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When trustees are confronted with the question whether their fund should introduce member investment choice, there will be a number of arguments in favour and a number of arguments against this notion. How can you as a trustee and a layman then take a rational decision? Here are some guidelines that may assist:

  • You should know what the fund would like to achieve.
  • You should know what the needs of the fund’s stakeholders are.
  • You need to ascertain that you apply the basic principles of governance.
  • You should be wary of flawed arguments, such as “member carries the investment risk so the member should be entitled to make his own investment decisions” and “the life stage model is international best practice, so there can’t be any question”.

The 5 year period from July 2005 to June 2010 is a very representative period in terms of long-term investment returns as it covers both a bull and a bear run in the markets but produced returns reflecting what one can expect over the long-term.

We have used this period to put the life stage model on the test bench and were intrigued by the outcomes and observations that this produced. Our conclusions follow.

Conclusion

The 5 year period from July 2005 to June 2010 has been a highly volatile period in investment markets encompassing both a severe down turn and a dramatic recovery. In real terms, the returns generated over this period are quite representative of long-term expectations. Because of these features of this particular period they make for good testing ground of the life stage model.

From the results of this particular research project one can deduce the following:

  • Returns are linked to risk and higher equity exposure (or higher risk) produces higher returns;
  • The average balanced portfolio outperforms the lower risk portfolios;
  • The life stage model will lose returns for a fund’s membership overall, unless the lower risk can be compensated by higher risk in the earlier life stages;
  • Smoothed, systematic switching to the conservative and cash portfolios, produced a higher end value than remaining in the balanced portfolio over the full period (this is similar to the principle of ‘Rand cost averaging’);
  • Switching at specified times produced higher end values in some events, but there is a significant risk of losing value compared to the average balanced portfolio as well;
  • What combination of portfolios to use depends on one’s objectives as measured in terms of absolute outcome, volatility of outcomes and probability of underperforming the average balanced portfolio;
  • Assuming the objective would be to maximise the absolute outcome, to minimise volatility and to minimise the probability of underperforming the average balanced portfolio and applying different weightings to the increasing levels of desired outcomes, a combination of balanced and conservative portfolios produces the highest score;
  • As the result of the fact that balanced and conservative portfolios both contain a significant equity component, their behaviour in volatile markets is synchronous while cash typically behaves counter cyclical.

Based on the experience of this 5 year period, trustees contemplating the introduction of the life stage model, should be very clear on what their objectives are in terms of absolute returns, volatility and probability of underperformance.

They need to be aware that employing lower risk portfolios will reduce the returns for the fund and its members overall unless this can be compensated with a portfolio presenting a risk profile higher than the average prudential balanced portfolio.

The cash portfolio should preferably be by member choice, and for member specific reasons only. This choice should require special individual attention by the trustees to avoid any undue risk exposure.

Furthermore, considering that human nature finds losses more painful than missed opportunities, instead of switching at particular dates, it is advisable to switch a regular amount in respect of the aggregate value of all relevant members’ retirement capital on a regular basis, because the pain of losing outweighs the pleasure of gaining. This would have to be done by the trustees on behalf of their members and cannot be left to the individual.

Important notice and disclaimer
This article summarises the understanding, observation and notes of the author and lays no claim on accuracy, correctness or completeness. Retirement Fund Solutions Namibia (Pty) Ltd does not accept any liability for the content of this contribution and no decision should be taken on the basis of the information contained herein before having confirmed the detail with the relevant party. Any views expressed herein are those of the author and not necessarily those of Retirement Fund Solutions.

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