Redeemed or doomed by your default investment strategy?

By Marcus Rautenbach, Head: Investment Consulting

The value of adopting strong default strategies have long been promoted by Simeka Consultants & Actuaries. Research tells us that if we want to ensure good retirement outcomes for members, we not only have to adjust our member communication but also the benefit structures of retirement funds. In doing so we have to employ the principles of the architecture of choice, and implement appropriate defaults so that a retirement fund’s benefit structure itself will guide and support members to a good retirement outcome.

Lifestage strategies
One of the key factors in producing a good retirement outcome is an appropriate investment return. The default investment strategy adopted by retirement funds is therefore crucial for success. To ensure suitable growth, members should in principle be invested in a fairly aggressive, high equity portfolio – during all but the last five to six years before retirement. During this period they need to be protected against market fluctuations and be invested in an investment offering greater security and or better alignment with the life annuity they plan to purchase.

Lifestage portfolios are effectively constructed on these principles. Another advantage of lifestage is that it enables the trustees to adopt an individualised investment plan for each member based on his or her chosen retirement date. Not surprisingly, it suits the investment needs of most members like a glove and is one of the reasons why such a large percentage of members select the default portfolio.

An appropriate default investment strategy should however take into account the member profile and demographics of the fund. The members of some retirement funds may not have a high degree of financial literacy and may be very suspicious of normal market movements. They may also be particularly exposed and ill-equipped to deal with the market fluctuations. A lack of job security, often results in members having to rely on their withdrawal benefits as an income. Funds with members in this profile frequently select guaranteed portfolios as the default investment strategy. In view of the significant differences in income and investment needs of members, it is often advisable to offer additional portfolios so that members with more sophisticated needs and requirements can select a more appropriate portolio

Cost efficiency
An aspect that all funds need to consider during 2014 is cost efficiency. The cost issue was also brought to the fore in National Treasury’s discussion paper “Charges in South African Retirement Funds” of July 2013. Research shows that South African retirement funds tend to be expensive. In the United Kingdom for example measures were proposed in November 2013 to limit retirement fund charges to 1% p.a. initially and later to 0.75% p.a.

National Treasury argues that one way in which retirement funds can implement appropriate default investment strategies and reduced charges is to introduce a passive investment strategy. Passive investments (also known as index tracking investments) provide basic market exposure to a predetermined index or basket of indices without any stock selection deviations. Investors obtain the market return but forfeit the manager out/under-performance. The charges for passive investment portfolios are considerably lower than that of active portfolios.

Passive default strategies
A first step would be to analyse the members who will likely to be investing in the default portfolio to determine a suitable asset allocation between equity, bonds, money market and global investments. Then a suitable passive portfolio can be selected or constructed consisting of index-tracking equity, bonds and global portfolios. Members less than five years from retirement are best invested in a portfolio that mimics their annuity portfolio.
The passive default investment strategy should be supported by a targeted communication strategy that informs members of events and progress and a annuitisation strategy that enables retirees to seamlessly transfer into an appropriate annuity at very low cost.

Retirement funds should consider a passive default investment strategy for the following reasons:

• It provides market-related investment performance consistently
• It can reduce costs significantly
• The asset allocation is reviewed regularly to ensure alignment with member needs and requirements
• It can provide retirees with the option of a seamless transfer into a suitable annuity
• It reduces the risk of inappropriate manager selection in retirement funds.

Retirement reform pressures will require each fund to assess its cost structures and take appropriate action in the next few years. In this context a passive default investment strategy will have significant advantages.