Price 1.60% 1.72% 1.85% 1.99% 2.14% 2.28% 2.44% 2.60% 2.76%

Put Option Price 1.60% 1.47% 1.36% 1.24% 1.14% 1.04% 0.95% 0.86% 0.78%

Active Fee 0.00% 0.25% 0.50% 0.75% 1.00% 1.24% 1.49% 1.74% 1.98%

Table 2: The naïve price of the options for different non-random manager outperformance

4 The naïve model assumes European call and put options on the active (long-short) portfolio of the manager, issued at current fair-value for a period of one year. The model assumes further that the manager is exposed to a 4% tracking error (volatility of the active portfolio), a low-medium risk portfolio.

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ALEXANDER FORBES

The active management fee for a zero-skill manager would be the same as a passive management fee as the:

Call option Price = Put option Price

However, unlike other financial transactions e.g. insurance, where your premiums reflect the long run value of your risk; paying an active management fee equal to the expected value of your return puts you no better off than having a passive investment!

More importantly, if you pay a fee that is higher than the expected value of the manager’s additional performance, then the long term value of the investment will simply erode. This is irrespective of the skill of the manager; as any fee charged above the value being added will create a performance drag on the portfolio.

Principle 3: You need to eat off the same plate

Investment management, at its heart, is built on trust and the belief that the manager acts in the best interest of his client at all times. Therefore, there is little point in transferring all of the relative risk to the investor and the majority of the benefit accruing to the manager.

In table 3 below, we explore the percentage of the value earned by the manager across different potential outcomes, based on a fee charge of 1.00%. We ignore all negative outcomes as no value accrues to the investor.

The manager receives 50% or more of the fee for all performance outcomes except for when his performance is greater than 2.00%. If the expected value of the manager’s outperformance is anything less than 2.00%, then there is an intuitively unfair balance of outcomes at a 1% flat active fee level.

It is suggested that the alignment of interests between the manager and the investor is best served when the benefits of the value created is not skewed towards one party.

Understanding your manager

Richard Ennis in his 2005 article: “Are active management fees too high?” alludes to the fact that the higher the fee of a manager, the more certainty is required to validate that the manager can add value above his fee level. This implies that intermediaries who define investment strategies for funds or individuals need to be very cognisant of the associated cost structure. This must be factored into any process used for selecting the most appropriate investment managers for a strategy.

The challenge for manager fees is establishing whether the manager generates skillful or random outcomes. To determine this you would need by a robust fund strategy and manager research framework; using both qualitative and quantitative metrics. One would need more information, insight and transparency from a manager with higher fees as there is a greater risk of being incorrect in the assessment.

It is worth reiterating that past performance is not a reflection of future performance. However, deconstructing performance and attributing the outcomes can provide insight into the quality and consistency of the underlying investment process.


0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00%

Active Fee % to Manager

1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%

400% 200% 133% 100% 80% 67% 57% 50%

Table 3: % Value earned by manager on a 1% fee

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Performance fees: A mechanism to align objectives?

It is becoming fairly common for managers to reduce their base fee in order to have a 20% participation in the outperformance. Theoretically, this should align the interests between the investment manager and the investor. However, there are a few criticisms of a performance fee methodology:

1. The biggest risk to the investor is setting a poor performance benchmark within the investment strategy. It both misprices the quality of the manager skill and results in excessive performance fees to be paid. An abused and inappropriate performance benchmark is Consumer Inflation when set as within multi-asset long only growth strategies.

2. Many administrative fee calculations are flawed and usually based on an Assets-under-Management metric which results in newer members of the fund being charged for performance that was not delivered to them.

3. Performance fees can result in excessive risk taking by the manager. This can be controlled by implementing a strong monitoring process and embedded prospective risk constraints in the mandate.

4. Inappropriate setting of the performance calculation can also result in poor investor outcomes:

• Poorly constructed or multiple horizon performance windows can result in the same performance being charged multiple times (e.g. performance fees jointly based on 1-year and 3-year performance windows);

• Lack of hurdle rates and watermarks can result in the investor being charged performance fees during periods where value is being lost.

If the correct steps are taken to overcome these (not insignificant) limitations, a performance fee may create a positive alignment and it is possible to evaluate whether their structure is fair given certain inputs.

This is where the principles and the option framework converge to deliver a fair price based on risk and return metrics. Table 4 below calculates the fair total base fee chargeable by managers of different skill, assuming a 4% prospective tracking error and a passive management fee of 15bps for say a passive equity fund. We incorporate the principle that value created needs to be shared and apply a “Fairness Adjustment” of 50% to the Active Fee5. As the manager will now have a 20% participation in the positive performance, he will pay a fee to the investor for this right. This “Perf. Premium” is 20% of the Call option price calculated.


