Issue: April/June 2010
Editorials

COVER STORY

In pursuit of perfection

Try, try, try, but it can take just too darned long. As matters stand, a revised Reg 28 is way overdue. Public comments are wanted and there’ll be many to sift. Hope for sufficient unanimity so that pension funds’ modern-day prudential investment rules can be quickly finalised.

It took less than two years for SA’s new democratic constitution to be hammered out at Codesa. For SA’s new dispensation on retirement funds to be agreed, it’s been over five years since National Treasury released its first discussion paper on reforms and no end to the discussions is yet in sight.

And so we arrive at the draft revisions to Regulation 28, the prudential limits for investment by retirement funds in particular asset classes, tabled by Finance Minister Pravin Gordhan in his latest Budget. They’re for public comment, the latest in a series of what are supposed to be incremental reforms rather than a big-bang rewrite of the 1956 Pension Funds Act. Such will be the diversity and complexity of public comments that they could take another age to filter and implement.

This is against a background of a world financial crisis that world leaders seek, ideally through world consensus on key principles, to prevent from being repeated. But already, as the US and European authorities move under respective domestic political pressures to push ahead with regulatory reforms of their own, the ideal of cross-border harmonisation – vital when money moves between countries at the click of a mouse – has begun to look elusive.

All of which has a bearing on Regulation 28. It was last amended in 1998, well before housing loans to the sub-prime US market were “securitised” into derivative packages for contamination of the global financial system; well before the warning of Warren Buffet, that derivatives were “weapons of financial mass destruction”, was seen to have meaning; well before they wreaked havoc on investment banks, causing bailouts and recession and public debts that will take years to overcome; well before such exotic derivatives as ‘credit default swaps’ resulted not in higher yield but in huge losses for the portfolios of pension funds exposed to risks they didn’t understand.

As it’s stated in National Treasury’s explanatory memorandum: “Innovation and other developments since 1998, and the recent financial crisis, necessitates the urgent amendment of Regulation 28, pending a holistic review of the Regulations”. This is under s36 of the Pension Funds Act which allows the Minister powers of prescription.

Pravin Gordhan

Gordhan...give triple-bottom line SRI/ESG a hand too

For post-1998 “innovation and other developments”, read particularly derivatives, private equity and hedge funds. The existing Reg 28 makes no specific provision for them, and regulators worldwide continue to grapple with them (most recently in the way that derivatives camouflaged the public debt of Greece). Note also that Reg 28 amendment is seen as “urgent” while holistic review is “pending”.

Perhaps this is as it should be because SA is actively engaged through the IMF, G-20 and other international bodies to improve regulatory standards globally. Having been spared the worst of the crisis as much by good judgment and efficient regulation, not least of exchange controls fortunately (as it turns out) in place, Reg 28 now begs to be updated.

National Treasury’s draft is a promising start. Yet it’s only a start, and maybe not a first start. On the website of the Financial Services Board there’s another explanatory memorandum for a revised Reg 28, produced under the auspices of the FSB’s pensions advisory committee and apparently dated May 2008, that’s more comprehensive than the National Treasury production.

REG 28: NOW AND NEXT

The underlying philosophy is to mitigate risk by ensuring an appropriate spread of fund investments.

Present maxima
No more than:

  • 75% in equities
  • 25% in property
  • 95% in a combination of equities and property
  • 5% in sponsoring employer
  • 15% in large-cap listed equity
  • 10% in any other single equity
  • 20% in any single bank
  • 15% offshore (but 20% can be allowed)
  • 2,5% in “other” assets (where derivatives, undefined, now fall)

