Governance and Investment Management of Public Pension Funds Dimitri Vittas November 2008 1
Outline of Paper Types and Role of Public Pension Funds. Past Poor Record and Weak Governance. Recent Initiatives and Performance in Four OECD Countries. Lessons for Other Countries. 2
Types of Public Pension Funds Public pension schemes come in many varieties. Traditional public pension schemes are based either on flat universal benefits or on earnings-related benefits. Their main attraction is that they are defined-benefit schemes that are independent of asset returns and financial market performance. National provident funds are defined-contribution schemes where benefits depend on contributions and financial returns. The returns are often administered rather than market-based. In notional defined-contribution (NDC) schemes, benefits depend on contributions and administered imputed returns. Recent years have seen public pension funds that are based on contributions and market-based returns. 3
Role of Public Pension Funds Public pension schemes may be completely unfunded, partially funded, or fully funded. When they are partially or fully funded, they have the potential to benefit from low operating costs, emanating from scale economies and avoidance of marketing costs. However, this potential is often dissipated by poor asset management and operating inefficiencies. Their role varies considerably depending on whether they act as buffer funds for defined-benefit public schemes or operate as defined-contribution schemes based on individual accounts. This presentation focuses on the governance and management issues raised by the buffer funds for public pension schemes. 4
Poor Record In most countries, traditional public pension funds had a poor record of operating efficiency and asset management. They often suffered from bloated bureaucracies and highly deficient record keeping. Their asset returns were low because they were forced to invest in government bonds and housing loans at low nominal interest rates. In high inflation countries, real returns were often negative. Public pension funds in most countries in Latin America and Africa suffered a large erosion of their reserves, especially during highly inflationary times. But even in low inflation countries, asset returns were much below market levels and much below returns reported by private pension funds. 5
Weak Governance The main reason for the poor investment performance was weak governance. In most public pension schemes, directors were political appointees with little expertise and limited independence from government policies. Investment policies were stipulated in law and constrained the ability of pension funds to diversify their assets, invest in corporate equities and bonds, or in overseas securities. In many countries public pension funds were directed to invest in government bonds, housing loans or domestic assets, especially during difficult times. 6
Some Notable Exceptions In the US, the best known examples are CALPERS, the fund that covers public sector employees in California, and the Thrift Savings Plan (TSP), which covers employees of the federal government. In Canada, the Caisse de Dépôt et Placement du Québec (CDPQ) and the Ontario Teachers Pension Plan (OTPP) and, in Europe, the Dutch ABP (which covers civil servants) and the Danish ATP (which is a mandatory defined-contribution supplementary pension scheme) have also been notable exceptions. All these funds have adopted sophisticated and market-based investment policies and have achieved enviable records of high asset returns and low operating costs. 7
Effective or Notional Reserves Some public pension schemes are part of general government and invest in non-marketable government securities. Their holdings are excluded from published data on the level of the public debt. The reserves of these institutions are described as notional. Their ability to meet future benefits depends on the ability of the government to provide the necessary funds. Public pension funds that invest in marketable government securities are in principle in a stronger position but in reality their ability to meet future benefits depends on the solvency of the government and the liquidity of the government bond market. 8
Examples of Funds with Notional Reserves Cyprus: The Social Insurance Fund has accumulated reserves equal to 36% of GDP. These are not included in public debt, which is close to 60% of GDP. Including the SIF reserves would raise public debt to nearly 100% of GDP. Egypt: The social insurance institutions has notional reserves exceeding 40% of GDP. The administered rate has fluctuated from highly negative to highly positive. US: The Social Security Trust Fund has well over $2 trillion or about 15% of GDP. Including the notional reserves of the SSTF in public debt would raise its total to $12 trillion or about 80% of GDP. Notional reserves have been used to finance tax cuts or public spending or both. 9
Recent Initiatives in Public Pension Funds Faced with growing financial pressures arising from changing demographics, several countries have decided to modernize existing pension funds. Japan, Korea and Sweden have taken steps to remove or relax existing restrictions on the investment policies of their public pension funds. Other countries decided to create new public pension funds with substantial reserves to help finance the rising cost of public pensions. This presentation focuses on four such countries: Norway, Canada, Ireland, and New Zealand. 10
