If managed correctly, retirement fund investing is not only beneficial for investors, but will contribute to the local economy as well. This article provides a high-level overview of some of the key elements in the retirement fund investment process that help facilitate these outcomes.
Retirement funds and financial markets
Well-performing financial markets have the potential to generate and stimulate economic growth and development. Where surplus capital – like that of long-term savings in a retirement fund investment portfolio – is invested prudently into appropriate asset classes, it can have the added benefit of earning investment returns for retirement fund members and pensioners (to pay pensions) while also developing the local economy (the latter being achieved through job creation, improved infrastructure, social well-being etc.).
The purpose of investment
The financial system’s purpose is to allocate capital from those entities where investment capital is in surplus (such as investors and savers), to those in deficit – or where investment capital is needed for growth (such as lenders/beneficiaries of investor capital) – who in turn make use of the investor capital productively to earn appropriate returns for investors.
Financial markets therefore facilitate access to investment opportunities that can optimise an investor’s expected returns over a period of time with consideration of the investor’s appetite for risking their invested capital.
The examples below illustrate:
- Earning better returns: An asset manager sets up an investment fund that invests in a selection of companies. The asset manager aims to generate higher returns than the benchmark returns offered in the market. To achieve this, the fund might take on more risk.
- Protecting against losses: An asset manager sets up a fund that diversifies risk by investing in less risky assets classes, such as money markets and government bonds, in addition to equity shares in companies. In this case, if the shares in the companies are not producing the expected returns, or are making losses, the investor’s capital and returns should, to an extent, be protected from potential losses on higher-risk investments such as equity. This would be as a result of more predictable (less risky) returns available via fixed returns on government bonds and money markets. Essentially, the investor does not “have all their eggs in one basket”. Less risky investment portfolios such as these are generally expected to yield lower returns.
Regulating retirement fund investment
South Africa’s National Treasury has opted through Regulation 28 of the Pension Funds Act to limit the maximum percentage exposure which a retirement fund may invest in a specific asset class. The aim is to reduce the risk of over-concentrating a retirement fund’s investment portfolio into either a single asset class or any single investment.
Regulation 28, which acts in conjunction with the South African Reserve Bank’s (SARB’s) exchange control regulations, limits the amount of retirement fund capital available to be invested outside of South Africa. Regulation 28 was first introduced in 2011, and is amended as necessary so that its regulatory objectives keep pace with market developments in South Africa and internationally. The most recent update to Regulation 28 took place in February 2018, based on the SARB’s Exchange Control Circular No. 7/2018, enabling retirement funds to invest internationally up to the revised limit of 30% in respect of foreign portfolio investments, and an additional 10% in respect of foreign portfolio investments in Africa.
*See the the link on the www.multidimensions.co.za/totrust website for more information on prudential limits per Regulation 28.
Understanding liability driven investment
Regulation 28 requires that a retirement fund board must at all times apply a number of key principles, including:
“Ensure that the fund’s assets are appropriate for its liabilities.”
Traditionally, liability driven investing (LDI) has been used for managing the risks of defined benefit pension funds or insurance company obligations, which have liability obligations that they have to meet. The institution’s actuaries or accountants will place a value on this liability (a statutory obligation), which will change due to fluctuating factors like interest rates or inflation, for example. Even if the obligations in rand terms are known in advance, the value placed on these liabilities can be extremely volatile.
The primary goal of any corporate defined benefit retirement fund is to be able to pay all current and future pensions to their members when they fall due (pension liabilities), and to provide annual pension increases in line with the needs of their pensioners – typically linked to inflation. These are the promises a fund makes to its members.
In the case of a corporate defined benefit fund, the employer carries the financial burden of having to pay any shortfall in assets relative to these promises; and the extent to which the employer is willing and able to meet the shortfall becomes important when considering a liability driven investment approach. For this reason, a close matching of assets to liabilities has become increasingly important. This is especially important in today’s environment of volatile markets and unpredictable returns, where pension portfolios are exposed to inflation and interest-rate risk, which could push them into hard-to-manage deficits. If a fund’s investment portfolio experiences disappointing returns, pensioners generally receive reduced or no pension increases. In addition, if there are deficits, the sponsoring company (which carries the risk) will have to make up the deficit in the fund.
Given its focus on both assets and liabilities, LDI is an essential investment tool for trustees. Importantly, it helps pension funds meet the pension promises made to its pensioners. A properly executed LDI strategy will play a significant role in enabling a fund to manage its risks better; more confidently meet its long-term goals; and, ultimately, keep its promises to its members and pensioners.
- Understanding South African Financial Markets (6th edition).
Chapter 1, page 201.
- National Treasury, [Online]: http://www.treasury.gov.za/publications/other/Reg28/
- FSCA, [Online]: https://www.fsca.co.za/Regulated%20Entities/Pages/UI-Retirement-Fund.aspx