Proposed changes

  • There are crisper limits on a fund’s aggregate holdings. Notably, although a maximum of 75% may still be invested in JSE-listed equities, a maximum of 15% per issuer may be invested in shares with market capitalisations over R20bn and 10% in those with a market cap below R20bn;
  • Maximum percentages of “aggregate fair value” of total fund assets are prescribed for various categories or kinds of assets. Where relevant, they’re broken into credit-rating bands e.g. for liquid assets inside SA, they’re spread over 30% per issuer in Band 1, 25% in Band 2 and 20% in Band 3;
  • The Registrar may prescribe which agencies can issue credit ratings. For asset categories exposed to credit risk, the ‘credit rating bands’ indicate limits on the proportions that can be invested with differently-rated issuers;
  • 100% for assets in liquid form for assets in SA; 20% offshore plus 5% for African investments; 5% for Krugerrands; 100% for listed securities and securities issued or guaranteed by a government; 5% for unlisted securities; 25% for immovable property and secured property loans; 5% for investment in the fund’s participating employer; 95% for housing loans to fund members, and 2,5% for “other” assets falling into none of these categories;
  • “Consideration must be given” to whether diversification requirements should be split along broad investment categories of liquid assets and listed securities, as well as such anomalies as Krugerrands and immovable property;
  • Where an individual fund member can chose his underlying investments, they must comply with Reg 28;
  • Retirement annuities must be invested within the Reg 28 limits;
  • Reg 28 definitions are aligned to definitions in other securities legislation, with Islamic-complaint instruments (which disallow interest-bearing products) built into these definitions;
  • istinctions will be made between direct and indirect exposures to fixed property, including property shares;
  • Measures to ensure that the fund is protected against use of derivatives for gearing and “irresponsible borrowing”;
  • Up to 20% of assets offshore and an additional 5% for “African assets”;
  • Rules to govern scrip lending;
  • Investment into derivatives is permitted subject to conditions that will be prescribed. It won’t be allowed for leverage or gearing;
  • The “look-through principle” will be applied for calculating exposures. This is to prevent funds from possible circumvention of prudential limits by investing through layers of investment vehicles that mask the underlying investment exposure e.g. to the share of one company.

The status of the one in relation to the other is unclear. However, the FSB version points out that in its formulation “participation was invited from major stakeholders and retirement-fund practitioners” such as Business South Africa, the Cosatu and Fedusa trade union federations, the Institute of Chartered Accountants, the Actuarial Society and the Pension Lawyers Association.

So are we now in for another round of inputs, debates and consultations that will cover the same ground as previously? Is it to be National Treasury or the FSB that will assume the lead? Or might there be tensions, as between National Treasury and Social Development, that’s complicated the process of retirement-fund reform? How wearisome and wasteful.

So are we now in for another round of inputs, debates and consultations that will cover the same ground as previously? Is it to be National Treasury or the FSB that will assume the lead? Or might there be tensions, as between National Treasury and Social Development, that’s complicated the process of retirement-fund reform? How wearisome and wasteful.

Meanwhile, the FSB has forged ahead. Last December it put out draft circular PF133, setting out proposals for how pension funds can invest in derivatives and how they should be disclosed. Basically, it says, they’re okay so long as derivatives are used to reduce investment risk and not for speculation. National Treasury says the same.

There’s to be no leverage or uncovered positions. Importantly too, derivatives can’t allow the limits of Reg 28 to be exceeded for investment in a particular share or asset class. Disclosure requires application of the “look-through” principle, implied by the FSB but spelled out in the National Treasury document, for calculating a pension fund’s exposures specifically to derivatives and foreign assets as well as investments in an underlying asset class through other vehicles.

There’s to be no leverage or uncovered positions. Importantly too, derivatives can’t allow the limits of Reg 28 to be exceeded for investment in a particular share or asset class. Disclosure requires application of the “look-through” principle, implied by the FSB but spelled out in the National Treasury document, for calculating a pension fund’s exposures specifically to derivatives and foreign assets as well as investments in an underlying asset class through other vehicles.

Be that as it may, for practical purposes it cannot be inordinately difficult simply to amend the existing Reg 28 in two of the most critical areas. To prescribe the use of derivatives (following comments received on PF133) and increase the limits for offshore investment (consistent with exchange control’s 20% allowance) cover essential components requiring immediate redress. On an analogy with the stymieing of pensions reform, everybody agrees that mandatory preservation is imperative but still it hangs in the air.

There’s surely a case to be made for promulgation of these derivatives and offshore elements without awaiting the outcome of time-consuming debate over lesser intricacies (see box), whenever that might be. Such is the rapid pace of financial innovation, against the cumbersome nature of bureaucracies to deal with it, that a Reg 28 perfect for today might be imperfect by tomorrow.

