South African retirement fund regulation goes much further in encouraging ESG investing than jurisdictions such as the United States, making the country worth watching (as we saw at the recent Impact Investing Lawyers Working Group annual conference at New York University’s Grunin Centre for Law and Social Entrepreneurship).

The regulatory position of South African retirement funds on ESG investing attracted great interest at this conference, which highlighted the contrast in how ESG ‘fits’ into the regulatory framework for retirement funds in South Africa, compared with  the United States.
 
Purely financial perspective in US
The US regulatory regime governing private retirement plans makes no direct mention of ESG investment. Theoretically, the US federal pension regulator, DOL, does allow funds to consider ESG investments, provided these investments produce financial returns comparable to non-ESG investments. 

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In other words, US funds must approach investments from a purely financial perspective that emphasises maximum returns. As one US commentator noted, for ESG, that means they can take ESG factors into account if they believe it will maximise returns, but they cannot select investments based on social considerations – meaning ESG investing has to be done as a financial metric.

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Not surprisingly then, while an increasing number of individual plan participants and investors in the US might say they want to integrate ESG factors into their retirement portfolios, the numbers remain low.

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South African regulation is ESG-friendly by comparison.  ESG investments are specifically mentioned in the Pension Funds Act, Regulation 28, which states that ‘prudent investing should give appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund’s assets, including factors of an ESG nature’.
 
SA’s ESG-friendly regulation 
While regulation 28 does not compel ESG investing, it does oblige funds to consider ESG criteria when making investments. This requirement recently gained further substance when the South African Financial Sector Conduct Authority (FSCA) issued a guidance note on what retirement funds should be saying about ESG in their investment policy statements. 

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Significantly, the FSCA said funds holding assets that ‘limit’ the application of ESG factors should explain how this limitation is to the advantage of the fund and its members. Alternatively, the fund should spell out what it intends doing to correct the situation and, if no remedial action is planned, the reasons for this.

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Another difference is that, unlike in the US where retirement fund decisions must be strictly financially-based, South African regulation does not insist on maximising financial returns at all costs. In South Africa, the standard is not expressed as maximum financial return but as ‘adequate risk-adjusted returns’ suitable for a fund’s member profile, liquidity needs and liabilities, according to Regulation 28 of the Pension Funds Act.

This provision for ‘adequate’ rather than maximum returns does not mean South African funds are, or can be, any less diligent or rigorous than their American counterparts when it comes to investment decisions. 

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Regulation 28 does not compel ESG investing but it does compel inquiry, diligence and investment process in considering investments. Thus, there is no watering down of ‘classical’ definitions of fiduciary duty, which remains a common law question in South Africa. The difference is that there is a statutory basis in South Africa for defence of an investment strategy or decision that can be aligned to the principles of ‘adequacy’, ‘responsibility’ and ‘financial soundness’.
 
How SA funds can catch up with regulation
ESG considerations were first introduced into retirement fund regulation in South Africa in 2011 and have been incrementally strengthened, most recently in mid-2019 through the FSCA’s helpful guidance on how to integrate ESG con-cepts into retirement funds’ investment policy statements. 

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So far, though, the impact of these changes on the market has been relatively muted. Most of the ESG activity has been in the big public service funds, which can directly manage projects and holdings, tolerate illiquidity, dictate product development and achieve high-price entry points. Apart from the handful of big public sector funds with this kind of clout, few South African retirement funds can and do dictate their own investment philosophy on the investment market. 

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Most private funds still rely on external investment managers to determine their investment strategy and this limits their ESG exposure, as does the tendency for funds to ‘piggyback’ on listed investment portfolios and even private equity portfolios not designed for their long-term investment horizons, return expectations or liquidity needs.

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However, support for ESG investing is almost certain to grow in South Africa, given the supportive regulatory environment and the awakening of shareholder activism. Funds will undoubtedly find themselves giving more and more attention to ESG considerations and especially to ways of becoming more active in ESG investing.

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Collective investment could be well worth considering. On their own, few private funds have the ability to influence their investments, but collectively, they could make ESG investing a power to be reckoned with. 

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South Africa is already ahead of the norm in ESG investment regulation; now it is up to retirement funds themselves to take the ball and run with it. 

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Geral is Head of Banking and Financial Services Regulatory at Bowmans