A successful investment strategy requires clear goals. Employers should have a good idea of what members want so that they can grow member contributions and, ultimately, provide a more than adequate pension when they retire.

While employers are responsible, they might not have the expertise to actively monitor and administer a fund – that is where a trusted adviser like Old Mutual Corporate can help.

Ndlovu and Van der Vyver talk about the most important considerations for employers and employees so that both parties are aware of potential risks and how to mitigate them.

Want to read the conversation instead? See the transcript of this podcast below.

Malusi Ndlovu 00:04 

Welcome to Big Business Insights, the Old Mutual Corporate podcast where we discuss human capital and benefit issues that concern all businesses, from up-and-coming companies to established corporate enterprises. Each episode focuses on one topic to bring you insights and help you make informed decisions for your business, your employees, and yourself.

Malusi Ndlovu 00:25
You're back with me, Malusi Ndlovu, and we are continuing our talk on pension fund investments and saving for retirement with Old Mutual's Fred van der Vyver. Hi, Fred.

Fred van der Vyver 00:38
Hello, Malusi. It's nice to be here again.

Malusi Ndlovu 00:41
Great. So, risk sharing is important in retirement funds, because it allows you to take a lot of risk in the long run for each member, while also ensuring that the outcomes are as consistent as possible. What is the role of Smoothed Bonus funds in this risk sharing?

Fred van der Vyver 01:02
Ja, I think if I can maybe just start off by explaining what we mean by risk sharing. Because risk sharing is simply a very effective risk management tool that we already apply in so many other areas of our lives that we recognise we have risk. Health insurance is a good example. A medical aid is one big risk sharing scheme, where you share the risk of unexpectedly high medical costs with all the other members in the scheme. Similarly, if you think about it, car insurance is risk sharing, because you share the risk of financial loss or damage to your car with everybody else that buys car insurance. So, risk sharing in the retirement context is effectively sharing the risk that markets are down at the point when you need to draw from your retirement savings. We all know markets go up and down. So, the risk that markets are down is not really the risk we need to be worried about. The risk we need to be worried about is the risk that markets are down when I retire, or when I get retrenched, and need to use some of those savings. And so, in that context, Smoothed Bonus portfolios are designed to facilitate that risk sharing. In a Smoothed Bonus portfolio, we invest the underlying portfolio in risky growth assets that go up and down like any other typical market linked Balanced fund would do. But then we declare a smoother return, we smooth out the returns, so that at any point in time, the benefit that you get from the Smoothed Bonus fund is either higher or lower than the actual underlying market value. And so, if you think about it, what we are doing is we are facilitating a scheme whereby all the investors in that fund share with one another the risk that markets are down when they need to draw on their savings.

Malusi Ndlovu 03:12
Sure, that's very interesting. I imagine for this to work; you need quite a lot of people to be sharing that risk. Otherwise, it's not going to work very well if it's just you and I, because if I claim, I'm going to deplete the entire pool of savings, or if you can claim, you deplete the entire pool. How does this relate to size?

Fred van der Vyver 03:33
Exactly. I mean, we can easily think about it in the medical aid scheme. If you only have three people in there, and the one person needs a very expensive medical procedure, the premiums of the other two are going to go through the roof. And so, in the same way to optimally facilitate risk sharing in a Smoothed Bonus fund, you need what we call critical mass and diversity of your portfolio. And so ideally, what you want, is you want a large number of investors or members from a retirement fund investing in this portfolio, that are distributed across the industry from different companies and different industries that will be affected in different ways by economic events, and also distributed across the age spectrum so that you don't have everybody retiring at the same time.

Malusi Ndlovu 04:26
Ja.

Fred van der Vyver 04:27
And so, while we all appreciate the value of smoothing, we also recognise that it's not very easy to do it optimally. You need critical mass; you need to have a large, diversified book. And then it almost becomes like a snowball effect where the momentum builds and you end up in a very well run, established Smoothed Bonus portfolio.

Malusi Ndlovu 04:53
You know, as you're talking Fred, it sounds a lot like the old defined benefit world in some sense. I know it's not exactly like that. How is this different or the same to the defined benefits world of retirement funds and compared to the defined contribution world of retirement funds, which we are going into.

