Starting a Fund - What to Consider
There are a few aspects to consider when starting a retirement fund for your employees:
1. Legal structure
A retirement (pension or provident) fund is a legal entity, separate from the employer and service providers. All contributions and investments are held by the fund in the name of the fund.
A stand-alone fund serves just one employer; an umbrella fund combines many employers under one legal structure.
Umbrella Funds
An umbrella fund is appropriate for all employers who lack size to extract scale benefits from a stand-alone fund.
An umbrella fund reduces the average cost per member and can provide other advantages such as professional governance. Members and employers can benefit from higher returns and lower regulatory risk. The South African retirement industry is heading strongly in the direction of umbrella funds: the number of stand-alone retirement funds in South Africa has almost halved over the past few years.
Stand-alone Funds
A stand-alone retirement fund is appropriate for very large employers that do not need to pool assets to obtain benefits of scale. The key advantage of a stand-alone fund is control over the Board of Trustees and the appointment of service providers.
A stand-alone fund with less than R200m of assets is unlikely to be cost effective, and an umbrella fund may be more appropriate.
A stand-alone fund serves just one employer; an umbrella fund combines many employers under one legal structure.
Umbrella Funds
An umbrella fund is appropriate for all employers who lack size to extract scale benefits from a stand-alone fund.
An umbrella fund reduces the average cost per member and can provide other advantages such as professional governance. Members and employers can benefit from higher returns and lower regulatory risk. The South African retirement industry is heading strongly in the direction of umbrella funds: the number of stand-alone retirement funds in South Africa has almost halved over the past few years.
Stand-alone Funds
A stand-alone retirement fund is appropriate for very large employers that do not need to pool assets to obtain benefits of scale. The key advantage of a stand-alone fund is control over the Board of Trustees and the appointment of service providers.
A stand-alone fund with less than R200m of assets is unlikely to be cost effective, and an umbrella fund may be more appropriate.
2. Who should be eligible to join?
Membership criteria: Who should be eligible to join?
This is a matter of company policy and must be laid down in the rules of the fund. Some companies exclude contract workers, weekly paid staff or factory workers; others with high staff turnover prescribe waiting periods before new employees can join. The criteria for eligibility must be objectively determinable. Our research indicates companies with high staff turnover should prescribe a waiting period of 3 months, 6 months or even 12 months.
Once a fund is established and the eligibility criteria have been set, all existing employees meeting these criteria are invited to join. Thereafter, all new employees who meet the eligibility criteria must join as one of their terms of employment.
This is a matter of company policy and must be laid down in the rules of the fund. Some companies exclude contract workers, weekly paid staff or factory workers; others with high staff turnover prescribe waiting periods before new employees can join. The criteria for eligibility must be objectively determinable. Our research indicates companies with high staff turnover should prescribe a waiting period of 3 months, 6 months or even 12 months.
Once a fund is established and the eligibility criteria have been set, all existing employees meeting these criteria are invited to join. Thereafter, all new employees who meet the eligibility criteria must join as one of their terms of employment.
3. Contribution rates (as a % of salary)
There is no right contribution rate. Daberistic believes an appropriate savings strategy is a 17% contribution rate for a 40 year working life, but you have options in this regard. Some companies provide one contribution rate and insurance benefit package for all employees. Others set up different employee categories and vary the contribution rate and/or insurance benefits by category. You can thus be flexible in designing employees’ benefits package.
Our research shows an employer with generous employee benefits typically has the following contribution rates:
Employer contribution: 7.5%
Plus Cost of risk benefits and administration covered by employer: 3.0%
(Total employer contribution including cost: 10.5%)
Employee contribution: 7.5%
Total to retirement investment account: 15.0%
An employer with average employee benefits typically has the following contribution rates:
Employer contribution: 5.0%
Plus Cost of risk benefits and administration covered by employer: 2.3%
(Total employer contribution including cost: 7.3%)
Employee contribution: 5.0%
Total to retirement investment account: 10.0%
You can raise the contribution rate at the annual salary increase, by diverting a portion of the increase to the retirement fund contribution. Employees may also make additional voluntary contributions to top up their retirement savings.
Our research shows an employer with generous employee benefits typically has the following contribution rates:
Employer contribution: 7.5%
Plus Cost of risk benefits and administration covered by employer: 3.0%
(Total employer contribution including cost: 10.5%)
Employee contribution: 7.5%
Total to retirement investment account: 15.0%
An employer with average employee benefits typically has the following contribution rates:
Employer contribution: 5.0%
Plus Cost of risk benefits and administration covered by employer: 2.3%
(Total employer contribution including cost: 7.3%)
Employee contribution: 5.0%
Total to retirement investment account: 10.0%
You can raise the contribution rate at the annual salary increase, by diverting a portion of the increase to the retirement fund contribution. Employees may also make additional voluntary contributions to top up their retirement savings.
