02
Content
The Public Issue of Private Pension Funds
UT
I
By Simon Drimer
1994’s Bestseller
n 1994, the world pensions industry came the closest it has ever come to having its own bestseller airport novel: “Averting the Old Age Crisis,” a report released by the World Bank, became the major touchstone for pension debate worldwide, and contained many criticisms of the fundamental bases for existing public pension schemes. “Averting” galvanised the pensions debate, introduced a common vocabulary and brought the retirement crisis into sharp focus. In order to meet this crisis, countries were warned they needed to reform their public pension systems. “Averting” proposed a recipe involving three pillars: a publicly managed mandatory first pillar to combat poverty, a privately managed mandatory savings second pillar (usually tied to employment) and a third voluntary savings pillar. The new orthodoxy in pensions policy established by “averting” was based on diversifying the retirement income streams across the three pillars. Most countries are now seeking to develop multi-pillar pension systems with a funded second pillar based on the employment relationship and a third pillar based on individual initiative. For the second pillar, there is frequently a debate on whether or not contributing to a funded system should be made compulsory. Since “diversification” in practice means moving into the second pillar, “averting” legitimised the establishment of private pensions to shore up retirement provisions. Most Asian countries, including Malaysia, have avoided the first pillar altogether. Malaysia’s EPF (Employees Provident Fund), a compulsory national provident fund, sits squarely on the second pillar. The areas of interest for Malaysia are the gap in the second pillar, i.e. a voluntary work-related pensions scheme, and the third pillar. It is the voluntary gap in the second pillar that is the focus of this paper: private pensions. It is now likely that the Malaysian government will introduce a private pensions regime for Malaysians in the coming few years. In this paper, we will use the three-pillar model established by the World Bank in 1994 as a framework, and consider developments in private pension systems in general and the Australian and Chilean pension models in particular. The pensions systems in these two countries are often used as reference points, and it is broadly accepted that both these models are robust and appropriate – although not without their problems. Since both the Australian and Chilean models have been in place for some time now, we are able to objectively consider their successes and failures, and see what guidance they might offer to Malaysia. We will also see what roles the unit trust industry in Malaysia might logically play in Malaysia’s private pensions industry.
Private Pension Systems
There is a universal trend towards greater privatisation of retirement income. 1
This is occurring through explicit privatisation of social security and through legislative cutbacks in the generosity of social security benefits. Chile has almost entirely privatised its system of retirement income, and other countries have adopted partial versions of its system. Countries differ in the role of the private system (the second pillar) in retirement provision. In some countries, private pensions are voluntary, offering a small supplement to state pensions. In others, private pensions are the backbone of the retirement. Apart from occupational pension plans, complementary pensions may be organised as personal pensions. Here the individual contracts directly with the pension fund company and affiliation to the pension plan does not usually depend on continued employment with a particular employer, and the employer may have no involvement in the plan. Traditionally, private pension plans in OECD (Organisation for Economic Cooperation and Development) countries have been established by employers and promised workers a defined benefit based on final salaries (i.e. there was certainty as to the amount paid out as a pension, as opposed to defined contribution, which made the pension amounts a function of the contributions and investment performance and tax). In many countries however, these defined benefit schemes have been converted to defined contribution schemes where the investment risk, rather than lying with the pension fund, lies with the individual (similar to the operation of unit trusts, or unit-linked life insurance policies). The earliest and simplest form of complementary pension schemes involved employers making continued payments to employees once they had retired. These informal arrangements were then given substance in employment contracts, and also accounting standards, which required companies to recognise their liabilities. Many countries have gone a step further in protecting the employees’ entitlements to pension money and require employers to establish a segregated fund of invested assets, which is either held in a separate legal entity or effectively ring-fenced. The development of complementary private schemes would be viewed by the Malaysian Government as desirable in a number of ways: • • • • They help to spread the risks across a range of types of pension provision They can play a role in helping the development of more stable and liquid capital markets They may help individuals to identify more clearly with their accumulating pension “wealth” and to feel a sense of ownership of the underlying assets They can redress the weaknesses of the EPF
Let us now turn to perhaps most well-known private pensions model (though it is not complementary to anything): the Chilean model.
The Chilean Model
One of General Augusto Pinochet’s more positive and constructive legacies for the Chilean population was the privately administered pension system his government implemented in 1981, since viewed as a worldwide role model for private pensions. The mandatory individual account pension systems pioneered by Chile have now become the predominant system in Latin America and central and eastern Europe, and are looked upon with envy by countries seeking to diversify into private pensions. The Chilean Pension Savings Account (PSA) model is one of the more functional pension models in the world, and it contains many elements that are worth studying. The Chilean PSA system is essentially a mandatory second pillar with defined contributions – there is no first pillar in Chile. Neither the worker nor the employer pays a social security tax to the state, and 2
nor does the worker collect a government-funded pension. Instead, during his working life, the worker automatically has 10 percent of his wages deposited by his employer each month into his own, individual PSA. There are seven administration companies Administradoras de Fondos de Pensiones (AFPs) and each AFP operates the equivalent of a unit trust that invests in stocks and bonds. Investment decisions are made by the AFP – i.e. the investor has no discretion. Government regulation sets only guidelines and maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio. There is no obligation whatsoever to invest in government or any other type of bonds (contrary to popular belief). These companies can engage in no other activities and are subject to government regulations intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud. Self-employed workers are not compelled to enter the pension system but they can voluntarily adhere to any AFP, while army and police personnel are excluded from the system because they have their own pension scheme. A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a kind of voluntary savings scheme. At retirement, workers use the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers make programmed withdrawals from their accounts, and the amount of those withdrawals depends on the worker’s life expectancy and those of his dependents. Workers are free to change from one AFP company to another and for this reason there is, in theory, competition among the companies to provide a higher return on investment, better customer service or a lower commission. In practice, however, all the competition is around service. The Chilean pension model has had enormous impact both domestically and across the world. There is now more than 95 percent coverage of the Chilean economically active population, and pension savings are now equivalent to more than 65 percent of Chilean GDP (gross domestic product). The financial sector has also benefited enormously from the development of the PSAs. While there were initially restrictions on investments, these have now been progressively eased: there is not the same degree of investment in government bonds as is seen in other Latin American countries’ pension systems. Investment returns have also been good: the average rate of return net of administrative costs for the average retirement savings account has ranged between 7.0 and 7.5 percent over the past 20 years. But there have been some problems … Costs are still high (but declining), although not as high as they have been made out to be. In effect, the annual
cost to PSA members as a percentage of assets under management is in the order of 1 percent. Alarming cost figures have been presented, but these are usually expressed as a percentage of contributions. Members of the PSAs also lack discretion as to how their money is invested and there is also plenty of switching from fund to fund, as a result of intensive marketing activity by the PSAs. This switching is a result of the regulatory constraints that operate on the PSAs around pricing and investment returns: the funds must make good any deviance of more than two percentage points from the industry average and this encourages the PSAs to cluster together, herd-like, in their investment strategies.