0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00%

Call Option Price 1.60% 1.72% 1.85% 1.99% 2.14% 2.28% 2.44% 2.60% 2.76%

Put Option Price 1.60% 1.47% 1.36% 1.24% 1.14% 1.04% 0.95% 0.86% 0.78%

Active Fee 0.00% 0.25% 0.50% 0.75% 1.00% 1.24% 1.49% 1.74% 1.98%

Fairness Adj. 0.00% 0.13% 0.25% 0.37% 0.50% 0.62% 0.74% 0.87% 0.99%

Perf. Premium 0.32% 0.34% 0.37% 0.40% 0.43% 0.46% 0.49% 0.52% 0.55%

Passive Fee 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15%

Total Base Fee -0.17% -0.07% 0.03% 0.13% 0.22% 0.31% 0.41% 0.50% 0.59%

Table 4: A naïve fair price fee structure with 20% participation in outperformance for different manager skill

5 A Fairness Adjustment of 50% is clearly open for debate. This is really where negotiations play a critical role.

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ALEXANDER FORBES

Under this pricing framework, a manager with no skill or even partial skill (up to 0.25%) would have to pay the investor to manage the assets!

The manager who has the skill to deliver 1.00% additional performance should charge 0.22% to manage the investment and participate in 20% of the outperformance. This is very comparable to the passive management fee of 0.15%.

The fair pricing framework allows us to compare managers in a common fee framework.

Example 3.1.: Suppose the manager selection process for an investment strategy has shortlisted two managers with the same skill of 1%. One charges 0.5% flat fee and the other charges 0.22% with a 20% participation. In this case the manager fees are equivalent, and other factors need to be considered.

Example 3.2.: Suppose the manager selection process for an investment strategy has shortlisted two managers with the same skill of 1%. One charges 0.4% flat fee and the other charges 0.22% with a 20% participation. In this case the manager charging 0.4% is cheaper. Other factors that are to be considered must be weighed in context of 0.1% fee saving.

Conclusion

The naïve model presented has many flaws, but we are attempting to illustrate certain principles.

A fund or investor should have a very clear understanding of their investment strategy. The return expectations need to be clearly understood relative to the objective. Simultaneously, the return expectations need to be consistent with the risk to be assumed. Some funds would have a risk budget incorporated into their investment policy statements, which would provide more defined guidelines for this.

Paying a fair management fee is important. A poorly applied fee basis can and will erode the outcome of the investment strategy, irrespective of the skill of the manager (over-paying a good manager will still lose value).

The naïve approach presented in this article demonstrates a basis for establishing the fee levels to be charged for investment strategies at a given level of risk. The framework incorporates three key principles:

• Don’t pay for more than the value received• Don’t pay for randomness• The manager and investor need to have commonly aligned objectives

The fair pricing framework, with good inputs, allows us to determine expensive and cheaper options. The naïve model can be extended into more complex and individualized models for different asset classes, style and strategies.

The real challenge is to differentiate skillful versus random outcomes. Each advisor needs to ensure that their manager evaluation processes make these distinctions. There is more need to be correct on this assessment for managers with higher fees.

The advisor will add significant value by defining appropriate benchmarks and performance targets for the investment strategy. In particular where segregated mandates are to be implemented, significant effort should be spent in defining the benchmarks, risk criteria and metrics, performance targets and the methodology of the performance fees (if any).

It is hoped that alternate perspective of measuring the quality of the fee payable on the portfolios assists in managing your investment strategy more efficiently and contributes towards a positive outcome for the member.

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In the few months leading up to February 2014 we’ve seen several legislative changes which give effect to some of the 2013 retirement reform proposals and a heightened regulatory environment for financial service providers and funds as discussed at previous Hot Topics seminars.

The Budget Speech is scheduled for 26 February 2013. At the March 2014 Hot Topics presentations we will cover aspects of the Budget Speech impacting on savings, and retirement savings in particular. This could include further progress on retirement reform as well as the implications of the many legislative changes already and recently introduced.

To serve as an introduction, we summarise the more important aspects of the recent changes below. For full details, readers are invited to read various On the Scales publications produced by Alexander Forbes. A list of recent editions is shown below for reference:

SECTION 3: Reform

QUESTION 9

The 2014 National Budget Speech - what should trustees consider?

No. Publication Title

19/2013 The Protection of Personal Information Act

1/2014 Twin Peaks Model of Financial Regulation – Financial Sector Regulation Bill of 2013

2/2014 Financial Services Laws General Amendment Act 2013

3/2014 Financial Services Laws General Amendment Act 2013 – Introduces whistle blowing provisions for principal officers, trustees and administrators

4/2014 Financial Services Laws General Amendment Act 2013 – Surplus provisions

5/2014 Promulgation of the Taxation Laws Amendment Act, 2013

6/2014 Penalties for the late submission of actuarial valuations

7/2014 Changes to the Financial Services Board Act

8/2014 Removal of all funds’ valuation exemption

Promulgation of the Taxation Laws Amendment Act 2013

The Taxation Laws Amendment Act, Act 31 of 2013 was promulgated on 12 December 2013. This Act contains various provisions, and importantly gives effect to some of the proposed retirement reforms presented by the Minister of Finance in February 2013, including the uniform tax treatment of contributions to allow for a single tax deductible contribution rate for members irrespective the type of fund (i.e. 27.5% of remuneration or taxable income, subject to a R350 000 cap) and the retirement benefit design of provident funds. Additionally, there are changes to the tax treatment of disability income policies. With effect from 1 March 2015 pension to provident fund transfers will no longer be taxable.

