Risk-based supervision of the new Georgian pension fund

Transcription

1 Policy Briefings Series [PB/01/2019] Risk-based supervision of the new Georgian pension fund Dr Alexander Lehmann German Economic Team Georgia Berlin/Tbilisi, January 2019

2 Risk-based supervision of the Georgian pension fund 1. Pension fund diversification in Georgia 2. Allocation and returns in emerging market pension funds 3. Principles in pension fund supervision 4. Best practice for the investment policy document Requirements in Georgia under the Law The OECD principles and use of further discretion in supervision Specific instruments a. Quantitative investment limits b. Permissible investment instruments c. Risk measures d. Guarantees and other return targets 5. Case studies of pension fund supervision 6. Conclusions References 2

3 1. Pension fund diversification in Georgia 3

4 1. Pension fund diversification in Georgia The Law on Pension Savings envisages a defined contribution scheme that is mandatory for employees under the age of 40. Contributions will be jointly funded by employees, employers, and the state. Challenges in implementation: for the government: Despite limited financial literacy and variable asset returns enrolment will need to be sustained for older beneficiaries (who may opt out) and be made attractive for the self-employed (who may opt in). Employers need to be fully engaged in running the system (despite widespread informality) The political consensus on the budget funding for the DC scheme needs to be maintained, even though a traditional PAYG scheme is absent in Georgia and budget funding for the basic pension is limited for the NBG as pension supervisor: Under the Law there is a clear objective that fund allocation is to aim for return maximization. This objective needs to be safeguarded against claims for captive sources of domestic funding. Variable returns need to be explained to parliament and government, and to the public. Financial literacy in the field of pensions needs to be nurtured. A private fund management industry needs to be developed in a highly concentrated banking sector 4

5 Capital market development from pension fund investment Within the constraint of targeting sustainable retirement income and intergenerational equity, funded pension schemes can have secondary positive effects on capital market development: Pension accumulations provide a stable long term source of debt funding for domestic issuers, reducing term premium of debt, and facilitating corporate bond issuance. Pension funds provide risk capital where private equity activity is limited, as in Georgia. They are a captive and reliable demand for initial issuance, reducing volatility inherent in foreign funding that is prone to sudden stops fund managers exert a positive influence on corporate governance. and their specialist expertise will assist in developing alternative asset classes, such as private equity, infrastructure funds etc. 5

6 The experience in emerging markets has been more mixed, Funded pension scheme can boost local capital market development, though only if: Stability in the pensions regulatory framework sustains a reliable demand for local securities by institutional investors Fund industry regulation encourages equity investment as the asset class that is most likely to develop early There is good overall financial sector regulation, e.g. accounting, disclosure, corporate governance. The fiscal position does not deteriorate as costs from the transition from a redistribution (PAYG) to a funded system accumulate. 6

7 but in some emerging markets pension funds account for the majority of institutional investment Composition of total institutional investment Source: OECD survey on institutional investment,

8 The parameters of investment allocation under the Georgian Law (Art ) Low risk portfolio Medium risk High risk Cash and deposits < 75% <50% <25% Debt securities N.a. <75% <50% Equities <20% 20-40% 40-60% Other instruments <10% <10% Limit on fx instruments < 20% <40% <60% First five years: only low risk portfolio Investment horizon: min. 5 years for low risk portfolio. Longer for medium, and longer still for high risk portfolios (Art ). Additional fx and lari investment instruments may be permitted by the NBG (Art ). 8

9 But the potential flows into the three portfolios may quickly exceed market capitalisation within Georgia Market capitalisation, % of GDP 6.7 Georgia 49.9 Russian Federation Turkey Poland Slovenia Source: Bank for International Settlements, World Bank, IMF and capital market development strategy from the Ministry of Economy of Georgia and National Bank of Georgia; eop Projected cumulative inflows into the Georgian pension fund GEL bn Source: GET Georgia, based on ISET calculations. The present domestic bond and equity capitalisation is extremely limited, once allocations into the medium and high risk portfolios commence. This could result in destabilizing asset price cycles or compromise standards of issuer quality. 9