And the rest of Latin America …
The Chile model has strongly influenced surrounding countries in Latin America, and the Latin American countries are at the forefront of global pension reform. Eight have reformed their pension systems in the past 20 years, and additional reforms are now being considered throughout the region. Overall, the experience in Latin America has been positive, with some qualifications. Many Latin American countries have followed the Chilean model. Although reforms have differed across countries, most countries abandoned all or a significant part of their public social security systems in favour of privately managed, individual-account-based, definedcontribution, funded systems (similar to the 401(k) plans in the United States, with the difference that they 3
are mandatory) largely along the lines suggested in “averting.” The reformed systems have shown success on a number of measures: volume of assets under the management of the private pension funds, gross returns, and number of participants. There have been a number of economic and labour market benefits to the host countries attributed to the pension reforms, and the privatised pension systems have been the driving force behind financial sector reforms. But there have been problems of course. Some of the problems are Chilean problems intensified, some are new. Latin American pension schemes tend to be: • • • • • • low coverage poorly diversified poor in investment performance low on member choice flawed in performance measures high cost
make intelligent and well-informed decisions. Giving contributors more types of investments to choose from should be combined with educating them about the importance of saving, investment diversification, and the power of compounding over time. Flawed measurement of fund performance Currently, fund performance assessments are based on comparing the return of one fund with the average return of all funds in the pension system. With a growing concentration of pension fund assets in a few funds in most countries, such regulation creates incentives for funds to “herd” around the leaders and hold portfolios that are nearly identical to each other and yield similar returns, thereby narrowing the choices available to contributors. Using the pension industry’s average performance as a benchmark skirts the crucial issue of how well the benchmark itself is performing, compared with other investment opportunities. High costs
Low coverage The Latin American pension systems cover only a fraction (about one third) of the economically active population – thus many people are not provided for. These systems are mostly accessible only to formal sector workers, and only a fraction of these actually contribute, even though many workers are affiliated with the new systems. Therefore, many Latin Americans are still not covered by a formal system of retirement income security. Note the selfemployed in Malaysia, who are left out of the EPF. Poor investment diversification Poor diversification is usually a result of tight investment restrictions. Relaxing regulations on asset allocations by pension funds increases the possibilities for diversification, reduces risks, and usually increases returns. Most Latin American funds are still, many years after inception, heavily invested in government bonds (in the order of 7080 percent). A more balanced portfolio of domestic and international assets (including equities) would provide greater opportunities for wealth creation and permit further development and strengthening of financial and capital markets, one of the stated objectives of pension reform. Low on member choice Contributors to private pension systems in Latin America have little choice in terms of the portfolio allocations that might be best for their stage of life or for their risk preferences. At present, in most Latin American countries, each fund manager offers only one fund to all contributors (and the holdings and returns of most funds are similar), whereas, outside Latin America, the trend in definedcontribution systems is to allow workers to tailor their portfolios to their individual needs. Of course, increased choice does not automatically enable contributors to 4 Most Latin American pension systems have high cost structures: commissions, which, in most pension funds, are based on contributors’ wages and charged up front for the life of the contribution, are higher in Latin America than elsewhere. The way commissions are structured, combined with the erratic work history of the typical contributor, affects poorer workers disproportionately. Lowering administrative costs will require some basic changes in most countries’ pension funds – for example, from some current models where both collection and management of assets have been decentralised to models with centralised collection. However, centralisation requires improved governance, better regulation, and reduced political interference. The overall conclusion is that second pillar is probably too prominent in Latin America, and should be scaled back, freeing resources into the third pillar (voluntary savings). This would bring competition into the oligopolistic pension fund industry, reducing costs and improving transparency. The World Bank has concluded that there is also a need to build up the first pillar – a public safety net to prevent poverty in old age.
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With a growing concentration of pension fund assets in a few funds in most countries, such regulation creates incentives for funds to “herd” around the leaders and hold portfolios that are nearly identical to each other and yield similar returns, thereby narrowing the choices available to contributors.
