Everything you need to know about Regulation 28

Gareth Stokes, FAnews Online Editor

Financial services regulation should evolve along with the industry to accommodate modern day investment practices. A brief history of South African pension fund legislation suggests that the regulators have been slightly behind the curve. The main body of law was bundled in the Pension Funds Act 24 of 1956, but the industry had to wait another six years, until 1962, for the first promulgation of Regulation 28. This regulation was designed to ‘fill the gap’ post-prescribed assets (when funds could only hold cash and government bonds). It stipulated the maximum holdings by asset class a pension or provident fund could invest in. These limits became increasingly inappropriate and in 1998 a first draft of a principle-based Regulation 28 saw the light of day. This draft was never promulgated, in part because it would be too difficult to police and monitor.

We have to wind the clock forward more than a decade, to February 2010, for the next attempt at ‘updating’ the regulation. The first draft of the current Regulation 28 was published in February 2010, the second draft in December of the same year, and the final draft in February 2011. And stakeholders in the financial services industry will have to comply with the revised regulations from 1 July. Talk about a fast-track implementation! To find out more about Regulation 28 and what it means to the industry we attended a presentation by Andrew Davison, acsis Head of Institutional Asset Consulting. He kicked off his talk with a look at some important 21st Century retirement trends.

A five-decade time lapse forces new thinking...

The revised Regulation 28 is an acknowledgment that five-decade old retirement thinking is out of place in the modern world. Legislation had to be tailored to accommodate the myriad new and innovative investment products on offer and to factor in changing retirement trends. One of these trends is that we are living much longer in retirement. “Longevity is having a much bigger impact on retirees than people realise,” notes Davison. A table ‘borrowed’ from The Economist confirms that citizens in OECD countries are living up to twice as long in retirement in the 21^st Century compared to three decades ago. In France, where the official retirement age was (until recently) pegged at 60 years, a typical citizen who retired between 1965 and 1975 was expected to live 10 years in retirement. In contrast, a person retiring between 2002 and 2007 should live for another 25 years!

Although South Africans have lower life expectancies than OECD citizens we tend to survive just as long in retirement. “We are living longer and are being affected by exactly the same improvements in healthcare and the like,” says Davison. “The amount of time spent in retirement has doubled and the amount we need for a comfortable retirement has grown apace.” A male retiring at age 65 with a R10 000 per month inflation-linked retirement income requirement and a life expectancy of 80 years would need R1.3 million at retirement. Add five years to his life expectancy and the same solution would ‘cost’ R1.7 million.

Ways to ‘fix’ a retirement funding shortfall include saving more (by making larger monthly contributions, saving from an earlier age or working in retirement) and preserving your retirement capital when you change jobs. The investment return achieved on your retirement savings also helps. “The better your decision making in terms of your investment strategy the greater your lump sum at retirement,” says Davison. And that’s why the revision to Regulation 28 was so long overdue!

New Regulation 28 had to tackle a number or concerns...

Apart from being inappropriate for today’s largely defined contribution retirement environment the old Regulation 28 had a number of undesired outcomes. Davison believes the 75% equity maximum encouraged a herd mentality whereby everyone in the industry adopted a balanced fund approach invested at or close to the maximum in the riskiest asset class. He also felt that there was not enough guidance in the regulation in terms of investment strategy. It merely told fund managers what they couldn’t do.

A more serious problem was the absence of a limit for investments in cash and SA Government Bonds, which encouraged reckless conservatism. Nowadays we realise risk is an important component of a long-term retirement plan. Studies confirm that you have to hold equities to stand a reasonable chance of returning inflation plus 5% over 10 years. If you’re 100% invested in fixed income (cash and bonds) then the probability of breaking even over 10 years, generating returns equal to inflation, is only 70%!

Pay attention, from 1 July 2011 retirement assets must...

The new Regulation 28 introduces a number of changes. Thus far the media has focused on changes to asset class limits, most notably the inclusion of hedge funds as a recognised asset classes. The 75% maximum for equities remains, though a number of equity sub-categories have been introduced. A retirement fund cannot invest more than 15% of its assets in a single large cap share, nor can it hold more than 5% in the sponsoring employee. The latter restriction is designed to prevent a repeat of the Enron debacle in the US. Employees in that firm were heavily invested in its stock and ended up losing their jobs and their retirement savings when the company went to the wall.

The new regulation makes allowance for differences (in risk and administrative complexity) of investments in listed and unlisted property. Up to 25% of a retirement funds’ assets can be invested in property, with a cap of 15% on unlisted property. Davison explains: “Direct property in a defined contribution portfolio is difficult to administer and allocate to the member.” He urged pension fund trustees to think carefully about the suitability of unlisted property in their funds.

Offshore investment caps have been legislated in line with exchange controls. Funds can now hold up to 25% of total assets offshore, with a 5% ‘bonus’ allowance for offshore investment in Africa. Davison believes we’ve reached a point where exchange controls are no longer an issue for retirement funds. You should after all be largely invested in the economy in which you intend retiring.

Alternatives and the ‘look through’ principle

Under the previous dispensation a fund could only invest 2.5% of total assets in the ‘other’ category. Regulation 28 allows up to 15% in alternative asset classes, including hedge funds (10% maximum) and private equities (10% maximum). Funds must exercise caution with these risky asset classes and are further limited to at most 2.5% in a single hedge fund, or 5% in a fund of hedge funds. This rule encourages diversification and limits concentration risk. Overall at least 65% of total assets have to be invested in traditional asset classes. “This makes sense because alternative asset classes tend to be complex – people don’t have a good understanding of these products and they’re not always that transparent,” says Davison.

Asset limits aside the major change in Regulation 28 is the application of the ‘look through’ principle which prevents retirement fund trustees and their investment advisers from using structures or vehicles to ‘mask’ the underlying investments in that structure. Over the next few months the industry can expect a number of guidance notes to clarify aspects around the practical implementation of Regulation 28!

Editor’s thoughts: Regulation 28 creates a more flexible set of rules which retirement fund trustees and their investment advisers can use to achieve inflation-plus returns for their members’. It successfully addresses many of the shortcomings of the previous regulation and creates ‘legal’ channels for funds with a preference for alternative assets. Are you confident the new Regulation 28 does enough to safeguard your retirement assets? Please add your comment below, or send it to gareth@fanews.co.za