The benefits of increasing offshore exposure in post-retirement: Written by: Luke McMahon, Research and Investment Analyst at Glacier by Sanlam

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1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h 16 M a r c h V o l u m e The benefits of increasing offshore exposure in post-retirement: Written by: Luke McMahon, Research and Investment Analyst at Glacier by Sanlam (Disclaimer: The compilation of this article was started shortly before the unexpected announcement by SA s Minister of Finance in the Annual Budget Speech 2018 that treasury is to increase the prudential limits on offshore investments for funds under management by institutional investors and limits for collective investment scheme management companies and investment-linked business of long-term insurers to 40% from 35%; and for non-linked long-term insurers and retirement funds to 30% from 25%. Additional allowance for investment in Africa was increased from 5% to 10%). "Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money." Jonathan Clements One of the most significant once-off life events a person will ever experience is retirement. Therefore, a large portion of an individual s working life is committed toward preparing for this occurrence, as one does not get a second chance at it. This transition from actively earning an income to passively generating an income while in retirement is so important that an entire profession (financial adviser) and industry (financial services) is dedicated to helping individuals prepare for it successfully. The kind of lifestyle one can hope to live in retirement is firmly dependent on the plan one sets out in order to achieve the desired level of income in retirement from the cumulative savings and investments one makes whilst working. For most working individuals this saving and investment initiative is done through pre-retirement savings vehicles such as pension, preservation and retirement annuity funds. Page 1

2 Pre-retirement investment portfolios pension or retirement annuity funds Regulation 28 When constructing a portfolio for a retirement-saving vehicle, one needs to be aware that there are certain rules and regulations which need to be adhered to. Regulation 28 of the Pension Fund Act limits the extent to which retirement funds may invest in particular assets or in particular asset classes. The main purpose is to protect the members retirement provision from the effects of poorly diversified investment portfolios. This is done by limiting the maximum exposure to more risky asset classes, making sure that no unnecessary risks are taken with retirement money. A brief summary of the maximum limitations are provided in figure 1 below. Figure 1. Asset class limitations Source: Sanlam Retirement It is evident from the above figure that regulatory investment guidelines promote sufficient diversification across all asset classes. And a topic which has received much attention within the financial services industry is the allowed allocation that South African (SA) investors have toward offshore assets. In 2011, legislation was promulgated that this allowance be raised from 20% to 25% within retirement savings vehicles. In addition to this, SA investors were further allowed to invest 5% in Africa as well. Subsequently, in the 2018 budget speech, we now know that this limitation has been raised to 30% offshore and 10% Africa assets. Post-retirement investment portfolios living annuity and living income products Post-retirement prudential guidelines Unlike pre-retirement funds, post-retirement portfolios are not legally required to adhere to the investment guidelines as detailed in Regulation 28 of the Pension Funds Act. However, the Association for Savings and Investments South Africa (ASISA) still recommends that policyholders take these guidelines into consideration when compiling their post-retirement living annuity portfolios. In 2016, 31.03% of living annuity policies did not apply the prudential investment guidelines compared to 33.59% in 2015 signifying an increasing number of individuals in retirement are following the prudential Page 2

3 investment guidelines. Hence, this would mean that a greater number of individuals in retirement would have been limiting their offshore exposure to 25% within their portfolios. Benefits of increasing offshore asset exposure in your post-retirement portfolio A pertinent question to ask then is, how much of the post-retirement portfolio should be invested in offshore assets? To demonstrate the impact of incorporating foreign assets in a local SA portfolio, we refer to a study conducted by Bradfield & Munro (2015, p. 413) whereby they performed a meanvariance efficient frontier analysis of domestic and foreign assets (excluding foreign property) in a proxy portfolio, using data from 1971 to The mean-variance efficient frontier analysis yielded the following result in terms of where the non-foreign asset frontier (blue line) is positioned as opposed to a foreign asset inclusion frontier (red line), as depicted below. Figure 2. Source. Bradfield & Munro (2015) It is quite evident from the figure above that the inclusion of foreign assets significantly shifts the efficient frontier to the left, i.e. the volatility is reduced and shifts the frontier upward, i.e. returns are enhanced. This particular study yielded an optimal foreign asset allocation weighting of 41% toward global bonds in the optimal mean-variance portfolio. However, this result does not necessarily hold as the optimal foreign asset allocation for different risk-profiled portfolios. The diagram below shows the detailed composition of local and foreign allocations per asset class weight (January 1971 to December 2010) for varying SA CPI (absolute return target) portfolios. Page 3

