Scope

This document is designed to create scenarios that suggest a real monetary effect on Retirement Funds in South Africa should Prescribed Assets be implemented. In order to create a framework for discussion around the potential implications, we can look to the history of Prescribed Assets in South Africa.

Real historic impact of Prescribed Assets

According to research done by the Helen Suzman Foundation, at its height, it was prescribed that Government Pension Funds had no choice but to invest 75% of their assets in the debt of state-owned enterprises. Long-term insurers had to invest 33% of their assets similarly.

A look back at the impact reveals the following statistics:

  • In the 1960’s, inflation was around 3%, which resulted in prescribed assets providing a positive real return
  • In the 1970’s, inflation averaged 11%, with a prescribed asset real return of -4%. In this time, the stock market returned an average of 24.5%, which resulted in a -17.2% opportunity cost in nominal terms (excluding inflation) due to an investment in prescribed assets as opposed to the stock market
  • In the 1980’s, inflation averaged 14.5%. The real return on prescribed assets was -1%, with the nominal opportunity cost of not investing in the stock market being -6.7%

These stats demonstrate that the impact of prescribed assets on Retirement Funds in South Africa’s history is dire. In order to achieve the best possible outcome using prescribed assets, two conditions must be unambiguously satisfied:

  • Unquestionable fiscal discipline
  • A strong economy

South Africa is unable to demonstrate either, which means we can assume, based on our history of prescribed assets failing to deliver value and the two conditions for success to be far from being met, that any investment in government owned bonds or infrastructure is likely to produce poor results.

What would the numbers look like?

At this stage, it is difficult to know in exactly what form the forced investment structure would be implemented. We can assume that there will be a change to Regulation 28, which means that a new category of investment would be opened to include some form of investment in government bonds or directly into enterprises or projects.

Possibility A:

In this what-if possibility, Regulation 28 is amended to demonstrate a reduction in certain asset class caps to drive the behaviour they see as necessary to implement their agenda, we can try to create a picture of how Fund returns will look in the short-medium term.

Importantly, whilst we cannot predict how the markets will perform in future, we can certainly look back and see how they have performed in the past. In the two scenarios below, we have taken a typical balanced fund that targets CPI + 6% to see how that has behaved over the last 10 years to 31 July 2020. The strategic asset allocation used in the example is meant to achieve the target return with the highest probability of success and taking the lowest level of risk possible. The assumed returns for each class are based on actual returns over the last decade.

Based on the above premise for projections, we have put together two scenarios based on Regulation 28 mandating two different investment limits. Note however, that we still do not know what to expect from Prescribed Assets, and that these scenarios are merely designed to demonstrate material changes to returns. Should you wish to create different scenarios based on your current investment strategy, please feel free to contact us.

Assuming a real return of just 0% in the prescribed asset allocation:

Scenario 1: A reduction in offshore equity allocation of 10% (excluding Africa)

 

Balanced Fund                                                       (CPI + 6%) Scenario 1                                              (Reduce offshore e.g. by 10%) Assumed Returns (based on last 10 years)
Asset allocation Returns Asset allocation Returns
FTSE/JSE All Share Index 50,0% 5,1% 50,0% 5,1% 10,1%
All Bond Index 15,0% 1,2% 15,0% 1,2% 8,2%
Prescribed Assets 0,0% 0,0% 10,0% 0,5% 5,0%
STeFI Call (Cash) 5,0% 0,3% 5,0% 0,3% 5,9%
SA Listed Property Index 5,0% 0,3% 5,0% 0,3% 5,0%
MSCI All Country World Index 25,0% 4,6% 15,0% 2,8% 18,5%
100,0% 11,5% 100,0% 10,1%

 

Scenario 1 above shows that by reducing the offshore equity exposure by 10% to accommodate prescribed assets, the performance of the portfolio would reduce by 1,4%.

The last 10 years has seen lower that expected returns from the FTSE/JSE All Share Index. It has been a decade of lower returns from our local equity market. On the other hand, offshore equities have done relatively well with the aid of a weaker Rand and the impact of reducing this exposure is quite clear in the return numbers.

Scenario 2: A reduction in local equity allocation of 10%

Balanced Fund                                                       (CPI + 6%) Scenario 2                                             (Reduce local eq by 10%) Assumed Returns (based on last 10 years)
Asset allocation Returns Asset allocation Returns
FTSE/JSE All Share Index 50,0% 5,1% 40,0% 4,0% 10,1%
All Bond Index 15,0% 1,2% 15,0% 1,2% 8,2%
Prescribed Assets 0,0% 0,0% 10,0% 0,5% 5,0%
STeFI Call (Cash) 5,0% 0,3% 5,0% 0,3% 5,9%
SA Listed Property Index 5,0% 0,3% 5,0% 0,3% 5,0%
MSCI All Country World Index 25,0% 4,6% 25,0% 4,6% 18,5%
100,0% 11,5% 100,0% 10,9%

 

Scenario 2 above shows that by reducing the local equity exposure by 10% to accommodate prescribed assets, the performance of the portfolio would reduce by 0,6%.

As we know, past performance is no indication of future performance. The performance of the markets over the next decade will be dictated by a number of factors. For any balanced fund, any improvement in performance over what we have seen in the last decade will largely be determined by how well our local equity market performs.

Possibility B:

Let’s assume that there is a forced investment of 10% for every Regulation 28 compliant Fund into a government entity/bond/project. If there is no further stipulation reducing the caps on certain asset classes, it will be up to the Fund’s Management Board to decide on where to reduce certain investments to meet the 10% stipulation.

This process is best done using empirical data as per the scenarios described above, completed by an independent Investment Consultant. While it is always good practise to constantly pay attention to the current strategy performance vs. real outcomes, the implementation of Prescribed Assets will add a new dimension of uncertainty to Funds’ returns. The scenarios contemplated above have worked with an assumed low percentage of investment into Prescribed Assets, however, the impact could be much higher should the Government wish to mandate higher levels of investment into their projects.

Conclusion:

From historical data and the current requirements to be met for Prescribed Assets to provide positive returns, we can be certain that Funds that are forced to investment in Government projects will face a reduction in returns. It is therefore imperative that Management Boards begin looking at their current investment strategies compared to what they might look like in the future.

Two considerations from these outcomes:

  • In the past, even though returns on Prescribed Assets were lower than market returns, certain state-owned enterprises were more profitable than they are now (e.g. Eskom). This means that the 0% real returns we based our calculations on are erring on the side of optimism.
  • The South Africa equity market has performed poorly over the past decade, hence the very limited reduction in returns when creating a scenario of swopping local investment for Prescribed Assets. However, we must consider that given the information we have, it is likely that the local equity market has a greater chance of increasing returns over the next ten years as compared to returns on investments in Prescribed Assets.

When considering the above two points and should the changes to Regulation 28 be higher than 10% invested in Prescribed Assets, the outcomes will be far worse than we have described.

Management Boards and Consultants who work together have a singular duty: to ensure that members of the fund are provided with the right investment options to suit their needs. This is only valuable if Fund members are communicated with effectively and are empowered to make the correct decisions if they have the choice.

It is our recommendation that Management Boards of Funds pay even closer attention to their investment strategy now, as well as begin creating options to try to achieve the best possible outcomes for their members. Given that we are in a wild economic environment, Funds cannot afford to implement a “fire and forget” strategy, hoping that assets will return what is expected of them over a long period of time.

As independent consultants to Funds, we provide advice that is not tied to any provider. This means that our advice is objective and is not tainted by the opportunity to increase our income through incentives that benefit us first, and members second.