Norway I Norway s Petroleum Fund was created in 1990 but the first transfer of reserves was not effected until 1996. The basic objective is to manage excess oil revenues for future generations. The Petroleum Fund was renamed Government Pension Fund Global in January 2006 and is constrained to invest only in overseas assets. There is also a much smaller GPF Norway. There is no independent institutional structure for the GPFG. The fund is a government account with the central bank. The Ministry of Finance formulates investment policy and sets asset allocation strategy, subject to parliamentary approval. A fiscal rule, approved by Parliament, limits budget deficits to 4% of the value of the fund. An advisory council on investment strategy has been appointed. 11
Norway II Operational management has been assigned to the central bank. The central bank has a commercial mandate to maximize investment returns subject to the asset allocation strategy set by the Ministry. The central bank created a special management unit, NBIM, with its own salary structure. The central bank is required to observe full transparency and public accountability, maintain asset segregation and safe external custody, report quarterly and annually on performance, and have accounts fully audited. NBIM monitors closely the performance of external managers. Over time it has expanded internal active management and staff levels. 12
Norway III Total assets increased from 26% of GDP in 2000 to 83% in 2006. Despite its long investment horizon, the fund has adopted a conservative asset allocation. Initially it invested totally in bonds. After 1997, its allocation targets were 60% bonds and 40% equities. A recent decision aims to increase equity allocation to 60% and to consider alternative asset classes. Good investment returns; superior returns of internal over external managers. Low admin costs:10 bp. 13
Canada I New independent investment board, CPPIB, was created in 1998 as an autonomous entity outside general government. It is funded by CPP transfers following increase in contribution rates and small reduction in benefits as well as some privatization proceeds. First transfer was effected in March 1999. High level of public debt prevented budget transfers. Past sizable bond holdings of CPP were initially managed by the Federal Department of Finance but have now been transferred to CPPIB. Board of Directors is appointed by government from professionals selected by government-appointed nominating committee. Board appoints Chief Executive and supervises management team. Board sets investment policy and asset allocation strategy. 14
Canada II Commercial mandate to maximize investment returns with a prudent level of risk. Clear rules on public accountability and transparency, independence from government, governance guidelines and conflict of interest rules. Initial emphasis on external managers and passive investment approach, subject to some refinements. Early use of customized indexing to avoid exposure to index-dominating companies. Also, enhanced indexing to benefit from pricing opportunities (i.e., growing companies likely to be included in market index.) Over time, increased emphasis on active management, alternative asset classes and even principal investing to generate higher returns without increasing risk exposure. 15
Canada III Total assets of CPPIB rose from 0.2% of GDP in 2000 to 6.2% in 2006. Including past bond holdings, assets increased from 4.1% to 6.8% of GDP. CPPIB invested initially 100% in listed equities but lowered equity allocation to 53% by 2006 when fixed income amounted to 30%, alternative investments to 11%, and inflation-linked bonds to 4%. Growing focus on achieving excess returns. Large staff expansion. Involvement in private equity funds, infrastructure projects, even hostile buyouts. Increase in investment expenses. Increase in executive compensation. Effective insulation from politicians but exposure to managerial risk. 16
Ireland I A new fund and independent commission were created in 2000 to manage assets to meet the pressure of demographic aging. The National Pensions Reserve Fund (NPRF) is funded with annual government contributions (1% of GNP) and privatization proceeds. The NPRF Commission (NPRFC) consists of government appointed professionals with staggered terms. The National Treasury Management Agency was appointed as executive manager of the fund for 10 years. Irish public debt has been reduced substantially over time and now amounts to 20% of GDP. Selection of custodians and external managers follows strict EU procurement standards. Both safe custody of assets and close monitoring of the performance of external managers are ensured by proper use of sophisticated systems that complement the work of custodians. 17
Ireland II Total assets of NPRF rose from 6.6% of GDP in 2000 to 10.8% in 2006 (12.6% of GNP). The first transfer was effected in April 2001. In 2001 all assets were invested in cash but allocations to equities grew quickly and reached nearly 80% in 2005. Investments in bonds fluctuated around 15%, while recently investments in corporate bonds and alternative assets started to grow. External consultants helped determine asset allocation strategy. Much of the portfolio is passively managed but active management, and fees to external managers, are increasing. Investment income averaged 6.5% between 2001 and 2006 but with significant volatility from year to year. Operating expenses, mostly represented by fees to external managers, increased over time and amounted to 17 bp in 2006. The equity portfolio is equally divided between Europe and global, with a growing allocation in emerging markets. Investments in Irish equities are less than 1% of total assets. Investments in Irish government bonds are not allowed. 18
