By: Dr Stuart Theobald, CFA
Prescribed assets are increasingly being looked to as a solution for both urgent and longer-term development funding needs. This is a mistake. Prescribed assets would be a cure far worse than the illness. It would distort capital markets, undermine market efficiency and discipline, harm investor confidence and reduce foreign investment. This downside far outweighs the potential benefit of increased funding for government priorities, an upside that can be far better met through other means.
In this paper we look at some of the background history on prescribed assets and the consequences of their use.
Prescribed assets are an unusual phenomenon. South Africa is one of few countries to have imposed a prescribed assets regime on the institutional savings market, which it did during Apartheid when insurance companies and pension funds were compelled to invest in municipal and other government debt. This reflects both the comparative level of development of the institutional savings market and the level of fiscal desperation that the government has occasionally found itself in. It is unusual to find a combination of these elements in one country.
Somewhat more common are prescriptions on public sector pension funds which look after the savings of civil servants, usually with a government guarantee on benefits. With a guarantee in place, the investment performance of the assets is less crucial for beneficiaries. Examples include national provident funds in Singapore and Malaysia that were required to invest most of their funds in non-marketable government bonds and the ATP public pension fund in Sweden that was required to invest in government bonds as well as mortgage credit institution bonds at interest rates that were significantly lower than market rates. This was true in South Africa during the prescribed assets era when the Public Investment Commissioners (the forerunner of today’s Public Investment Corporation) were required to hold 75% of their portfolio in government bonds. Yet these examples show the use of public sector savings. There are no examples we could find, outside of war time, of private sector savings being directed into government bonds.
The ANC’s election manifesto for the May 2019 election included only one sentence on the issue: “Investigate the introduction of prescribed assets on financial institutions’ funds to unlock resources for investments in social and economic development.” This followed an only slightly less terse statement from the 2017 Nasrec elective conference: “Government should introduce measures to ensure adequate financial resources are directed to developmental purposes. A new prescribed asset requirement should be investigated to ensure that a portion of all financial institutions funds be invested in public infrastructure, skills development and job-creation.”
This statement was in a resolution on investment and allocation of resources, which also included a reference to a Sovereign Wealth Fund that “should be set up to ensure that the free-carry shares in mining and other resource sectors be retained by the state, acting as the custodian of the people as a whole.” The issue of compulsory free carry in mining has not been referenced in the election manifesto but is a serious issue for businesses in that sector. The issue of prescription can therefore be seen as part of a broader intervention in the allocation of capital in the economy and the inclusion of prescribed assets in the election manifesto was a first step.
Beyond the manifesto and Nasrec references, the issue of prescribed assets has been on the periphery of policy debates for some time. For instance, the New Growth Path envisages that compulsory participation in private pension funds should be “linked to increased investment in DFIs [development finance institutions] to finance employment-creating projects”. Of course, this wording does not imply prescribed investment as there are market-based incentives that could be used, but one can detect in the phrasing that compulsion is being considered.
The institutional savings industry is highly regulated the world over. The line between regulation that is strictly in the best interest of savers and that which is in the best interest of government or political factions is sometimes blurred. Prudential guidelines, which are well developed in South Africa, attempt to balance the profitability and safety of investments by specifying exposure limits to asset classes. In South Africa, these have clearly been created with the interests of the end-beneficiary in mind, rather than the recipients of investment flows, and largely captured by Regulation 28 of the Pension Funds Act. This, however, does not specify any minimum allocation to any asset type, but rather specifies maximums in order to avoid over-exposure to high risk assets. The current regulation 28 limits are:
– Equity 75%
– Listed Property 25%
– Offshore Assets 30%
– Alternatives (e.g. private equity, hedge funds) 10%
In the Apartheid incarnation, prescribed assets were legislated in 1958 via the Prescribed Assets Act. This directed pension funds and insurance companies to invest in government bonds that were used to fund semi-governmental institutions, such as universities, the South African Broadcasting Corporation, and developments in the homelands . They were repealed in 1989 following recommendations by the Jacobs Committee in 1988.
The period of prescribed assets provides important lessons on the effect that the mechanism has. During Apartheid the prescribed assets proved to be a serious stumbling block to the development of financial markets in South Africa. It distorted the fixed income market, disrupting normal price signals. One of the most important functions of the bond market is to set the yield curve, an important price discovery mechanism that aggregates views about the future trajectory of interest rates. The yield curve enables government, businesses and consumers to plan around likely future borrowing costs, rather than the spot interest rate that prevails in any one moment. South Africa has a well-developed yield curve with price visibility out to 2050. Prescribed assets disrupt this by forcing investment flows into certain assets in the yield curve and therefore disturbing the pricing signals at those points. Without a well-functioning market that provides price discovery, the cost of all forms of debt increases as appropriate prices are less visible.
