August 23, 2021

The investment future for medical schemes

By Marcus Rautenbach, Principal Investment Consultant

Medical schemes operate in a demanding environment. What is particularly challenging is the short time scale over which sub-optimal investment results translate into higher contributions required from members. This would reduce a particular medical scheme’s ability to offer competitive tariffs.

A further complication is the prevailing low interest rate environment. Medical schemes maintain significant cash and money market exposure as required by Regulations 29 and 30 in Annexure B of the Medical Schemes Act (No. 131 of 1998). Lower interest rates result in lower investment income for medical schemes.

Regulation 30 prohibits exposure to offshore equity, and constrains exposure to domestic equity to 40% of the market value of assets (unless a scheme has received exemption from the Registrar of Medical Schemes) while domestic property exposure is limited to 15% of the market value of assets.

Together, the low interest rate environment and constrained exposure to growth assets result in a narrow range of potential investment returns for medical schemes, namely approximately 2% to 3% p.a. above the prevailing inflation rate.

Medical schemes with greater exposure to cash and money market investments could experience pressure on their investment returns. While accumulated reserves and less demanding claim patterns (the effects of lockdowns and postponement of selective procedures) may provide some breathing space to these schemes, continued low interest rates could have an impact on these schemes, especially in the light of rising medical inflation (translating into negative real interest rates).

So, how can medical schemes improve their investment outcomes? Simeka’s survey of investment managers’ real (after-inflation) return expectations for the next five years provided some insight.

The survey shows that the expected after-inflation investment return for the next five years for a typical medical scheme fund (Regulation 30 composite) in June 2021 is 3.5% p.a. This compares to the 3.5% p.a. in the survey conducted in 2020 and is higher than the expected after-inflation return of 3.3% in the 2019 survey.

Expected after-inflation investment returns for the five years following from June:
Asset Class 2021 2020 2019
Local Equity 7.0% 6.4% 5.8%
Bonds – Nominal 4.0% 5.1% 3.6%
Bonds – Inflation 3.0% 4.2% 3.0%
Property 4.5% 6.7% 5.3%
Cash 0.7% 1.1% 1.6%
Off­shore Bonds -0.7% -1.8% -0.1%
Cash -0.5% -0.9% -0.1%
Regulation 30 composite* 3.5% 3.5% 3.3%
* Regulation 30 composite = 35% domestic shares + 20% domestic bonds + 35% domestic money market instruments + 5% global bonds + 5% global cash

The shifts in the expected returns for individual asset classes are important to note.

As the expected returns for domestic bonds and domestic cash are noticeably lower than in the 2020 survey, medical schemes with large exposures to domestic bonds and cash can expect to experience continued pressure on investment returns. The five-year expected after-inflation return for domestic bonds is 1.1% p.a. lower in 2021 than in 2020. As inflation is expected to remain between 4% and 5%, the reduction of 1.1% p.a. will have a meaningful impact on investment results. Similarly, the five-year expected after-inflation return for domestic cash is 0.4% p.a. lower in 2021 than in 2020. With the repurchase rate (repo rate) at 3.5% p.a., the reduction of 0.4% p.a. cannot be ignored.

Medical schemes that maintain higher exposure to interest-bearing investments may be affected more than others.

The five-year expected after-inflation return for domestic shares in the 2021 survey is 7.0% p.a., up from 6.4% p.a. in the 2020 survey and 5.8% p.a. in the 2019 survey. Simply put, if a medical scheme switches 10% of its investment exposure from cash to equity, it could expect an increase to its investment returns of approximately 0.7% p.a. over the next five years. In a low return environment, an extra 0.7% p.a. boost to a scheme’s investment returns could be meaningful.

Similarly, it is important to optimise a scheme’s equity exposure. Medical schemes have limited exposure to equity, either due to Regulation 30 or practical requirements (e.g. cash flow or reserve requirements). Therefore, it is all the more important to achieve optimal returns on a scheme’s equity exposure. Our approach is to introduce specialist equity funds to a scheme, in addition to its cash exposure and Regulation 30 complaint balanced funds.

What is the key take-outs?

  • The current average five-year (historical) investment return of Regulation 30 compliant funds is 6.7% p.a. and the inflation rate over the same five-year period is 4.7% p.a.
  • The average Regulation 30 compliant fund has outperformed inflation by 2.0% p.a.
  • Based on our analysis, we believe that medical schemes may be required to adopt a more focused approach to boost investment returns in the next five years, placing greater reliance on growth investments.
  • The National Health Insurance (NHI) scheme is likely to change the landscape in which medical schemes operate.
  • Medical schemes also may face additional challenges in a world of successive iterations of the coronavirus.
  • It just seems sensible to approach the future from as strong a financial position as possible