10 2. Allocation and returns in emerging market pension funds 10

11 There are only few emerging markets where private pension funds have become significant Total assets in funded and private pension arrangements, % of GDP, 2017 Selected OECD countries other countries Source: OECD, 2018, Pension markets in focus 11

12 Allocation by pension funds across asset classes Poland (1) Australia (2) Lithuania Belgium Chile Finland (3) France (4) Norway Estonia (5) Austria New Zealand United States (6) Ireland (7) Netherlands Switzerland (1,8) Canada (1,9) Iceland (10) Luxembourg Latv ia Denmark (11) Mexico Portugal Italy (1,12) Israel Sweden (13) Spain (1) United Kingdom Turkey Greece Japan (14) Hungary (1) Germany (15) Korea (16) Slovak Republic Slovenia Czech Republic Equity Bills and bonds Cash and deposits CIS (when look-through unavailable) Equity allocation widely different, given specific allocation restrictions, e.g. in Poland. Generally 20-30% in equity, even in well developed advanced countries. Bills and bonds generally in public securities, though private bond allocation can be significant (e.g. Latvia 11%, Slovak Rep. 32 % or Slovenia 22%). This may comprise bonds issued by state-backed enterprises. Other Source: OECD 12

13 Investment performance All but three of the 57 pension funds surveyed by the OECD showed positive real returns in Performance was better the higher the equity allocation Also over the longer 15 year period, real average annual net returns were positive in nearly all jurisdictions. Source: OECD 13

14 Drawing on private fund management expertise will diversify, and possibly improve on, public returns Real return of public vs private funds Source: OECD, 2015, Annual Survey of Large Pension Funds and Public Pension Reserve Funds 14

15 3. Principles in pension fund supervision 15

16 Pension fund supervision Pension funds do not generate significant systemic risk: No leverage. Borrowing only for short term liquidity needs, hence no multiplier effects in profits or losses. Long average duration of liabilities. Pension funds are the preeminent long-term investors. No risk of disruptive legal insolvency. Underfunding in defined benefit schemes will need to be resolved through adjustments in funding and entitlements. Very limited use of derivatives. In fact, pension funds are seen to be stabilizing the financial system: Pension funds tend to rebalance portfolios in response to adverse asset price developments. This counters the de-stabilizing behaviour of leveraged institutions like banks, which in times of stress tend to put more pressure on asset prices. Source: Beetsma et al. (2016) 16

17 Pension fund supervision Systemic risks can nevertheless materialize, from: Large exposures or correlated investment decisions in specific asset market segments (e.g. long-term asset types, such as infrastructure assets) Abrupt changes in the law or regulation lead to large asset reallocations, reduced inflows or withdrawals (e.g. Poland 2012) Adjustments in capital stock/drawdown entitlements that impact on disposable income and aggregate demand (Beetsma and Vos, 2016) 17

18 Risk-based supervision focuses the supervisor s limited resources on the greatest risks to financial stability, and system sustainability: Investment risk Returns at the point of retirement that are too low to fund adequate income will discredit the system, and could lead to abrupt regulatory changes with ramifications for the entire financial system, as happened frequently in central Europe. Overall investment risk in pension savings can be limited by adopting a risk averse strategy within the low-risk portfolio. The default enrolment respects the life cycle rule of reducing risk as retirement approaches. Pro-cyclical investment behaviour by participants destroys returns. Liquidity risk where participants have rights for opt out, early redemptions, or frequent switching Operational risks where private fund managers are involved Containing administrative costs should be a key focus to sustain returns and political acceptance of the DC scheme. 18

19 Implications for the NBG s pension fund supervision It will be important to build up public trust early on. The public is unlikely to tolerate much volatility. It is appropriate to restrict portfolio choice to a low-risk style initially. In the illiquid Georgian capital markets concentrated or correlated portfolios need to be avoided. Abrupt regulatory/legal changes could be destabilizing; political consensus around the system needs to be maintained. Investment risk should be the key consideration for the NBG as the supervisor of a defined contribution (DC) plan where members will ultimately have a some choice between funds of different risk styles. Medium and high risk portfolios will be offered after five years. Participants will then have the option to switch, possibly as often as once a year. Liquidity risk is a second consideration in Georgia s shallow capital markets, though there is limited scope for opt-out under the law. 19

