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Low-cost passive management of your retirement fund savings, in preference to often high-cost active asset management, has been given an implied stamp of approval by National Treasury in proposals it unveiled this week to cut retirement-funding costs and improve member benefits.
In the last of five discussion papers published over the past year aimed at reforming the private retirement-funding industry, Treasury says its proposals on costs are intended to provide options for discussion.
Treasury says the charges levied by commercial retirement funds, such as retirement annuity funds and umbrella funds, are among the highest in the world, while stand-alone occupational funds offered by employers are comparatively low-cost – but even with these funds members can be exploited by financial services providers.
Treasury says costs in the R2.3-trillion retirement-savings industry can be brought down by, among other things, consolidating funds, making membership of funds compulsory for all employees, preserving retirement savings until retirement, and improving the regulation and management of funds.
Treasury also sets its sights on charges levied by the financial services sector, proposing solutions for consideration by the broader retirement-funding industry.
In dealing with the costs of asset management, Treasury is critical of the under-utilisation of passive management, the use of performance fees by active managers, and the opaque costs of smoothed-bonus, capital-guaranteed products provided by life assurers.
Treasury says retirement fund investment consultants, like other intermediaries, have a bias towards recommending products and services which increase their income, such as favouring active management over passive management.
Consultants can earn higher fees if they can persuade retirement fund trustees to employ them to assess and monitor the skills of various active managers managing different portfolios of assets.
Other examples of where consultants and others can earn additional fees are investment mandates that incorporate performance fees or complex, highly structured investment products.
Treasury says the alternative to active management, and a way for retirement funds to cut costs, is to make greater use of passive asset management. This means putting your investments in products that track various investment market indices. For example, a passive portfolio could track the FTSE/JSE All Share Index or sections of a market, such as the financial sector.
Active investment managers seek to identify under-priced assets in the hope that their portfolios will out-perform their peers.
Treasury says passive management is much cheaper than active management because there is little judgment involved and little trading. In the long run, the saving on fees compounds and becomes substantial.
“By definition, the ‘average’ investor, whether active or passive, can only perform in line with the market. Half of funds invested will underperform the market in any given year, and half will outperform. Together, they make up the market. After expenses, the ‘average’ investor must therefore under-perform the market,” Treasury says.
It says the case for active management is built on the idea that outperforming managers consistently outperform and that past manager performance is a guide to future performance. In the absence of consistent historic outperformance, “the case for active management falls down”.
Treasury says two important issues are often overlooked when examining the historical fund returns of active managers. These are:
* Performance table survivor bias: actively managed portfolios that underperform are less likely to survive than funds that outperform. Performance tables include only portfolios that are currently trading. This results in an exaggerated average performance of active managers in comparison to benchmark indices.
* Risk: many funds may take on extra investment risk. The effect is significant enough to make a substantial difference when analysing historical returns.
Treasury warns that you should view with scepticism any analysis of historical manager outperformance that does not correct for these two factors.
Broadly speaking, despite a large number of studies over many years, statistically robust evidence in favour of the persistent out-performance of active managers is weak, after taking these factors into account, Treasury says.
It says modern financial markets see investment managers trading highly standardised securities with many other skilled financial professionals from all over the world.
“All have a direct financial interest in exploiting any mispricing between different securities, and the cost of trading is lower than it has ever been. Consistently outperforming in such a world is extraordinarily difficult, and getting more so.”
This has driven the increased recognition of the benefits of passive investment management – in both unit trusts and exchange traded funds internationally.
Treasury says that locally index-tracking portfolios are making slow progress for a number of reasons, including:
* There is limited availability to retail investors on many linked-investment services provider (lisp) administration platforms, particularly on the cheaper fund platforms.
* Behavioural factors, most notably the triumph of hope over experience. Few investors, wholesale or retail, seem willing to recognise their apparent inability to pick managers or stocks successfully and accept index-related performance.
