Recent ANC Comments on Prescribed Assets for Financial Institutions - Brief II of II

The potential consequences of prescribed assets

Introduction

If government were to go ahead to pass legislation that requires financial institutions to place a fixed percentage of their investments in prescribed assets, this could have a very real negative impact on financial institutions as well as the economy as a whole. Specifically, it will most likely lead to the following eight negative outcomes (discussed in more detail below):

1. Lower than market returns for investment funds and an erosion of investment value.
2. Asset / liability mismatches for pension funds, banks, and insurance companies.
3. Defined pension funds not being able to meet their pension payment requirements.
4. Tax payers having to fund a shortfall at the GEPF.
5. Reduced incentives to save for retirement.
6. A negative impact on the stock-market and the country’s overall financial stability.
7. Decreased foreign investment in South African government bonds and SOE debt.
8. A crowding out of growth inducing private sector investment.

1. Diminished returns for investment funds

Making investment funds instruments of government policy would be counter to the fiduciary duty of fund managers to act in the best interests of its members – as per Regulation 28 of the Pension Funds Act for example – as it will result in lower than market returns for the beneficiaries.

Such a large-scale forced asset allocation will most likely result in an imbalance between desirable projects and investment funds, with fund managers chasing after the same assets, ie. those prescribed assets which are considered sought after. This excess demand will artificially decrease the return on these assets while increasing the risk to funds that have no choice but to invest in the less desirable assets, with the result being an erosion of fund value.

It will also limit the fund manager’s ability to allocate assets in reaction to market conditions. Not only will this cause lower than market returns, it may also cause negative real returns, which, as described in the previous Brief, is what happened during apartheid’s prescribed assets policy era.

To illustrate the diminished returns that could occur over 10 years as a result of prescribed assets, we have created a capital levy spreadsheet/Excel model. This model consists of a portfolio of equities and government bonds, and calculates the resulting capital levy (diminished return) as a percentage of total investments. Using mid-market inputs in the left-hand-side table below, we get 10 year capital levies as per the three different percentages of prescribed assets shown:

To download the capital levy spreadsheet/Excel model with its adjustable inputs, click here.

2. Asset / liability mismatches

Forcing the hand of financial institutions in asset allocation could very likely result in mismatches between the institution’s assets and the liabilities it needs to service. Asset / liability matching seeks to ensure that, first, the institution’s assets are growing at a rate of return which at least matches its liabilities and, second, that liquid assets are available to service the liabilities as and when they become due. 

a. Pension funds
Let us use unit trusts, which qualify as appropriate investments for pension funds, as an example and proxy for pension funds. Currently such unit trusts hold around R2.3 trillion in aggregate, of which R350 billion is in money market assets with short term maturities of one day to a year. Forcing some of these investments into long-term government and SOE debt could lead to mismatches between the payouts a fund is required to make and the liquid assets available – which would lead to major complications for both the funds and those relying on the payouts, such as pensioners. Furthermore, most unit trusts are more heavily weighted towards equities to allow daily liquidity for investors, which is not suited towards long-term buy and hold strategies.[1]

b. Banks
A bank’s liabilities are the deposits it holds and the interest it is obligated to pay on the deposits. Their assets are loans for which they receive interest. In addition to loans, investment portfolios also form a part of bank assets, which they use to ensure that their liabilities are matched and serviced when needed. Limiting a bank’s freedom to choose its investments, given its liabilities, will increase the risk of an asset / liability mismatch, forcing banks to hold larger reserves, thereby decreasing the amount of loans it can make to the public, which would harm the country’s economic growth.

c. Insurance companies
The products offered by insurance companies require a premium for the service of receiving payout for a claim when an incident occurs or a financial milestone is triggered. Thus, in order to match their investment assets (made up of premiums) with potential liability payouts, insurance companies use sophisticated modelling strategies that integrate statistical probabilities of potential outcomes which may require large lump sum payouts to customers. As with banks and pension funds, limiting an insurer’s freedom to choose its investments given its liabilities will increase the risk of an asset / liability mismatch. This is especially true for short-term insurers, because SOE and government debt are both long term investments.

3. Defined contribution pension funds

Compared to the past, the vast majority of retirement funds today are defined contribution funds, as opposed to defined benefit funds. With defined benefit funds, pension payments at a specific level were effectively guaranteed, as the responsibility fell on the employer. With defined contribution funds however, pensioners and workers are directly affected by the risk and return of the funds into which they have contributed their pension contributions. Therefore, maximising returns at acceptable levels of risk should be the pension fund’s only consideration.

4. The GEPF

But what about the county’s largest pension fund, the Government Employees Pension Fund (GEPF), which is a defined benefit fund; will it be able to avoid any difficulties if prescribed assets are applied to it? Unfortunately not, for the exact reason that it is a defined benefit fund and its pension payments need to reach the predetermined absolute level guaranteed by the employer – government. Government would therefore have to stand in to cover any shortfall, placing additional pressure on the already overburdened fiscus and tax-payers.

5. Reduced retirement savings

A limitation on the rights of pension funds to make choices about fund allocation and associated risks and rewards, could reduce the willingness of pension fund members to save for retirement; which is counter to government’s aim to encourage savings through preferential tax treatment. Reduced retirement savings will cause future social issues and increase the burden on the fiscus in trying to deal with these.

6. The stock-market and financial stability

South Africa’s various categories of fund managers currently hold over R10.8 trillion in stock. This stock is accumulated over long time periods, and the sudden and potentially very large scale sale of shares that will be required to move funds into prescribed assets will have a negative impact of the stock-market, with the potential to affect the country’s financial stability.[2]

7. Foreigners holding government debt

Foreign investors are the single largest holders of South African government debt, holding 38% of total outstanding debt. There is the risk that prescribed assets could discourage foreign holdings of local debt (government or SOE) because it will create artificial demand for bonds, resulting in lower yields. While this would be good for current holders of the debt, there will be a point where foreigners are not compensated for the risk in real terms. The resulting oversupply of would have to absorbed by local savings/investment funds.

8. Crowding out of the private sector

The consequences of prescribed assets in point 7 above will be government crowding out the private sector as less savings/investment funds will be available for private sector borrowing. This crowding out also tends coincide with periods of low growth rates and lower fixed investment. Furthermore, prescribed assets may also suppress the demand for other important asset classes, such as listed equities and corporate debt.[3]

Conclusion

With SOEs unable to raise funds in the capital markets, coupled with the funding shortfall that currently exists in government, the ANC has threatened to turn to a policy of prescribed assets for financial institutions. This ignores first, the fact that financial institutions are and have been willing to invest in well conceived government programmes, and secondly, it ignores what lies at the root of the current funding crisis, namely corruption and poor governance.

Imposing investment allocations from the top and ignoring market signals that call for proper governance of SOEs and other public institutions, will not help to incentivise public officials to improve their performance. Instead it will encourage them to kick the can further down the road, in addition to which a number of SOEs in any event hold both a monopolistic and regulatory advantage. It will also cause at least some of the further negative consequences listed in points 1-8 above, which South Africa cannot afford to bear on top of the current issues it faces.

Charles Collocott
Policy Researcher
Charles.c@hsf.org.za