20 4. Best practice for the investment policy document 20

21 Requirements in Georgia under the Law The investment policy document defines investment strategy and principles, used in adopting decisions related to management of assets (Art p) and is developed by the investment board (Art a) For each investment portfolio the investment policy document is to identify: investment objectives; strategic allocation; risk profile including investment horizon; and procedures for making investment decisions. NBG will inspect compliance with Art 27 (Art. 6 and Art. 27.7) Investment guidelines by the Investment Board will be approved based on the investment policy document for each of the three portfolios (Art ) Respective responsibilities of supervisory board and NBG need to be clearer But considerable scope remains to shape investment allocation within the law (Art , 18 and 19) 21

22 OECD Principles on investment and risk management The law seems to be in line with best practice as laid out by the OECD: Investment objectives need to be consistent with retirement income objectives, taking into account acceptable risk for beneficiaries (OECD Principle 4.6) The investment policy should identify the asset allocation strategy for the pension fund (the long-term asset mix across the main investment categories), the overall performance objectives for the pension fund or plan, and the means of monitoring performance. The investment policy should also identify when deviations from the asset allocation strategy and performance objectives can be tolerated (4.7) The investment policy should address whether, why, to what extent and how more complex and less transparent classes of assets, and investments in markets or instruments that are subject to limited governance or regulation, including alternative investments and derivatives, will be used. The investment policy should also address the appropriate extent of exposure to counterparty risk (4.8) 22

23 OECD principles A sound investment risk management process that supports the achievement of the investment objectives should be established. It should measure and seek to appropriately control portfolio risk and to manage the assets and eventual liabilities in a coherent and integrated manner (4.9). 23

24 The NBG is empowered to deploy the traditional instruments of pension supervision a. Quantitative investment limits Such limits complement the prudent person rule. They are the primary tool where there are only few pension fund managers. They should promote and balance the prudential principles of security, profitability, and liquidity pursuant to which assets should be invested (OECD principle 4.13); Enforcing quantitative limits to investment risk is a typical role for a pension supervisor; there should be an established procedure for correcting breaches within specified time limits (OECD 4.15). OECD survey of investment regulation of pension funds: Equity investments capped in most countries. The allocation limits under Art. 27 of the Georgian law are in line with those in other emerging markets. Restrictions on bond investment are less common, in particular for government bonds. 24

25 b. Permissible investment instruments There is a need for minimum credit rating of lari instruments in the portfolio (Pensions Law Art. 6.4b). This is sensible, given the limited capacity for independent risk analysis within the pension fund (OECD Principle 4.19). Most countries surveyed by the OECD forbid investment in real estate or private equity or loan funds. Monitoring of operational and governance risks in such investments is likely to be costly. The possible allocation into other instruments in Georgia s medium and high risk funds should not be utilized in the near future. Limitations on the overall share of foreign assets are common practice. There is no floor for this allocation in Georgia. Foreign equity should be limited to passive funds in advanced country markets. The limits on single-issuers in the Georgian law are also in line with international standards (these could be binding initially given the scarcity of instruments). 25

26 c. Risk measures Investment limits could be complemented, or substituted by, risk measures, such as VaR. This measures the maximum loss in a portfolio with a given probability at a certain point in time. This approach has been pioneered by Mexico. But in illiquid markets such as in Georgia, distribution of returns will be hard to quantify. And participants are still exposed to risks in the decumulation phase (of annuitization rates being unattractive). 26

27 d. Guarantees and other return targets Minimum absolute return requirements are rare, and require a solvency analysis of individual fund managers. Benchmarks based on equity and fixed income indices are common, and provide managers with a minimum performance target. They may result in a herding in these instruments (eg by Polish funds in the few liquid equities listed locally, Stewart, 2014). Novel approaches target a replacement rate at the point of retirement, and structuring portfolios around this (eg Impavido et al., 2009). This is not practical in an emerging market setting, eg due to the absence of inflation-indexed instruments. 27