Fred van der Vyver 05:14
It is the same, while also being very different. And let me maybe explain that in this way. I love history, when it comes to the history of our industry, and how things developed. So, if you will indulge me for a moment. Back in the 80s, the predominant way of providing for people's future income needs in a pension fund or retirement system was through what was called defined benefit retirement funds. And effectively what a defined benefit retirement fund was, was that you worked for a company, the company paid your salary to provide for your monthly income needs. But at the same time, contributions were made that then guaranteed you a certain income when you retire, on a fixed formula based on years of service or years of contribution.

Malusi Ndlovu 06:05
Hence the name defined benefit.

Fred van der Vyver 06:07
That benefit was defined.

Malusi Ndlovu 06:08
Ja.

Fred van der Vyver 06:09
As long as you contribute for the period of your active working life, your benefit was defined. Now, how did they achieve that defined benefit outcome? It was by investing appropriately in assets that deliver sufficient amount of returns. But then managing that risk, because even though the benefit was defined, the underlying investments were still volatile. And so, what it effectively resulted in was the principle of sharing investment risk amongst all the members of a defined benefit fund. As well as an employer coming and providing an ultimate guarantor of last resort, if we can put it that way, by guaranteeing that benefit. For various reasons that we don't have time in this discussion to go into, there were problems with defined benefit funds. I'm not saying, you know, it was the silver bullet, you know, for one, the liability that that guarantee placed on an employer's balance sheet was highly problematic and could sometimes dwarf their financial results or completely skew the financial results because of the need to provide for that future liability. And so, for that, and many other reasons, in the industry, we saw a shift towards what we now know as the predominant way of saving for retirement, which is defined contribution funds. And so, while the difference seems subtle, the implications of that shift was quite significant. Because what we moved to was a system where there was no guarantee of the outcome. The only thing that was defined was that we were contributing a certain amount of your salary every month. And even that is not guaranteed, because people can choose what level they need to contribute, which is a challenge and a conversation for a different day.

Malusi Ndlovu 06:09
Another podcast.

Fred van der Vyver 08:04
Exactly. But the reality is, if you think about it, what happened in the shift from defined benefit to defined contribution funds, is that where in a defined contribution space in the predominant way that it's being applied in South Africa, is that all the investment risk, and in many cases, also all the longevity risk, the risk of living longer than the average person out there, has been shifted on to each individual. And so, what that means is each individual now bears the risk of markets being down when they need to draw their money, and each individual bears the risk of living longer and outliving their savings. And that has resulted in highly volatile outcomes. It's resulted in a situation where people may save for a very long time, a significant amount, but there is no guarantee in the outcome.

Fred van der Vyver 09:04
It sounds obvious. But do we sometimes pause and think about what does that do for the original intent? The original intent was secure a future income need, and in the context of what companies want to provide their employees with, a value proposition, is I not only secure your current income needs, but I also provide you with an employee benefits package that secures your future needs. But if we design it in a system where all the risk is shifted on to the member, there is no security. You know, it's a gamble so to speak, due to factors outside your control.

Malusi Ndlovu 09:04
Ja.

Malusi Ndlovu 09:44
The member may as well just invest on their own in an individual arrangement and they would get identical outcomes.

Fred van der Vyver 09:54
Ja, philosophically, correct. Yes, there may be some fee experience differences, etc. But the point is if you only save in your own capacity, and you don't share risk with other members that have the same investment objective, your outcome is highly dependent on factors completely outside your control. And those factors being what is happening in the world at the time when you need to draw your money, and when you need to use that money to provide for your needs. And so, all of us can just think about, you know, numerous examples of things happening completely outside our control: the war in Ukraine, the Covid pandemic, but even before that, the economic crises we've had to endure in South Africa, the impact of Nene gate, the electricity crisis we have. All those things are not in our control, yet they have a very material impact on our retirement income one day, which is not ideal, you want to find a way to protect members from those factors that are outside their control.

Malusi Ndlovu 11:04
And that's where the Smoothed Bonus funds come in, and they really try to balance that. What has been the trend internationally in relation to the way that these outcomes are being managed?

