Regulation 28 is not the problem, investor behaviours are

It’s textbook stuff that diversification is an essential element of investing that is likely to improve the risk-adjusted return.


There’s a narrative on the go that retirement fund members are being done in by Regulation 28, because it condemns them to low returns.   


Regulation 28 limits the extent to which retirement funds may invest in individual assets and asset classes. Although the aim is to protect members from poorly diversified portfolios, some commentators maintain that the category limit on “equities” (75%) and foreign investments (30%) actually prejudices them.


The argument is that equities have historically been the best-performing asset class long-term, and investors should not be forced to dilute their potential return by holding other asset classes. Furthermore, having unrestricted access to offshore markets would improve performance and diversification, a view underlined by the dismal run of the JSE since 2014.   


It’s a valid concern, because asset mix is one of the two factors that determine the long-run investment return. A portfolio earning a sub-optimal return could quite possibly ruin the pension of even diligent savers. It doesn’t take much to spoil the party either: earning just 1% less per annum over 40 years can knock 30% off your retirement income.


Investors doing it to themselves


Sadly, many investors do tend to leave that kind of money — and often much more — on the table. But mostly it’s down to their own lack of awareness, which manifests in poor investment choices and behaviours.


Some shy away from high equity portfolios, which tend to deliver the best long-term returns, because they are described as “high risk”. But the “risk” here refers to the likelihood of short-term losses, which is not something that should concern investors saving for a retirement in the distant future.


Besides the asset mix, the other factor defining the long-term return is fees. It’s not uncommon for retirement annuity members to pay fees of 3% per annum, to cover administration, investment management and advice. Yet cheaper options, costing 1% per annum or less, are readily available. The higher fees don’t deliver a higher return, so it simply makes no sense to pay them. All they do is decimate your pension.


Then there is the question of investment style. Investors can rely on index funds to deliver the market return at low cost, yet most fall short of that because their money is invested with an underperforming fund manager. They also shoot themselves in the foot by changing their strategy or fund manager after recent market developments have favoured another. This “rearview mirror” approach tends to have a “buy-high, sell-low” outcome.


Then there are those who save outside of retirement funds because they prefer the flexibility of investing directly in the market or in unit trusts. But this flexibility comes at a cost: it encourages market timing and triggers annual tax on interest, dividends and realised capital gains. Morningstar estimates the annual tax drag on the return at 1.23% per annum. With no such taxes in retirement funds, these savings grow at a faster rate and deliver a higher pension.


Investors who commit two or three of these follies are unlikely to see any real (after-inflation) growth on their savings. They have practically zero chance of achieving a comfortable retirement and doing away with Regulation 28 won’t change that.


The impact of Regulation 28 on returns


It’s in the stars whether the current Regulation 28 stands in the way of earning a decent return in future. We can, however, assess the impact it would have had in the past. For the sake of simplicity, we have used just the basic portfolio building blocks: equities, bonds and cash, both local and international.


To make the point, just four different asset allocation strategies are forecast:

Portfolios A and B exclude the 75% equities limit, with portfolio B also lifting the 30% offshore limit. Portfolio C is a typical Regulation 28-compliant portfolio and portfolio D is a Regulation 28-compliant portfolio without the 30% offshore limit.


Returns are shown in real terms, stripping out the effects of inflation.


The results (also based on other portfolio combinations not shown here) confirm that, over the long-term, investors would have benefited from having a higher rather than a lower equity allocation. But the range of outcomes for the above four portfolios is much closer than one might expect, narrowing as the investment term lengthens (see Figure 2). Over 40 years, there is very little to choose between them. Only over the past five and 10 years would investors have benefited materially (+1% per annum) from a higher equity and/or a higher offshore exposure, compared to a Regulation 28 portfolio.

However, short-term outcomes are always going to be more disparate, simply because there is less time for mean reversion to kick in. This does not mean that the strategy that worked best over those periods will continue to do so.


It certainly wasn’t the case historically. Figure 3 shows the five-year returns going back to 1968, in five-yearly intervals. The range of outcomes is as high as 14.4% and as low as 1.6%. Every strategy has a turn at delivering either the best or the worst outcome.  

Although the 100% equity portfolios are most likely to fare best over five years, it’s not a sure thing. Nor is there a pattern that reveals the winning strategy from one period to the next year.


The worst way to tackle this uncertainty is to adopt a rearview mirror approach and switch to the previous “best” strategy at the end of every five years. Doing that would have reduced the compound return over 40 years to only 6.2% per annum, which is 2.9 percentage points behind the “worst” portfolio strategy over 40 years.


If anything, it would have paid to be a contrarian, switching to the “worst” strategy every five years. This would have delivered compound growth of 9.9% per annum, one percentage point above the best-performing portfolio.


That’s much easier said than done, of course, going against the prevailing sentiment (which presently favours taking more money offshore rather than loading up on SA). It may or may not prove the correct thing to do; no one knows whether any of these patterns (or lack thereof) will continue in future.


Other considerations


It’s textbook stuff that diversification is an essential element of investing that is likely to improve the risk-adjusted return. With regular rebalancing, diversification can even deliver a portfolio return that exceeds that of the best-performing asset class. The call for a full equity allocation in a retirement portfolio is thus unlikely to resonate with any serious investor.


On this point, it is worth noting that the two equity portfolios deliver considerably more volatile returns than the two diversified portfolios. The higher offshore allocation, too, leads to higher volatility. 

To the extent that volatility encourages the poor investor behaviours mentioned previously, some investors may be better served with the less volatile returns offered by a Regulation 28-compliant portfolio, simply because they are more likely to stick to the plan.


The bottom line


Regulation 28 is flawed, mainly because it vacillates between rules and principles and conflates investment objectives with policy objectives. It has not, however, stood in the way of owning a sensible portfolio, or investors earning an adequate return on their retirement savings.


“Sensible” means that the portfolio is rational in the context of the time horizon, well-diversified and regularly rebalanced.


It may well be that if the malaise in the local economy continues indefinitely, the offshore limit may prove too onerous. But the Reserve Bank has increased this limit before and may well do so again in future, if necessary. It is also worth remembering that the FTSE/JSE all-share index provides considerable exposure to other markets and currencies.  


But if all sensible roads lead to Rome, or thereabouts, then it’s the other return-eroding factors that investors should look to curb, particularly high fees. It’s far easier to score an annual fee saving of 1% than it is to pick the “best” strategy over the next 40 years, or to navigate the markets with tactical switches over that time.


To put it another way, investors should look to perfect their own behaviour and choices, rather than to perfect the asset allocation. Over the long term, that will add far more to their savings than tweaking their share market exposure or investing more money offshore.  






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