4 Figure 3. Source. Bradfield & Munro (2015) In each of the scenarios the optimal asset allocation weighting toward foreign assets was found to be above 25%, with more aggressive CPI target portfolios (CPI+5% - CPI+8%) having a minimum weighting of more than 35% allocated toward foreign assets. As the benchmarks became more aggressive, so the inclusion of foreign equity became more prevalent within the portfolios. However, it must be noted that with this additional foreign equity inclusion, the probability of achieving a more aggressive target over a rolling three-year horizon diminished from 81% (CPI+1%) to 50% (CPI+8%). Nonetheless, SA investors striving for the optimal mix of assets to achieve their risk-adjusted return targets within their portfolios, could possibly have incurred an opportunity cost in terms of performance by only sticking to the previous prudential investment guideline of 25% foreign asset exposure. This point is further illustrated by looking at the returns of SA equity versus foreign equity over the last seven years as at the end of December SA vs foreign equity performance over the last seven years A notable observation within the financial services industry is that SA retirees, in conjunction with their advisers, are actively increasing their exposure to equities within their retirement portfolios, at the cost of cash holdings, in order to keep up with the growth required to maintain their income. Aggregate asset class figures across all post-retirement living annuity portfolios on the Glacier investment platform show that the allocation to equities has steadily grown from 39% in 2011 to 50% in Since this is a growing phenomenon, it would therefore be prudent to determine what form of equity (local or offshore) would have placed an SA investor in better stead over the last few years. Figure 4 below shows the performance of SA equity (FTSE/JSE All Share Index and TOP40) vs various offshore equity markets in rand terms. Page 4

5 Foreign equity markets have displayed higher investment growth over the last seven years Sharp strengthening of the rand negatively affected the returns of offshore assets for SA investors in December 17. Figure 4. SA vs foreign equity performance over seven years Source. Morningstar & Glacier Research Foreign equity has displayed better risk-adjusted returns over the last seven years Figure 5. SA vs foreign equity performance over seven years Source. Morningstar & Glacier Research From a pure return and risk-adjusted return perspective, it is evident that SA investors would have generated greater performance in rand terms from offshore equity than SA equity over the last seven year period, ending 31 December Furthermore, good diversification would have been achieved by the inclusion of offshore equity with SA equity as demonstrated in the correlation matrix table below. US equity (S&P 500) being the least correlated with SA equity. Page 5

6 Foreign equity returns have displayed low correlations with SA equity returns Figure 6. Diversification benefit through low correlated returns Source. Morningstar & Glacier Research Therefore, revisiting the fact that post-retirement living annuity portfolios in SA are not legally required to adhere to prudential investment guidelines as detailed in Regulation 28, investors in post-retirement products could potentially have benefitted more over the last seven years by increasing their offshore exposure above the 25% limitation, as suggested by prior empirical research. Fortuitous change in retirement investment offshore regulation Given the timing of when this article was originally written and having subsequently demonstrated the potential benefits of greater offshore inclusion in SA portfolios, it seems somewhat fortuitous now that regulation has changed regarding the offshore allowance for SA investors saving toward retirement. What seemingly was a strong case being built for post-retirement portfolios to increase offshore exposure beyond the previous prudential investment guideline limit of 25%, has turned into an unexpected windfall for pre-retirement investments under the new regulation. Having said this, it is prudent to visit the current stance taken by ASISA on this matter, as it directly affects SA investment managers and investors alike. ASISA FUND CLASSIFICATION STANDARD EXEMPTION 1 MARCH 2018 On 21 February 2018 during the Budget Speech, the Minister of Finance announced an increase in the offshore allocation limits for institutional investors. The increased limits became effective on the same day. To align the limits applicable to South African portfolios as set out in the ASISA Fund Classification Standard, the ASISA Investments Board Committee accepted the recommendation of the ASISA Fund Classification Standing Committee to grant an exemption to members to afford the Committee time to review the Standard and prepare proposals for amendment. Members are exempted from the foreign exposure limits referred to in paragraph 4.1 of the Fund Classification, subject to the revised offshore allocation limits. The definition for South African portfolios will thus now read: Page 6

7 South African Portfolios: These are collective investment portfolios that invest at least 60% of their assets in South African investment markets. These collective investment portfolios may invest a maximum of 30% of their assets outside of South Africa plus an additional 10% of their assets in Africa excluding South Africa. This exemption is effective immediately and is subject to supplemental deeds allowing for such a change. Conclusion Having a clearly defined retirement plan is crucial in your working years, as much as it is in your actual retirement. In addition to this, ensuring that your portfolio is well-diversified across asset classes and geographical markets is critical in balancing risk and return. Also, striking a sound balance between growth and income in your retirement portfolio is equally crucial to safeguard the longevity of your retirement income. For investors looking to achieve higher growth opportunities and greater diversification in retirement, considering a higher offshore allocation may be prudent. With recent changes in legislation, this now also holds true for pre-retirement investments. Lastly, in addition to making the decision to include offshore exposure in your portfolio, one needs to ensure that the investment platform through which you wish to access this exposure has sufficient offshore asset allowance to accommodate this action. Page 7