• Hilan Berger

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