* Moral-hazard problems caused by intermediary incentives. Treasury says this may be caused by rebates paid by investment managers to intermediaries, including lisps, and a reluctance by active managers to undercut their own actively managed investment funds on the platforms they control.
* A lack of appreciation of the cumulative nature of apparently small annual fees by investors.
* Investors may fail to appreciate that the outperformance reported by their investment managers is often measured relative to undemanding or entirely inappropriate self-reported benchmarks.
PROPOSALS TO CUT COSTS
National Treasury says there are numerous ways to bring down the cost of saving for retirement, which would result in you receiving a better pension.
Treasury has put forward the following proposals for discussion:
* Fund consolidation. Most retirement funds do not have the necessary membership and asset size to achieve sufficient economies of scale, which leads to higher costs and lower benefits for members.
* Improved fund governance. This includes putting a stop to conflicts of interest where, for example, a service provider encourages a fund to use a particular service, because it would unfairly make a profit at the expense of the fund and ultimately its members.
* Stronger regulation. A strong and effective regulator is essential to ensure a well-functioning retirement system. The regulator needs to have the power to monitor all aspects of the retirement-funding system, including costs, and to intervene when necessary to protect the interests of members.
* Workplace retirement provision. With the higher costs associated with individually distributed retirement vehicles, such as retirement annuities (RAs), and employees’ low level of financial literacy, Treasury recommends that the workplace remains the primary arena where retirement savings products are distributed.
* Simplified products. To increase competition based on price, Treasury proposes that retirement products be simplified significantly before they can qualify for tax exemptions for members.
This may imply a standardisation of permitted charging structures, a requirement that all members are charged on the same basis, and a restriction on the investment options, if any, that funds may offer their members to those that comply with prescribed standards.
Retirement funds that grant their members a choice of investment portfolios may have to provide default portfolios that meet more stringent requirements, including an outright ban on any exit penalties for early retirement or loyalty bonuses and, possibly, a cap on recurring charges, to prevent product and service providers from shifting from one form of charge to another.
* Effective selling. The need to sell products and provide consumers with advice may be compromised by high costs and remuneration structures that result in conflicts of interest. Work is under way in the retail space to explore ways in which the incentives offered to intermediaries may be better aligned with serving consumers’ needs.
Various aspects of linked-investment services provider (lisp) platforms, including the payment of rebates by investment managers to lisps, are to be investigated.
* Compulsory fund membership for all employees. Employers may automatically have to enroll their employees in a retirement fund, which may be a stand-alone pension fund, an umbrella fund or an RA fund.
* The creation of a retirement fund exchange or clearing house. To ensure cost-effective compulsory fund membership, an exchange could be created that would enable smaller employers and their employees to compare different retirement plans easily and to choose one that meets their needs without requiring financial advice.
Funds that satisfy certain criteria, including economies of scale, design, efficiency and simplicity, will be permitted to list on the exchange.
* Default funds. Default funds could be provided on the retirement fund exchange for employers who do not specify a fund for use by their employees. Default funds could also be used to facilitate the preservation of savings before retirement and to ensure that unclaimed retirement benefits are managed effectively.
YOU CAN READ AND COMMENT ON THE PAPER
National Treasury’s discussion document on the cost of saving for retirement, entitled “Charges in South African retirement funds”, contains a comprehensive review of charges and costs, which, among other things, compares the retirement system in South Africa with that in other countries.
The discussion document proposes various policy interventions that could remedy some of the shortcomings it identifies.
The paper highlights the importance of saving for retirement and the need for you, as a retirement fund member, to receive value for money.
The proposals contained in this discussion document and four others will form the basis of the reform of the retirement fund industry, in an attempt to improve your chances of a financially secure retirement.
All the discussion documents can be found on Treasury’s website, www.treasury.gov.za
Comments on the charges discussion document can be submitted by September 30 to Dr David McCarthy, retirement policy specialist by email to email@example.com. Fax to 012 315 5206, or post to Private Bag X115, Pretoria, 0001.