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The impact of Regulation 28 on returns

Have investors been missing out?

It’s nearly eight years since the revised Regulation 28 of the Pension Fund Act came into effect. While pension funds have had to comply with the earlier regulations since 1962, the asset allocation limits they set out only began to apply to individual members from July 1, 2011.

Practically this meant that for the first time any investor’s individual retirement portfolio, whether it was held in a retirement annuity (RA) or a company pension fund, had to meet the Regulation 28 limits. The intention was to ensure some level of broad diversification and therefore investor protection.

Ever since the limits were introduced, however, there have been critics who believe that the restrictions could have an unintended consequence – they could reduce investors’ ability to generate inflation-beating returns.

In particular they focus on two areas: that Regulation 28 limits equity exposure to 75% of a portfolio, and that only 30% can be held offshore, with an additional 10% in the rest of Africa. (This used to be only 25% offshore and 5% in the rest of Africa, but was increased in the 2018 budget.)

Equity limit

Critics argue that the limit on equity exposure is most problematic for young investors. This is because those with decades to go until retirement should be investing in growth assets, and don’t really need to worry about the short-term volatility.

Restricting any portfolio to holding a maximum of 75% in listed shares, they say, is therefore an unnecessary dampener on returns.

However, this has not been the case over the last eight years. Since 2011, Regulation 28 portfolios have delivered returns very much in line with local equity funds. As the table below shows, the returns from top performers and median performers in both categories are almost identical.

Unit trust returns: July 1, 2011 to April 30, 2019
  SA Equity Regulation 28
Top performing fund 12.53% 12.5%
Median fund 9.4% 9.38%
Mean return 9.17% 9.24%
Worst performing fund 1.77% 3.98%

Source: Morningstar

Local investors have therefore not been giving up any returns relative to pure local equity funds. In fact, the likelihood is that their ultimate experience has been better because they would have achieved those returns with far lower volatility.

That would make them less likely to switch and more likely to stay invested. Since chasing performance and changing between funds can be a substantial drag on returns, this has probably been a positive for investors.

It is also worth considering that the returns quoted above for Regulation 28-compliant funds are for unit trusts that meet the asset allocation limits. Returns within retirement funding vehicles would in practice have been higher, since they would have attracted no tax.

Offshore limit

Only comparing returns against local equity funds is, however, not telling a complete story. Like Regulation 28-compliant unit trusts, South African equity portfolios must invest predominantly in local assets.

Over the last few years, however, the JSE has underperformed global markets in general and the US market in particular – by a substantial margin. Between July 1, 2011 and April 30, 2019, the FTSE/JSE All Share Index produced annualised growth of 11.45%, while the MSCI All Country World Index was up 19.27% per year in rand terms.

Therefore, as the below table shows, global equity funds have materially outperformed Regulation 28-compliant unit trusts. In fact, the worst-performing global equity fund returned almost as much as the top-performing Regulation 28 fund.

Unit trust returns: July 1, 2011 to April 30, 2019
  Global equity Regulation 28
Top performing fund 22.01% 12.5%
Median fund 16.57% 9.38%
Mean return 16.53% 9.24%
Worst performing fund 11.96% 3.98%

Source: Morningstar

Looking at these numbers, it’s difficult to argue with the view that investors have not missed out. They have been unable to benefit from the growth available in international markets due to the Regulation 28 restrictions.

Blended view

However, it’s unfair to take this comparison at face value. One cannot assume that any fund manager would have been prescient enough to move their portfolio 100% offshore at exactly this moment, and be brave enough to keep it there. This also would not have been particularly prudent. The extra risk and volatility associated with offshore investments would make this a less than optimal long-term strategy.

This makes the calculation a little more difficult, but if one creates three theoretical portfolios using 50% of the top-performing, median, and worst-performing local equity funds and 50% of the corresponding global equity funds, one could use these for comparative purposes. This is shown in the table below:

Theoretical unit trust returns: July 1, 2011 to April 30, 2019
  Blended local and global equity Regulation 28
Top performing fund 17.27% 12.5%
Median fund 12.99% 9.24%
Worst performing fund 6.87% 3.98%

Source: Morningstar, Moneyweb

Although this is a far-from-perfect analysis, the median blended equity portfolio would have outperformed the best-performing Regulation 28 fund. This does suggest that investors have been denied some returns since the Regulation 28 limits were put in place.

