July 25 2011 at 10:51am

By Bruce Cameron

Regulation 28 of the Pension Funds Act ensures that no irresponsible decisions are taken in investing your retirement savings, which you accumulate using the tax incentives provided by the government.

For example, in terms of a revised regulation 28, which comes into effect on July 1 this year, a fund may not invest more than 75 percent of its portfolio in equities, whether inside or outside South Africa, and there are limits on the number of shares a fund can hold in a single company, depending on the companys size. For instance, a fund may invest no more than 15 percent of its portfolio in a company that is worth R20 billion or more (see The new prudential limits, below).

The government argues that if it is giving you tax incentives to save for retirement and in retirement, then it has the right to ensure that your money is invested responsibly. The incentives range from not applying capital gains tax to retirement savings and allowing you to deduct contributions from your taxable income (up to certain limits), to providing you with favourable tax rates on taking lump sums at retirement and deferring taxing you on your investment returns in retirement until you withdraw the money as a pension.

The government relies on what is called modern portfolio theory to ensure the prudential investment of your money. This simply means that your money must be spread across all the asset classes of cash, bonds, property and equity. It achieves this by setting maximum limits on what may be invested in any class or sub-class.

The regulation also aims at preventing employers from looting your retirement savings as happened in the infamous collapse of American oil giant Enron by limiting how much of your money in an occupational retirement scheme may be invested in your employers business.

Other aims of the regulation are:

* Ensuring that your savings are invested in ways that support economic development and growth; and

* Giving stronger direction to retirement fund trustees by way of guiding principles to comply with the spirit of the law, overlaid with well-defined rules. The government believes this will help to overcome the shortcomings of trustees, many of whom do not have expertise in investment and the liquidity requirements of a fund, good governance and risk management.

Currently, the regulations cover about R1.1 trillion of the R5.2 trillion of household savings in South Africa, according to the National Treasury. Another R1 trillion held in the Government Employees Pension Fund could soon be brought into the net.

The Treasury is not saying that it wants such low risk that you receive pedestrian or no growth on your savings. It wants younger fund members to achieve inflation-beating capital growth, and inflation-matching income for older and retired members.

It is determined to maintain tight controls over the way in which retirement savings are invested so that fund members are protected and so that savings grow, thereby stimulating economic growth.

The Treasury says these objectives for retirement fund members can be achieved by the right mix of low-risk but low-return safe assets and higher-risk but higher-return innovative products.

It says the rules to achieve this should strike a balance between regulatory paternalism and empowering those who manage your retirement savings to make decisions that are appropriate for your fund.

Over the past few years, regulation 28, which goes back to 1956, has been undergoing a major overhaul. This has been sparked primarily by the lifting of exchange controls (which now allow retirement funds to invest up to 25 percent of their assets offshore) and the industry exploiting loopholes in the regulation, but also by major developments in the asset management industry, which has created a new set of investment instruments based mainly on derivatives such as futures and options, which can be used to protect a retirement fund from losing money.

In the process of the review, many in the industry agitated for a more lenient, principles-based rather than rules-based approach to investing retirement fund money. Asset managers, in particular hedge fund managers many of whom have failed in the past two years, with survivors providing fairly pedestrian performance but reaping big profits have been lobbying for more scope to use derivatives to gear their investment portfolios.

The government is allowing hedge funds to be included as an investment for retirement funds, but with strict requirements that a hedge fund be defined as such (whereas previously a hedge fund could be reported as a debenture or anything else). Added to this there are strict diversification limits placed on retirement funds, so that if a hedge fund investment goes bad, the retirement fund can lose at most 2.5 percent of its total asset base.

The look-through principle, meaning that funds must reveal their underlying assets, does not apply to hedge funds. The hedge fund itself is seen as the final asset.

Although exposure to derivatives and gearing (borrowing money to invest) by asset managers has been relaxed, the use of derivatives is generally limited to hedging against losses, and gearing is still limited because, while used to increase potential profits, it can also multiply losses.

In briefings in Pretoria and Cape Town in December, after the release of the second draft of the revised regulation 28, Katherine Gibson, the director of financial markets and competitiveness at the Treasury, rejected a more laissez faire approach to regulation, reflecting the governments wariness of the retirement fund service industry for not sticking to both the letter and the spirit of the law.

The government also adamantly sticks to its guns that retirement funds should never borrow for the purposes of investing. The only time a fund is allowed to borrow is if it runs into liquidity problems and needs money to pay members leaving the fund.

Pointedly, Gibson says the regulations do not absolve your retirement fund trustees from carefully considering their own investment policy statement, which prescribes how the funds assets must be invested and any limitations on those investments.

A new preamble to the revised regulation 28 highlights the fiduciary responsibility of retirement fund trustees to invest your savings in a way that promotes the long-term sustainability of the asset values, taking into account environmental, social and governance consequences of the investments.

An accompanying memorandum provides better guidelines for trustees deciding on an appropriate investment strategy for their particular fund.

The preamble also promotes:

* Trustee education; and

* The monitoring by trustees of compliance by the fund and its service providers, while ensuring that the liabilities (your pension benefits) match the assets held by the fund, performing due diligence on investments, and not relying entirely on credit rating agencies for assessing credit risks.

