Edition: June / Aug 2017
The expedient of ‘prescribed assets’ again looms.
Institutional investors are between a rock and a hard place. Government
might have to change the rules so that it can limit their fiduciary discretion
and poach from long-term savings.
SA retirement funds face a quandary. It’s implicit in Regulation 28 of the Pension Funds Act that sets out their prudential requirements for making and remaining in an investment.
There lies the rub. The sovereign-debt downgrades turn Regulation 28 into a Catch-22. If funds comply, they stand to be damned in one way. If they don’t, they stand to be damned in another.
A fund’s entire portfolio can comprise investment in fixed-interest bonds issued or backed by the SA government. Funds aren’t obliged to invest in them, but unexceptionally they do as part and parcel of asset diversification. Where the bonds have been downgraded to junk, which reflects a heightened risk of default, Regulation 28 only matters in so far as funds “may” take credit ratings into account in performing their stipulated due-diligence assessments.
Critically, however, Regulation 28 goes further. Its requirements for “adequate risk-adjusted returns”, which are the bedrock of prudence, threaten a conflict with requirements of the fiscus, which is running short of revenue-raising options.
On the one hand, compliance with the regulation obliges fund trustees to “consider any factor which may materially affect the sustainable long-term performance of the asset including, but not limited to, those of an environmental, social and governance (ESG) character”. In its preamble, the regulation also emphasises that this concept of “responsible investment” applies “across all assets and categories of assets and should promote the interests of a fund in a stable and transparent environment”.
On the other hand, should the trustees’ consideration of such due-diligence factors lead them to steer clear of bonds on which government entities rely, the funds invite the reintroduction government-prescribed assets; in other words, being compelled to invest in specified bonds notwithstanding their price and risk relative to more attractive alternatives or to the disregarded ESG criteria for which many state-owned enterprises are notorious.
Eskom represents an outstanding example. Were it still to find a way for pushing its nuclear-build ambition, institutional investors will still need to be convinced that their support of it won’t contravene Regulation 28 in terms of sustainable long-term performance as defined. Either this or, as with other SOEs that veer from the crippled to the crippling, the present regulation will have to be rewritten.
Heads and the SOEs win, tails and the funds lose. Prescription, used by the National Party government in the apartheid days of foreign disinvestment, is the blunt instrument for when bonds lack buyers.
It means a compulsion to invest in assets at uncompetitive returns, thus smacking savers, and simultaneously allowing government to evade market disciplines in bond issues. A perpetuation of the policy turmoil following the cabinet changes, which provoked the credit downgrades, will similarly smack savers anyway.
All that’s required for prescription is amendment to Regulation 28. In the past, National Treasury was meticulous in its consultation processes that preceded amendment. In the present, anything can happen. New finance minister Malusi Gigaba, who must foot the expenditures that evoke the policy enthusiasms of President Jacob Zuma, blows hot and cold.
What are retirement funds to do? Stand up to be counted, quite simply by compliance with the letter and spirit of Regulation 28. If it leads to prudential discretion being replaced by administrative fiat, so be it. At least the funds won’t then be complicit in the overturn of their regulatory duty, as demarcated, and the villain who’s ignored warning after warning of the extraordinarily high stakes will have no place to hide for accountability.
Nobody in government dares tell the 17m recipients of social grants that the real value of amounts they receive are in jeopardy. Coming atop the turmoil over the SA State Security Agency, it’s politically too explosive. The 17m recipients comprise a lot of voters.
Social grants are essential not only to alleviate the plight of the poor but also as a national insurance against the spread of civil unrest. The threat to the grants’ real value being diminished flows from the junk downgrades in at least one of three respects:
- Higher inflation – triggered by a weaker rand that will push up the prices of essential imports such as fuel, and perhaps exacerbated by a reprioritised National Treasury having a more relaxed approach to fiscal discipline – will automatically reduce the grants’ purchasing capacity;
- Government’s increased borrowing costs will necessarily constrain its ability to top up the grants;
- Lower economic growth unavoidably accompanies lower tax revenues to fund social expenditure, simultaneously swelling the ranks of grant dependents.
Add to these 17m the many millions of savers in retirement funds and other collective schemes, including stokvels, as well as frustrated job seekers and workers facing retrenchment in the event of recession. Everyman will be hit, and certainly not “business” or the more privileged classes alone.
Rarely has the need for a mass financial-education programme been as urgent. The essential antidote for an electorate too easily duped, time isn’t on its side.
This is no occasion to dither. Rather, it’s occasion to strengthen the arm of financial institutions – fiduciaries for savers – that were previously instrumental in the reversal of Nenegate. A tax revolt is illegal. The shaping of bond portfolios, consistent with Regulation 28, is the opposite.
Last year fixed-interest asset manager Futuregrowth tried to show the way, temporarily as it turned out, by suspending additional loans to certain badly-run state enterprises. A valid precedent was modified when parent Old Mutual Emerging Markets persuaded Futuregrowth to pursue bilateral discussions on their governance.
Times, and circumstances, have subsequently changed for the worse. Attitudes must change with them, as exemplified in the forthright stance from Business Leadership SA whose members include custodians of the nation’s savings. It might or might not be significant that the new OMEM chief executive is Peter Moyo, a BLSA director.
To date, SA enjoys a bit of a respite. Compared with Nenegate, bond yields and the rand exchange rate have been hit relatively little. Whereas it’s probable that the downgrades to junk status had already have been priced in, it possibly also reflects an anticipation of positive outcomes from shifts in the governing party’s tectonic plates.
Less fanciful, but like waiting for the other shoe to drop, is that not all the major rating agencies have so far (at time of writing) downgraded the rand to junk. Most SA bonds are still held in the local currency. But were there to be further downgrade, an immediate impact would be forced selling by foreign funds (holding almost 40% of SA bonds) whose mandates disallow sub-grade investments.
For its part, the JSE Top 40 index is largely sustained by rand hedges. Come prescription, however, and retirement funds could have little choice than partly to deflect from their rand-hedge shares into junk-rated bonds.
What happens with markets, and their affect on retirement funds, is usually unpredictable; but not entirely so right now. Certainly predictable, and already evident, is the impact of the downgrades on business confidence; hence on fixed investment,
public-private partnerships, economic growth,
job creation and ultimately on social stability.
None of this is sanguine for so long as talk from people in power, laden with populist clichés, has sinister rings. That’s all the more reason for a counter-thrust from the people expected to pay these pipers. They too have power, and a regulatory obligation as well.