4. Risk benefits
There is no obligation – or need – to provide insurance cover (such as life cover, disability, dread disease and funeral) with a retirement fund, although these may be facilitated. The prevalent practice is to include a range of risk benefits. The typical set of risk benefits is as follows:
1. Group Life Assurance - life cover offered on a group basis, typically at 4 times annual salary. For example, if an employee's annual salary is R200,000, his Group Life cover will be R800,000.
2. Income Protection Benefit - it pays a monthly income to an employee who is unable to work due to accident or sickness, after a waiting period (generally 3 months). The monthly benefit is payable until the employee recovers and returns to work, or until his retirement age.
3. Funeral Benefit - This is a popular benefit with South African employees. It covers the employee, her spouse and children. An amount of up to R20,000 is paid in the event of death of the employee or his family members, to assist with funeral arrangements.
There are essentially two types of risk benefits: approved and unapproved.
An approved risk benefit is a contract between the retirement fund and the insurer; an unapproved benefit is a contract between the employer or the employees as a group and the insurer. There are differences in regulation and tax treatment between these two types of contracts.
The trend is to offer unapproved benefits so that in the event of a claim, the payout is tax free.
1. Group Life Assurance - life cover offered on a group basis, typically at 4 times annual salary. For example, if an employee's annual salary is R200,000, his Group Life cover will be R800,000.
2. Income Protection Benefit - it pays a monthly income to an employee who is unable to work due to accident or sickness, after a waiting period (generally 3 months). The monthly benefit is payable until the employee recovers and returns to work, or until his retirement age.
3. Funeral Benefit - This is a popular benefit with South African employees. It covers the employee, her spouse and children. An amount of up to R20,000 is paid in the event of death of the employee or his family members, to assist with funeral arrangements.
There are essentially two types of risk benefits: approved and unapproved.
An approved risk benefit is a contract between the retirement fund and the insurer; an unapproved benefit is a contract between the employer or the employees as a group and the insurer. There are differences in regulation and tax treatment between these two types of contracts.
The trend is to offer unapproved benefits so that in the event of a claim, the payout is tax free.
5. Service providers
The following services are offered to company retirement funds:
Advice/consulting
This covers initial consultations, benefit quotations, quotation comparisons and analysis, guidance on the key decisions when starting or optimizing your retirement fund. Ongoing consulting services may include legal updates, actuarial reports and investment advice.
Administration
The main functions include contribution collection, forwarding contributions to risk providers and the investment managers, managing member exits and benefit payments and reporting (employer and employee).
Investment management
A fund may have one or more investment managers. The manager should invest the fund assets according to their specific investment mandate (although some funds do not have clearly defined mandates and benchmarks). Investment performance should be measured against an appropriate and specified benchmark (although again, many funds fall well short of this basic requirement).
In South Africa, a good fund manager should achieve an annualised return of 10% (or CPI + 4%) over 5- to 10-year period, after investment management fees. Note investment returns do not come in a straight line, there will be periods of good returns and periods of poor returns.
Service provider charges
Consulting and administration: as % of salary, generally between 0.5% and 1%. Some administrators also charge an administration fee (as a % of assets) for managing the investments.
Investment management: as % of assets, generally between 0.5% and 1.5% pa. May include performance fees.
Investment advisors may charge a fee as a % of assets.
These costs are often not fully disclosed and thus difficult to measure. The average cost of retirement investing is around 3% pa of investment assets.
Other selection criteria
Cost cannot be the only criteria. In selecting your service provider, you should also consider qualitative aspects. These includes the accuracy and consistency of communication (reports and performance feed-back), financial strength (whether backed by a reputable insurer), administrative competence (this may require a due diligence review), the level of transparency (on costs, fees and performance), the ease and functionality of online services, the emphasis on governance, the make-up of the Board of Trustees (ideally professional and independent) and the ethical values espoused by the organisation.
- Advice/consulting
- Administration
- Investment management
Advice/consulting
This covers initial consultations, benefit quotations, quotation comparisons and analysis, guidance on the key decisions when starting or optimizing your retirement fund. Ongoing consulting services may include legal updates, actuarial reports and investment advice.
Administration
The main functions include contribution collection, forwarding contributions to risk providers and the investment managers, managing member exits and benefit payments and reporting (employer and employee).
Investment management
A fund may have one or more investment managers. The manager should invest the fund assets according to their specific investment mandate (although some funds do not have clearly defined mandates and benchmarks). Investment performance should be measured against an appropriate and specified benchmark (although again, many funds fall well short of this basic requirement).
In South Africa, a good fund manager should achieve an annualised return of 10% (or CPI + 4%) over 5- to 10-year period, after investment management fees. Note investment returns do not come in a straight line, there will be periods of good returns and periods of poor returns.