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Australia
Australia has a fully liberalised, three-pillar system and there is considerable determination to encourage the second pillar to relieve the first. The first pillar is a universal old age pension, means tested on the basis of assets and income. The second pillar (superannuation) consists of an obligatory 9 percent of salary paid into a defined contribution fund (usually – although some defined benefit funds are still in existence). This 9 percent is tax advantaged, as are additional voluntary contributions (third pillar). There is considerable choice as to how each individual’s pension money is invested, and by whom, and the vehicle can be either an occupational pension scheme or a personal pension. Most employers now operate defined contribution schemes, either as separate employersponsored arrangements, or under centralised master trusts. Premature use of pension savings is rigorously discouraged in Australia’s superannuation system. Costs are reasonable by international standards: the average fee level in Australia is 1.3 percent of assets annually, but there is considerable variation between types of funds (from 0.6 percent for government, corporate and industry funds to about 3.5 percent if a high cost retail master trust structure is being used). Within Australia, there is likely to be increasing focus and resentment towards those operators at the higher end of the range, in the lead up and wake of the introduction of Choice of Fund in June this year. By any measure, the Australian superannuation system has been hugely successful, and is a major reason why Australia now has the fourth largest fund management industry (by assets) in the world – a startling fact considering Australia only has 20 million people. Australia ranks first (best) in the “Ageing Vulnerability Index.”1 The current trajectory of worker contributions shows that most people in Australia will not be able to provide fully for their retirement, nevertheless superannuation has broken the back of the retirement income problem. There are some negatives in the Australian system however: • The superannuation regime, particularly taxation rules, is extremely complex and this complexity has created dependence on a large and relatively expensive financial planning industry. While Australian investors are relatively 5
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financially sophisticated, there is still insufficient understanding of portfolio theory and risk/return relationships, and most superannuation investors park their funds in unnecessarily conservative asset portfolios. Integration of the superannuation system (the second pillar) with the old age pension (the first pillar) is poor.
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Source: Centre for Strategic & International Studies
Singapore’s CPF
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Before we move onto the lessons learnt from these major international privatised pension systems, it is worthwhile also considering some lessons learnt from the CPF (Central Provident Fund), across the Causeway. The CPF suffers principally from: • • • Ability of members to access their savings early in life Poor investment performance (due largely to asset class restrictions and conservative investment philosophies) Opaque management and disclosure
IS, but private sector fees are still opaque and too high. Returns on CPF-IS products have been poor, partly due to investment conditions, and partly due to high costs: CPF assets experienced a zero real return from 1987 to 1997. In addition, the annuity market is highly inefficient. On the plus side, there is a good financial education programme attached to the Singapore CPF, and good coverage of employees. Of interest are the proposed changes in Singapore. The CPF Board proposes far-reaching changes, in particular the introduction of Privately-managed Pension Plans (PPPs) under centralised administration. The proposal is for one Master Administrator and multiple Plan Providers. Plan structures will entail simple, low cost, no front-end charges, annuity facilitation, regular savings emphasis. Distribution will be through banks, brokers, insurance companies, IFAs, and investment administrators. Thus the CPF Board will effectively insert a simple and low cost private investment option between CPF savings and retail products.
Creating a single mandatory savings pillar instead of constructing a multi-tier system has resulted in an inadequate, and inequitable system of financing retirement. In Singapore, initial efforts at allowing choice and flexibility within the CPF – the Enhanced Investment Scheme – saw massive mis-selling by life insurance agents. The worst abuses have been removed in CPF-
Malaysia
The primary pension savings vehicle in Malaysia is the Employees Provident Fund (EPF), which is firmly rooted within the second pillar. It is generally accepted that retirement funds accumulated through the EPF, alone, will be insufficient to safeguard retirement financial needs for most people. Its primary responsibility is to ensure that its members have financial security in their old age in the form of adequate savings to support their retirement. While the EPF has a high coverage rate (more than 95 percent, although this does not include self-employed), there are a number of reasons why the EPF is not fulfilling, and will not fulfil, this promise: • • • • The relatively young age at which funds are accessible The nature of the access to funds The segregation of contributions into dedicated accounts (housing, health, retirement – all with the same investment approach) The poor investment performance of the EPF funds (around 4 percent for the past 30 years – this low figure due largely to restrictions: at least 70 percent in government securities, no offshore assets) The EPF has also had opaque management/ investment strategies and limited autonomy, hidden risks and liabilities of itself – diversifying retirement income streams and also in the context of the Capital Market Master Plan: building a private pensions system outside the EPF will improve diversity, stability and liquidity of Malaysian investment markets.
Lessons Learnt
We learn a number of lessons from the experience of other countries that have gone before Malaysia in private pensions, and this brings us to some possible prescriptions for Malaysia. The first three are very important: Offshore investments Whatever system is put in place for Malaysia’s private pensions, the investment regime must be more liberal than the one governing the EPF. The conservative approach to investment of the EPF may limit the stress on investors’ nerves but it does little for the fund balances of Malaysian citizens at the point of retirement. Appropriately diversified, and risky, investments, combined with proper education and understanding of Malaysian investors about the risk/return tradeoff, will combine to dramatically improve retirement balances through the benefit of compounding of returns. Appropriate diversification will entail offshore investments, particularly in equities, and the Malaysian government’s relaxation of investment constraints, which are currently shored up by misinformed views about volatility and risk/ return, must be treated as a high priority. Any Malaysian citizen with a time horizon longer than 15 years should be investing in a diversified portfolio, which includes a high percentage of international equities, unless they have an unusually timid approach to risk. The Chilean pensions model allows portfolio diversification, and largely through investments in overseas markets (now approximately 30 percent of all pension funds) investment returns for PSAs have been healthy (7-7.5 percent real, net of fees, over the past 20 years).
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The Malaysian Government is considering the introduction of private pensions to supplement the EPF. Any supplementary pension system in Malaysia is likely to reside outside the EPF, for the following reasons: • • • 6 The self-employed are not currently covered by EPF (one quarter of population) EPF’s investment policy is too conservative and low-yielding A private pensions system is a worthy end in and
Investment vehicle Pension providers should clearly be grounded in funds management activities. Our bias in writing this article for this particular publication does not need to be declared: of course we see a significant role for the Malaysian unit trust industry in managing private pensions. In many other countries, particularly developed ones, the unit trust/fund management industry would have the pre-eminent position and entitlement to managing pension money. In many Asian countries, however, the entanglement of life risk protection with savings vehicles (whole of life policies, for example), combined with a dominant distribution channel (tied insurance agents), has put life insurance companies in the box seat for the major role. And in Malaysia specifically we see a particular prejudice against the unit trust industry, which we have not seen elsewhere in our travels. We would like to point out here that life insurers are not the natural owners of the pension fund management mandate. The pure fund managers – i.e. unit trust companies and institutional fund managers – have a more obvious entitlement. In Malaysia the unit trust industry has had some negative press in recent years through poor performance and volatility. This is not an indictment of the unit trust vehicle itself, but more on the investment constraints the industry operates under: an illiquid and small domestic market, and inability to invest sufficiently (and therefore
diversify) in overseas investments. The Malaysian lay person’s suspicion (and the government’s suspicion, apparently) over international bond and equity markets, and the apparent lack of understanding about risk/return relationships and appropriate diversification, creates a dangerous situation when policy is being made about retirement provision. It is true that the current fee levels in the Malaysian unit trust industry are likely to be an issue with any pension provision role, although not as much of an issue as the fee levels in the life insurance industry will be for life insurers. Fees must come down. Centralisation & Administrative Efficiency We do not believe that centralisation is necessary, these days, for administrative efficiency. The traditional view has been that decentralisation almost guarantees inefficiency and high fees. This is not the case. We recently performed a strategic review for a large (US$3 billion assets under management, 250,000-member) government superannuation fund in Australia. As part of the work programme, we studied the efficiency of the administration function within superannuation funds. This is what we found.
