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Taking Stock Spring 2019

Regulation 28 is restrictive – but not in the way you might think

18 November 2019
Author: Sangeeth SewnathDeputy Managing Director

Reading time: 4 minutes

At a glance:

  • The tax benefits associated with a Regulation 28 retirement portfolio provide a material boost to retirement savings, which more than compensate for prevailing asset class restrictions.
  • Significantly increased offshore exposure is not as important a return driver over the long term as recent performance would suggest.
  • 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.

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 period.*

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?

Tax benefits and asset class restrictions

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).

Is an additional 2.5% per annum attainable?

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.

Asset class restrictions don’t hurt performance in the way you expect them to

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.

Income assets are the biggest detractor

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.

 

*As at the end of October 2019. Global equities are represented by the MSCI ACWI and SA equities by the FTSE/ JSE ALSI.

Sangeeth Sewnath
Sangeeth Sewnath Deputy Managing Director

Important information

All information provided is product related and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Collective investment scheme funds are generally medium to long term investments and the manager, Investec Fund Managers SA (RF) (Pty) Ltd, gives no guarantee with respect to the capital or the return of the fund. Past performance is not necessarily a guide to future performance. The value of participatory interests (units) may go down as well as up. Funds are traded at ruling prices and can engage in borrowing and scrip lending. The fund may borrow up to 10% of its market value to bridge insufficient liquidity. A schedule of charges, fees and advisor fees is available on request from the manager which is registered under the Collective Investment Schemes Control Act. Additional advisor fees may be paid and if so, are subject to the relevant FAIS disclosure requirements. Performance shown is that of the fund and individual investor performance may differ as a result of initial fees, actual investment date, date of any subsequent reinvestment and any dividend withholding tax. There are different fee classes of units on the fund and the information presented is for the most expensive class. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. Where the fund invests in the units of foreign collective investment schemes, these may levy additional charges which are included in the relevant Total Expense Ratio (TER). A higher TER does not necessarily imply a poor return, nor does a low TER imply a good return. The ratio does not include transaction costs.. Additional information on the funds may be obtained, free of charge, at www.investecassetmanagement.com. The Manager, PO Box 1655, Cape Town, 8000, Tel: 0860 500 100. The scheme trustee is FirstRand Bank Limited, PO Box 7713, Johannesburg, 2000, Tel: (011) 282 1808. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA).

This document is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd is an authorised financial services provider. Issued, November 2019.

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