That said, the drafts have something else in common. It’s in what they omit. Nowhere in either is there mention of socially-responsible investment. SRI seems still to be grouped in the category of “other”, confined to a 2,5% maximum of a fund’s assets. At present, this “other” category includes derivatives. But once derivatives are removed, what else will fall under “other”? If nothing else, is 2,5% sufficient for SRI?

In its good-governance circular PF130, the FSB sticks to the view that a fund’s primary obligation is to provide optimum returns for its beneficiaries. Only once these returns have been met, it says, should SRI be considered.

The implication that SRI necessarily produces sub-optimal returns is inaccurate and outmoded. Neither is SRI an “other” asset class. It is integral to the investment mainstream.

So far as the FSB is concerned, this is partially recognised in the circular’s recommendation for funds as shareholders to influence the behaviour of companies. So far as National Treasury is concerned, silence on the accommodation of SRI contradicts objectives of the Financial Sector Charter that Gordhan told parliament he intended to “revitalise”.

Derivatives are like handguns, believes Alexander Forbes principal consultant Joao Frasco: “In the hands of the right people, they aren’t dangerous. But how do you ensure that the right people are using them for the right reasons, to hedge out market risk, within the restrictions? How will trustees know the underlying strategies?”

At the end of the day, good regulation turns on two factors; first, the quality of inputs for drafting enforceable rules; second, the regulators’ capacity (shown as deficient in the sophisticated US and UK) to implement effective oversight of complex structured products being endlessly created. Taken together, and only together, will a new Reg 28 be a potent weapon in the armoury of financial supervision. The retirement-fund industry certainly needs it, in a collaborative endeavour, with end-users uppermost in mind.

DEVILS IN THE DETAILS

By the April 16 cut-off date, National Treasury will have been bombarded with comments it’s invited on the draft Reg 28. Upfront amongst the heavies are sure to be the Actuarial Society, as a professional body representing its views on the pensions, investment and insurance (retirement annuity) aspects, as well as Asisa which represents over 150 savings and investment institutions.

It’s all rather nice, they’re inclined to respond, but where the devil is the detail? “A draft for comment cannot be too specific,” points out Asisa chief executive Leon Campher. “The detail is very much the subject of our current engagement.”

Fair enough. Entrenched, at least, is common definitions for uniformity to run across the numerous regulations that govern investment – like pensions and mutual funds – to prevent arbitrage between respective regimes.

Yet even some of the rather nice principles would be helped by a little elaboration. For instance, the draft says that scrip lending will be subject to conditions but doesn’t indicate what types of conditions are in mind. The same with derivatives; despite the draft circular PF133 having been scrutinised for months, there’s no way of knowing how hedging (allowed) is to be differentiated from speculation (not allowed).

Derivatives are like handguns, believes Alexander Forbes principal consultant Joao Frasco: “In the hands of the right people, they aren’t dangerous. But how do you ensure that the right people are using them for the right reasons, to hedge out market risk, within the restrictions? How will trustees know the underlying strategies?”

A positive on derivatives, notes Brandon Furstenburg of Mergence Africa, relates to the look-through principle. Rather than being lumped into the black hole of “other”, as something distinct and apart, it will be seen whether they’re causing over-exposure to an underlying asset.

Housing loans to fund members are a red herring, reckons Liberty Life head of retirement reform Rowan Burger. Although the draft allows funds to grant these loans, in compliance with the National Credit Act they will still have to be registered with an authorised credit provider. Because a fund will be unable to grant a loan that a bank won’t, there’s no advantage in approaching a fund.

In fact, there are such disadvantages as an increase in fund administration costs and, should the member’s repayments not be properly recorded by the fund’s administrator, the borrower can land on the credit register as a defaulter. “Those most in need of pensions-backed housing loans won’t be able to get them,” Burger predicts.

The draft is light on private equity and hedge funds, although Gordhan had mentioned in his Budget speech that the scope of regulation would be extended to include them. They aren’t even listed amongst the definitions. Presumably, once there is definition and regulation, private equity will fit under the 5% allowed for unlisted securities. Less clear is whether hedge funds are supposed to fit at all.

From the perspective of pension funds, a problem with private equity is illiquidity in that investment value is realised on exit. This can take perhaps 10 years. But then, pension funds are long-term investors.

