elcome to the second edition of CALIBRATE, Lib er ty C orp ora t e’s quarterly investment newsletter.
JUSTIN ROFFEY Editor Justin heads up investment product development at Liberty Corporate, and is tasked with creating new and innovative ways to build a world class suite of investments Corporate’s clients. In his spare for Liberty Corporate’s clients. In his spare time he enjoys chess, tennis and producing music.
In our first edition, “The philosophy of intelligent investing”, we introduced the different investment teams at Liberty Corporate and how they approach the task of creating financial freedom through our framework of Intelligent Investing. In this next edition, “Change favours the prepared”, we show how Intelligent Investing responds to change and creates opportunity. Change is often imposed on us by factors beyond our control. Next year will mark a surprising number of important global anniversaries. Andrew Kemp takes us on a journey that puts these momentous events, and the changes that these have caused, into perspective. Change to one’s investment returns is referred to as volatility. Famida Singh explores how, for the past 30 years, investment in property has kept volatility in a portfolio low, while keeping returns high.
“Change is often imposed on us by factors beyond our control.”
She looks at how this might react to the changing economic environment of the future. The National Treasury is a powerful agent of change, and its focus on reforming the retirement industry will have far-reaching implications for us all. De Wet explains how Liberty Corporate is at the forefront of thinking and product development here. Ishara Sukraj and Louis Theron have recently authored an important academic paper that really shakes the foundation of one of defined benefits funds’ most important principles: How to value your liability. By proposing a new and more market-related method, they truly embody our principle of Intelligent Investing. In the first part of a series of articles for CALIBRATE, they will explain their approach and how to implement it. I hope you enjoy this edition of CALIBRATE, and look forward to the next step on our journey in 2014. Justin Joffey Editor
Change Favours the Prepared
ANDREW KEMP Head: Investment Strategies
ortune may favour the bold, but change favours the prepared. Or to quote Machiavelli: “Whosoever desires constant success must change his conduct with the times”. In every era, what was once considered a major disruption ultimately becomes a part of everyday life, until eventually, your grandchildren can’t imagine a world without it. The industrial revolution, the railway age, the commercialisation of flight, and the electronic society are all examples of great social change brought about by the cheap availability of goods and services that altered lives forever. However, what we consume is not the only source of change. As 2014 looms closer, it brings with it several key anniversaries that have influenced the lives of people around the world, and changed how we think, work and invest.
A cloud of dust
A child entering primary school has lived his or her entire life under quantitative easing (QE). The “free money policy” initiated by the US Federal Reserve in response to the near-collapse of the financial system in 2008.
September 11, 2014, will mark 13 years since the US declared a “War on Terror”. Today’s teenager has never known a world without it. Invasive airport security and vastly increased safety awareness, at times bordering on paranoia, are now considered normal when it comes to global travel and entry to public buildings such as libraries and universities. Beyond the short-term shocks to business confidence and stock markets at the time, one could argue that we still live with the indirect impacts of higher oil prices, and a world superpower saddled with expensive middle-eastern wars, vastly reduced civil liberties and domestic unemployment.
“Whosoever desires constant success must change his conduct with the times”
This global regime of all-time low interest rates has helped to deliver a strong international market recovery; however, it is widely accepted that QE will eventually fall out of favour as its inevitable consequences of inflation and asset bubbles begin to assert themselves. This will herald significant change throughout the global and domestic economy as interest rates normalise from their historic lows.
The political pendulum Closer to home, April 2014 will mark 20 years of democracy in South Africa, while June will mark the 50th anniversary of Nelson Mandela’s conviction. It is an amazing sign of how far we have progressed as a society, that South African children at university or seeking their first jobs have only ever known a stable, inclusive democracy. This enormous change marked the beginning of an era that revitalised investment in South Africa (and even Africa as a whole). This renewed growth also helped to shield us from the worst of the 2008 financial turmoil. However, 2014 is of course also the year of our next elections, and that alone could bring unexpected winds of change as politicians battle it out to see who will win amidst a tough economy, job losses, strikes and labour unrest. Coping with change 2014 will also mark 100 years since the beginning of the First World War. Demonstrating hope and resilience in the face of adversity, humanity’s progress in the following century has been nothing short of remarkable and is set to continue as Africa, Asia and South America rise to take their place in a truly global world. At each point in living memory, from the youngest child to the last few survivors of the First World War, there have been obstacles, challenges, and fears that have made investing for growth a challenging prospect.
Even now, our economic future is clouded with issues of unemployment and dismal global economic growth under even the strongest stimulus, while a strong equity market recovery has occurred under very low volumes – begging questions of how long it can last. Institutions the world over have been forced to seek riskier and riskier sources of yield as the historically low interest rates crowd out the possibility of low-risk, inflation-beating returns.
