In the Retirement Benefits Industry, the role of investing the schemes’ funds is left to the Fund Manager. However, the Retirement Benefits Authority (RBA) regulates investment of these funds by prescribing the asset classes that the retirement benefits assets can be invested in and the limits for each class, which ensures that member benefits are protected. This has led to increased confidence and accelerated growth of the industry. As of December 2018, it had Ksh 1.2 trillion in assets under management, making it the largest institutional investor in the country. The schemes’ Trustees then develop an Investment Policy Statement that should be adhered to by the Fund Manager when investing the schemes funds and this is based on the risk appetite of the board of trustees.
Based on the mode of investment of funds, schemes can be categorized into either guaranteed schemes, which offer a guaranteed minimum rate of return, and segregated schemes, which offer market-based returns.
Generally, a guaranteed fund is for those who are risk-averse while a segregated fund is suitable for a more aggressive fund that is seeking higher returns and is willing to take on higher levels of risk. This decision is guided by the objectives of the scheme.
Guaranteed Funds & Segregated funds
Guaranteed funds are offered by insurance companies where the insurance company guarantees a minimum rate of return (the maximum rate by law that can be guaranteed being 4%). The funds in guaranteed schemes are mainly invested in low-risk securities, such as government securities, and thus have offered lower returns compared to segregated schemes. In cases where the fund’s returns surpass the minimum guaranteed rate, the insurance company may at its own discretion decide to top up the minimum rate with a bonus rate of return. The benefit of such a fund is that regardless of market performance, the member enjoys the set minimum rate of return. However, the insurance company directs a portion of the returns made by the fund to reserves to ensure that in case the fund’s performance in the subsequent years doesn’t meet the minimum guaranteed rate, they can use it to shore up the returns to meet the guaranteed rate. The downside to this is that if members exit, they forfeit some of the returns that are attributed to them in the reserve and thus don’t get the actual return of their contributions.
Segregated funds, on the other hand, are invested directly by the Fund Manager who is appointed by the Trustees to the scheme. The trustees also execute an Investment Policy Statement, which outlines how the funds should be invested and limits for each asset class. The limits are mainly guided by the age/liability and risk profile of the scheme. A scheme where the average age of the members is close to retirement, say 50 years, ought to invest their funds in liquid and less risky investments while in schemes where the average age of the members is lower, the trustees may seek a more aggressive investment policy that will enable the scheme to generate higher returns. In a segregated scheme, all the returns by the fund minus the expenses are attributed to the members and therefore they get the true return from their contributions.
According to a report by Cytonn, guaranteed funds have offered lower returns (9.8%) compared to segregated funds (11.3%) as the insurance companies hold some reserve every year to cater for years where the performance of the market is below the promised rate. For instance, in 2013, guaranteed funds declared a return of 12.1%, which was 8% points lower than the average return of 20.1% declared by segregated funds. However, in 2015 when markets dipped and segregated funds declared an average return of 1.4%, guaranteed funds declared a return of 8.1%, 6.7% points higher than the average return declared by segregated funds. Below is an illustration showing the performance of guaranteed schemes and segregated schemes over the last 6 years.
Advantages and Disadvantages of each Scheme
For guaranteed funds, the main advantage is that member contributions are protected since they earn a minimum rate of return. In addition, the scheme doesn’t require a lot of management since the investment of the funds is handled by the insurance company. However, the rate of return of the fund is determined by the insurance company and may be lower than the overall market performance as the insurance company will direct some of the returns to a reserve fund.
On the other hand, for segregated funds, members of a scheme get to receive all the returns earned through their contributions. They also have some control over how their funds are managed since they have a Trustee. The biggest drawback, however, is that members of the scheme are not protected by a minimum rate of return and the return is based on market performance.
When choosing between a segregated fund or a guaranteed fund, you should consider a few factors. The first is risk appetite. As see above, guaranteed funds are suitable for conservative schemes as the minimum return is guaranteed. This, however, translates to lower returns compared to segregated schemes, which are mostly preferred by schemes with higher risk appetite. Secondly, look at the returns. A scheme looking for high returns is best suited to invest as a segregated scheme, due to their high-risk high-return nature. Lastly, consider the age liability of the scheme. A scheme whose average age is close to retirement ought to be more conservative and invest in guaranteed funds. However, schemes with a younger demographics, say an average age of below 30 years are more aggressive and should be segregated as they will get the risk-return benefits
The current pension’s penetration rate of 20% of the labor force is still low and the growth of this industry is highly pegged on attracting more people into Retirement Benefits Schemes. Based on the information above, we see that both schemes have different benefits which can guide the choice between schemes. More risk-averse members should opt for a guaranteed fund while those who are risk-takers can go for the segregated fund.