Investment strategy for a defined benefit fund
The defined benefit fund, also referred to as a liability-driven investment (i.e. ensuring there will be enough assets to cover a certain liability in the future), is typically formula-based, taking various factors – such as years to retirement and pensionable salary – into account. The investment strategy in this instance is left to the trustees of the defined benefit fund.
Risk tolerance is a function of the type of risk and the extent of risk the fund can adopt to meet its return objectives. Therefore, a defined benefit fund’s long-term investment goal of return – in line with or in excess of inflation – needs to be achieved as accurately as possible with the appropriate risk budget.
Asset class diversification is a fundamental risk management tool. As a starting point, the fund needs to adopt a long-term strategic asset allocation model taking the following information, for example, into account:
- The fund’s current financial position;
- The fund’s future liabilities;
- The expected long-term risk/return profile of the various asset classes within the fund, such as cash, equities, bonds and property, both locally and globally.
Equities, for example, although typically offering higher returns, are far more volatile than that of cash and therefore exposure to such an asset class should be limited to reduce the potential of significant capital losses over the short to medium term (which ties into the 75% equity limit prescribed by Regulation 28).
A fund may be further diversified by ensuring exposure to different asset managers, investment styles and active and passive investments. With this in mind, funds typically outsource the management of investments to several underlying asset managers to achieve this additional level of diversification. These asset managers would be provided with a specific mandate to ensure that their strategies are aligned with the overall required objectives.
Asset managers can manage portfolios for a specific asset class (listed SA equities, for example) or for a range of asset classes (a balanced fund, for example) with a specific objective such as a required minimum rate of return or capital preservation. Added to these objectives can be environmental, social and governance (ESG) considerations or other socio-economic measurable impacts, for example.
An assessment of risk factors
There are several important risk factors to consider when assessing and monitoring particular asset classes that a pension fund is invested in. These factors can include liquidity risk (the risk that an asset can’t be bought or sold quickly in an unlisted investment, for example), counter-party risk (the probability that a party in a transaction will default on their contractual obligations in a credit investment for example) or ESG risk (non-traditional factors having financial implications).
The investment strategy of the fund should ensure that such risks are addressed and reported on. An example of this in practice would be to ensure the integration of ESG factors in an asset manager’s investment process.
Investment strategy for a defined contribution fund
A defined contribution plan allows the member to make the investment decisions. This plan is largely dependent on the size of contributions made, the underlying investments and the associated fees, with the member taking on the investment risk.
For a member in a defined contribution fund, the choice of underlying investments is up to them. The member would be provided with a list of potential funds to invest in with different asset managers, different objectives and therefore different risk/return profiles. The ultimate selection would be a function of the member’s tolerance for risk, current age, investment time horizon, investment knowledge, personal beliefs and preferences, as well as contributions.
Types of pension funds
There are two types of pension funds, namely defined contribution and defined benefit funds. A defined benefit plan provides employees with a specified amount at retirement whereas a defined contribution plan allows employers and members to contribute a certain amount over time to save for the member’s retirement.
The type of plan will determine the underlying investment strategy of the fund and its risk/return profile. The risk/return profile of a pension fund’s assets over time will impact a member’s ultimate retirement benefit, therefore effective management of the investment strategy is vital.
Calculating the defined benefit contribution
A defined benefit fund provides a guaranteed pension benefit on retirement, which is calculated based on the member’s final average salary multiplied by the years of their fund membership as an employee. The rate at which the employed member contributes to the fund is usually fixed as a percentage of their remuneration.
The employer’s rate of contributions is usually calculated by the fund’s valuator who works out the rate at which the employer will need to contribute to the fund to enable the fund to pay the member their guaranteed pension benefit after retirement. The employer carries the investment risk of the fund having to guarantee the member’s pension after retirement.
Calculating the defined contribution
A defined contribution fund provides a pension benefit on retirement, which is calculated based on the accumulated contributions made to the fund by the member (and/or, if applicable, the member’s employer). The returns earned on the investment of those contributions, less deductions of the costs of running the fund and providing for death and disability benefits, are added to the pension benefit.
The rates at which the member and employer contribute to the fund are fixed or defined as a percentage of the member’s remuneration. Importantly, the amount of the member’s pension is not guaranteed, but is rather determined by the contributions made by the member and employer, combined with the fund’s investment performance. This means that the member carries the risks and rewards of their final pension amount.
CFA Institute: Available: www.cfainstitute.org
FSCA; Available: www.fsca.co.za