Administration Service Companies & Government Fund DC Schemes – Administration Costs The solid circles are government pension funds that perform their own administration, and the hollow circles are third party administrators. This chart reveals two important facts: • There are indeed scale economies in the administration function in Australian superannuation. It is highly likely that all across the world, in the pension administration function, there are scale economies, but the curve for each industry and probably even category of business within each industry, will be different depending on a number of factors including the level of technology development in that industry and the availability of third party administrators. The presence of third party administrators means that small pension funds (and therefore their members) can also ‘capture’ economies of scale, albeit after a profit margin for the third party administrator is extracted. In the chart above, a number of relatively small funds have chosen to insource the administration function, and have suffered from lack of scale as a consequence.
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It is no longer the case that privately managed individual accounts lose the economies of scale of a publicly managed scheme. Through aggregation/pooling, scale economies can be partially regained at least. In addition, a system with multiple individual account managers is likely to give more satisfaction to members (from the improved service they are expected to receive and through the choices which the system lets them make). Scale economies are important, but just how important depends on the level of technology development in each industry (for example, use of master trust platforms); which part of the value chain we are talking about (for instance, administration, custody services, asset management); the
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extent to which outsourcing companies are operating in the industry (for example, third party administrators for pension fund administration); and the ability within the industry to aggregate/pool assets and accounts to achieve scale (for example, mezzanine wholesale investments) So the key point here is that centralisation of administration is one, but not the only, way to achieve economies of scale. Participation Mandatory participation is one obvious way to underwrite high coverage rates, particularly for sectors of the workforce not currently covered by the EPF (for example, the selfemployed), so that those individuals who are currently excluded, such as the self-employed, are covered. However it is not clear whether there are currently adequate incentives for the self-employed to comply, and enforcing compliance is administratively expensive and difficult. There are other levers that can be pulled though, such as lowering barriers to participation in private pensions, education of workers about the necessity of saving for retirement, creating the conditions for improved investment performance, and setting of minimum benefit guarantees. If the second pillar is voluntary, strong inducement should be given to employers to set up externally funded occupational pension schemes, as this is the most effective way of increasing coverage. Tax benefits and subsidies are likely to be a necessary feature of any voluntary scheme. Employer-sponsored pension funds are generally more efficient and help to lower the transaction costs and administrative overheads. Individual accounts require a great deal of regulation, however. Disclosure This alone is not sufficient to contain costs and abuses, if investors are unable to fully understand what is being disclosed: high distribution and administration charges will swallow people’s savings, and disclosure must be complemented with healthy competition, investor education and perhaps constraints on providers. Investor Choice Providing options is dangerous without proper education:
People do not exercise choice rationally, and default investments should be steered into wholesale options with appropriately aggressive risk profiles. Choice is expensive and requires financial education and disclosure. In Australia, there is considerable individual empowerment but general apathy over people’s retirement savings, to such an extent that default asset allocations are important. Consumer Protection This has become more important in recent years, and is a greater imperative with individual accounts where there is more opportunity for abuse. In Latin America some convoluted consumer protection measures have resulted in high marketing costs and frequent switching between funds, investment performance guarantees (for instance, as in Chile, where fund managers must make good any significant deviation from their peer group) and limits on expense charges (for example, stakeholder pensions in Britain). There are many opportunities for mis-selling with individual pension accounts (witness the British experience). Administration Costs Market forces will not necessarily contain administration costs, and centralisation is not a necessary condition for efficiency (see previous discussion). Fees This is a thorny problem, and we do not believe it has been given the prominence it deserves among pension policy makers. The “miracle” of compound interest can work against the investor as much as for him. Over a 30-year investment period, annual fees of just 2 percent of assets will reduce the final retirement balance by 4045 percent (compared to no fees at all; or alternatively, a comparable situation is 4 percent annual fees as against 2 percent). These dramatic compounding effects apply just as equally to low investment performance: achieving 4 percent return each year for 30 years, when a higher risk profile could have achieved 6 percent each year, results in a retirement balance that is also 40-45 percent lower than would have been the case otherwise. Pension plans are investing increasingly in foreign securities. Regulations inhibiting foreign pension investments are being relaxed across the globe (see previous discussion).
