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Q&A: Investment Linked Life Annuities (ILLA) and Regulation 28

Published: June 5, 2013 by Pieter Koekemoer, Coronation

Our Q&A service provides you with the opportunity to pose difficult questions or to identify an issue that you would like us to research further.  Our aim is to respond to questions posed on the Q&A section of the site by either conducting our own research and reporting on our findings, or by approaching industry experts to share their views on the topic.  In this instance we asked Pieter Koekemoer, Head of Personal Investments at Coronation, to respond to the issue raised


Question:

Anticipated changes to Regulation 28, possibly within the next few months, are widely expected to bring ILLA’s into Regulation 28’s investment control remit. Should an adviser wish to adjust a client’s holdings prior to any rule change, which would be the most appropriate funds to choose to do so? Historically regulation changes have not been retrospective.


Answer From Pieter Koekemoer:

Head of Personal Investments at Coronation

“Let’s deal with the likelihood that ILLAs will be subject to investment constraints first. This topic is high on the agenda because National Treasury (NT) is currently in the 2nd round of consultation on their plans to reform the private sector retirement market. A key focus area is to make the post retirement income market work better, which is likely to include changes to the way ILLAs are governed currently. It’s important to note though that the topic of a blanket application of investment restrictions is pure conjecture at the moment – NT’s latest document issued on 27 February this year contains no reference to this. Most of NT’s focus is on ensuring that retirement fund trustees make default annuity options available to retirees. The rumours probably emanate from extrapolating the current member-level pre-retirement approach into the post-retirement world. While this is a possible outcome, it is not the base case in my view.  Given the acknowledgment by NT that nudging retirees to a certain solution rather than forcing them into it is a more desirable system design principle, I would argue that investment restrictions are more consistent with the default option than with ‘opt-out’ privately sourced ILLAs. Even if restrictions were to be enforced on all ILLAs, this will probably not happen before 2015 at the earliest given the significant legislative intervention required (it will require promulgation of a new act rather than just the issue of a new regulation or pension fund circular). And as the question indicated, changes are rarely applied retrospectively, with pre-existing rights typically grandfathered in regulation.

The next aspect to pause at is the appropriate strategic asset allocation for a living annuity portfolio. The vast majority of annuitants have a tight trade-off between their required income drawdown rate and the time horizon over which an income is expected to be paid. Most retirees therefore just cannot afford to take too much investment risk. If you are in the position where you need to draw an income of 5%+ from your retirement capital, it is prudent to be invested in a moderate to conservative multi-asset portfolio, with 40%-60% maximum allocation to growth assets. The rationale for this position is simply that you need to manage sequence-of-returns risk. If you are unlucky enough to have a terrible market return year early in retirement, even the 75% equity cap of a reg. 28 compliant fund is arguably too risky. This is why the current ASISA Guideline on Living Annuities requires a nudge in the direction of Reg 28 limits in the pre-investment disclosures made to clients. If however your required drawdown rate is more in line with the prevailing dividend yield (2.5%-3%), you have significantly more ability to take on risk in your living annuity portfolio.

Assuming that your client is one of the lucky few that can justify more growth asset exposure in their living annuity, you probably want to look at multi-asset funds that can go beyond the reg. 28 equity and foreign limits. The most obvious category to evaluate is the Worldwide – Multi-Asset – Flexible category. There are two main types of funds in this universe: less-constrained houseview funds such as Coronation Market Plus, and clean-slate funds with an offshore bias such as Coronation Optimum Growth. The former aim to improve on the outcome produced by the more constrained reg. 28 compliant funds, but will retain a bias towards SA assets over time. Market Plus for example has no equity exposure limit (compared to 75 % for reg 28 funds) and can invest up to 35% in offshore assets (compared to 25% for reg 28 funds). If your managers get their calls right, you can expect an increase of 1%to 2% over a reg 28 fund over time. The latter represents a more aggressive option, as you are asking the manager to make a call on SA exposure vs. global exposure. Funds such as Optimum Growth will have more of an offshore bias, with on average a 60%-70% global / 30%-40% domestic split. While rand returns are going to be more volatile year on year, our current assessment of the opportunity set makes this sort of portfolio a good option on a ten year view. If you are wondering why I prefer multi-asset funds for the job, it is to buy some protection against a poorly drafted grandfathering clause, similar to the experience in the pre-retirement world: When member level compliance with reg 28 was implemented, only a weak vested right protection was introduced. In this case, you frustratingly lose your vested rights protection if you want to switch between funds. This argues in favour of using a wider rather than narrower mandate to retain flexibility over time.”