With 20 years’ experience of converting from DB to DC, South Africa points the way ahead for the UK suggests Petri Greeff, RisCura
It has been hard to miss. Africa has been in the media rather a lot – and with good reason. In just the last month, publications like The Economist and the Financial Times have had special supplements reporting that Africa is at its “tipping point” for sustained growth. But there has been something brewing at the bottom of the continent over the last 20 years that has largely gone unnoticed. With auto-enrolment well under way in the UK and the spotlight firmly on defined contribution (DC), it is time to take a closer look at many aspects of South African DC schemes to get some inspiration, but three things stand out: mindset, investment choice and attitude.
Evolution in isolation…
By way of a short introduction, let me first provide a brief history on the DC industry in South Africa, starting with the current situation. Today, roughly 26% of South Africa’s working population are members of a registered pension (defined benefit – DB) or retirement (DC) scheme totalling about R1 trillion or, in the UK equivalent, £70bn of assets. Around 70% of the working population belong to a multitude of DC schemes, with the largest having close to £2bn of assets. The top 20% of these schemes by assets make up close to 87% of all DC scheme assets, with many hundred smaller schemes making up the balance.
Looking back 20 or so years, the DC industry in South Africa expanded significantly due to the large scale switchover from DB pension scheme benefits to DC retirement benefits. This switchover involved a conversion of accrued DB benefits into an equivalent value of DC member pots and was viewed as positive for both employees and employers. For the former, this meant direct ownership of their assets (which was seen as a good thing) and, for the latter, it meant the transfer of the investment risks associated with DB schemes on to the members in a DC scheme.
Unlike the UK’s contract based DC schemes, most of these new DC schemes in South Africa were trust based schemes where members could access their pot when they resigned from an employer and had no compulsory annuitisation at retirement. The lack of control in schemes led to some unique challenges for the industry. There have been cases of members who treat a retirement fund as a savings fund and resign from one employer to get access to their savings pot and then join another employer to start saving again. Or, at retirement, members would not invest their savings pot wisely into an income replacement asset and spend the bulk of it on items that had little income generating value during retirement. Ultimately, these members become the burden of the state at retirement and reforms have been recently under way to address this. After 20 years, South Africa has plenty of retirements from DC.
The overnight creation of large DC schemes that took place also meant that DC retirement funds received instant attention from the investment industry, unlike the UK where the growth of DC figures is often a rushed last agenda point in trustee meetings. For other adopters of DC schemes, learning points include progressive thinking about investment strategy, understanding what investment choice means and how regulation can support and grow an industry.
Thinking about retirement
Over the past ten years, investment strategies for DC schemes in South Africa have moved from the traditional capital protection strategies to sophisticated income protection strategies using concepts of liability driven investment borrowed from DB schemes. The thinking behind this was that investment strategies for DC retirement benefits should not necessarily aim to protect the member’s pot of savings from market losses as they head to retirement, but instead aim to protect the income purchasing power of the member’s pot. First movers were the very large DC schemes with dedicated investment committees and soon after many smaller DC schemes followed the trend. Today many trustees in South Africa understand that safety could equal risk and that risk could equal safety, hence they are very supportive of a liability driven investment (LDI) approach for DC schemes.
In this approach to LDI, the assumption is made that members have some level of income expectation after retirement. When you look at a DC scheme closely, it is nothing but a collection of single member DB schemes, each having their own balance sheet and funding level. On the left side of the balance sheet, the majority of assets would be the member’s savings in the scheme, but for some it could also be savings outside the scheme. On the right side of the balance sheet, the liability would be the member’s income expectation after retirement as captured through an appropriate income replacement ratio. As each member is in essence running their own DB scheme, an LDI approach similar to that of a DB fund can be followed. Aggregating upwards across the different members or groups of members based on their retirement age, we arrive at an asset allocation for the scheme driven by the members’ income expectations during retirement.
Spoilt for choice
A member of a stakeholder pension plan here in the UK recently mentioned to me their confusion at having to choose between 50+different investment funds and to understand the intricate differences between the Japanese Equity Fund and the Far Eastern Fund, in order for them to invest for their retirement. Sometimes too much choice is not a good thing, especially when it requires members to make investment choices that directly impact the quality of their retirement.
In South Africa most DC schemes either offer a single investment portfolio for all members or a combination of three or four life styled investment portfolios based on the members’ years to retirement. Apart from that, only a few DC schemes allow members to choose which life styled funds they prefer to invest in. Although these options seem limited compared to the breadth available in the UK, the trustees of DC schemes in South Africa have also realised that when members are faced with too much choice the natural human reaction would be to delay or postpone the decision. Unfortunately, given the limited amount of time each member has before retiring, it is essential that members are equipped to make the right decision. Wrong decisions may end up being very expensive decisions to correct.
All pension and retirement schemes in South Africa are governed by regulation under the Financial Services Board, a regulatory body like the Financial Services Authority. The most prominent is Regulation 28 that limits the extent to which these schemes can invest in any asset or asset class. Whereas regulation is sometimes perceived as a negative that stifles growth and opportunity, the regulatory landscape in South Africa reminds schemes of their fiduciary duty to invest responsibly and prudently according to the schemes’ member profile and liabilities while being cognisant of the environmental, social and governance issues around investments.
Regulation 28 has protected investors from the effect of over-exposure to risky assets, opaque financial structures and ill diversified portfolios by demanding transparency and limiting certain allocations. For example, the maximum exposure to any equity asset classes for a pension or retirement scheme is 75%. In addition to this, the exposure limit to assets outside South Africa is 25% and this protected the investment of many schemes and their members during the recent global financial crisis.
A recent update to Regulation 28 allows for the additional allocation of 5% allocation to Africa on top of the 25% offshore allocation to help support economic development and growth of the continent while in turn financially benefitting members as the recent stellar performance of African investments has shown.
What can the UK learn?
The attitude of South African advisers towards the DC industry has been markedly better than the current UK one. Even though DC industry was helped by becoming very big very quickly, trustees and advisers got up to speed by concentrating on the little things that make DC work. In the UK there is still too much general overview commentary and no real focus on how the industry will need to work once DC becomes more prominent. Trustees should also be preparing themselves for becoming DC trustees and the different skills that involves.
The following summarises what DC schemes in the UK could learn from their South African counterparts.
The most important lesson should be the way that DC schemes in South Africa think about retirement benefits. It is not about protecting the member’s pot of savings, but protecting the income purchasing power of that pot to try to gain the retirement they desire.
Another important lesson is the thinking behind the restricted investment choice offered to members of DC schemes in South Africa. They recognised that schemes would not be serving members properly by offering too much choice.
The last lesson is the attitude towards regulation and the positive, long term impact it can have on the savings pot of DC scheme members.
In a nutshell
- Forgotten market: pension provision in South Africa converted wholesale from DB to DC 20 years ago.
- Lessons to learn: the challenges the UK faces today with DC have already been faced and addressed in South Africa.
- Investment strategy: LDI techniques can be successfully applied to DC.
Please contact Petri Greeff.
*This article first appeared on Pensions World, one of the oldest and most respected titles in its field.