Fred van der Vyver 11:17
I think before we talk about trends, I'll maybe just say what is happening currently. And I don't want to overdramatise this, but I think we are in for a rude awakening, in the sense that, you know, as we shifted from defined benefit to defined contribution funds, not many people fully appreciated the implications of that.

Malusi Ndlovu 11:39
That's right.

Fred van der Vyver 11:40
You know, so many times you speak to somebody on the street, and you ask them, do you have a secure retirement plan in place, and they go, ja, I work for a company, I've got a pension fund. And that's where the response stops. If you then dig in, you realise that he is a member of a defined contribution fund and is invested in highly volatile assets, and there is no security that he's going to have enough. And so, in South Africa, but also internationally, we have seen significantly variable outcomes. A very interesting paper was written by a large consultancy in the UK, where they've looked at the outcomes of defined contribution funds over the years. And they found that purely based on when you retired, your outcome could have been affected by more than 50% because of movements in equity markets and the cost of annuities that you buy. So, you could say that, in a pure defined contribution system internationally, there is a recognition that the outcome is more dependent on the timing rather than the behaviour of the member.

Malusi Ndlovu 12:51
That is scary.

Fred van der Vyver 12:52
It is.

Malusi Ndlovu 12:53
So, you save for 20, 30 years of your life. And then by virtue of the accident of when you take the money out and retire, you could be impacted by as much as 50%.

Fred van der Vyver 13:07
They looked at and - just think about it, there was a time when equity markets ran strongly and delivered very good returns in the 1990s and maybe the early 2000s. And then there was a period of time when equity markets came down, but at the same time bond yields came down as well. And what that meant was the cost of securing an income for the rest of your life went up. And where those two met resulted in very, very volatile outcomes. And so yes, we can understand the mathematics behind it, and we can explain it. But that doesn't help with getting people to have confidence in the system. Because ultimately, what you want to do is you are competing with people's immediate consumption needs, if you're thinking about, you know, trying to get people to engage and actively save for their retirement. And if you ask a person to save 15% of his salary, and you really try and engage that member around doing everything in that member's control - cut your monthly expenses, cut your cost of living to be able to save for the long term - but then you play to that member as he does that, the volatility in his projected outcome and ultimately in his actual outcome, what does that do for confidence and engagement and anxiety and the ability for that member to then focus on their job at hand. And so, this is where we're seeing internationally a recognition that the move to defined contribution fund and shifting all the investment and longevity risk onto members results in volatile outcomes that negates the original intention. And so internationally, people are starting to study what are the unique features of some of the best pension systems around the world. And people would maybe be surprised to find that some of the best systems around the world are systems designed by countries like the Netherlands and the Nordic countries and to some extent, Canadian systems. And while there are many differences, there is a common thread in that those highly successful pension systems all use some element of risk sharing, to manage the risk, rather than risk avoidance. And that is where we are seeing the world go, is to say, can we find some middle ground between defined benefit and defined contribution funds. Not go all the way back to defined benefit funds, where an employer needs to guarantee your pension and all the issues around that, but at least not throw out the baby with the bathwater, you know, and at least retain some of those well-established risk management principles of risk sharing. And so, the UK for one is now legislating what they call collective defined contribution funds, which is a third category of fund that sits somewhere between a defined benefit and a defined contribution plan. And essentially, what that is, is allowing smoothing of investment returns within a defined contribution construct. And if you think about that, it just makes a lot of logical sense.

Malusi Ndlovu 16:25
Ja, absolutely. Absolutely. And the countries that you spoke about, I imagine a lot of what they're doing is at a national level, using the national fund maybe, or even industry funds, which are quite big. Now, how can one move closer to replicating that in South Africa? Given that we don't have a national fund. And I certainly don't think we will have anytime soon. How can we do so with our existing retirement fund environment?