Conclusion
It strikes us, looking in from the outside, that there is a golden opportunity here for the Malaysian Government in reforming the pension system to make the sort of bold, progressive strides that former Prime Minister Tun Dr Mahathir Mohamed was encouraging in Malaysia most recently. Private pension reform seems to us to be a relatively simple way for Malaysia to become an admired benchmark across the globe, as well as achieving the happy outcome of shoring up the population’s retirement security. Let us hope that economics, not politics, plays the most important role in the reform process. UT _____________________________________________________________________________________________ The writer is the principal consultant of Singapore-based NMG Financial Services Consulting. 8
UT
I
By Simon Drimer
1994’s Bestseller
n 1994, the world pensions industry came the closest it has ever come to having its own bestseller airport novel: “Averting the Old Age Crisis,” a report released by the World Bank, became the major touchstone for pension debate worldwide, and contained many criticisms of the fundamental bases for existing public pension schemes. “Averting” galvanised the pensions debate, introduced a common vocabulary and brought the retirement crisis into sharp focus. In order to meet this crisis, countries were warned they needed to reform their public pension systems. “Averting” proposed a recipe involving three pillars: a publicly managed mandatory first pillar to combat poverty, a privately managed mandatory savings second pillar (usually tied to employment) and a third voluntary savings pillar. The new orthodoxy in pensions policy established by “averting” was based on diversifying the retirement income streams across the three pillars. Most countries are now seeking to develop multi-pillar pension systems with a funded second pillar based on the employment relationship and a third pillar based on individual initiative. For the second pillar, there is frequently a debate on whether or not contributing to a funded system should be made compulsory. Since “diversification” in practice means moving into the second pillar, “averting” legitimised the establishment of private pensions to shore up retirement provisions. Most Asian countries, including Malaysia, have avoided the first pillar altogether. Malaysia’s EPF (Employees Provident Fund), a compulsory national provident fund, sits squarely on the second pillar. The areas of interest for Malaysia are the gap in the second pillar, i.e. a voluntary work-related pensions scheme, and the third pillar. It is the voluntary gap in the second pillar that is the focus of this paper: private pensions. It is now likely that the Malaysian government will introduce a private pensions regime for Malaysians in the coming few years. In this paper, we will use the three-pillar model established by the World Bank in 1994 as a framework, and consider developments in private pension systems in general and the Australian and Chilean pension models in particular. The pensions systems in these two countries are often used as reference points, and it is broadly accepted that both these models are robust and appropriate – although not without their problems. Since both the Australian and Chilean models have been in place for some time now, we are able to objectively consider their successes and failures, and see what guidance they might offer to Malaysia. We will also see what roles the unit trust industry in Malaysia might logically play in Malaysia’s private pensions industry.
Private Pension Systems
There is a universal trend towards greater privatisation of retirement income. 1
This is occurring through explicit privatisation of social security and through legislative cutbacks in the generosity of social security benefits. Chile has almost entirely privatised its system of retirement income, and other countries have adopted partial versions of its system. Countries differ in the role of the private system (the second pillar) in retirement provision. In some countries, private pensions are voluntary, offering a small supplement to state pensions. In others, private pensions are the backbone of the retirement. Apart from occupational pension plans, complementary pensions may be organised as personal pensions. Here the individual contracts directly with the pension fund company and affiliation to the pension plan does not usually depend on continued employment with a particular employer, and the employer may have no involvement in the plan. Traditionally, private pension plans in OECD (Organisation for Economic Cooperation and Development) countries have been established by employers and promised workers a defined benefit based on final salaries (i.e. there was certainty as to the amount paid out as a pension, as opposed to defined contribution, which made the pension amounts a function of the contributions and investment performance and tax). In many countries however, these defined benefit schemes have been converted to defined contribution schemes where the investment risk, rather than lying with the pension fund, lies with the individual (similar to the operation of unit trusts, or unit-linked life insurance policies). The earliest and simplest form of complementary pension schemes involved employers making continued payments to employees once they had retired. These informal arrangements were then given substance in employment contracts, and also accounting standards, which required companies to recognise their liabilities. Many countries have gone a step further in protecting the employees’ entitlements to pension money and require employers to establish a segregated fund of invested assets, which is either held in a separate legal entity or effectively ring-fenced. The development of complementary private schemes would be viewed by the Malaysian Government as desirable in a number of ways: • • • • They help to spread the risks across a range of types of pension provision They can play a role in helping the development of more stable and liquid capital markets They may help individuals to identify more clearly with their accumulating pension “wealth” and to feel a sense of ownership of the underlying assets They can redress the weaknesses of the EPF
Let us now turn to perhaps most well-known private pensions model (though it is not complementary to anything): the Chilean model.
The Chilean Model
One of General Augusto Pinochet’s more positive and constructive legacies for the Chilean population was the privately administered pension system his government implemented in 1981, since viewed as a worldwide role model for private pensions. The mandatory individual account pension systems pioneered by Chile have now become the predominant system in Latin America and central and eastern Europe, and are looked upon with envy by countries seeking to diversify into private pensions. The Chilean Pension Savings Account (PSA) model is one of the more functional pension models in the world, and it contains many elements that are worth studying. The Chilean PSA system is essentially a mandatory second pillar with defined contributions – there is no first pillar in Chile. Neither the worker nor the employer pays a social security tax to the state, and 2
nor does the worker collect a government-funded pension. Instead, during his working life, the worker automatically has 10 percent of his wages deposited by his employer each month into his own, individual PSA. There are seven administration companies Administradoras de Fondos de Pensiones (AFPs) and each AFP operates the equivalent of a unit trust that invests in stocks and bonds. Investment decisions are made by the AFP – i.e. the investor has no discretion. Government regulation sets only guidelines and maximum percentage limits both for specific types of instruments and for the overall mix of the portfolio. There is no obligation whatsoever to invest in government or any other type of bonds (contrary to popular belief). These companies can engage in no other activities and are subject to government regulations intended to guarantee a diversified and low-risk portfolio and to prevent theft or fraud. Self-employed workers are not compelled to enter the pension system but they can voluntarily adhere to any AFP, while army and police personnel are excluded from the system because they have their own pension scheme. A worker may contribute an additional 10 percent of his wages each month, which is also deductible from taxable income, as a kind of voluntary savings scheme. At retirement, workers use the funds accumulated in their accounts to purchase annuities from insurance companies. Alternatively, workers make programmed withdrawals from their accounts, and the amount of those withdrawals depends on the worker’s life expectancy and those of his dependents. Workers are free to change from one AFP company to another and for this reason there is, in theory, competition among the companies to provide a higher return on investment, better customer service or a lower commission. In practice, however, all the competition is around service. The Chilean pension model has had enormous impact both domestically and across the world. There is now more than 95 percent coverage of the Chilean economically active population, and pension savings are now equivalent to more than 65 percent of Chilean GDP (gross domestic product). The financial sector has also benefited enormously from the development of the PSAs. While there were initially restrictions on investments, these have now been progressively eased: there is not the same degree of investment in government bonds as is seen in other Latin American countries’ pension systems. Investment returns have also been good: the average rate of return net of administrative costs for the average retirement savings account has ranged between 7.0 and 7.5 percent over the past 20 years. But there have been some problems … Costs are still high (but declining), although not as high as they have been made out to be. In effect, the annual
cost to PSA members as a percentage of assets under management is in the order of 1 percent. Alarming cost figures have been presented, but these are usually expressed as a percentage of contributions. Members of the PSAs also lack discretion as to how their money is invested and there is also plenty of switching from fund to fund, as a result of intensive marketing activity by the PSAs. This switching is a result of the regulatory constraints that operate on the PSAs around pricing and investment returns: the funds must make good any deviance of more than two percentage points from the industry average and this encourages the PSAs to cluster together, herd-like, in their investment strategies.