Hedge funds, on the other hand, are short-term extremists. They’re into borrowing to buy shares and shorting to sell them -- selling shares they don’t own in the hope of buying them later at a lower price – neither practice meeting with regulatory enthusiasm for pensions funds. On some limit or another, however, pension funds should be able to include the private-equity and hedge-fund exotics in the process of risk mitigation.

A group that will be overjoyed with the draft is credit-rating agencies. Having emerged from the financial crisis with their reputations discredited by careless ratings which contributed to the systemic near-collapse, they’re now to be core for rating of issuers (like banks) within the approved bands. Just as well that many SA asset managers do their own in-house due diligence, usually more conservative, for the draft is silent on the actual ratings (triple-A or whatever) to be applied.

There’s much more to be said, and it will be said. Take, for instance, the screamingly absent reference in the draft to the combination of environmental, social and governance (ESG) considerations for retirement funds’ investment decision-making. Some of the larger pension funds and asset managers are likely to have strong views, as well they should.


Brandon Furstenburg

Furstenburg...unintended consequences
CONSIDER THESE SPECIFICS

Having crossed from the public to the private sector, Brandon Furstenburg has a unique insight from both perches. As an official of National Treasury, he helped draft its discussion papers on retirement-fund reform which he prominently promoted to the industry. Then he moved to Liberty Life and now views the Reg 28 proposals from his new vantage as chief operating officer at Mergence Africa:

  • The explanatory memo refers to the “look-through” principle. However, there’s no mention of it in the draft regulation. No definition is provided and no clause entrenches it. The principle itself is sound but it must apply across the entire spectrum of fund investment and not to derivatives exclusively;
  • Life assurers, some retirement funds and various managers of collective investment schemes (which run retirement annuities through their life licences), will probably be unhappy with application of Reg 28 at the level of individual fund members. For years there’s been inconsistency across members and funds where assurers issued a guarantee under an RA policy and thereby circumvented the Reg 28 limits. As the limits will now apply irrespective of the guarantee, some funds could be heavily impacted. There are quite a few funds with individual-member choice that would be out of line with the draft;
  • The new Reg 28 will become effective on date of promulgation (unless otherwise stated). This implies that existing policies and funds will have to become compliant immediately. It will lead to portfolio shuffling on a large scale, causing market moves in individual stocks that can be significant. Also, high trading volumes come at a cost to fund members and so cannot be in their interest. Careful thought should be given to the timing of implementation;
  • There’s a 10-fold increase to a R20bn market capitalisation as the cut-off between large and small stocks (see ‘Now & Next’ box). The rationale isn’t properly explained. At end-January the JSE’s Top 40 had four shares with a market cap of less than R20bn and five on the borderline. The proposed change could affect portfolios and funds, such as those which use tracker indices, so also inviting large-scale portfolio trades at a cost to fund members. While an increase in the cut-off is warranted, perhaps such a big increase is not;
  • The draft seems to say that 95% of a fund’s assets can be granted as loans to members for housing. This doesn’t concur with the policy Treasury has espoused that a pension fund should not be used to grant direct housing loans as it is primarily a retirementfunding vehicle. Abuse around pension monies for housing is rife. That the average size of these loans is small indicates that they’re used mainly for consumption rather than housing improvements. Treasury has also said previously that direct loans from the fund should be stopped and the fund should be allowed only to guarantee a loan against a member’s benefit. The draft undermines this principle;
  • It appears that the holding of unlisted instruments is limited to 5% under the “unlisted securities” category, whereas the existing regulation has a listed and unlisted debenture category with a 25% limit. The draft can mean a large change for some funds, forced (and hence likely at a sub-optimal price) to unwind their positions. It can also stifle innovation and growth in the SRI market.

    “We need to ask whether the macro-economic effects were properly considered and must recognise that retirement funds are a massive source of capital,” says Furstenburg. “Regulation needs to accommodate the fact that these monies act as a spur to development, realising economic gain for both fund members and those who seek capital.”

    Irrespective of regulatory limits, which can only ever be a guide, he emphasises that trustees would still have to make their decisions prudently. Because of the huge impact that trustees’ decisions can have on the economy, he’d prefer not only a review of Reg 28 but better guidance from the regulator and the industry on proper investment process. This should address the conduct of trustees, especially on the process by which they allocate fund assets for investment by outside managers.