STUART THEOBALD: Public policy issue makes pensions political

Posted in: Intellidex in the media on November 30, 2020

This column is by Stuart Theobald and was first published in Business Day.

No-one wants to say this too loudly, but pensions are political. If we are to have sensible discussions over what should and shouldn’t be done with pensions, it is important to accept this starting point.

Before you jump onto Twitter with a tirade about your money that you worked hard for being yours to do with as you please, take a breath. Let’s think about why pensions have this special character.

Pension regimes deal with a public policy issue. We need people to be economically independent in retirement. Ideally, we need them to reach retirement with enough money to maintain a lifestyle matching that of their earning years.

Pension schemes have thus been developed with strong incentives to encourage retirement savings. Some countries have compulsory systems, but in SA we’ve taken a voluntary approach in which companies and employees are incentivised to contribute to pensions through a generous tax deduction.

You can contribute up to 27.5% of your income, capped at R350,000, to your retirement savings and not pay tax on that money. People earning at the 45% marginal tax rate could save R157,500 a year in tax by putting R350,000 into their pensions. They are taxed, to some extent, on withdrawals, but the tax deferment over a lifetime of contributions makes an enormous difference to how much they have at the end of it.

This public subsidy for retirement savings is often used as a justification for restrictions on the way that money is invested on public policy grounds. There are legitimate and illegitimate kinds of restrictions.

The legitimate ones are those that serve the primary public interest objective: ensuring retirees are not financially vulnerable. To do that, governments worldwide impose a set of rules on how the money can be managed, known as prudential guidelines. These effectively impose an appropriate risk/return framework on pension fund investment.

In SA, pension funds are subject to regulation 28 of the Pensions Fund Act that places ceilings on exposures to single issuers and certain asset classes.

Prescribed assets

Good pension systems also boost a country’s savings rate and, therefore, economic growth. As we learn often in developing countries, a first step towards economic growth is pension reform.

So far so good. The problem arises when politicians try to dictate exactly what should be done with these savings. We have had an unhealthy discussion in SA about prescribed assets. This was partly how the apartheid government funded itself, by forcing pensions into parastatal bonds. It is at odds with the original public policy intention because it undermines the returns earned on pensions, damages the incentives for people to contribute to them, and weakens the probabilities that they will be financially secure in retirement.

It also undermines the economic growth objectives of having savings by restricting the amounts available and the market discipline of active decision making over savings — the choice and oversight investment managers apply.

In the last few weeks there has also been a brouhaha about foreign exposure in pension funds. Foreign exposure is important from a prudential perspective because it allows diversification, which improves the risk-return profile of a portfolio. But too much is problematic because it increases risks.

Retirees have to pay for their lifestyles in rand, and taking on too much currency risk worsens the likelihood of being able to do so (just like how banks cannot have large mismatches in the currency of their assets and liabilities).

This is not uncommon — it was found in a 2019 study of pension schemes by the Organisation for Economic Co-operation and Development that about 82 of 84 countries studied, from Australia to Zambia, had some form of foreign exposure restriction on pension schemes. (I say “about” because much depends on definitions, but the 40% foreign limit in SA is not unusual compared with the rest of the world).

A problem in SA is that foreign investment exposure has historically been limited by exchange control when it should rather be limited by prudential regulation. Regulation 28 does set limits, but only by reference to exchange control rather than directly applying itself. That came to the fore when a further relaxation of exchange controls caused confusion about how it affected regulation 28, such that it has now been withdrawn for public consultation.

Debates are also ongoing about mobilising pension funds for infrastructure investment. This can be healthy — there are many forms of infrastructure investment that are ideal for pension funds because it can provide long-term cash flows at low risk. But this can also be unhealthy if pension funds are expected to invest not because of the economic benefits to savers, but because of other public policy priorities.

In these and other debates about pension funds, the public policy position must be looked at with clear eyes. We need to understand what it is we want to achieve with pension systems before we try to engineer the outcomes.

Theobald is chairman at Intellidex.

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