And the rest of Latin America …
The Chile model has strongly influenced surrounding countries in Latin America, and the Latin American countries are at the forefront of global pension reform. Eight have reformed their pension systems in the past 20 years, and additional reforms are now being considered throughout the region. Overall, the experience in Latin America has been positive, with some qualifications. Many Latin American countries have followed the Chilean model. Although reforms have differed across countries, most countries abandoned all or a significant part of their public social security systems in favour of privately managed, individual-account-based, definedcontribution, funded systems (similar to the 401(k) plans in the United States, with the difference that they 3
are mandatory) largely along the lines suggested in “averting.” The reformed systems have shown success on a number of measures: volume of assets under the management of the private pension funds, gross returns, and number of participants. There have been a number of economic and labour market benefits to the host countries attributed to the pension reforms, and the privatised pension systems have been the driving force behind financial sector reforms. But there have been problems of course. Some of the problems are Chilean problems intensified, some are new. Latin American pension schemes tend to be: • • • • • • low coverage poorly diversified poor in investment performance low on member choice flawed in performance measures high cost
make intelligent and well-informed decisions. Giving contributors more types of investments to choose from should be combined with educating them about the importance of saving, investment diversification, and the power of compounding over time. Flawed measurement of fund performance Currently, fund performance assessments are based on comparing the return of one fund with the average return of all funds in the pension system. With a growing concentration of pension fund assets in a few funds in most countries, such regulation creates incentives for funds to “herd” around the leaders and hold portfolios that are nearly identical to each other and yield similar returns, thereby narrowing the choices available to contributors. Using the pension industry’s average performance as a benchmark skirts the crucial issue of how well the benchmark itself is performing, compared with other investment opportunities. High costs
Low coverage The Latin American pension systems cover only a fraction (about one third) of the economically active population – thus many people are not provided for. These systems are mostly accessible only to formal sector workers, and only a fraction of these actually contribute, even though many workers are affiliated with the new systems. Therefore, many Latin Americans are still not covered by a formal system of retirement income security. Note the selfemployed in Malaysia, who are left out of the EPF. Poor investment diversification Poor diversification is usually a result of tight investment restrictions. Relaxing regulations on asset allocations by pension funds increases the possibilities for diversification, reduces risks, and usually increases returns. Most Latin American funds are still, many years after inception, heavily invested in government bonds (in the order of 7080 percent). A more balanced portfolio of domestic and international assets (including equities) would provide greater opportunities for wealth creation and permit further development and strengthening of financial and capital markets, one of the stated objectives of pension reform. Low on member choice Contributors to private pension systems in Latin America have little choice in terms of the portfolio allocations that might be best for their stage of life or for their risk preferences. At present, in most Latin American countries, each fund manager offers only one fund to all contributors (and the holdings and returns of most funds are similar), whereas, outside Latin America, the trend in definedcontribution systems is to allow workers to tailor their portfolios to their individual needs. Of course, increased choice does not automatically enable contributors to 4 Most Latin American pension systems have high cost structures: commissions, which, in most pension funds, are based on contributors’ wages and charged up front for the life of the contribution, are higher in Latin America than elsewhere. The way commissions are structured, combined with the erratic work history of the typical contributor, affects poorer workers disproportionately. Lowering administrative costs will require some basic changes in most countries’ pension funds – for example, from some current models where both collection and management of assets have been decentralised to models with centralised collection. However, centralisation requires improved governance, better regulation, and reduced political interference. The overall conclusion is that second pillar is probably too prominent in Latin America, and should be scaled back, freeing resources into the third pillar (voluntary savings). This would bring competition into the oligopolistic pension fund industry, reducing costs and improving transparency. The World Bank has concluded that there is also a need to build up the first pillar – a public safety net to prevent poverty in old age.
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With a growing concentration of pension fund assets in a few funds in most countries, such regulation creates incentives for funds to “herd” around the leaders and hold portfolios that are nearly identical to each other and yield similar returns, thereby narrowing the choices available to contributors.
