NEWS RELEASE
THE LIFE OFFICES’ ASSOCIATION (LOA)
DATE: 9 June 2006
SMOOTHED BONUS FUNDS AND THEIR PRACTICES EXPLAINED
In a recent determination, the Pension Funds Adjudicator raised a number of questions
about smoothed bonus funds, their use of the Market Value Adjuster (MVA) and the
purpose of smoothed bonus fund stabilisation reserves.
Jannie Venter, convener of the Life Offices’ Association (LOA) Products Standing
Committee, says while it is not the intention of the LOA to comment on the actual ruling, it
is important to explain how the practices mentioned above are used to protect policyholders,
both by South African life insurers as well as international financial services providers.
Venter also points out that during the demutualisation of life insurance companies some
years back, the workings of smoothed bonus funds were described in detail in the
Demutualisation Rules.
“These Rules were approved by the High Court to ensure adequate policyholder protection
after demutualisation. Included in these rules are detailed descriptions of how these funds
are managed, including how and when Market Value Adjusters can be applied and how they
work. The High Court recognized that these mechanisms are necessary for the protection of
policyholders.”
Understanding smoothed bonus funds
In South Africa they are called smoothed bonus funds, while the British invest in a similar
product referred to as with-profit funds. Both essentially operate in similar ways.
Designed to combine stability with the benefits of stock market exposure, smoothed bonus
funds aim to provide investors with inflation-beating smoothed returns over the medium-tolong-term (these funds are only available through life policies for a minimum term of five
years or through retirement annuities). These funds are designed to smooth out the
fluctuations in the market returns of the underlying assets, namely local equity, property,
fixed interest instruments, as well as foreign securities.
Venter explains that this is achieved by retaining a portion of the returns during times of
excellent market performance in order to beef up the investment returns in bear markets.
Returns are allocated to policyholders in the form of an annual bonus. The percentage
depends on the state of the fund’s reserves, as well as the company’s outlook for investment
markets. Bonuses are normally declared annually and added to the fund value.
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Venter points out that bonus rates are not arbitrarily determined. “They need to be approved
by a company’s Statutory Actuary, who needs to comply with professional guidance notes
which cover smoothed bonus business.”
It is common for a portion of the annual bonus to be guaranteed. That means it cannot be
taken away from investors once it has been declared, provided the policy is held until
maturity. Further, it is also common for a minimum bonus to be guaranteed over the term of
the policy, often in the form of a minimum maturity value.
An interim bonus rate is set at the same time as the Smoothed Bonus rate is declared. It is
set in advance with the aim of providing a fair return to policyholders who exit the fund due
to contractual claims prior to the next bonus declaration. The interim rate may be adjusted
upwards or downwards during the year depending on market movements to ensure fair
values for both exiting policyholders as well as those who remain invested.
The Market Value Adjuster (MVA)
During extremely adverse market conditions a downward adjustment may be applied to the
policy values of clients leaving the smoothed bonus fund before the maturity date. A
common exception is if the early exit is as a result of the policyholder passing away, in which
case no adjustment will be made.
Venter says if the market value of the fund is less than the smoothed value, the fund - and
hence the remaining policyholders - will suffer a loss on claims paying out the smoothed
value.
“The MVA therefore provides the market value, rather than the smoothed value, to
investors who choose to leave the fund early. The aim is to protect the interests of those
investors who remain in the fund by making sure that the assets available are not eroded by
investors leaving the fund during a market downturn. The fund needs this protection
because policyholders can choose to leave early, and hence select against the fund.”
He explains that smoothed bonus funds do not apply positive MVAs in times of good
market conditions for similar reasons.
“If a fund has to pay out a value over and above the smoothed value of the fund, it would
not be able to build up a stabilisation reserve, because there would be no funds to hold back.
So it is treating maturing policies and those leaving early in the same manner.”
Stabilisation reserves
A smoothed bonus fund enables policyholders to share in the investment returns accrued in
a fund through bonuses. Not all of the returns are apportioned to clients via bonuses. Some
of the money is held back in years of good market performance to bolster the stabilisation
reserves, which allow the fund to smooth the effects of poor market performance.
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Venter stresses that no portion of these reserves is ever distributed to shareholders in life
companies. However, he says, the life company is the final guarantor of the health of the
fund, should the smoothing mechanism fail. For this guarantee, the life company charges a
guarantee fee against the fund.
Smoothing versus marked-linked investments
Venter says research shows that over the longer-term the returns of smoothed funds are very
competitive relative to those delivered by market-linked balanced portfolios. In addition, the
market-linked portfolios do not provide the stability of returns offered by smoothed bonus
portfolios.
The smoothed bonus fund, through the smoothing process, also significantly reduces
exposure to short-term investment market volatility. This is very important for policyholders
who cannot delay taking the policy benefits and cannot afford to be directly exposed to the
market right up to the maturity date of their policies.
The comparison below of the performance of one of South Africa’s oldest smoothed bonus
funds against a market-linked balanced portfolio and inflation was made using a R100 000
lump sum investment on 1 September 1984.
The graph clearly illustrates that, over the longer-term, the fund has yielded returns in line
with the market-linked portfolio (in addition to the guarantees provided). The fund, through
the smoothing process, also significantly reduced exposure to short-term investment market
volatility.
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Before investing in smoothed bonus funds investors should:

Check the long-term track record of actual bonus declarations delivered by the smoothed
bonus portfolio you are considering.

Consider their appetite for risk. Smoothed bonus portfolios were not designed to
outperform equities over the longer-term. Therefore, if you have a long-term view and
you can stomach the equity roller coaster, you may want to consider more aggressive
investment options for a portion of your investment portfolio.
Ends
The LOA is the trade association for South Africa’s long-term insurance industry. Its 36
member companies provide over 90% of the insurance business in South Africa and its
members administer assets in excess of R900 billion. The LOA represents insurance
companies to the Government, Parliament, and to the regulatory and other agencies, and is
an influential voice on public policy and financial services issues. The LOA also plays a selfregulatory role as far as the long-term insurance industry is concerned by way of the LOA
Code of Conduct which can be accessed via the LOA website at www.loa.co.za.
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