“Humanity’s progress in the following century has been nothing short of remarkable ”
This has prompted investors to ask themselves whether they are adequately compensated for the risks they are taking – or whether such riskiness is actually the norm, and the last 50 years of history have simply lulled us into false security. No matter how many changes we live through, or how these affect the world, we can never be sure what the next shock will be or when it will arrive. One thing we can be certain of is that change is easier to deal with together, as families, and as communities. Since 1957, Liberty has been there to assist individuals to cope with the impact of change.
We do not claim to have an eye into the future; but we do have the knowledge and tools to deal with new situations head on. To be flexible in our approach to change. To think critically and to incorporate technology and innovation. To advise and to offer the solutions to enable you to adapt to your changing needs. Faced together, change is just another word for opportunity.
Retirement Reform – The Winds of Change
DE WET VAN DER SPUY Executive: Corporate Product
etirement reform proposals have been presented in detail by the National Treasury over the course of the past year and will have a significant impact on the structure of retirement fund investments in the future. The retirement industry has generally welcomed the proposals and is now shifting its focus to align retirement products and services appropriately. The National Treasury and the industry have both stressed the importance of controlling costs and reducing complexity by standardising investment options. It is also a core objective to improve transparency and communication and promote a better understanding among retirement fund members of the various investment options available to them. There are four major investmentrelated themes driving retirement reform thinking: 1. Cost reduction As an underlying theme, the National Treasury believes that costs in the South African retirement industry are disproportionately high in comparison to international standards. Investment fees are often confused and occasionally cross-subsidised with other types of fees, such as administration charges and platform fees. However, if one
looks specifically at the fees for investment management, South Africans in general subscribe to an active management mind-set that places them in a higher investment fee paying environment. This is because active management tends to incorporate both high base fees and opaque performance fees. As a result, the National Treasury is supportive of passive investment, and states on record that, “active fund management in South Africa needs careful examination and justification, and trustees should study passive investment strategies very seriously”.
“Humanity’s progress in the following century has been nothing short of remarkable ”
2. Removal of inappropriate guarantees The most recent reform proposals also take a dim view of the unnecessary cost drag imposed on members through the excessive use of expensive guaranteed products. Evidence, over the past 40 years that these products have been sold, has shown that these guarantees are almost never called upon, while they impose a certain and substantial reduction of up to -38% in the case of a 2% per year guarantee charge, in benefits to members. Discussions about this have highlighted the use of alternative investment techniques, such as tactical asset allocation and pure smoothing, in order to achieve long-
term growth and reduce short-term volatility. 3. Standard product features The National Treasury believes that both the complexity and sheer number of available investment products drive up costs for members. This proliferation makes comparisons between options very difficult, which leads to a less competitive and efficient industry. As such, reform proposals are to ensure that simple and appropriate default investment options are made available to members, and possibly to legislate the available structures and their total cost in future.
4. Member education Financial literacy and the basic understanding of retirement solutions and options of the average member remain a concern for the National Treasury, and the industry. The result is members making inappropriate investment decisions or accepting high-cost solutions. How will these affect your investment strategy? Successful implementation of these reforms will benefit tens of millions of South Africans, both those who invest in default products, as well as those who select their own strategy. The ideal new generation investment strategy for retirement funds (standalone and umbrella alike) will ensure an appropriate default option for the majority of members who choose default, and selective choice for members who decide to pursue their own investment strategy.
â€œDeveloping a solution to meet the diverse needs of the majority of membersâ€?
Constructing an appropriate default solution Developing a solution to meet the diverse needs of the majority of members who go with the default option, means that the primary objective must be to target the needs of the average
member and balance long-term growth with short-term volatility. As such, the likely features of new generation default investments will be: Life stage model of investing: A single investment portfolio is an inappropriate option for all members at all stages of their lives. Passive building blocks with active overlay: Less than 10% of domestic institutional investments are passively invested, compared to between 50-60% internationally. In addition to a passive core, funds should incorporate tactical asset allocation and make use of satellite active managers to pursue a more aggressive investment strategy on a small portion of the fund. New generation risk management techniques: Libertyâ€™s research has shown that on any existing fund, by overlaying limited smoothing, the overall risk (or short-term volatility) is significantly reduced without necessarily giving up on long-term growth. The protection provided through this approach substantially reduces the need for inappropriate and expensive guarantees. Selective member choice Although the majority of members are likely to select the default option, some members will have
adequate financial insight, or unique investment needs and objectives that require them to choose other investment options. However, reform proposals would like to limit complexity while ensuring the desired levels of trustee governance. Therefore, it is likely that the selection of choices to be made available to members will be limited. Furthermore, with fewer options available to members, funds will be able to benefit from improved economies of scale in terms of administrative and investment costs.