The regulations come into effect on July 1. Funds that are out of kilter with the regulations and cannot re-adjust their holdings by July 1 must apply for an extension before May 31.

Individual retirement fund contracts bought before April 1 this year will be exempt from the new provisions, but if you make any changes to the contract, the revised regulations will then apply.

The revision includes:

* A requirement that the regulations are applied at both member and retirement fund level. Until now, with industry funds such as retirement annuities, preservation funds and umbrella retirement funds, the limits have been set at fund level, leaving members out of kilter with the requirements of regulation 28. This has resulted in some members being able to cherry pick assets to the disadvantage of others — for example, some members have been fully invested offshore, closing out other members. This negated the main objective of regulation 28 in that it let individual members channel more investments into high-risk options than the regulation allowed.

* The regulation no longer provides for the automatic exemption of assets invested through life assurance policies that offer a partial guarantee (but that are otherwise linked to the performance of underlying investments). Full exemption is allowed only when there is a full capital guarantee provided by the life assurance company. The Treasury is relying on the Long-term Insurance Act to ensure that the underlying investments will be prudentially invested. The tightening up is a consequence of the broader asset management industry using the Long-term Insurance Act to create structures to side-step the requirements of regulation 28.

* The introduction of the look-through principle, so that trustees and members can actually see where the money is eventually invested and the risks to which they are exposed. Complex pyramid structures have been increasingly used by asset managers to hide costs and higher-risk investment vehicles from fund trustees and fund members.

* Easing restrictions on debt to allow more investment in corporate debt issued by listed companies and regulated entities where the government does not provide a guarantee on the debt.

* Easing restrictions on alternative investments including hedge funds and unlisted equities. The easing on unlisted equities, including private equity funds, is to ensure that investment into this pro-development funding channel is not impeded. There is an overall limit of 15 percent of retirement fund assets in hedge funds and private equity funds (alternative investments). Investment in a single hedge fund or private equity fund is restricted to 2.5 percent, but the limit is higher (five percent of retirement fund assets for each entity) if the investment is through a fund of funds.

Linked to the revised regulation 28 will be legislation to exert greater control on credit rating agencies, which also have a role to play in assuring the prudential investment of money by rating the risk of different assets, particularly cash instruments.

Following the questionable role of some credit rating agencies in the current global economic crisis, both in South Africa and abroad, the agencies are to be subject to greater oversight, including registration and controls on conflicts of interest, such as acting as both consultants and risk-raters on products.

THE NEW PRUDENTIAL LIMITS

The main asset class limits and sub-limits on retirement funds in terms of the second draft revision of regulation 28 are:

* Cash: 100 percent of retirement fund assets may be held in cash instruments but with sub-limits of 25 percent on deposits with any one local bank and five percent with foreign banks. The definition of cash instruments has been broadened to include Islamic liquidity management financial instruments.

* Debt: 100 percent of assets may be held in any South African government-issued or guaranteed debt instruments (bonds) and 75 percent for all other debt instruments. Instruments guaranteed by foreign governments are limited to 10 percent of a funds assets for each issuer but with the 25-percent limit on all foreign investments coming into play. Other sub-limits that apply include a limit of five percent in any unlisted bond. Sub-limits on listed bonds depend on the size of the bond issuer. For example, there is a limit of 25 percent on bank-issued bonds where the market capitalisation (the number of shares issued multiplied by the share price) of the bank is R20 billion or more, which decreases to 10 percent for banks with a market capitalisation of less than R2 billion. There are tougher restrictions on other corporate bonds (a limit of 50 percent of a retirement funds assets) and 10 percent in any one bond if it is listed on a securities exchange. Islamic instruments are again included.

* Equities: the limit on equities remains at 75 percent, but there is the introduction of limits on individual companies based on their market capitalisation. For example, a fund may invest up to 15 percent of its assets in a company with a market capitalisation of R20 billion or more, but only five percent if the market capitalisation of the company is less than R2 billion.

* Immovable property: a retirement fund may invest up to 25 percent in property, including listed real estate companies, with sub-limits on investments in individual entities depending on the size of the entity. For example, only 15 percent of a funds assets may be invested in a property company or units in a property collective investment scheme if its market capitalisation is more than R10 billion, but only five percent if the market capitalisation is less than R3 billion. Property equity investments are not included in the 75-percent equity limit.

* Commodities: a retirement fund may invest up to 10 percent of its assets in commodities. The full 10 percent may be in gold, but there is a limit of five percent in other commodities.

* Alternative investments: the overall limit has been increased from 2.5 percent to 15 percent, but hedge funds and private equity funds are each limited to 10 percent, and there are further sub-limits on single entities. For example, five percent may be invested in individual funds of funds but only 2.5 percent in a single private equity or hedge fund.

* Foreign investments: there is an overall limit of 25 percent, with offshore investments also being included in the calculations for each asset class.

* Investment in the business of a participating employer: as a general rule, this is limited to five percent of the assets of an occupational retirement fund, but 10 percent is permitted with the agreement of the Registrar of Pension Funds.

The regulations prohibit double counting. So the total equity limit of 75 percent applies across asset classes. For example, if five percent of assets are invested in private equity, only 70 percent may be invested in listed equity.

This article was first published in the 2nd quarter 2011 edition of Personal Finance magazine.