28 5. Case studies of pension fund supervision 28

29 Poland: excessive regulation stifles competition One of the earliest pension systems, established in 1999, original contributions at 7.3% of gross wages Series of reversals : contributions reduced to 2.3%, then half of assets switched back into state system, banning gov. bonds entirely; participants needed to reconfirm continuing enrolment (only 15% did so). The supervisor enforced two regulatory requirements: limitations on asset allocation (very restrictive initially < 40% in shares, and < 5% foreign assets). guaranteed minimum rate of return, based on the average rate of return of all funds over the past years. Underperformance would need to be covered by a fund s own resources (introducing solvency risk to a DC scheme). This led to closely correlated portfolio allocations between the funds, limiting investment choices ( herding ). Also there was a predominant allocation into domestic, blue-chip equities (>80% of portfolios in 2016), where the funds controlled much of the free float. This high risk allocation (within a multi-pillar system) backfired following equity underperformance in

30 Performance of the Polish pension funds was highly correlated ND: source? 30

31 Lithuania: a liberal strategy Pension funds managed by licensed asset management companies (which hold other funds). Number and type of pension funds offered depend on demand (between 2 and 5 per company). Each fund governed by guidelines defined by the management company, which it may change without notice. A benchmark portfolio is presented to the supervisor. The management company documents performance relative to a target replacement rate, given a number of parameters, such as risk-free rates, correlations etc. There are no penalties for diverting from the benchmark. Hence a wide variety of styles are offered. One of the highest equity allocations in the OECD sample. 3.7% p.a. average annual real return over the past five years. 31

32 Armenia System in effect since 2014, controversial at introduction. About 200,000 participants, of which about 1/3 public sector employees. Private sector participants have not exercised right to opt out reform will expand participation to 280,000 by including younger participants. 98% of participants in conservative fund. Av. annual returns 11% in fixed income, 9% in conservative fund. Debate ahead of system introduction and recent expansion underlines need for broad social dialogue. Upcoming capital market strategy will widen asset choice. Source: Central Bank of Armenia. 32

33 6. Conclusions The key challenge for the NBG as the supervisor is to build early trust in the pension fund as a savings vehicle oriented towards long-term returns, in particular by limiting investment risk. Pension funds generally have a stabilizing influence in financial markets. Yet, in illiquid Georgian capital markets absorbing substantial inflows will be a challenge. Excessive volatility in returns, and pro-cyclical investment pattern by participants can undermine the credibility of the system. Abrupt regulatory/policy changes can then lead to financial system risks. It is sensible to remain in a low risk portfolio in the early years, and remain in simple, and cost-efficient instruments. This will be a predominantly domestic allocation, though within the constraints of the local capital market. 33

34 Conclusions: requirements for the investment policy document The parameters set in the law are in line with those applied to pension funds in other emerging markets; there is no need to become more restrictive. Benchmarks or other risk measures are not practical to monitor fund performance. The investment policy document should spell out an NBG policy on limiting investment risks in greater detail. Specifically: foreign allocation only in highly-rated bonds, or in passively managed equity funds; Restrictive requirements for credit rating of domestic securities, and additional requirements for corporate governance standards may be sensible; no authorization of additional instruments in the early years. The document needs to be remain under ongoing review, in collaboration with the supervisory board of the Agency. 34

35 References Ashcroft, J. and F. Stewart (2010): Managing and supervising risks in defined contribution pension systems, IOPS Working Paper no. 12. Beetsma, R., S. Vos, and C. Wanningen (2016): Systemic aspects of pension funds and the role of supervision, CESifo 4/2016. Impavideo, G., E. Lasagabaster, and M. Garcia (2010): New policies for mandatory defined contribution pensions. OECD core principles of private pension regulation, OECD (2018): Survey of investment regulation of pension funds. Stewart, F. (2014): Proving incentives for long-term investment pension funds: the use of outcome-based benchmarks. 35

36 Contact Dr Alexander Lehmann Niklas Dornbusch German Economic Team Georgia c/o BE Berlin Economics GmbH Schillerstraße 59, Berlin Tel: /