The umbrella fund decision: more complicated than just cost savings

by Subedra Reddy and Aaryikh Rawthee | 29,Oct,2024 | NBC Holdings, Q4 2024, Special Feature

George Brown

 

Many boards of trustees of standalone funds face a decision on whether or not to move into an umbrella fund. There are many possible reasons to make such a move including:

  • Lower expenses
  • Reduced responsibilities
  • Reduced liability
  • Reduced time and effort
  • Professional trustees making decisions

On the other hand there are many possible reasons not to make such a move including:

  • Reduced choice of investment managers
  • Reduced choice of insurers
  • No member trustees or elections
  • Trustees whose prime accountability is to the sponsor and not members

In this article I will try to focus on two of the aspects above. One possible reason to move into an umbrella fund – lower expenses. One possible reason not to move into an umbrella fund – reduced choice of investment managers. Why these two? In my view they are the main reasons to consider. They also are quantifiable. Which allows me to put in tables. I like tables.

Lower expenses

Most umbrella funds are able to offer a considerable cost saving relative to standalone funds. The magnitude of the saving depends on the size of the standalone fund. On a small fund of less than 100 members you could possibly obtain a saving of around 80% of fund expenses. The cost saving comes from the fact that expenses are being split among many more members. For example, let’s assume that the audit fee for a 100 member standalone fund is R75 000. This would be a cost of R62 per member per month. The audit fee for a 30 000 member umbrella fund could be around R150 000. This would be a cost of 42c per member per month. This is a substantial saving.

Even if the standalone fund has 1000 members you would still be looking at a cost of R6.25 per member per month vs the umbrella cost of 42c per member per month.

The reduction on administration fees is not quite as substantial but can still quite easily be a 50% saving. When you add in the FSCA levies, fidelity cover, trustee meeting costs, principal officer costs, bank charges, etc. you end up with a huge saving for members. It seems then like a no brainer, that the move to an umbrella fund makes economic sense. Well let’s quantify this saving.

Consider the following scenarios regarding cost savings:

Under a standalone fund Mr Gumede faces a total cost of 1% of Fund Salary. This 1% gets deducted from his total contributions to give a net amount allocated to retirement savings of 12% of Fund Salary.

It can then be seen that there is an improvement in outcomes by moving to an umbrella fund due to the lower fund expenses. Mr Gumede’s pension can increase from R14 039 a month to R14 624 a month in scenario C. Is this enough to justify the move to an umbrella fund? Even a 90% reduction in costs only improves Mr Gumede’s pension by about R1000 a month. Some would argue that any improvement in member outcomes is a win. Yes, this is a win. But at what cost?

Reduced investment choice

Generally, an umbrella fund will provide a choice of investment managers to participating employers. This choice will not represent the entire universe of available investment managers. Depending on the umbrella fund, the choice can be quite wide or severely limited. Some umbrella funds may only offer one investment manager. The range of investment managers offered is usually the result of intense due diligence and research. However, the investment manager owned by the sponsor will often feature prominently. This is not to say that you are forced to choose the investment manager owned by the sponsor, but most participating employers end up making this choice.

It is very difficult for any investment manager to consistently beat the market and its peers over an extended period of time. That is why it is very important for boards of trustees to monitor investment performance regularly, together with expert advice from investment consultants. It also shows why limiting the universe of available investment managers is not a good thing over the long term. How do the trustees of the umbrella fund know that these are the best investment managers available and will always be the best? In practice then, you could well be sacrificing investment return by moving to an umbrella fund due to the limited choice of investment managers available.

Here are some possible scenarios of the impact of a reduced investment return. All of these scenarios use a fund expense of 1% of salary.

 

We have assumed that Mr Gumede would get a return of 11% p.a. in a standalone fund. He would then get a pension at age 60 of R14 039 a month. It is difficult to say what the impact of reduced investment choice would be, but I have provided some scenarios above. So, if the future investment return drops by 0.5% p.a. due to the reduced investment choice, then Mr Gumede’s pension would drop to R12 573 a month. If the return drops by 2% p.a., then his pension would drop to R9 146 a month. These are very big drops. The impact of a reduced investment return far outweighs the benefit of reduced expenses.

The actual drop in investment return would depend on what and how restricted the choices are. For instance, if you are considering an umbrella fund sponsored by an insurance company and the only investment choice available is the investment company owned by that insurer, then I would expect a significant drop in performance over time. Of course, there is no guarantee that investment performance will drop if you join an umbrella fund. If the standalone fund is run poorly by its trustees, then it is very possible that returns could increase in an umbrella fund.

Lower expenses and reduced investment choice combined

The following table combines the previous two factors i.e. what happens if I join an umbrella fund, and expenses reduce but investment return also reduces.

So Mr Gumede will be looking at a replacement ratio at age 60 of 56% if he moves to an umbrella fund with a 50% cost reduction but a 1% reduction in investment return vs a replacement ratio of 67% in his standalone fund.

If the investment return was the same in both the standalone fund and the umbrella fund his replacement ratio would increase from 67% to 70% if there was a 50% reduction in costs in the umbrella fund.

 

Replacement Ratio

So Mr Gumede will be looking at a monthly pension at age 60 of R13 097 if he moves to an umbrella fund with a 50% cost reduction but a 0.5% reduction in investment return vs a monthly pension of R14 039 in his standalone fund.

If the investment return was the same in both the standalone fund and the umbrella fund his monthly pension would increase from R14 039 to R14 624 if there was a 50% reduction in costs in the umbrella fund.

So what?

Deciding to move from a standalone fund to an umbrella fund is a very difficult and complicated decision. Funds are not automatically better than standalone funds and vice versa. The decision is certainly a lot more complicated than comparing expenses across both funds. In fact, the investment choice and performance in the umbrella fund is much more important in terms of final outcomes than a reduction in costs. Even a 90% reduction in costs is outweighed by a 0.5% p.a. change in investment return. Make sure then to get advice from an experienced consultant and preferably an investment consultant.

Subedra Reddy
Executive Head: Actuarial DC Funds at NBC Holdings | + posts
Aaryikh Rawthee
+ posts