Twin Peaks model of financial regulation – Financial Sector Regulation Bill of 2013

The twin peaks model was first proposed in Government’s policy document titled “A safer financial sector to serve South Africa better” (see On the Scales 12 of 2011 and On the Scales 4 of 2013). The model seeks to split the regulation of financial institutions into two main sections; market conduct under the Financial Services board (“FSB”) and prudential regulation under the South African Reserve Bank (“SARB”). National Treasury has now released a draft bill, the Financial Sector Regulation Bill of 2013 (the Bill) as the first step towards putting in place the twin peaks model. The Bill highlights the need for improved co-ordination between regulators in South Africa, gives effect to a twin peaks regulatory system, as well as the Treating Customers Fairly initiative by setting up the regulatory authorities, other supporting institutions and setting out the powers of the regulatory authorities.

The purpose of the Bill is to set up a regulatory system that supports economic growth by promoting mainly financial stability, the safety and soundness of financial institutions and the fair treatment and protection of financial services consumers.

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ALEXANDER FORBES

Financial Services Laws General Amendment Act 2013

The long awaited Financial Services Laws General Amendment Act was signed into law and published on 14 January 2014. The Minister has determined that the majority of the Act will be effective 28 February 2014, with some pension fund changes effective 30 May 2014 and 29 August 2014.

Pensions Funds Act changes include amendments to several definitions, the inclusion of several new definitions, changes to take into account the impact of the updated Companies Act and changes to clarify the Registrar’s powers and extend them in some respects.

In respect of Trustees, the Act requires that the composition of the board must at all times comply with the rules of the Fund and that a board vacancy would need to be filled within a ‘period as prescribed’. Importantly the Act requires that all trustees must attain prescribed skills and training within 6 months of becoming a trustee. In addition the prescribed level of skills must be maintained through the term of office. Further changes affecting Trustees include expanding the requirements for trustees under Section 7(C) to act independently; extending a trustee’s fiduciary duties to members and beneficiaries in respect of accrued benefits or the amounts accrued to provide a benefit; and complying with any other prescribed requirements.

An enabling provision is included in the Act to allow the Registrar to prescribe the criteria that funds will need to abide by in their communication to members.

The Act provides for potential exemption of a particular board member, in the event of proceedings against the board, from joint and several liability if he/she has been found to have acted independently of the other members of the Board and discharged his/her fiduciary duties in a honest and reasonable manner. The circumstances in which the Registrar may intervene in the management of the fund have been amended. The Act extends personal liability for non-payment of contributions to individuals, including controlling shareholders, members or partners and every person who controls or is involved in the management of the employer’s financial affairs. The fund must request the employer to notify it in writing of the identity of the persons so personally liable. The fund will have prescribed reporting requirements in respect of this new provision. Certain contraventions of the Act will be criminalised and penalties imposed for these transgressions.

Clarity is now provided that reasonable expenses may be deducted by a fund from the member’s individual account, even where there are no contributions. This clears up a difficulty for certain funds, such as preservation and beneficiary funds, where there are no ongoing contributions from which expenses can be deducted.

There are whistle-blowing provisions included in the Act:

Whistle blowing obligations on trustees, principal officers and administrators: The amendments to the Act place a duty on trustees, principal officers and administrators to report to the Registrar any material irregularities relating to the fund, and requires that where a trustee or administrator or principal officer becomes aware of any material matter relating to the affairs of the pension fund which, in the opinion of the trustee or administrator or principal officer, may seriously prejudice the financial viability of the fund or its members, he or she must inform the Registrar in writing.

Importantly the Act requires that all trustees must attain prescribed skills and training within 6 months of becoming a trustee. In addition the prescribed level of skills must be maintained through the term of office.

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Trustees to advise the Registrar if they are removed as a trustee: The Act requires that every trustee must within 21 days of removal as a trustee - for reasons other than the expiry of that trustees’ term of appointment or voluntary resignation , submit a written report to the Registrar detailing the trustee’s perceived reasons for the termination.

Protection of disclosure: The Registrar will set out a process for the submission of disclosures by a fund or any party or stakeholder associated with the fund. This process for submission must be confidential and must provide appropriate measures for the protection of disclosures.

In addition to the provisions contained in the Protected Disclosures Act, any disclosure made by any relevant stakeholder to the Registrar, is a protected disclosure. Any person making the disclosures may not suffer any occupational or other prejudice.

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