There can be objective reasons to move funds offshore, for example for a more diversified portfolio, access to growth sectors not represented in South Africa, or if you expect to incur a material part of your retirement expenses in another currency and want to take exchange rate risk out of the equation.
One way to evade the shackles of Regulation 28 of the Pension Funds Act, which limits offshore holdings in retirement funds to 30%, is to move savings into a living annuity as soon as possible. Living annuities are phased-withdrawal products, without asset restrictions, including the offshore limit.
Given the lacklustre performance of the JSE in recent years, investors have taken advantage, spurred on by rand strength, and moved their LA funds offshore. Their insurers must, however, abide by exchange control limits at the enterprise level, and some now push up against these. As a result, many living annuity providers have been forced to impose offshore limits even where Regulation 28 does not demand it.
This might not be all bad, though, because no matter how desirable the idea of ‘escape from SA’ might seem, moving more money abroad simply does not guarantee a higher return, or a smoother ride. Rather, it is likely to stress retirees and test their commitment to the plan.
It can be hard to shake off the niggling sense that the rand is sure to lose value against hard currencies over time if the historical inflation differentials persist. Then there is the issue of concentration risk, being over-exposed to an economy that is insignificant in the global context, a stock exchange that is poorly constituted, and a bond market that is rated sub-investment grade.
Even if these arguments don’t hold, there is the underlying fear that South Africa is in an irreversible decline, and that the only safe investment is an offshore investment.
Countering these perceptions is the fundamental problem of the asset-liability mismatch (retirement income in a different currency from expenses). It’s worse if the currency is as manic-depressive as the rand, and if investors are forced to draw down come what may.
There is also the historical evidence of how more global portfolios would have fared against the Reg 28 edition. Although these trends don’t necessarily point to the future, they do underline the risks of an aggressive offshore strategy.
Here, we have constructed four portfolios invested in equities, bonds and cash, but with different local/international splits.
As an aside, there is a tendency to compare the return of local balanced funds to the US share market, as though that were the alternative. The US share market has delivered exceptional returns over the past few years but, in a properly constituted offshore portfolio, investors would be invested in global equities, bonds and cash.
Over the past five years, world equities excluding the US (as measured by the MSCI EAFE index, for example) have barely matched the JSE in rand terms, and global bonds and cash have performed far worse than their local counterparts.
Figure 1 shows the relative performance of three high-equity portfolios with increasingly higher offshore exposure against the Reg 28 standard (70% local/30% international).
An interesting observation upfront: measured backwards from 2020, the annual returns of the four portfolios over the last 60, 30, 20 and 5 years are very close. Only over the past 10 years would the higher offshore mix really have paid off.
Intermittently, though, there are extended periods of out- and under-performance for all variants. The 50:50 local/offshore split still tracks the Reg 28 portfolio quite closely, so it requires a more substantial increase, to really impact the relative return.
Fig 1: Relative performance of a high-equity portfolio (75% equities, 18% bonds, 5% cash)
Source: Dimson, Staunton and Marsh, DataStream, 10X Investments
Historically, this has moved in cycles. For example, if investors had invested 80% offshore after the dot.com bubble burst in 2001, and the rand crashed, they would still be behind today. With compulsory drawdowns, they would have locked in a lot of that underperformance. But, on a relative basis, they would have done much better since 2010.
The point is, it has not been a one-way bet, which means that switching to a higher offshore allocation comes with considerable timing risk. With hindsight, the timing may look obvious, but it never does in the moment. Back in 2001, almost no one expected the rand to recover the way it did, and in 2010, after we hosted a successful World Cup, no one saw this as a turning point in the other direction.
Simply following the curve will also not work, because of the numerous short-term trend reversals within the broader cycles. And when the critical trend reversals do happen, they tend to be sharp and quick.
The timing risk can be mitigated by approaching the targeted local/offshore mix with a phased, rules-based approach that ignores market sentiment.
Part of the challenge will be to stick to the plan, even if it underperforms for many years. Few retirees, dependant on their savings for income, have the stomach for that. Many are spooked by a slight market correction and risk losing their nerve and switching at the wrong time.
Portfolios with higher offshore exposure have historically also presented with more volatile returns and, importantly, more extreme one-year negative returns. Year-on-year, these portfolio losses are magnified by fees and withdrawals. Although negative-return years are rare, one sharp drop in retirement savings invariably impairs future drawdowns.
Some living annuity holders prefer to invest conservatively in a low equity portfolio, either locally or abroad. Here, the exchange rate plays an even bigger role. Whereas the rand tends to moderate the return from international equities (strengthening when international equities do well and weakening when they are under pressure) it manifests or accentuates the performance (positive or negative) of defensive international assets. This increases the return volatility of low equity portfolios with high offshore exposure.
Such portfolios also recorded many more negative-return years. The 20/80 portfolio posted six ‘down’ years since 2001, compared with just one for the Reg 28 edition. Retirees looking for reliable, year-on-year positive returns would have been horrified.
Beyond that, we observe the same cyclical tendencies, sharp turning points and short-term trend reversals that make timing an offshore switch a game worth winning, but not a game worth playing.
Fig 2: Relative performance of a low equity portfolio (30% equity, 45% bonds, 25% cash)
Source: Dimson, Staunton and Marsh, DataStream, 10X Investments
This is not a case against a higher offshore allocation, but rather a caution that it is not a one-way bet. We advocate a gradual increase of international allocation for objective reasons only.
SA-sceptics may disagree and argue that the trend reversal in 2010 was unlike the others, in that it was gradual and tracked the slow, steady decline of South Africa during the Zuma years. But we should also look at what happened elsewhere, particularly the US, and ask whether the drivers of that outperformance – low interest rates, the level of quantitative easing and economic stimulus, and high valuations – are sustainable. No one knows.
What we do know is that just because it feels better to invest offshore does not mean it is going to be better.
The content herein is provided as general information. It is not intended as nor does it constitute financial, tax, legal, investment, or other advice.