Fred van der Vyver 16:5
Ja. Maybe let me just go back to that. It's not just in national funds of these developed countries that they use risk sharing. It is also an employer-based privatised funds like we have in South Africa. What is interesting is that they would then share the investment risk amongst all the employees of a specific company or group of associated companies. And if you think about that, it would be like the pension fund of a very large employer in South Africa as well. So, they would design what is then called a collective defined contribution fund that smooths the returns amongst the 15,000 employees of a large company. I think the most current example is the Royal Mail in the UK, a very, very large company, with thousands of employees. And they've created their own collective defined contribution scheme, which is the fine contribution fund in the sense that there is no guarantee around your benefits. But at least they share the risk. In the South African context, we can actually provide an even better solution in the sense that we allow for multi-employers, multiple employers to join what is known as a commercial umbrella fund. And in setting a default investment strategy for all those employers, we can then facilitate risk sharing, not just between members of a specific company, but risk sharing between members across industries and across companies, by way of them all investing in the same portfolio. And that's precisely what we're doing in our Smoothed Bonus fund as the default investment strategy on SuperFund. So, you know, in a way, what we've been doing in SuperFund, for many years already, and continue to see as the most optimal way of investing retirement savings as a default, is building a very large collective defined contribution fund, across employers and members in South Africa.

Malusi Ndlovu 19:03
Size matters, diversity matters. And you're able to achieve that in these large, open multi-employer umbrella funds.

Fred van der Vyver 19:11
Because if you think about it, in the way that they do in the UK at the moment by designing a collective defined contribution fund per large employer, that is only really available as an option for very large companies. Whereas the way we do it in South Africa, if you share that risk at a portfolio level, like what we're doing, you can allow small or medium-sized employers to also participate in that risk sharing with other employees in the same way, which is actually even better. And that allows for more consistent outcomes amongst members.

Malusi Ndlovu 19:51
I want to touch on the role of guarantees within the Smoothed Bonus funds, Fred, because they also have guarantees as well, which provide an extra layer of protection. How do guarantees play a role within the funds?

Fred van der Vyver 20:07
Ja. That's a very good question, and sometimes a bit controversial. But let me go back to defined benefit funds first. So, we discussed that there was risk sharing happening. But one of the problems with a defined benefit fund that only facilitated risk sharing was, if things go wrong, how do you still maintain the ability to pay that defined benefit? And that's where the employer had to step in and provide that guarantee. And in some cases, it was a very onerous guarantee. But there's a recognition that risk sharing facilitates risk sharing amongst a group of, you know, investors or members. But if things go very wrong and stay wrong for a long period of time, there's a finite limit to the extent to which members can support one another if things continue to go wrong. And therefore, you need a guarantor of last resort. That was the employer in a DB fund. And so, I briefly discussed that the collective defined contribution schemes that are being designed internationally and being rolled out in the UK. While that facilitates risk sharing, there is still no guarantee you will have smoother outcomes, but the outcomes are not guaranteed. In our context, we use risk sharing in our Smoothed Bonus portfolios through the smoothing, but in the same way as a DB fund guaranteed benefits at an absolute minimum level, we do provide fixed guarantees, in addition. And instead of each employer having to provide that guarantee, the insurance company provides that guarantee, and it provides the facility to say if things go bad, and I mean really bad, and they stay bad for 5, 10, 15 years, there's a place where the insurance company would come in, and also chip in money to support those benefit payments out of the system, which is highly valuable if you think about it. So often, people argue that yes, is there really a value in the guarantee, because markets go up and eventually or markets go down, and they will go up again. But we so easily lose sight of, you know, situations around the world. And the classic example is Japan - but it's not only Japan - where you can have a severe downturn in your investment markets in general without an immediate recovery thereafter. And if that period extends for a number of years, there is a possibility that even risk sharing will not be good enough to maintain benefits. And that's really where the guarantee becomes highly valuable.

Malusi Ndlovu 20:26
Thanks, Fred. This is fascinating, as always, we can spend a lot of time talking about this. Thank you very much for coming through.

Fred van der Vyver 23:07
Thank you, Malusi. I really enjoyed it.

Malusi Ndlovu 23:09
I've been talking to Fred van der Vyver. He's the Head of Old Mutual's Smoothed Bonus Funds, as well as the Head of Old Mutual's SuperFund umbrella, South Africa's largest open multi-employer retirement fund.

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