A look at smoothed bonus portfolios

OVER THE PAST two years retirement fund members have witnessed one of the most volatile investment periods in living history. No wonder many members are feeling unsure about their investment choices. How well then, might smoothed bonus funds address investor concerns about loss of capital?

What are smoothed bonus portfolios?

Members in smoothed bonus portfolios receive investment returns through regular bonus declarations. Those bonus declarations are based on the returns achieved on the portfolio’s underlying investments. However, some returns may be set aside during periods of strong market growth to be used to boost returns during periods of weaker performance. Effectively such portfolios “smooth” returns, either by holding back or releasing investment returns, depending on whether the fund is in a surplus or deficit.

Importantly, a member’s book value depends on bonus rates declared and doesn’t exhibit the same volatility as the underlying assets. Declared bonuses can never be negative. The book value is paid on death, disability, resignation, retrenchment or retirement. That lessens the risk of disinvesting from the market at the wrong time.

Smoothing merely changes the timing of when investment returns are released and doesn’t reduce or increase the returns. Over time, the bonuses should produce a similar return to the underlying investment in the fund (after deduction of the guarantee costs).

The smoothed bonus product range includes product offerings that provide fully vesting bonuses, while others provide bonuses that consist of a vesting and non-vesting portion. Vesting bonuses can never be removed or reduced. Non-vested bonuses, however, can be removed if the portfolio is severely underfunded. As such, smoothed bonus portfolios with fully vesting bonuses offer a much stronger guarantee – but that comes at a greater cost.

What are the costs associated with a smoothed bonus portfolio?

Insurers are required to hold a specified amount of capital to provide the guarantees underlying the smoothed bonus portfolio. If the portfolio becomes significantly underfunded, financial assistance in the form of an interest-free loan from the insurer’s shareholder fund to the smoothed bonus portfolio might be required.

To compensate for the fact a portion of the insurer’s capital is tied down by offering those portfolios (and that money loaned to a portfolio may never be recovered), insurers charge a guarantee fee/capital charge in addition to the normal asset management fee.

Those fees vary between insurers. The guarantee fee also differs significantly between those portfolios with partially vesting bonuses (usually between 0,9% to 1%/year) and those with fully vesting bonuses (usually 1,6% to 1,8%/year).

Are there other costs?

Some argue there are other costs, mostly relating to asset allocation, smoothing and disinvestment conditions. Most smoothed bonus portfolios tend to have an asset allocation similar to a conservative to moderate balanced fund. In a strong bull market those portfolios are therefore likely to underperform best investment house view portfolios. It’s important for member communication to create realistic return expectations for members. Such portfolios don’t try to compete with more aggressive market-linked portfolios.

Additionally one of the consequences of smoothing is that bonuses often lag market returns. When there’s a market downturn those portfolios often still declare strong bonuses based on the surpluses built up before the downturn. After exceptionally severe downturns those portfolios could be in deficit. Bonuses could take a while to recover to more normal levels as the portfolio tries to strengthen its funding position. Some members complain about low bonuses when investment returns pick up, forgetting they received good bonuses during the downturn.

Although smoothed bonus funds provide valuable guarantees on benefit payments, other exits – such as termination or investment switches – will occur at the lower of book and market value. These portfolios are therefore not suited to members who wish to switch. During a market downturn the portfolio could be underfunded and members might receive a lower value on switching than anticipated. For those members who don’t intend switching out of the portfolio before exiting their retirement fund that’s not an issue.

The above is perhaps the greatest concern for clients invested in smoothed bonus portfolios: if an insurer allows the portfolio’s funding level to deteriorate to such an extent it’s unlikely to recover – then members are unable to disinvest without receiving a reduced payout. That situation becomes even more problematic if the insurer is unable or unwilling to provide financial support to the portfolio.

Important considerations for choosing a smoothed bonus portfolio

When considering a smoothed bonus portfolio for your members it’s important to remember the various products on offer differ between insurers. In particular investigate the following (See table):

Smoothed bonus portfolios remain a relevant and important investment option available to retirement fund members, either as a default option or as an investment for those close to retirement.

DANIE VAN ZYL

Sanlam Employee Benefits

VAN ZYL is head of guaranteed investments at Sanlam Employee Benefits, responsible for both smoothed bonus and pooled derivative-based portfolios. He joined Sanlam in 1998 and is a fellow of the Actuarial Society of SA. He has wide-ranging experience in annuity, risk, cell-captive and investment offerings in the employee benefits industry.