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Australia
Australia has a fully liberalised, three-pillar system and there is considerable determination to encourage the second pillar to relieve the first. The first pillar is a universal old age pension, means tested on the basis of assets and income. The second pillar (superannuation) consists of an obligatory 9 percent of salary paid into a defined contribution fund (usually – although some defined benefit funds are still in existence). This 9 percent is tax advantaged, as are additional voluntary contributions (third pillar). There is considerable choice as to how each individual’s pension money is invested, and by whom, and the vehicle can be either an occupational pension scheme or a personal pension. Most employers now operate defined contribution schemes, either as separate employersponsored arrangements, or under centralised master trusts. Premature use of pension savings is rigorously discouraged in Australia’s superannuation system. Costs are reasonable by international standards: the average fee level in Australia is 1.3 percent of assets annually, but there is considerable variation between types of funds (from 0.6 percent for government, corporate and industry funds to about 3.5 percent if a high cost retail master trust structure is being used). Within Australia, there is likely to be increasing focus and resentment towards those operators at the higher end of the range, in the lead up and wake of the introduction of Choice of Fund in June this year. By any measure, the Australian superannuation system has been hugely successful, and is a major reason why Australia now has the fourth largest fund management industry (by assets) in the world – a startling fact considering Australia only has 20 million people. Australia ranks first (best) in the “Ageing Vulnerability Index.”1 The current trajectory of worker contributions shows that most people in Australia will not be able to provide fully for their retirement, nevertheless superannuation has broken the back of the retirement income problem. There are some negatives in the Australian system however: • The superannuation regime, particularly taxation rules, is extremely complex and this complexity has created dependence on a large and relatively expensive financial planning industry. While Australian investors are relatively 5
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financially sophisticated, there is still insufficient understanding of portfolio theory and risk/return relationships, and most superannuation investors park their funds in unnecessarily conservative asset portfolios. Integration of the superannuation system (the second pillar) with the old age pension (the first pillar) is poor.
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Source: Centre for Strategic & International Studies
Singapore’s CPF
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Before we move onto the lessons learnt from these major international privatised pension systems, it is worthwhile also considering some lessons learnt from the CPF (Central Provident Fund), across the Causeway. The CPF suffers principally from: • • • Ability of members to access their savings early in life Poor investment performance (due largely to asset class restrictions and conservative investment philosophies) Opaque management and disclosure
IS, but private sector fees are still opaque and too high. Returns on CPF-IS products have been poor, partly due to investment conditions, and partly due to high costs: CPF assets experienced a zero real return from 1987 to 1997. In addition, the annuity market is highly inefficient. On the plus side, there is a good financial education programme attached to the Singapore CPF, and good coverage of employees. Of interest are the proposed changes in Singapore. The CPF Board proposes far-reaching changes, in particular the introduction of Privately-managed Pension Plans (PPPs) under centralised administration. The proposal is for one Master Administrator and multiple Plan Providers. Plan structures will entail simple, low cost, no front-end charges, annuity facilitation, regular savings emphasis. Distribution will be through banks, brokers, insurance companies, IFAs, and investment administrators. Thus the CPF Board will effectively insert a simple and low cost private investment option between CPF savings and retail products.
Creating a single mandatory savings pillar instead of constructing a multi-tier system has resulted in an inadequate, and inequitable system of financing retirement. In Singapore, initial efforts at allowing choice and flexibility within the CPF – the Enhanced Investment Scheme – saw massive mis-selling by life insurance agents. The worst abuses have been removed in CPF-
Malaysia
The primary pension savings vehicle in Malaysia is the Employees Provident Fund (EPF), which is firmly rooted within the second pillar. It is generally accepted that retirement funds accumulated through the EPF, alone, will be insufficient to safeguard retirement financial needs for most people. Its primary responsibility is to ensure that its members have financial security in their old age in the form of adequate savings to support their retirement. While the EPF has a high coverage rate (more than 95 percent, although this does not include self-employed), there are a number of reasons why the EPF is not fulfilling, and will not fulfil, this promise: • • • • The relatively young age at which funds are accessible The nature of the access to funds The segregation of contributions into dedicated accounts (housing, health, retirement – all with the same investment approach) The poor investment performance of the EPF funds (around 4 percent for the past 30 years – this low figure due largely to restrictions: at least 70 percent in government securities, no offshore assets) The EPF has also had opaque management/ investment strategies and limited autonomy, hidden risks and liabilities of itself – diversifying retirement income streams and also in the context of the Capital Market Master Plan: building a private pensions system outside the EPF will improve diversity, stability and liquidity of Malaysian investment markets.
Lessons Learnt
We learn a number of lessons from the experience of other countries that have gone before Malaysia in private pensions, and this brings us to some possible prescriptions for Malaysia. The first three are very important: Offshore investments Whatever system is put in place for Malaysia’s private pensions, the investment regime must be more liberal than the one governing the EPF. The conservative approach to investment of the EPF may limit the stress on investors’ nerves but it does little for the fund balances of Malaysian citizens at the point of retirement. Appropriately diversified, and risky, investments, combined with proper education and understanding of Malaysian investors about the risk/return tradeoff, will combine to dramatically improve retirement balances through the benefit of compounding of returns. Appropriate diversification will entail offshore investments, particularly in equities, and the Malaysian government’s relaxation of investment constraints, which are currently shored up by misinformed views about volatility and risk/ return, must be treated as a high priority. Any Malaysian citizen with a time horizon longer than 15 years should be investing in a diversified portfolio, which includes a high percentage of international equities, unless they have an unusually timid approach to risk. The Chilean pensions model allows portfolio diversification, and largely through investments in overseas markets (now approximately 30 percent of all pension funds) investment returns for PSAs have been healthy (7-7.5 percent real, net of fees, over the past 20 years).
