Regulation 28 – what’s the real cost?

The changes to Regulation 28 of the Pension Funds Act are due to come into effect on December 31, 2011. At face value what appear to be minor changes in terms of reporting and tweaks to the asset classes and limits, are in fact much more onerous. “The changes,” says Francesca Kilfoil, employee benefit specialist with PSG Konsult Corporate, “will result in huge ramifications for all industry players.” Kilfoil presented a paper at a recent Employee Benefits Conference in which she took a look at some of the cost implications of the regulation changes.

Regulation 28, in terms of section 36 of the Pension Funds Act No 24 of 1956, governs the asset allocation of all retirement funds, which includes pensions, provident funds, retirement annuities and preservation funds. According to the National Treasury all retirement fund investments should be invested “in a prudent manner whereby economic development and growth can be achieved.”

“The intention of Regulation 28 is very clear,” says Kilfoil. “It aims to protect the savings of the retirement fund member and ensure adequate risk adjusted returns, at a member level, to meet sufficient liquidity needs and liabilities. In line with the funds’ interest, all investing should be stable, transparent and sustainable in the long-term and apply across all asset classes. This means a broader investment selection and lower correlation between portfolios.”

The revised regulation has been long awaited as it was last amended in 1998. Drafts of the revision were released in February and December 2010 for public comment. The final regulation was approved by the Minister and gazetted on March 4, 2011 with an effective date of July 1, 2011. However, in considering the practical difficulties for funds to effect full compliance in such a short period of time, the Financial Services Board (FSB) applied a six month transition period until December 31, 2011.

“During this initial six month period, which we are almost half way through, funds are expected to adjust their monitoring and reporting systems and ensure that the investments are realigned within the new asset class parameters,” explains Kilfoil.
“With the deadline looming and a great deal of uncertainty around the implementation of the required reporting, does this allow sufficient time for retirement funds to fully comply with the revised regulation? And, more importantly, is the December deadline realistic?” Kilfoil asks. “However, before we debate this, let’s take a look at the appropriateness of the revised regulation as the changes do come at a significant cost to the industry. Which, I believe will result in pension fund members carrying the load.”
Setting the Scene

According to the FSB there are currently around 3500 registered funds with private retirement assets totally R1.1 trillion. South Africa’s gross savings as a percentage of GDP is approximately 15.4% which lags significantly behind China – in first position – at 53.8% and with only around 5% of South Africans making adequate provision for their retirement, it is important that pension funds are properly managed and reviewed on a regular basis.

“In terms of their fiduciary duties and responsibilities Trustees are going to have to ensure that their funds are moving towards full compliance within the transition period,” says Kilfoil. “Apart from the actual asset classes and limits, the most significant change is in terms of reporting. Investment limits now apply at an individual member level and no longer at a fund level. As a result, for the larger funds, especially those offering individual member choice, compliance could mean an extensive exercise to implement new monitoring and control measures. This could prove to be a very expensive exercise and our concern is who will ultimately pay for these system enhancements.”

The Registrar is allowing funds to be exempt from having to report any breach of the regulation limits immediately, on a member level, and is satisfied that member breaches can be reported on a quarterly basis. With the first report due for the period ending March 31, 2012.

However, should a fund be in breach of a regulation limit, the fund has a maximum of 12 months to realign the investment. Any such breach must be reported to the FSB immediately. This poses another reporting obstacle for retirement funds as market movements could be the cause of funds being non-compliant. With regular monthly contributions to group schemes, should a fund be in breach of a limit, the investment must not be permitted if it exacerbates the breach. This in turn could complicate the requirement to invest contributions within a certain time period.

“The revised regulation is probably the most onerous for asset managers,” maintains Kilfoil. “Currently all asset managers are required to report compliance on fund level but, effective January 1, 2012 this requirement is was also at a member level. For those operating in a retail space this is probably no big deal as they already have systems, processes and procedures in place however, on the institutional side, substantial system modifications will be required.”

She explains that currently institutional asset managers do not hold member records – they are held by the fund administrator – who in most cases are separate legal entities. As such, some kind of interface between the asset manager and fund administrator will be required or the asset manager has to spec, test and implement monitoring systems before the end of the year in order to report any breaches. It is possible that the new regulation may force certain parties to merge their businesses in order to comply. Alternatively asset managers may have to outsource this function to a third party!

“This is where costs become a factor,” says Kilfoil. “Asset managers may have to increase fees by 2 or 3 basis points to recover or partly finance the increased cost of outsourcing, merging and system adjustments.”

Asset managers also need to take cognisance of the new “look- through” principal and apply it to all investments at an underlying asset level. This means that a fund cannot attempt to circumvent the asset class limits in the regulations where the asset is actually made up of a number of underlying assets. The fund is required to disclose the underlying assets in each asset class so that the real economic exposure is apparent. Private equity and hedge funds are to be excluded from this principle as these vehicles are to be seen as the final asset.

Hedge Funds create an additional challenge because pricing changes monthly and not daily, which will impact the requirement for the reporting of breaches on a daily basis. “How can this be accommodated and at what cost?” she asks.

“We know that the ultimate responsibility for reporting non compliance lies with the Board, however, credible and accurate data needs to be fed from the asset manager whilst it is the administrator who holds the member records. It will be the employer’s responsibility to inform and educate their members regarding Regulation 28 or at least allow the consultants to do so.”
As for the members – Regulation 28 can be viewed as a positive or negative. Members with individual member choice can construct a 100% risky portfolio with a combination of equities, property and hedge funds. Members are not permitted to invest outside of the limits laid out in the Regulation however currently there are cases whereby members who participate in umbrella arrangements are invested 100% in property or 100% in equities.

Traditionally, members close to retirement have moved their accumulated assets into cash or near cash instruments. The new regulation will only permit a maximum of 25% in any single money market instrument, which again has potential for increased costs.

“Our concern is that the new Regulation may discourage funds from offering individual member choice as a result of a potential increase in costs due to the reporting requirements. Ultimately, we suspect, it will be the member who picks up any additional costs incurred in the implementation of Regulation 28. This will most probably be in the form of higher asset management fees,” says Kilfoil.

“It is essential that Investment Policy Statements are revised to take into account the new reporting requirements and that an appropriate risk management policy is adopted. It is furthermore essential that Trustees are made aware of any additional fees or potential risks.

“So my questions around Regulation 28 remain, is the compliance deadline realistic, have the cost implications been carefully considered and are we discouraging individual investment choice?”

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