â€œThe ideal new generation investment strategy for retirement funds will ensure an appropriate default option for the majority of membersâ€œ
When the music stops
FAMIDA SINGH Head: Investment Sales & Marketing
nvestors have always sought out assets capable of generating a return greater than inflation, and consistently for the past 30 years, South African property, both listed and unlisted, has done just that. More specifically, the past five years have proven to be especially fruitful for listed property, as declining bond yields and the prospect of longterm global low interest rates, courtesy of the US government’s policy of quantitative easing (QE), have seen returns on listed property average at 22.5% per year. Such returns are unlikely to continue forever, and as if to highlight how fragile markets are even while exhibiting strong growth, the US Federal Reserve’s “taper talk” in May that signalled a potential end to this regime, saw the South African listed property market (J253) gave up most of its 2013 gains.
This market sentiment not only dampened listed property’s long-term performance, but can also be seen as a warning to both equity and property bulls. It has reminded them that this great performance is inextricably coupled with bond yields, interest rates and inflation, none of which are within an individual’s control. By clearly reminding us that nothing lasts forever and that change favours the prepared, we then ask what role property should play in the portfolio of the future? In addition, how does one judge the optimal allocation to this unique asset class?
The impact of an end to quantitative easing. For the past five years, the financial world has danced to the consistent beat of cheap money that the US Federal Reserve and the European Central Bank have been playing since 2008. And like in a game of musical chairs, investors are concerned that once the music stops everyone will be left scrambling to find a seat.
“More specifically, the past five years have proven to be especially fruitful for listed property ”
What this means in financial terms is that an inflation-led cycle of rate hikes, occurring without strong economic growth and/or increasing employment, will likely see all asset classes come under pressure, not only bond markets. It is entirely possible that this may not happen, and that growth may continue to build slowly with rates remaining low for a protracted period. Even so, the downside risks remain worth watching as equity valuations become more stretched, increased risk is taken for diminishing yields, and economic growth remains anaemic.
Rate hikes, balanced funds, and property investments In a low-growth, inflationled, rate hike environment, diversification will remain the first line of defence for a balanced fund, and property still offers important diversification benefits. Portfolios with desirable characteristics such as low gearing, predictable tenancy renewals, and prime positioning, will be preferred and will likely fare better. By avoiding highly geared companies, investors can reduce much of the noise and volatility caused by fluctuating bond yields and interest rates. Unlisted property doesn’t borrow to invest and isn’t subject to the whims of market sentiment. Liberty’s Unlisted Property portfolio has always delivered on its CPI plus 5% annual return over a five-year rolling period. The investor’s major concerns will then be vacancy and rental yields – a far more palatable risk set.
“invest in a property strategy based on high-quality, well-tenanted opportunities”
However, rental agreements are generally three to fiveyear contracts, with escalating inflation-linked clauses that are staggered to provide a smooth profile of maturing agreements, resulting in significant income visibility for property companies.
Where to from here? The conclusion from this simple analysis is that property retains a valuable place in a wellconstructed portfolio, although one should be selective in the mix between listed and unlisted property based on their different characteristics. We are certainly not saying that QE will end tomorrow, and all indications are that rates will remain low by historical standards for some time yet to come. Yet, the initial signs that governments are thinking about ending QE are there, and when rates begin to rise, investors will re-price interest rate sensitive assets very quickly. Investors for the medium to long term would do well to consider the beneficial attributes of adding unlisted property to their portfolio.
The investor’s risk then really comes down to vacancy, and so it becomes essential to invest in a property strategy based on high-quality, well-tenanted opportunities in prime locations that can replace tenants easily and retain high occupancy. Unlisted property also retains its traditional smooth return characteristics, as valuations are based on biannual assessments of the actual property values, rather than being determined daily on the JSE, as is the case with listed property, reflecting current investor sentiment and market volatility.
Knowledge. When knowledge rolls up its sleeves, it can answer even the hardest of questions. It’s how we took the question ordinary people asked us 40 years ago and turned it into the richest square mile in Africa. When those people asked us: Do you know how to make what little I have, enough for the day I no longer work, or for the day I’m no longer around? We answered by taking a piece of farmland and building Sandton City, the cornerstone of the richest square mile in Africa. Because when you are asked to grow people’s money to change their reality, you cannot answer with theory or opinion. You answer with action. You answer with your sleeves rolled up. You take your knowledge and you get stuck in. You put it to work, for people.