Service provider charges
Consulting and administration: as % of salary, generally between 0.5% and 1%. Some administrators also charge an administration fee (as a % of assets) for managing the investments.
Investment management: as % of assets, generally between 0.5% and 1.5% pa. May include performance fees.
Investment advisors may charge a fee as a % of assets.
These costs are often not fully disclosed and thus difficult to measure. The average cost of retirement investing is around 3% pa of investment assets.
Other selection criteria
Cost cannot be the only criteria. In selecting your service provider, you should also consider qualitative aspects. These includes the accuracy and consistency of communication (reports and performance feed-back), financial strength (whether backed by a reputable insurer), administrative competence (this may require a due diligence review), the level of transparency (on costs, fees and performance), the ease and functionality of online services, the emphasis on governance, the make-up of the Board of Trustees (ideally professional and independent) and the ethical values espoused by the organisation.
6. Board of trustees and Principal Officer
Every fund must appoint a management board to run the affairs of the fund. This is called the board of trustees. In addition, the fund must appoint a principal officer, to deal with the day-to-day running of the fund.
The objective of the board of trustees is set out in Section 7C of the Pension Funds Act. This section provides that the object of the board shall be to direct, control and oversee the operations of a fund in accordance with the applicable laws and the rules of the Fund. In pursuing its object, the board “shall take all reasonable steps to ensure that the interests of members in terms of the rules of the fund and the provision of this Act are protected at all times.”
Appointees to a board of Trustees thus require legal training. Board members with insufficient training expose the fund to the risk of regulatory non-compliance. This risk can be minimized by appointing dedicated professional trustees, as are typically available in an umbrella fund.
The objective of the board of trustees is set out in Section 7C of the Pension Funds Act. This section provides that the object of the board shall be to direct, control and oversee the operations of a fund in accordance with the applicable laws and the rules of the Fund. In pursuing its object, the board “shall take all reasonable steps to ensure that the interests of members in terms of the rules of the fund and the provision of this Act are protected at all times.”
Appointees to a board of Trustees thus require legal training. Board members with insufficient training expose the fund to the risk of regulatory non-compliance. This risk can be minimized by appointing dedicated professional trustees, as are typically available in an umbrella fund.
7. Fund rules
Every retirement fund must have a set of fund rules within the form and format prescribed by the Pension Funds Act. The rules are registered with the Financial Services Board and SARS and are binding on the fund as well as the members, the employer, the service providers and officers of the fund.
An umbrella fund, which pools the investments of a number of employers, will have a set of general rules. Each participating employer will then draw up a set of special rules, which are then approved and registered.
An umbrella fund, which pools the investments of a number of employers, will have a set of general rules. Each participating employer will then draw up a set of special rules, which are then approved and registered.
8. Member investment choice
It is common practice to offer member investment choice, allowing employees to choose from a selection of investment managers and funds. Members unable or unwilling to choose are usually invested in a “default fund”. From past research it appears that around 80% of employees typically end up in the default fund.
The issue of choice is controversial, not only because few employees exercise it, but because few of the remaining employees exercise it appropriately.
If you offer member investment choice with a default fund, you should consider the following factors when deciding on the appropriate asset allocation strategy: What is the average duration members will stay with the fund? When they leave the fund, how likely are they to preserve their retirement savings, or cash it out? Does the investment portfolio offer some kind of guarantee, to cushion members from severe investment market downturns?
A further problem with choice is that it does not come free – the administration charge is loaded with the cost of providing choice. This cost is charged to all members, whether they exercise it or not. To the extent that the majority of members do not exercise choice, it is an unnecessary and avoidable cost.
The issue of choice is controversial, not only because few employees exercise it, but because few of the remaining employees exercise it appropriately.
If you offer member investment choice with a default fund, you should consider the following factors when deciding on the appropriate asset allocation strategy: What is the average duration members will stay with the fund? When they leave the fund, how likely are they to preserve their retirement savings, or cash it out? Does the investment portfolio offer some kind of guarantee, to cushion members from severe investment market downturns?
A further problem with choice is that it does not come free – the administration charge is loaded with the cost of providing choice. This cost is charged to all members, whether they exercise it or not. To the extent that the majority of members do not exercise choice, it is an unnecessary and avoidable cost.
9. The preservation fund option
A preservation fund is a retirement fund designed to warehouse the proceeds from previous pension or provident fund. Given that leaving employees have the option to cash in their retirement fund (which would undo much of the benefit), it is worthwhile encouraging parting employees to preserve their savings in a preservation fund.
A preservation fund preserves the accumulated savings and the attached tax benefits (tax-fee investment returns and lump sum payments); it also permits one (full or partial) withdrawal before retirement.
A preservation fund preserves the accumulated savings and the attached tax benefits (tax-fee investment returns and lump sum payments); it also permits one (full or partial) withdrawal before retirement.