Those returns would, however, have come with much higher volatility, and the additional currency risk that having such a large offshore holding entails. Investors would have had to accept those trade-offs.

Looking purely at performance also does not take into account that investors saving for retirement are pursuing a particular goal. The best way to reach that goal is rarely just by chasing the highest performance. Managing the risk is just as important.

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COMMENTS   28

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Risk management — yes what you say is true. However it can also be argued that being overly exposed to a single geography/market, similar to single asset class exposure, increases risk and vulnerability for investors as well.

SA has not been a safe haven the last years and it looks likely to continue for some time. From a risk managememt perspective alone, then there is still a strong argument in fscor of allowing a larger share of geographical diversity into pension and retirememt savings.

South Africa could well be more of a safe haven than you assume. There are big changes coming to the world. Brexit and Trump seem to be harbingers of a new and unpredictable world order. Being tucked away at the bottom of Africa, of limited strategic interest, and with some government cleanup and reform, Southern Africa (along with South America), could turn out to be the least risky regions for the next couple of decades.

Increases in the foreign volatility is also associated with increases in the domestic market, with the domestic market pricing in information from the foreign markets.

Having an internationally diversified portfolio allows domestic equity investors to lower risks for the same return, or, conversely, higher returns for the same risk.

Asset class and foreign investment limits should be scrapped as far as I am concerned.

A government can tackle the debt problem in various ways but in most cases, it uses only one, time-tested, proven and sneaky way. The government should implement austerity measures, sack 50% of government employees and freeze the pay levels of the rest for 10 years, abandon labour legislation, abandon the mining charter, privatize all SOE’s, scrap socialist laws, and so on. This won’t happen, simply because this is politically impossible to execute. This implies political suicide for the ANC. Kneeling before the IMF falls into this category.

So, to protect their salaried positions, ANC cadres will drop the issue in the lap of savers, in one of the following ways.

This takes us to the next alternatives which are all death sentences for savers. The government can refuse to repay the debt. This an outright default. We are on the brink of this kind of event. When Zim refused to repay the debt to the IMF, the Zim dollar depreciated by 75% overnight. Food prices will skyrocket, leading to food riots. Therefore, this option is also not politically acceptable.

The next option is default by stealth. This is where it gets interesting. Although the results are eventually similar, or worse, to those mentioned above, citizens do not mind if the government tackles the debt problem in this manner. The reason why citizens do not mind is that they do not understand the process, so they do not realise what is happening, and in fact, they do not really care (they are sheep). The government will “employ” the ignorance of savers to repay the debt. The process of inflation is used to transfer purchasing power, or real wealth, from savers to borrowers. Government is, of course, the largest borrower, and they also have power over the (true) rate of inflation. When the (true) rate of inflation is higher than the coupon on the government bond, savers are in fact servicing government debt. This is the worst form of investment because it incurs a certain loss of real wealth. Although the principle is guaranteed in nominal terms, the eventual repayment will be in depreciated currency (lower real terms).

In order for this process of “theft by stealth” to work effectively, investors have to be lured into the “shearing pen” to be fleeced. This pen is called Regulation 28. When you are herded into this pen, you will lose all your wool and some of your skin too. The ANC already started the construction of this pen at the Nasrec conference……

Correction- Regulation 28 is not the shearing pen. Regulation 28 is the structure(crush) that herds and forces investors into the shearing pen called Prescribed Assets. Prescribed Assets refers to the mandatory buying of government bonds. The foundation for prescribed assets (the shearing pen) was laid at the Nasrec Conference.

The biggest problem I have with the restrictions in offshore investing under regulation 28 is that the amount invested offshore in foreign currency has to decrease as the rand decreases in value. Hardly a desirable outcome. It would be better to leave the money off-shore rather than having to repatriate it under a depreciating rand.

I guess that the next 5 years will be interesting. We had an incompetent idiot in charge for a few years and the rand has weakened due to a variety of factors. Perhaps doing a comparison from say 2011 to 2015 and then doing a further comparison from 2015 to 2019 would be interesting. At R14.20 to the dollar the numbers will look pretty bleak.