New Zealand I The New Zealand Superannuation Fund (NZSF) and the Guardians of the NZSF were established in October 2001. The objective of the fund is to smooth out the financial burden on the budget from the impact of demographic aging on the universal pension scheme. The NZSF is funded by annual government contributions. Public debt amounts to 14% of GDP. Transfers are set annually. The Board of Guardians consists of government-appointed professionals with staggered terms, following proposal by a Nominating Committee. The Board appointed a Chief Executive in March 2003. A small executive staff is assisting the Board in selecting external managers, custodians and auditors, and monitoring their performance. The Board hired external consultants to determine its asset allocation strategy. It emphasized the importance of investing in growth assets and risk diversification. 19
New Zealand II The first transfer of contributions was made in October 2003. Total assets rose from 2.7% of GDP in June 2004 to 6.3% in 2006. Allocations to local equities are limited to 7.5% of total assets. The basic allocation is 80% growth assets and 20% fixed income. A recent review concluded that investments in alternative assets should be raised to 35% of total assets. Alternative assets grew from 3% to 20% of assets in fiscal 2006. Over time there has a clear move away from the concept of manager of managers in favor of operational management in forestry, timber and other areas. Fund performance averaged 14.2% since inception and exceeded the risk-free rate by 8 percentage points. This was much better than the target excess return of 2.5%. Operating expenses rose to 71 basis points in 2006, of which 54 bp were investment manager fees. This reflects the increasing allocation in alternative assets. 20
Synopsis Except for Norway, the other countries have many similarities: Separate legal entity, outside general government; political insulation with professional boards and independent investment policies; long investment horizon. High level of transparency, public disclosure and public accountability. All started with strong emphasis on passive investment, small staff and external management; managers of managers. Early deviations: pragmatic transition, customized indexing, enhanced indexing, some active investment, some internal management. Growing emphasis on alternative asset classes (private equity, infrastructure projects, real estate, emerging markets); operational management of projects; involvement in principal investing, including hostile takeovers; leading role in private equity and infrastructure; active internal management and trading; large staff expansion; increased executive compensation. 21
22 Lessons for Other Countries
Preconditions Public pension funds should be established only if they can rely on regular transfers of funds and can operate with long investment horizons. Care should be taken to avoid a large level of public debt. The size of the public pension fund should not be too large relative to the national economy and the local financial markets. Global diversification should be encouraged. Countries, which already have public pension funds and seek to modernize their investment operations, should also address questions regarding their relative size and should consider changing other parameters to ensure that their public pension fund does not acquire a dominant position in the local economy and financial market. The ability to enforce high standards of fund governance is crucial to the success of the new approach to public pension fund management. 23
Objective and Legal Status Objective: The public pension fund should have a clear and unequivocal commercial mandate. The mandate should be to seek to maximize long-term investment returns, subject to a prudent level of risk, and after taking fully into account the structure of its liabilities and the length of its investment horizon. Legal Status: The public pension fund should ideally be established as a separate legal entity and not as a general government agency. This would imply that it should not be treated as a budgetary unit and its assets should be legally segregated from the general government. This would ensure that its reserves would not become notional. 24
Institutional Independence and Funding Sources Institutional Independence: The public pension fund should be independent from government and should be insulated from political interference. It should be required to operate with a very high level of public transparency and should be subject to full public accountability to Parliament and its main stakeholders. Funding Sources: The public pension fund should have access to stable and long-term sources of funding. Ideally, funding should be in the form of regular transfers either from the surplus of worker contributions over pension benefits or directly from the budget. Funding could be supplemented with ad hoc transfers from privatization revenues or other financial transactions. 25
Board of Directors The public pension fund should have a small board of experts (less than 10) rather than representatives of stakeholders or ex-officio appointees. There should be a sufficient number of directors with adequate expertise and experience on financial matters, investment policies and portfolio management. To ensure the appointment of high-caliber professionals, a nominating committee should be created to identify a short list of candidates from which the Minister of Finance would make director appointments. To promote continuity, director appointments should be staggered. Appointments should be for fixed terms and could be renewed for a stated number of terms (2 or 3), while removals should only be permitted for just cause. The process of director removal should be clearly stipulated in the relevant act. 26
