Do defined contribution retirement funds have a future?


27 May 2009 11:06

Magda Wierzycka reckons we need to ensure that we take care of our retirement savings through more vigilance, stricter governance and appropriate regulation.

Having spent a couple of weeks in the US recently I came across some interesting parallels between the South African and the US retirement fund markets. 

The US retirement fund industry is not as far advanced as our own in having converted their defined benefit pension plans, where benefits are guaranteed by the employer and expressed as a percentage of one's final remuneration, to defined contribution ones, where members carry all the investment risk.  However, given the vastness of the US, there are a great many defined contribution arrangements in place.  Many of those offer multiple investment choice options to members.  Most incorporate the US version of life-stage modelling, where members' assets are invested according to a shifting asset allocation path approaching retirement, with the equity exposure declining over time. 

Interestingly, these life-stage funds have now come under intense regulatory scrutiny.  Life-stage funds are marketed as a simple route to safe retirement savings.  However, many have posted substantial losses over the past year, with some conservative products aimed at people close to retirement age delivering negative returns in excess of 40%.  Combined with the collapsing property market, this means that many people close to retirement can no longer afford to retire. The US Senate is thus urging regulators to legislate the composition, marketing and disclosure requirements relating to life-stage funds.  Whereas the latter two fall squarely within the ambit of regulation, the former is a huge step towards government's intervention in asset management.

In South Africa, member-level investment choice and life-stage modelling have been around for at least a decade.  Similarly to the US, our equity markets have suffered of late.  What has partly saved our investment performance, however, has been Regulation 28 (of the Pension Funds Act) which limits investment in equities by retirement funds to 75%, as well as foreign exchange controls which cap international exposure at 15%.  These antiquated, and often criticised, pieces of legislation had the combined effect of limiting the exposure to South African equity markets to 60-65% for even the most aggressive of products (there might also have been 10% to 15% held in international equities, where the depreciation of the Rand counterbalanced the fall in dollar values).

As a consequence, it may be tempting to consider the South African legislation as providing superior protection to investors.  However, this legislation merely places overall limits on exposure to different asset classes.  Our regulators have never suggested legislating specific asset allocation strategies for particular risk profiled products.  That is what the US Senate is proposing.   This seems rather extreme.  Regulation 28 and foreign exchange controls have worked to limit losses.  There are some valuable lessons in that, relating to diversification.  However, one can not help feeling that what was achieved was a matter of luck, and not intent. 

Current Regulation 28 was drafted in an era of defined benefit funds.  Hence, limits on equity exposure were more a function of securing institutional funding for the government bond market, than of trying to protect members of retirement funds.  We can do better.  The time has come to rewrite Regulation 28 to make it more relevant.  Twelve years have passed since I sat on an FSB committee tasked with re-writing Regulation 28, and since a revised draft of the Regulation was first circulated.  Nothing has yet come of that, although for twelve years the change has been imminent.

PF Circular 130, which was issued in 2007, has gone a long way towards preventing situations such as those experienced recently in the US as it places the onus on boards of trustees to ensure that the investment choices offered to members are appropriate for the profile of membership and that the trustees take expert advice where necessary.  The US would be better off looking at the principles set out in this circular and in the draft revision of our Regulation 28, than in regulating asset allocations for different risk profiled portfolios.

In the US retirement fund service providers are questioning the future of defined contribution plans in the face of government intervention.  In South Africa, this horse has already bolted.  The majority of schemes are defined contribution in nature and it is unlikely that we will ever see a reversal.  2008 has proved that systemic risks can cause unanticipated damage and considerable harm.  We need to ensure that we take care of our retirement savings through more vigilance, stricter governance and appropriate regulation.


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