Thanks Patrick,

I agree that balanced funds have in general been a good option. SA pension funds have lost a big opportunity following the S&P bull run which will most probably end soon. The limits on foreign investments by pension funds do not achieve anything to help the currency because over time this money will return as pensioners start drawing income.

Regulation 28 is the crush(drukgang) that herds and forces investors into the shearing pen called Prescribes Assets. The ANC is busy with the construction of this shearing pen at the moment. They laid the foundation at Nasrec.

Well done to MW for eventually addressing this issue. I have been heavily criticized for raising this issue for many years, but the outcome for investors in Reg 28 funds has not been good over the past 5-7 years. In fact, they have been dismal as most investors in pension, provident, RA’s and preservation funds have not beaten the inflation rate. The retirement industry needs to address this issue urgently. But, as I have said before, for anyone in the fund management business to criticise Reg 28 is a career-ending move. So they keep tjoepstil while ordinary investors saving for pension don’t realise how poor they are actually getting–and then they end up blaming the advisors for the poor outcome. It is for this reason that I recommend that anyone over the age of 55 with money in one of these funds seriously consider withdrawing what they can tax free and either transferring to a living annuity or cashing out altogether.

Thks Magnus : Are LA,s not subj to Prescribed Asset requirements ??

…I personally think that if/when prescribed assets is enacted, it will affect all domiciled investments, irrespective of the investment vehicle (so could be Living Annuities, Unit trusts, ETF’s…even if there are the global rand-hedge type), and weather its post-retirement compulsory funds, or pre-retirement fund buildup, incl. discretionary investment funds. Across the board.

The idea would be to cast the net as wide possible 🙁 so that impact on such funds could be as small as possible.

Not sure about bank / interest-bearing investments (e.g. money market, call & FD accounts). Probably would be exempted(?) But individuals could then move everything into cash to avoid prescribed assets….just to be caught with income tax on interest-bearing investments (above the R23K/R34K annual interest income level).

Obviously it will not affect funds located in foreign jurisdictions.

LA’s come in 2 forms:
1/ fund-owned, within a retirement fund, so Reg 28 (of the Pensions Fund Act) applies and
2/ member-owned, directly from an insurer, and then the Long Term Insurance Act applies which has no similar provision to Reg 28

No

Good advice for some. If you are in a company pension fund you can only get out when leaving the company.

I also analysed converting RA’s into an LA. Even taking 2.5% the tax implications are significant.

So I have to be resilient like the article suggests.

It would be prudent and beneficial to allow an increase of the Regulation 28 limits equity exposure to, say 80% (75%) of a portfolio and that 65% (30%) can be held offshore with an additional 10% (10%) in the rest of Africa. It is then up to the investor to decide on the allocation, based on personal circumstances, time horizon and risk appetite.
Note: Current limits indicated in brackets.

As to fears of increased volatility introduced by increased offshore exposure [currency affect] … an important aspect often overlooked is that when markets crash [Global and/or Local] the ZAR weakens.

Best example was in the 2008 Global financial crisis – ALSI dropped from 34,000 to 17,000 [50% decline] while the ZAR to US$ went from R6,00 to R12,00 … almost fully compensating in ZAR terms for those fully invested in offshore equities.

Rand hedge stocks held locally did not help – Anglo’s dropped from R500 to R140 … so fully invested locally was a disaster!

Sadly – it is probably a pipe dream to hope for Reg 28 to be altered to allow greater offshore exposure. Discretionary investment still going offshore and little coming in from foreigners – so net outflows will continue without any help from the retirement funds.

There is a way around Reg 28.

Apply each year for your R1m allowance to take abroad. Go park your cash safely out of the country in another bank account and then invest it.

Yes it would have to be after tax savings.

The article could have mentioned this as a workaround.

All after tax money you can invest wherever you want, all outside Reg 28 (except if one want’s to invest in balanced funds for whatever reason), so there are many ways to “get around Reg 28” besides yours.

…not that easy to “go Awol” with your (especially “compulsory”) money offshore.

What you’re referring to is “discretionary” monies (i.e. all your investments at the local bank, or unit trusts/ETFs, direct shares) that is NOT PART of “compulsory” funds (e.g. 2/3 living annuity post-retirement, and RA Fund assets pre-retirement)

Most discretionary funds (which you can take R1mil abroad without SARS clearance under the “single discretionary allowance”) is NOT SUBJECT to regulation-28 in any case. For the (other) compulsory Reg-28 funds…there is little escape for.