Liberty Group Ltd – an authorised financial services provider in terms of the FAIS Act (Licence No. 2409). Sandton City is owned by Liberty Group and 25% co-owned by Pareto Limited.
And that’s the advantage we offer, every day...
The Advantage of Knowing
Valuation Revolution How do you value a Defined Benefit Liability?
LOUIS THERON Annuities Actuary
hat is General Motors’ most important line of business? You could be forgiven for thinking that it might be manufacturing cars. It is actually their pension fund. GM’s stock market valuation is approximately $60 billion. Its defined benefit pension fund liabilities are worth $80 billion. What is a Defined Benefit Liability? Any promise that a company makes to its employees to provide a service to them after they retire is a defined benefit. Typically, these are promises to support employees into their old age by paying them a certain pension amount during their retirement, or to pay for their medical expenses. However, it can actually be any promise, for example, a telephone company may promise to subsidise its retired employees’ calls for life, or an airline may offer cheaper tickets during retirement to retired pilots.
Because these defined benefit liabilities stretch out into the future for the rest of retirees’ lives, the cost to deliver the promised service largely depends on two things: • How long the retirees live for. This is known as longevity risk, and while longevity can fluctuate, the 20th century has generally seen a massive increase in average life expectancy, reflecting better education, healthcare and access to electricity and clean drinking water. • How quickly the cost of providing the service rises. This is known as inflation risk, and it can differ significantly depending on the type of obligation. For example, pension increases are typically set to rise by CPI, whereas medical inflation has historically been significantly higher. These two factors will tell you how much you have to pay in the future. However, in order to take this future set of cash flows and determine what it is worth today, a third, and very important concept must be introduced – the discount rate. The discount rate is the focus of this article as well as the
remainder in this series. We will discuss and explore the impact of new thinking in this space, which is one of the most fundamental, far-reaching and tricky areas of finance: How to choose the correct discount rate for valuing the financial obligation for a company. This is not simply an academic debate. An incorrect discount rate can have a massive impact on people’s lives, as it did for citizens of Denver when the city was forced to declare bankruptcy.
“More specifically, the past five years have proven to be especially fruitful for listed property ”
The impact on companies Although there are strict accounting, actuarial and legislative guidelines for determining the value of defined benefit obligations, managing this type of financial risk is typically unrelated to the normal course of business for most companies, and because they have to declare the amount of their DB liabilities on their financial statements.
Any uncertainty can negatively affect the company’s valuation by asset managers, as well as the rates at which banks are willing to lend money. Another well-known example of the financial difficulties this may cause is British Airways.
“we lay the groundwork for understanding defined benefit obligations”
To minimise this impact, most companies invest in assets that will grow to meet their liabilities. The value of these assets is easily observed in the market, but to value the liability correctly, various assumptions, such as longevity and inflation mentioned above, are required. The most important of these assumptions is the discount rate that equates the future cash value of the liability to its present day value. The discount rate By taking a future value and transforming it into a present day amount, the discount rate expresses an estimate of the financial uncertainty during this period. Calculating it involves choosing a risk-free rate appropriate to the duration of the liability (typically a government or high-grade corporate bond with a similar maturity), and then adjusting it to take market risks, such as credit risk and liquidity risk into account. However, evaluating these market risk premiums can be
quite subjective. During times of economic uncertainty and intermittent or low growth, such as we have recently seen and will likely continue to see, this can create the very volatility it is intended to lessen should it result in the theoretical value of the liability differing from the market-observable value of the assets. As a result, there is a strong debate about the appropriate choice of discount rate between actuaries and financial economics theorists. The former argue that the discount rate should reflect the long-term returns you expect to receive on the assets you buy, while the latter prefer to discount at the market rates that we can observe currently. There is currently no consensus as to which approach is best, with each one having certain merits and drawbacks. What is important is to judge which approach is best suited to the company’s needs and obligations. In this article, we lay the groundwork for understanding defined benefit obligations and the importance of the discount rate. In the next articles in this series, we will discuss the more practical aspect of how to select the appropriate discount rate for your company or client, and explain how this leads to the ultimate investment strategy. In the research paper, “Swapping your funding basis” by Ishara Sukhraj and Louis Theron, practical application examples can be found of how to incorporate the abovementioned factors when calculating the appropriate
discount rate assumptions. Further detail is also provided in the paper on the specific topics discussed in this article. Other aspects covered by the research include a discussion around possible funding strategies, investment strategies and international practice. A full version of this paper can be accessed at www.intelligentinsurance.co.za/ Pages/articles.aspx.
Liberty Corporate 25 Ameshoff Street Braamfontein Johannesburg 011 408 3911 www.libertycorporate.co.za Voted by FIA as Best Employee Benefits Product Provider of 2013.