Prescribed assets not necessarily a train wreck

The mere mention that government is considering changing regulations pertaining to prescribed assets – which will compel pension funds to invest a certain percentage of their assets or new cash flows in specified assets – has led to heated debate and accusations about crooked politicians planning to grab pensions and investments.

Moneyweb approached Izak Odendaal, investment strategist at Old Mutual Wealth, for his views on this very sensitive and important subject.

One of his first answers puts the issue into perspective: “The fact that the ANC considered prescribed assets caused a huge uproar and a lot of uncertainty. This is indicative of the low level of trust in the government following the revelations of state capture and other problems. South Africans are very sceptical of government’s financial management and some of the more alarmist commentary has described prescribed assets as a form of confiscation.”

He points out that this is not strictly true, and that pension funds already have to comply with investment limits set by Regulation 28 of the Pension Fund Act.

While not forcing pension funds to specifically invest in government bonds, the regulations limit exposure to the stock market to 75%, prompting fund managers to consider government bonds. Odendaal indicates that bonds are suitable investments for pension funds, as is exposure to infrastructure projects that offer regular returns, such as renewable power projects.

Odendaal’s further insights and opinions are detailed below.

Why we’re talking about prescribed assets again

The debate flared up after the ANC’s January 2019 election manifesto contained a single line on the matter. It stated that the party would: “Investigate the introduction of prescribed assets on financial institutions’ funds to unlock resources for investments in social and economic development.”

It did not specify which financial institutions (banks, pension funds, insurers or asset managers) or what funds, resources and investments would or could be involved.

However, recent developments suggest that regulations to enforce prescribed assets are not currently on the cards.

The ANC’s July 2020 post-Covid-19 economic recovery policy document makes no mention of ‘prescribed assets’ per say, but proposes amending Regulation 28 of the Pension Funds Act to allow (not force) pension funds to invest directly in infrastructure assets and development finance institutions such as the Development Bank of SA and the Industrial Development Corporation.

The percentage they have in mind is not stated, but is unlikely to be more than 10%. It is not clear if and how this will apply to unit trust-based retirement products that have a daily liquidity requirement.

In other words, having considered implementing prescribed assets, the ANC appears to have been won over by the arguments against it.

Instead, the approach to be taken is to look at changing Regulation 28 to allow for greater investment in development assets, including project bonds.

ANC policy head Enoch Gogondwana was quoted in Business Day on August 18 as saying: “When we talk about tweaking Regulation 28, we are moving in a slightly different direction. We are moving from an environment where there is no enforced prescription to creating an environment where trustees can invest in infrastructure projects as long as those projects are profitable. I want to use this opportunity to dismiss and debunk the claim that we want to use the pension funds to bail out collapsing state-owned enterprises [SOEs] or fund a state-owned bank.”

Listen to Ryk van Niekerk’s interview with Enoch Godongwana, head of the ANC’S economic transformation subcommittee:

Previous regime of prescribed assets not comparable

South Africa had a prescribed assets (PA) regime from the 1950s to the late 1980s that compelled pension funds and insurers to invest a minimum portion of assets and cash flows mainly in government bonds and SOE debt.

The minimums changed over time, reaching a peak late in the 1970s. In 1984 the minimums were significantly relaxed, and in 1989 PA rules were replaced by prudential investment guidelines (commonly referred to as Regulation 28).

For a few years in the late 1970s, when government finances came under severe pressure, PA minimums were increased with the intention of channelling more funds to the government. However, PA mostly served as prudential guidelines, aimed at ensuring that pension funds invested appropriately to meet long-term obligations.

Comparisons with the past are problematic since there was not a liquid bond market prior to the 1980s. The government had only two annual auctions of bonds, with no secondary trading.

Today the local bond market is large and liquid, with an average daily turnover of more than R100 billion, several times that of the JSE equity market. South Africa was also not nearly as integrated in global capital markets as is the case today.

Ultimately, the return on bonds will be primarily driven by global yields and the outlook for local inflation and monetary policy. When prescribed asset limits were increased in the 1970s the world was experiencing rising inflation, with negative real yields and rising rates. Most countries experienced a massive bond bear market.

The situation today is different. Though there is no old-style PA regime in place at the moment, pension funds must still comply with prudential limits on asset allocation in terms of Regulation 28.

Most notably, pension funds (including retirement annuities) may only invest 30% abroad (plus a further 10% in Africa), with the rest in local markets. There is also a total limit on equity exposure of 75%, which means the rest has to be invested in interest-bearing assets.

Global assets (particularly US equities) outperformed local assets over the past few years, partly due to the weaker rand, so Regulation 28 has potentially cost local investors, but at other times local assets have outperformed global assets.

Still, in an ideal world, investment professionals would like to manage asset allocation decisions for pension funds based on liability structures, return objectives and market conditions without any dictates of regulators.

Pension funds love long-term returns

Globally, pension funds love infrastructure as an asset class because of stable and predictable long-term returns.

The problem has never been a lack of funding for infrastructure projects, but that the government tends to monopolise these projects.

Opening up the market for private participation would ‘crowd in’ private capital and expertise, resulting in growth and development.

The government’s renewable energy programme has been a huge success, attracting billions of rands of local and foreign capital. It should be used as a model for other infrastructure projects.

The head of the new infrastructure office in the presidency, Dr Kgosi Ramakgopa, confirmed to an Actuarial Society conference in August that there is no shortage of funding in South Africa, but that the issue is the limited pipeline of projects.

Confiscation and returns

The fact that the ANC considered prescribed assets caused a huge uproar as well as a lot of uncertainty that could unfortunately lead to people making ill-informed and premature financial decisions.

However, investors would still earn a return if PA rules were introduced. Government would not be confiscating their money.

If prescribed assets rules were to create a larger ‘captive’ market for government bonds, that could result in higher prices and lower yields.

This would be good for existing investors, but lower yields mean new investors would expect a lower future return.

However, with close to 40% of government bonds owned by foreign investors, the local bond market would still be priced in a global context. The government also issues a small amount dollar and euro bonds in global markets, and the pricing between these offshore and onshore bonds cannot completely decouple.

Despite PA concerns, government bonds are an attractive asset class, currently offering high real yields to investors.

A PA regime would likely result in asset allocation changes for pension funds, but the extent of the change, and therefore the extent to which the new asset allocation is potentially suboptimal, will of course depend on what is prescribed.

Changes not imminent

It is still early days in what is likely to be a lengthy process. The ruling party seems to have decided on its own stance, no doubt after heated debate internally.

It now has to instruct its officials in government to take the necessary step to turn it into law, a process that will allow for public input. Union buy-in, particularly the public sector unions, would be necessary.

These unions are likely to oppose any changes that could be detrimental to members’ funds. The investment industry, through the Association for Savings and Investment SA (Asisa), will similarly engage government on its concerns.

Conclusion

The introduction of PA would send the wrong message and would be negative for investor sentiment.

Though foreign investors would be unaffected, they would see it as a backward step in terms of the overall investment climate in SA.

Domestic investors are already deeply concerned about the prospect of prescribed assets, and the uncertainty is potentially damaging. Government is fully aware of this.

It is important to reiterate that we do not need prescribed assets. There is more than enough local capital available to fund the government and investment in development projects on a voluntary basis.

The missing link at the moment is trust and confidence.

Izak Odendaal is an investment strategist at Old Mutual Wealth.