The trouble is for working Saffas (pre-55 age) that have funds accumulated in Ret Annuity funds….you cannot withdraw before 55-age (unless you emigrate & do the “formal/financial emigration” process, with your SARS Emigration tax clearance cert in hand) before the Life Assurance company will release the funds. (And it will be heavily taxed as well upon exit prior 55-age). Or wait for 55-age & then ‘retire’ with much lower tax on the 1/3-portion….but 2/3’s will still have to go to a compulsory annuity….and part of prescribed assets.
Same issue if you still employed locally & your Pension/Provident fund is locked up…only way to cash out prior 55-age, is to resign from your employer…sure, you have the after-tax cash payout, but once again the tax bill may eat up a third or quarter of your retirement savings.

For Saffas that already retired (after 55 age) where they have 2/3rds locked up in Living Annuities & Guaranteed annuities….you’re also stuck with it within SA (unless if you go the emigration route & pay the heavy exit tax)
At least some retirees have also “discretionary” life savings (in various forms)…yes, I agree…can be taken abroad under the R1mil single discr allow.

But I think most of us have the bulk of their life-savings locked up in “compulsory” type funds (RA’s , Pension / Provident & preservation funds), while our discretionary funds…which is mostly NOT subject to Reg-28…makes up a tiny part of life savings.

Yes, you can do that, but I think most of our(?) worries lie with the Reg-28 ‘compulsory’ funds….which has restrictions, as explained.

The impact of fees is far greater

Eh? Fees impacts greater than poor returns? Please enlighten the rest of us how a total fee of 3% will bankrupt you when your investment returns could be less then 10% below the benchmark? The fee debate not the issue here, its government interference and how it affects all of us.

Back in the day, Regulation 28 was there to ensure South Africans life savings are invested in a “prudent” (risk-averse) manner. We viewed the outside world as a dangerous & unknown place 😉

The low % offshore limit were set (by the powers that be) to “protect” local investors from the so-called volatility of foreign investments (in fact, such volatility is merely a function of short-term rand movements in either direction…but we know the long-term trend is one-way…which adds long-term investment certainty). Strangely, many times asset managers described foreign investments as “high risk” , “volatile” to this day. As if the industry in SA distrusted the rest of the globe *lol* by viewing ourselves as a safer investment-destination (compared to mature, developed markets). Funny indeed.

Do investors in developed markets view SA as a stable/low-risk investment destination?? (…because we seem to view THEM as high-risk if we go by Regulation 28!!!)

Today, many of us have seen the light, and now view SA (making up 1% of global assets) as a higher emerging market risk (with its concentration or soveighnty risk) and we view “offshore” as SAFER….and we run to take our monies offshore. Rightly so. Just from a diversification principle, you’re safer abroad. The SA pensions-regulator want to “protect us from ourselves”… 😉

It’s laughable.

The CEO of 10X is vocal about it, quote: “Despite its claims, Regulation 28 DOES NOT SET prudent asset limits; it merely RESTRICTS the maximum exposure to each asset class and underlying security. In this, it IGNORES the investment time horizon, minimum limits and diversification principles. How does this protect the retirement fund member?”

Just to clarify, these are per annum returns? Slightly surprised to see an RSA equity delivering 12.5% per annum for 8 years. I guess its coming off the back of the 2008 crash.

But please confirm.

Finance 101 teaches you that over time riskier assets (such as equity) will outperform lower risk assets (bonds). Its called the risk premium Patrick.

So obviously investors are disadvantaged. While age is normally used as a proxy for risk tolerance that is an oversimplification. A well oof financially literate retired individual that generates more than enough income from his investment portfolio has completely different risk tolerance than a manual worker without high school maths earning minmimum wage.

Once again any form of deeper analysis seems beyond Mr Cairns. Just run past numbers using his free Morningstar subscription and make sweeping statemenmts

Probably a minority view but I think Reg. 28 does a good job of installing investment discipline and promoting diversification. People also forget that with property and alternatives one can construct an almost 100% growth-asset portfolio. A 100% equity exposure will provide slightly better returns – which is obviously valuable over the long haul – but the behavioural pitfalls and the inability of investors to cope with volatility will probably cause more bad investor behaviour and mistakes.

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