Posted on February 27th, 2009 in Industry News
Smoothed bonus funds are a popular investment vehicle, particularly for retirement funds. They combine the exposure to the equity markets, which is necessary for real returns in the longer term, with the short term protection of smoothed returns and a low probability of losing value. If you invested in a smoothed bonus fund before 2008, you are probably smiling now – it’s likely that you have not lost money on this portion of your assets in 2008. But, if you are a new investor considering putting money into a smoothed bonus fund now, be careful – you might be buying existing losses and reducing your potential return as a result.
How do they work?
Smoothed bonus funds generally operate by setting aside a portion of returns during times of good performance into a smoothing reserve. During times of economic downturn, this reserve is utilised to support returns to the investors. The level of the smoothing reserve (which some types of fund disclose to investors, while others only give a general indication) varies – it can be as high as 20-30% of the fund value, but it can fall into negative territory in times of protracted or severe negative returns.
Free falling markets
The current economic downturn is unprecedented in its scope – markets have sustained incredible drops and it is still uncertain when we can expect recovery. Most smoothed bonus funds in South Africa now hold a negative smoothing reserve, which means that their funding level is below 100%. If funding levels drop too far, investors may feel the effect of this directly. Many interim bonuses have already dropped to zero and there is the risk that interim bonuses which are not guaranteed may be removed. Once again, the risk exists that for funds with a guarantee level of less than 100%, fund values may actually be reduced – something most managers are trying hard to prevent. But, even if there is no direct intervention, investors can expect that in the short term, returns will be significantly reduced to bring reserves back into positive territory.
For investors who entered these funds before the crash, this is not a huge issue – they were there for the good times and now they are contributing to recovery from the bad times. For new investors, however, the proposition is to buy into a known reduction in returns over the next few years. In other words, every rand invested in such a fund buys only 80 or 90 cents worth of capital – not a choice any informed investor would make.
Recovery options
Fortunately, fund managers have realised this too and various options are emerging to prevent investors from taking their money elsewhere. Some investment houses are launching new tranches of their product – a brand new tranche starts 100% funded and is unaffected by the events of the last year. The new tranches will run concurrently with existing investments but will earn higher bonuses until the reserves of both tranches are equalised and then merged. Other product owners have announced that their funding level is already recovering, and at around 95% can be considered within “reasonable limits” – investors should however remember that until the fund reaches 100% funded, any investment is still subject to an immediate loss of value.
What alternatives are open to investors under these circumstances? New tranches of existing products are one reasonable alternative. Additionally, not all smoothed bonus funds operate in the way outlined here – some use derivative structures for smoothing and new investments in these funds are not penalised. A number of other products, such as absolute return funds, are aimed at a similar risk category and may meet your needs. Another alternative is to weather the storm in a short term cash type product and only consider traditional smoothed bonus funds once funding levels have recovered.
Get advice
If you are thinking about investing in a smoothed bonus fund, do your research well – your investment consultant or financial advisor should be able to assist you with selecting the right option.
February 2009
This article was written by Joanna Legutko
Joanna Legutko
Actuary
Joanna Legutko studied Actuarial Science at UCT and graduated in 1997, joining Old Mutual, where she was involved in investment product development. Three years later, she moved to the UK to work at NIB International, managing their multi-manager fund of funds products. Her next position in London was with Jardine Lloyd Thompson, which is where she gained exposure to the EB market as an actuary in their Pensions Consulting division. She qualified as an actuary in 2003 and joined Jacques Malan Consultants and Actuaries (RSA) (Pty) Ltd in 2006, where she heads up the Actuarial division.
