Posted on December 15th, 2010 in Industry News
The current Regulation 28, which governs the investments of pension funds, has been the subject of numerous proposed revisions over the past 10 years for good reason: its limits are outdated, it does not cater for many of the new investment vehicles and it has loopholes which have been exploited by the investment industry. The updated proposals, released earlier this month, are a refinement of the previous draft which reverts back to the rules based approach. Whilst the current draft is progressive and allows pension funds much needed opportunities for diversification while increasing risk management measures, the proposals open a door to alternative investment instruments that are still poorly understood by investors and may lead to increased risk for members.
Regulation 28 of the Pension Funds Act affects around 20% of South Africa’s household savings – about R1 trillion out of R5 trillion in total. The goal of the current revisions is to improve protection for members and account for new investment instruments in the market whilst encouraging economic growth. The key features which will have the most impact on the industry in our view are:
Member Level Compliance
Current regulations apply to a fund as a whole not to individual members. This means that, within the individual member choice environment, it is currently possible for someone to invest 100% in equities or 50% off-shore – as long as others in the same fund choose more conservative options to compensate. The new proposals enforce compliance at member level, which we strongly support. The easiest way to achieve this is to ensure that all individual options will be compliant in their own right, making any combination of them compliant, but funds with more sophisticated administration systems may still offer asset class specific investment options with verification that the member’s overall choice remains compliant. Many funds already only offer Regulation 28 options, as it reflects the spirit of the law in our view. However, retirement annuities and some large umbrella funds will be severely affected and will need to revise their investment strategies radically to comply.
Hedge Funds and Private Equity Funds
Funds will be able to allocate up to 15% to Hedge Funds and other alternative strategies (within specific sub-limits). The current limit is 2.5% (under “other assets” in the current regulation), but it was possible to gain higher exposure through creative structures. The new proposals employ a look-through principle which closes these loopholes. To compensate for this, however, the total permitted exposure has been significantly increased. This is likely in response to intense lobbying from Hedge Fund managers in the lead up to this proposal.
The result is that pension funds will be able to gain significant exposure to alternative strategies. However, hedge funds are still largely unregulated. Allowing a higher allocation may be seen as an endorsement of these vehicles by the regulator, leading trustees to consider strategies which may not be in the best interests of members.
The new regulation addresses this by requiring diversification of alternative investments – the 15% cannot be allocated to just one manager. The regulation also introduces principles of improved trustee education – this is a good principle but hard to monitor in practice. However, on the whole, boards of Trustees will be exposed to much more potential risk as Hedge Fund and Private Equity Fund managers chase the opportunity created by this regulation to market their products more aggressively.
Risk management through diversification
In the past, the main tool for risk management for pension funds was to limit exposure to risky assets. The alternative, which features prominently in the updated design, is to enforce diversification by limiting exposure to any single asset. This has already been used for equities, but is now a feature of the Hedge Funds, unlisted equities and debt, and Private Equity Funds. By ensuring that a fund is not exposed to any one particular risky asset, the overall risk is reduced – however, compliance and monitoring requirements are increased.
Rule based approach
After much debate and encouragement for a principle-based approach, the draft regulation is still rule-based (as is the current regulation). There is an overlay of principles intended as a starting point for developing a full principle-based model later. These include asset-liability matching, improved trustee education, investment decisions taking consideration of the spirit of the regulation, sustainable investing, BEE, and managing foreign exposure risks. However, the basic system still relies on rules and therefore constitutes a “one size fits all” approach, unable to adequately accommodate the different profiles of membership in different funds.
The argument against a principle-based approach is that it is difficult to monitor in the current industry of 7,000 funds. However, it is implied that once the number of funds has reduced – to as few as 300 to 400 funds, according to the National Treasury spokesperson – principle based regulation will be considered again.
Conclusion
The National Treasury is developing a model which addresses many problems of the current system. The dialogue with the public has been lively and comments have been considered and incorporated. The proposals as they stand still need much work – the basic rules have been developed, but the questions of how they will be monitored still need to be answered. National Treasury plans to release the final regulation in March 2011, which is a tight deadline with comments only closing at the end of January 2011.
Without principle-based regulation, Trustees will need to remain vigilant when considering new investment vehicles. The new regulations are likely to open the doors to new investment alternatives, which will need to be examined not only in light of regulations, but by considering the investment objectives of the Fund and its risk tolerance.
Please contact us if you would like any further information or advice on this subject.
Appendix
The key changes from the current regulation 28 are:
| Current Regulation | Proposed Regulation |
| Entirely rules-based | Rules-based, but with overriding principles: asset-liability matching; improved trustee education; investment decisions taking consideration of the spirit of the regulation; sustainable investing; BEE; and managing foreign exposure risks |
| Limited look-through to underlying assets | Look-through introduced – reporting will be done based on what underlying assets are held, not the structures (like linked policies) they are held through. Hedge funds will be classified as a final asset and thus look-through will not apply |
| Compliance is at fund level | Compliance is at member level – no member’s individual portfolio may exceed reg. 28 limits |
| Retirement annuities excluded from regulation 28 | Retirement annuities must comply |
| Insurance policies with guarantees exempt from regulation 28 | Insurance policies only automatically excluded if guaranteed is bona fide |
| No mention of derivatives, hedge funds and private equity funds (covered under “other”) | Derivatives, hedge funds and private equity funds explicitly defined and limits imposed |
| Cash includes money-market instruments. | Money-market instruments are moved to “debt category. |
| Debt holdings are limited as follows:
Max 100% in government bonds Max 25% in foreign bonds Max 25% in other local debt |
Debt holdingslimited as follows:
Max.100% in government bonds Max.75% in SA bank debt (includes money market) Max.25% in parastatals Max.25% in other corporate debt Max.15% in unlisted corporate debt (with requirements fordiversification) Introduction of creditrating requirements |
| Equityholdings are limited as follows:
Max.75% in equities Max.7.5% in unlisted equities Max. 10%/15% in any oneshare |
Equityholdings are limited as follows:
Max.75% in equities Max.10% in unlisted equities (subject to diversification requirements) Max. 5%/10%/15% in any oneshare depending on issuer size |
| Property
Max. 25% in directproperty, indirect property or mortgages |
Property
Listed property treated asdifferent from unlisted property. Listed property at max.5%/10%/15% in any one share depending on issuer size. Unlistedproperty limited to 15% |
| Commodities
Only Kruger Rands, at max.10% |
Commodities
Kruger Rands and otherexchange traded commodities, at combined maximum of 10% |
| Other
Not explicitly specified,limited to 2.5% |
Other
Specified to include Hedge funds and private equity. Limit increased to 15%with sub-limits |
| Housing loans of up to 95%of member credit, direct or indirect | Indirect housing loans at95%, direct limited to 5% of total assets |
| Derivatives and securitieslending not mentioned explicitly | Derivatives and securitieslending controlled by Registrar requirements |
