In one of my articles, I emphasised the need to protect members’ savings, which is the overriding principle of any regulator for the retirement benefits sector.
The Uganda Retirement Benefits Regulatory Authority (URBRA) Vision reads: “A Vibrant, Secure and Sustainable Retirement Benefits System” in Uganda. Despite the challenges, we at URBRA trust that the adopted regulatory and operational structures are capable of delivering strong governance and full transparency upon which a sustained level of members’ funds safety is built.
Most investors, even the most conservative-minded ones, want some level of income generation in their portfolios, even if it were only to provide a return that is just equivalent to the economy’s rate of inflation.
However, to make such investment decisions given a wide scope of choices, one needs knowledge about the size of the present and future obligations to members; the sustainability of the promised benefits made to members below a defined benefit arrangement; the scheme members’ demographics and an understanding of the inherent risks faced by a retirement scheme.
In this article, I focus on the investment motives that should override any scheme investment decision. The URBRA (investments of scheme funds) Regulations, 2014 lists the acceptable investment classes and prescribe the acceptable threshold to minimise the risk exposure that schemes may face.
The choice and combination of investment classes by a scheme is informed by the scheme’s objectives, which is enshrined in the scheme’s investment policy statement. While the options for investing retirement savings are many, every single investment vehicle can easily be categorised according to three primary objectives of - safety, income and growth of capital as described by Jason Van Bergen.
It is important to note that while it is possible for a scheme to have more than one of these objectives, the success of one tends to be at the expense of others.
Below, I examine the three primary objectives and the different investments classes that can be used to achieve them.
The first objective is “safety”.
There is truth to the adage that there is no such a thing as a completely safe and secure investment. We can, nonetheless, get close to ultimate safety for scheme funds through the purchase of government-issued securities in a stable economic system, or through the purchase of the highest quality corporate bonds issued by top rated companies. Such securities are arguably the best means of preserving scheme fund value while receiving a specified rate of return.
These includes treasury bills (T-bills), certificates of deposit (CD), commercial paper or bankers’ acceptance slips, or in the fixed income (bond) market in the form of government bonds and in corporate bonds. There is, however, a huge range of relative risk within the fixed income (bond) market.
While at one end there are government and high-grade corporate bonds, which are considered as the safest investments as already mentioned; at the other end are junk bonds, which have a lower investment grade characterised by more risk than some of the more speculative stocks. It is, therefore, incorrect to generalise that bonds are always safe. Nonetheless, corporate bonds tend to compensate their higher risk characteristic with a greater yield return than government securities.
The second objective is “Income” or to be precise, an increase in income (yields). There is an inverse relationship between safety and income. As income (yield) increases, safety tends to go down and vice versa. The safest investment classes or categories, therefore, tend to have the lowest rate of income return or yield.
Schemes must, therefore, be ready to sacrifice a certain degree of safety if they want to increase their incomes. In order to increase the rate of return on investment and take on risk above that of money market instruments or government bonds, schemes may choose to purchase corporate bonds or preferred shares normally with lower investment ratings but with high yields.
The third objective is “Growth of Capital”. While the other two investment objectives focus on safety and yields, growth of capital as an objective focuses on the potential of other assets that provide a rate of return through an increase in value, also referred to as a capital gain. Capital gains are entirely different from yields as they are only realised when an asset is sold for a price that is higher than the price at which it was originally purchased.
Ideally, investors seeking capital gains tend to differ from those who need a fixed ongoing source of investment returns from their portfolio. They are those who pursue the longer-term growth of the fund. Growth of capital is most closely associated with the purchase of common stocks, particularly growth securities, which offer low yields but with considerable potential for increase in value.
Notwithstanding, common stocks are generally ranked among the most speculative of investments as their return depends on what will happen in an unpredictable future. Common stockholders are also on the bottom of the priority ladder for ownership structure.
In the event of liquidation, common shareholders have rights to a company’s assets only after bondholders; preferred shareholders; and other debtholders are paid in full. While it is rare to find a common stock able to provide the near-absolute safety and income-generation of government bonds, “Blue-chip” have the potential to offer reasonable safety, modest income and growth of capital, generated through long-term increases in corporate earnings as the company matures.
Blue-chip stocks are shares of very large and well-recognized companies with a long history of sound financial performance. These stocks are known to have capabilities to endure tough market conditions and give high returns in good market conditions. Blue chip stocks generally cost high, as they have good reputation and are often market leaders in their respective industries.
All the three objectives of safety, income and growth should be informed by the scheme members’ demographics, which would influence the type of investments to hold in a portfolio. Where the scheme members’ average age is tending to retirement, then trustees must be cautious in pursuing growth of capital as an objective and in investing in highly illiquid investment classes.
Achieving a degree of liquidity, therefore, may require the sacrifice of a certain level of income or potential for capital gains. A young age membership structure, on the other hand, may consider having a bias towards growth of capital.
In conclusion, the advantages of one investment objective often comes at the expense of the benefits of another. In practice, though, most portfolios are guided by one distinguished objective with the other potential objectives occupying less significant weight.
Mr Nsubuga is the acting. CEO URBRA.