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The real debate around umbrella funds is: are they an accurate representation of the best our industry can evolve towards, or has the pension fund industry just found a better way to generate more profits? Do umbrella funds genuinely provide a scalable low cost alternative, or have employers simply found a clever way of abdicating all responsibility for providing members with an adequate retirement vehicle?
Here are two disturbing realities:
Umbrella funds, as such, come across as a logical way forward to address these stark realities. Consolidation and economies of scale go a long way to tackling both these problems.
But the reality is that umbrella funds in South Africa have not exactly covered themselves in glory. For many umbrella funds, the bulk of which are provided by financial service companies, the costs really haven’t come down dramatically for the end investor when compared to self-administered funds; and the notion that employers no longer have to worry about whether they have access to trustees with adequate investment knowledge is complicated by the reality that this new breed of “independent trustee” that now makes themselves available to the pension fund industry may not be quite as independent as one would like.
So the real debate around umbrella funds is: are they an accurate representation of the best our industry can evolve towards, or has the pension fund industry just found a better way to generate more profits? Do umbrella funds genuinely provide a scalable low cost alternative, or have employers simply found a clever way of abdicating all responsibility for providing members with an adequate retirement vehicle?
Let’s start with the starting value proposition to lower costs and ask more specifically: at what point does the umbrella option make greater financial sense than stand-alone funds? The work below, produced by Hugh Hacking of Old Mutual provides an excellent insight.
While these are only ballpark figures and variations should be expected they do suggest that at around 5000 fund members, trustees should be indifferent to whether they elect to go the umbrella route or the standalone route. Below 5000 members, the umbrella fund appears to be a more attractive alternative to a stand alone fund from a fee perspective at least. Above 5000 members and a stand alone fund begins to make greater economic sense.
But cost comparisons can be deceptive. Not all umbrella fund cost structures are equally attractive to all members. For example a fund where members are on average earning at the low end of the income scale, an umbrella fund that has low asset management fees but high administration fees can prove to be extremely erosive over time. But in a fund where the average members earn at the higher level of monthly income, a low asset management cost, high admin cost scenario might well be the most desirable.
The problem for many employers is that making these cross-product price comparisons is a Herculean task given that everyone seems to employ a different costing structure. Once again, Hugh Hacking provided valuable assistance in this area by showing that if one uses a reduction in yield calculation, products with a wide range of pricing options could be rendered comparable. (See Table A)
More importantly, not all the costs that the members may be exposed to are a function of the umbrella fund’s services. Many small funds are introduced to service providers through financial advisers who typically operate more in the retail space. Advisers are permitted to ask for as much as 3% on-going fees for providing this service. Although not all do, it’s important to ascertain if there are other fees might be accruing to your members and to control for them.
And while cost is not the only important consideration when it comes to umbrella funds, it is definitely the one thing that is in the employer’s control at the outset – so doing your homework pays off when you appreciate that these costs compound over the many years a retirement fund typically covers.
But employers should not confuse the business case for umbrella funds with the fiduciary case. Relinquishing control over the retirement savings assets for your employees must be done with a clear appreciation of what the trade-offs are.
There is no question that employing an umbrella fund framework means that you lose that critical connection with the future fortunes of your employees and pensioners that you once had through the stand alone fund. The options available to your members may well be limited to what’s on offer in the umbrella scheme, meaning members can’t just down track down every hot new investment idea that becomes a flavour of the minute. Of course, over the long term, this is probably one of the strongest features in favour of an umbrella fund. But if such a straight jacket merely causes members to flee to other alternatives, the exercise has defeated its purpose.
Similarly, the notion that your members will now have their bests interests protected by highly skilled industry specialists need to understand that the bulk of these trustee boards are made up of representatives from the financial service company providing the umbrella fund as well as carefully selected “independent” trustees. Never lose sight of who selects the “independent” trustee: the financial service company providing the umbrella fund. Employers who do care to retain some oversight on their employees retirement provisions would be well advised to select those financial service companies that allow them to have their own management committees that represent their members’ interests to these trustees.
Perhaps the other fiduciary issues relating to umbrella funds may be a bit more subtle. What follows here are a series of specific issues coupled with proposals as to how the industry might better address them.
1. Unlike defined benefit funds, the new world of defined contribution funds offers members no clarity about where they are going and whether they are likely to get there. With umbrella funds this situation may be further exacerbated as the presence of the employer or a consultant may be further diminished. It’s not enough that members face the full burden of risk – there is no standardized process or reporting mechanism to help members understand this point.
A standardized process (calculation) for determining the Net Replacement Ratio of a given strategy/product such that members have some insight as to how effectively a solution is likely to “replace” their current salary in the post-retirement environment. The operative term here is standardized. Right now a CPI +5 fund offered by one service provider may have used very different assumptions to derive that number from a CPI +5% offered by another service provider.
Employers, members and fund trustees should have access to a modeling tool that provides them with an on-going assessment as to how members are moving along their specified course and whether anything needs to be done in the decision-making process to rectify any potential shortfall problems.
2. Umbrella funds were designed to provide cost effective solution to smaller participating companies. But many funds sell unnecessarily complex products with the full knowledge that they can earn better fees on these projects.
Every fund should offer a truly low cost option (yes I can do this for you too.) This could be the default option. Employers and members need to understand exactly how opting away from this lowest cost, plain vanilla option adds costs and why. Then they need a framework (back to our modeling tool) that allows them to weigh out these trade-offs of these potentially higher, but less certain returns, to the performance drag introduced by the additional costs.
3. Member choice is a big mistake – but it’s a great money-spinner for the industry. Typically it tends to mean that members (and their advisers) end up chasing performance and name-brands at exactly the wrong time – but fund rules generally absolve trustees from any responsibility.
Trustees must insist on specific standards and pre-conditions before allowing for non-default opt-out decisions from members.
Have the lowest cost option be the default option and then insist that members understand that for every additional “frill” that they want included there is a commensurate increase in cost.
4. Currently the value chain of service providers is killing this product with fees.
Any service provider responsible for day to day activities on the fund (whether from administration, pricing, day to day cash flow management, day to day rebalancing or risk management, should be entitled to an annuity arrangement with the fund, in other words, an on-going fee that’s a function of total level of funds under management.
All other service providers (advisers who may request the design of a specific solution) need to charge specific service-related fees i.e. there needs to be a link between output and revenue.
It’s not enough that third parties just get their clients’ consent to charges of on-going fees, most clients don’t really know what is right and reasonable to protest. The fact is, it’s not right to pay on-going fees to any service provider who is not involved in the day to day management of the funds.
5. No one seems to make a profitable business out of pension fund administration so the industry tends to subsidise this “loss-leader” through charges elsewhere in the umbrella offering – and this is where it starts to get messy and confusing.
Insist on full transparency on all costs, etc. or cost “trade-offs”.
Translate those costs into the kind of Reduction In Framework that Hugh Hacking demonstrated so that they can be comaparable to other service providers.
More importantly, make sure that the formulas used to calculate these costs are done on the same basis across the industry so that employers can make meaningful comparisons.
6. And finally annuities.
As part of their low cost service/value proposition, umbrella funds should be required to provide group rate annuities to members with no up-front commissions
Okay okay – I can hear the industry saying: “Dream on Anne”. But someone out there will step up to the plate and do the right thing. At that point, umbrella funds will have a good shot at being the best face that the industry has to offer the future of retirement savings.
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