Nov 18, 2019
Many of the questions around Regulation 28 appear to stem from the appropriateness of the offshore restrictions. For example, if you have a discretionary portfolio targeting CPI plus 6% and a long-term horizon, you would probably have significantly more invested offshore than the maximum allocation of 30% currently imposed by Regulation 28.
However, while the question is appropriate, timing matters. The last ten years saw very strong global equity markets. In rand terms, global equities produced returns of approximately 5% per annum ahead of SA equities over this period1.
So, forgetting the last ten years, given that they may not be an accurate representation of the last twenty or thirty years, or for that matter, the next ten years, does Regulation 28 make sense in its entirety? Or should it change?
There are two dimensions to consider when addressing this question – on the one hand you’re faced with restrictions relating to the assets you may hold, and on the other, there is the tax benefit that you enjoy if you’re invested in retirement assets via a Regulation 28-compliant fund.
This juxtaposition suggests that the question you should be considering foremost is whether the tax benefit compensates for the asset allocation restrictions. Our analysis indicates that a fully discretionary portfolio must generate returns of approximately 2.5% per annum more than a Regulation 28 portfolio to exceed the tax benefit you receive from the latter.
This is based on certain parameters where we have made reasonable assumptions. The most sensitive consideration is whether we are in a decreasing or increasing tax environment, given the tax treatment of a retirement annuity and living annuity versus a discretionary investment. A decreasing income tax environment over time would benefit the retirement annuity and living annuity combination, whereas an increasing tax environment would benefit the discretionary savings combination (thereby shrinking the performance gap).
The question then becomes whether it is possible to generate an additional return of 2.5% per annum in a fully flexible portfolio. To explore this within the context of the South African environment, we compared the median performance of the multi-asset high-equity sector (which only consists of Regulation 28 funds) and the worldwide flexible sector, which comprises fully flexible discretionary portfolios. Over five years, the median of the worldwide flexible fund sector outperformed the median of the multi-asset high-equity sector by just under 2% per annum (Morningstar, as at 30 September 2019, NAV-based, net of fees, with gross income reinvested). The outperformance over ten years was just below 1.5% per annum.
The differential reduces further over longer periods, but the number of funds also becomes too small to draw meaningful conclusions. Looking at the theoretical 117 years of past data, we would expect the differential to be 1.9% per annum.
Based on this historical performance data, we can therefore conclude that the tax benefit of a Regulation 28 fund in a retirement product still outweighs the potential investment outperformance of a fully flexible portfolio.
However, this comparison still hasn’t fully addressed concerns relating to the investment restrictions imposed by Regulation 28. We believe the next question then is, if you were to change the investment restrictions, where would you have the most impact? The default response to this question would be to remove the offshore restrictions, largely driven by the outperformance of offshore equities over the last decade.
However, if you look at the longer-term history beyond the last decade, SA equities have a track record of generating higher returns than offshore equities. As investors saving for retirement generally have a long investment horizon, they need significant exposure to ‘high octane’ assets like SA equities to improve the return profile, while the offshore allocation provides diversification benefits and lowers the overall volatility of the portfolio.
The real issue with Regulation 28, in our view, is the allocation to income assets. Regulation 28 limits the total equity exposure to 75%. This means the portfolio will have a minimum of 25% exposure to bonds and property. The allocation to income assets has a significantly bigger impact on the long-term returns of Regulation 28 portfolios than the size of the offshore restriction.
In our view, the best way therefore to increase the return profile of a Regulation 28 portfolio is to allow flexibility to reduce the allocation to income assets rather than lifting the offshore limits.
1 As at the end of October 2019. Global equities are represented by the MSCI ACWI and SA equities by the FTSE/JSE ALSI.