Board Committees, Governance Policies and Internal Controls Board Committees: The Board of Directors should create several key committees with clear terms of reference and areas of responsibility. These should include an investment committee, an audit committee, a governance committee, and a compensation committee. Outside experts could be recruited to serve on these committees alongside board directors. Governance Policies: The Board of Directors should establish clear guidelines on corporate governance, including rules on conflicts of interest and ethical conduct by directors and senior managers of the fund. It should also establish clear policies on its role in promoting good practices of corporate governance in investee companies. These should emphasize transparency and public disclosure and full respect of shareholder rights. Internal Controls: The Audit Committee of the Board should establish clear policies on internal control systems and should especially institute a separation of investment decision making from back-office operations, such as confirmation and settlement of transactions, record keeping, and measurement and attribution of investment performance and risk. 27
Investment Policy and Strategic Asset Allocation I The Investment Committee could undertake the fundamental analysis of options but the Board of Directors should be responsible for approving the investment policy and asset allocation strategy. This should be based on the investment horizon of the fund and should take into account the structure of liabilities and risk tolerance of stakeholders as well as the expected returns and risk levels of different types of instruments. The strategic asset allocation should be subject to regular reviews and should be modified in the light of experience and changing market conditions. Performance measurement and benchmark portfolios should be determined by the Audit Committee but approved by the Board of Directors. 28
Investment Policy and Strategic Asset Allocation II Initially, passive investment in listed equities and bonds could be favored but over time consideration could also be given to active management and investment in unlisted securities, including alternative asset classes, such as private equity, real estate and infrastructure projects. Even with passive management, customized and enhanced indexing should be adopted at an early stage to mitigate risks and increase returns. In contrast, principal investing and assumption of managerial responsibilities in individual companies or projects should be avoided unless there are strong reasons and well-structured safeguards for such initiatives. 29
Executive Management The Board of Directors should have responsibility for appointing a Chief Executive Officer and approving the selection of top management, including a chief accountant, an internal auditor, and an actuary (if necessary). Alternatively, it could opt for appointing an external agency for the executive management of the fund. Executive management should specialize in managing long-term investment assets. It should employ staff with long experience and relevant skills in the markets in which the assets of the fund are to be invested. It should also recruit staff that is experienced in selecting, managing and monitoring the performance of external asset managers. Executive management should also develop sophisticated information systems to track the performance of asset managers. 30
Selection of External Service Providers The Board of Directors should be responsible for the selection and termination of various providers of external services, including a global custodian, a transition manager (if necessary), external asset managers, external auditors, and external consultants. Clear and detailed selection criteria should be adopted, while the performance of external asset managers should be monitored and evaluated by reference to well-constructed benchmarks that properly reflect the level of risk of particular assets. The Board of Directors should opt for using specialist external consultants in setting the asset allocation strategy and determining the selection criteria for other service providers. The appointment of a reputable global custodian is a particularly important decision because global custodians play a very critical role in the segregation and safekeeping of assets and in monitoring the performance of external asset managers. 31
Transparency and Public Disclosure The Board should abide by a very high level of transparency and public disclosure. It should publish audited annual financial statements, quarterly performance reviews as well as internal and external governance and other audit reviews. It should publish its investment policy objectives and all its corporate governance guidelines, conflict-of-interest rules and internal controls. Its chairperson should be required to report periodically to relevant Parliamentary committees. An external committee of experts should be appointed to review asset allocation strategies, performance measurement models, and executive compensation schemes to ensure that the investment policies of the fund promote the long-term interests of stakeholders. 32
Ongoing Challenges The preceding policy guidelines would create a sound framework for effective fund governance. If implemented successfully they would ensure insulation from political interference, although exposure to managerial risk would remain. Major managerial challenges would include five key issues: Whether and how to hedge the fund s liabilities? How aggressive should its investment policy be? How to measure its performance and risk exposure, especially if investments in illiquid assets are undertaken? What level of cushion to maintain to protect against large fluctuations in asset values and the emergence of a significant asset/liability mismatch? And how to determine executive compensation to discourage excessive risk taking while rewarding effort and innovation? 33