Apartheid-era prescribed assets also had a serious impact on returns. Pension funds were required to invest 53% of their assets and insurers 33% of their liabilities into public sector bonds. The return was much lower than that on listed equities and in the inflationary environment of the 1970s and 1980s, generated negative real returns.
Prescribed assets became effectively a stealth tax on wealth. The Jacobs Committee found that life insurance companies held on average 29% of their assets in prescribed assets in the 1970s and 1980s, and the negative real return translated into an effective tax on assets of 1% in the 1970s and 0.3% in the 1980s . State pension funds were pressured into funding even more prescribed assets than strictly required, resulting in serious unfunded liabilities by the end of Apartheid for funds such as Transnet’s.
The lesson of the previous prescribed asset regime are clear: it distorted and undermined the efficient functioning of the bond market and it damaged returns to institutional shareholders, creating unfunded liabilities to pension fund members.
In South Africa, the state capture era illustrated the importance of market discipline in interrupting the egregious diversion of investment into corruption that we saw at Eskom and elsewhere. The actions of the Development Bank of South Africa in refusing to role over Eskom debt in the face of a potential qualification of its financial accounts, was crucial in improving the financial management of Eskom. Similarly, public statements from the likes of asset manager Futuregrowth in refusing to fund state-owned enterprises unless governance was improved, were crucial to stanching financial mismanagement. Prescribed assets remove this form of market discipline.
To these a fourth and obvious consequence can be added: that it undermined the efficiency of capital allocation and therefore undermined economic growth. Investment is a key driver of economic growth and the efficiency with which investment is allocated directly effects the consequent impact on economic growth. When capital is directed at low-yielding government securities it is directed away from higher-yielding opportunities which by definition drive higher levels of economic returns. Capital markets should allocate capital, a scarce resource, to where it can most productively be used.
A counter argument to this point might be that prescribed state bonds can yield a higher public return rather than a private return. In other words, the impact on economic growth can be substantial but that these returns are public and not able to be directed to the providers of capital and therefore a usual market mechanism is not available. This may be true in the case of productive infrastructure, but it remains optimal to fund this through taxation rather than prescribed bonds. Any growth-enhancing investment increases GDP which then increases tax receipts. The public sector thereby obtains a return on investment enabling it to meet financing costs. This is obviously not true in all public good provision such as health and welfare, but the prescribed assets discussion so far has focused on infrastructure and related growth-enhancing investment.
Prescribed assets do nothing to add to the savings pool, but merely redirect savings from other investments. Indeed, by lowering the overall returns to savings through pension and insurance products, prescribed assets can actually lead to withdrawals from the savings pool as savers choose to redirect voluntary contributions into consumption or other private savings mechanisms, given the lower opportunity cost of doing so. In the New Growth Path the discussion of government investments is associated with compulsory pension savings. The use of compulsion appears to be a key part of government thinking on prescribed assets in order to avoid this problem.
Furthermore, prescribed assets and the damage to market efficiency also discourage foreign investors. Foreign capital flows have been critical to the funding of government since the democratic era. These have been attracted to the South African capital market by the institutional strength of the bond and equity markets. A smooth yield curve and commitment by government to respect market mechanisms to date has helped build foreign investor confidence. Prescribed assets and resultant distortions on
It might be argued that prescription does not necessarily distort the market because returns would anyway be market-related and investors would anyway invest in the relevant instruments. Indeed, when prescription was abolished in 1989 for some years after institutions were still required to invest 10% of assets into government bonds, however this proportion was below the “natural” investment level anyway so made no difference to investing behaviour. If this is the case, however, prescription serves no purpose.
For South Africa, the following negative consequences would result from prescribed assets:
• Less capital would be available for the private sector as some would be diverted to the public sector by prescription.
• Overall capital markets efficiency would decline, particularly in the bond market, with the yield curve being distorted and thereby increasing the transaction costs of all debt.
• Market discipline would be diminished and less able to influence the quality of financial management of the recipients of funding.
• A stealth wealth tax will be imposed on all pension savers to reflect the below-market returns on assets. For defined benefit schemes, this translates into a tax on companies. For defined contribution schemes, it is a tax on scheme members.
• Savers will have an incentive to avoid directing cash flows into pension savings or insurance products, which in the case of voluntary retirement annuities is likely to decrease overall savings.
• Foreign investor confidence in the efficiency of South African capital markets would be undermined, further reducing the available savings pool. Foreign capital availability has been key to funding government since democracy.
These are far in excess of any potential benefit from prescribed assets.