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The Malaysian Government is considering the introduction of private pensions to supplement the EPF. Any supplementary pension system in Malaysia is likely to reside outside the EPF, for the following reasons: • • • 6 The self-employed are not currently covered by EPF (one quarter of population) EPF’s investment policy is too conservative and low-yielding A private pensions system is a worthy end in and
Investment vehicle Pension providers should clearly be grounded in funds management activities. Our bias in writing this article for this particular publication does not need to be declared: of course we see a significant role for the Malaysian unit trust industry in managing private pensions. In many other countries, particularly developed ones, the unit trust/fund management industry would have the pre-eminent position and entitlement to managing pension money. In many Asian countries, however, the entanglement of life risk protection with savings vehicles (whole of life policies, for example), combined with a dominant distribution channel (tied insurance agents), has put life insurance companies in the box seat for the major role. And in Malaysia specifically we see a particular prejudice against the unit trust industry, which we have not seen elsewhere in our travels. We would like to point out here that life insurers are not the natural owners of the pension fund management mandate. The pure fund managers – i.e. unit trust companies and institutional fund managers – have a more obvious entitlement. In Malaysia the unit trust industry has had some negative press in recent years through poor performance and volatility. This is not an indictment of the unit trust vehicle itself, but more on the investment constraints the industry operates under: an illiquid and small domestic market, and inability to invest sufficiently (and therefore
diversify) in overseas investments. The Malaysian lay person’s suspicion (and the government’s suspicion, apparently) over international bond and equity markets, and the apparent lack of understanding about risk/return relationships and appropriate diversification, creates a dangerous situation when policy is being made about retirement provision. It is true that the current fee levels in the Malaysian unit trust industry are likely to be an issue with any pension provision role, although not as much of an issue as the fee levels in the life insurance industry will be for life insurers. Fees must come down. Centralisation & Administrative Efficiency We do not believe that centralisation is necessary, these days, for administrative efficiency. The traditional view has been that decentralisation almost guarantees inefficiency and high fees. This is not the case. We recently performed a strategic review for a large (US$3 billion assets under management, 250,000-member) government superannuation fund in Australia. As part of the work programme, we studied the efficiency of the administration function within superannuation funds. This is what we found.
Administration Service Companies & Government Fund DC Schemes – Administration Costs The solid circles are government pension funds that perform their own administration, and the hollow circles are third party administrators. This chart reveals two important facts: • There are indeed scale economies in the administration function in Australian superannuation. It is highly likely that all across the world, in the pension administration function, there are scale economies, but the curve for each industry and probably even category of business within each industry, will be different depending on a number of factors including the level of technology development in that industry and the availability of third party administrators. The presence of third party administrators means that small pension funds (and therefore their members) can also ‘capture’ economies of scale, albeit after a profit margin for the third party administrator is extracted. In the chart above, a number of relatively small funds have chosen to insource the administration function, and have suffered from lack of scale as a consequence.
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It is no longer the case that privately managed individual accounts lose the economies of scale of a publicly managed scheme. Through aggregation/pooling, scale economies can be partially regained at least. In addition, a system with multiple individual account managers is likely to give more satisfaction to members (from the improved service they are expected to receive and through the choices which the system lets them make). Scale economies are important, but just how important depends on the level of technology development in each industry (for example, use of master trust platforms); which part of the value chain we are talking about (for instance, administration, custody services, asset management); the
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extent to which outsourcing companies are operating in the industry (for example, third party administrators for pension fund administration); and the ability within the industry to aggregate/pool assets and accounts to achieve scale (for example, mezzanine wholesale investments) So the key point here is that centralisation of administration is one, but not the only, way to achieve economies of scale. Participation Mandatory participation is one obvious way to underwrite high coverage rates, particularly for sectors of the workforce not currently covered by the EPF (for example, the selfemployed), so that those individuals who are currently excluded, such as the self-employed, are covered. However it is not clear whether there are currently adequate incentives for the self-employed to comply, and enforcing compliance is administratively expensive and difficult. There are other levers that can be pulled though, such as lowering barriers to participation in private pensions, education of workers about the necessity of saving for retirement, creating the conditions for improved investment performance, and setting of minimum benefit guarantees. If the second pillar is voluntary, strong inducement should be given to employers to set up externally funded occupational pension schemes, as this is the most effective way of increasing coverage. Tax benefits and subsidies are likely to be a necessary feature of any voluntary scheme. Employer-sponsored pension funds are generally more efficient and help to lower the transaction costs and administrative overheads. Individual accounts require a great deal of regulation, however. Disclosure This alone is not sufficient to contain costs and abuses, if investors are unable to fully understand what is being disclosed: high distribution and administration charges will swallow people’s savings, and disclosure must be complemented with healthy competition, investor education and perhaps constraints on providers. Investor Choice Providing options is dangerous without proper education:
People do not exercise choice rationally, and default investments should be steered into wholesale options with appropriately aggressive risk profiles. Choice is expensive and requires financial education and disclosure. In Australia, there is considerable individual empowerment but general apathy over people’s retirement savings, to such an extent that default asset allocations are important. Consumer Protection This has become more important in recent years, and is a greater imperative with individual accounts where there is more opportunity for abuse. In Latin America some convoluted consumer protection measures have resulted in high marketing costs and frequent switching between funds, investment performance guarantees (for instance, as in Chile, where fund managers must make good any significant deviation from their peer group) and limits on expense charges (for example, stakeholder pensions in Britain). There are many opportunities for mis-selling with individual pension accounts (witness the British experience). Administration Costs Market forces will not necessarily contain administration costs, and centralisation is not a necessary condition for efficiency (see previous discussion). Fees This is a thorny problem, and we do not believe it has been given the prominence it deserves among pension policy makers. The “miracle” of compound interest can work against the investor as much as for him. Over a 30-year investment period, annual fees of just 2 percent of assets will reduce the final retirement balance by 4045 percent (compared to no fees at all; or alternatively, a comparable situation is 4 percent annual fees as against 2 percent). These dramatic compounding effects apply just as equally to low investment performance: achieving 4 percent return each year for 30 years, when a higher risk profile could have achieved 6 percent each year, results in a retirement balance that is also 40-45 percent lower than would have been the case otherwise. Pension plans are investing increasingly in foreign securities. Regulations inhibiting foreign pension investments are being relaxed across the globe (see previous discussion).
Conclusion
It strikes us, looking in from the outside, that there is a golden opportunity here for the Malaysian Government in reforming the pension system to make the sort of bold, progressive strides that former Prime Minister Tun Dr Mahathir Mohamed was encouraging in Malaysia most recently. Private pension reform seems to us to be a relatively simple way for Malaysia to become an admired benchmark across the globe, as well as achieving the happy outcome of shoring up the population’s retirement security. Let us hope that economics, not politics, plays the most important role in the reform process. UT _____________________________________________________________________________________________ The writer is the principal consultant of Singapore-based NMG Financial Services Consulting. 8
