Institutional Investment principles

Pension Fund Investment practices

Every institution is exposed to a range of risks which merit the development of robust risk management practices. For pension funds, the bearing of investment performance on the welfare of individuals in retirement compels us to be even more alert to risk and to consider risk as key decisionmaking tool.

Tawanda J Chituku (DAT, CFI (UK))

8/10/2011

Table of Contents
0. 1.0 1.1 2.0 2.1 2.2 2.3 Introduction........................................................................................................................... 3 Current investment practices of pension funds in Zimbabwe ................................. 4 Evaluation of the Status Quo ........................................................................................................... 5 INTERNATIONAL APPROACH TO INSTITUTIONAL INVESTMENT ........................... 7 SOUTH AFRICA REGULATION 28 .............................................................................................. 7 MOZAMBIQUE - DECREE NO. 53/2007 OF 3 DECEMBER ................................................... 8 KENYA RETIREMENTS BENEFITS AUTHORITY .................................................................. 9

2.4 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD COUNTRIES) ....................................................................................................................................................... 9 3.0 REGULATORY REGIMES IN OTHER SECTORS ................................................................... 10 4.0 5.0
5.1

Tying up the strings ........................................................................................................... 11 Conclusions and Recommendations ............................................................................. 12 Final remarks ..................................................................................................................... 13

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Investment principles for institutional investors (Pension Funds) The need for prudential investment management

0.

Introduction

The ongoing financial soundness of most, if not all, institutions is measured with specific reference to the assets held by the institution. In most countries, the methods and frequency of measuring the financial soundness of certain types of institution is covered within the countrys regulatory framework. Institutions that are typically required to undertake statutory valuations of different forms include insurance companies, medical aid schemes, pension funds, financial intermediaries etc. The rigidity of a regulated process imposes on institutions an inherent alertness towards demonstrating stable projected long-term financial soundness. An institutions projected long term financial soundness depends immensely on the future interaction between the institutions assets and liabilities. This elevates the investment of assets at the apex of the management functions carried out by the investment sub-committees of institutions. This paper has been written with a clear focus on pension funds, in particular, Defined Contribution funds. The reason being that investment risk is borne by Members; who will ultimately directly suffer the consequences of lost investment value or poor investment performance. The use of investment performance instead of investment return is intentional in order to avoid plunging the discussion into a one-dimensional viewpoint, but rather, encourage the consideration of all factors that can be used to measure investment performance. In essence, investment performance involves looking at risk, return, liquidity, stability of return and fulfilment of a given investment mandate. This paper presents a proposal on how best prudential investment management of pension funds can be achieved, by way of developing and issuing well articulated investment guidelines for pension funds. This is the driving force behind this paper, which is structured as follows; section 1 provides a scan of investment practices of pension funds in Zimbabwe. Section 2 provides a view of the international approach to institutional investment while section 3 reviews regulatory regimes in other sectors. We tie up the strings in section 4 and pitch our proposed approach to pension fund investment. Finally, we develop a set of conclusions and recommendations in section 5.

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1.0 Current investment practices of pension funds in Zimbabwe

As actuarial consultants to a number of pension funds, we have attended several Trustees meetings where, among other things, presentations and discussions on investment performance review, actuarial matters and administration issues were conducted. We took particular interest in the presentations on investment performance reviews, future asset allocation strategies and projections of future investment returns. One of our key objectives in those meetings was to introduce a relatively new concept to our portfolio of pension funds; an Investment Policy Statement, which is meant to guide the investment experts hired to manage fund assets. With that in mind, we noticed that in the presentations on investment performance, three themes seemed to come out very clearly, these were: That, pension fund assets are long term; That, equities will experience growth in coherence with the general economy and; That, consequently the fund will experience high returns.

We must point out that we were quite unsettled by the way these themes were pitched, for their lack of balance. The notion of a perceived absence of substantial downside risk on Zimbabwes stock market and the subsequent promotion of investment strategies that are focused on return, return and more return; leads to a one dimensional focus on investments based on assets and growth. We noticed that, by and large, the strategy pitches seemingly ignored the fundamental relationship between risk and return which can be exemplified by a two-sided balancing scale. We sat quietly and listened to the impressive presentations and projections of economic growth, low inflation and superb expected future stock market performance, two questions sprang up: What about liabilities; What about risk?

We were then motivated to spearhead the process of taking a second look at the way pension funds approach investments, in particular, to define the filtration process by which the asset allocation strategy of a fund should be governed. We also had in mind the Trustees that manage pension funds, in particular, their investment knowledge, and the risk that they would adopt asset managers viewpoints as biblical commandments. We say this because thus far, pension fund investment has really been a one man show i.e. the asset manager. In one meeting after the asset managers presentation, we followed with our risk management recommendations for the Fund. In response, the chairman said, by adopting a 75% allocation in equities the fund was effectively prudently managing risk, since there really was no significant risk in the big cap counters. This was an awful misinterpretation of the asset managers growth-focused presentation.
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The introduction to this paper articulates the need to bear in mind that at the end of it all, a pension fund needs to demonstrate financial soundness on a stable and consistent ongoing basis. Our concern is particularly for funds that exhibit excessive concentration levels in equities, the highest of which was 100% in one of the cases. This is further exacerbated by concentration within equities where there would be, say 30% of the funds equity investments held in a single counter. An analysis into our markets investment practices reveals some startling statistics. In general, average asset allocation to equities is around 75%, 20% to property and 5% to interest-bearing securities, based on a survey of approximately 35 pension funds. Most of the pension funds that we looked at, would additionally have exposures exceeding 20% in a single counter. Equity allocations appear uniform for most funds and across fund managers, largely dominated by large cap counters. There are some significant differences in property and money market with the advent of debentures, property units and private equity. More importantly, most fund managers participate on behalf of pension funds, in units or money market funds that they created or were created by their parent companies.

1.1 Evaluation of the Status Quo

Having looked at the empirical evidence above, it may be worth pointing out that in the majority of cases, the current asset allocations bear little or no reference to specific liability profiles of pension funds under management. Infact there appears to be disproportionate weight placed in managing under-performance risk as evidenced by the bias in equities, when there are other equally important risks like liquidity risk and asset-liability mismatching risk, which can deal pension funds a devastating blow if not properly managed. A natural consequence of this is that diversification levels across asset classes are still lower than expected. While it may be true that equities are expected to grow, based on fund asset managers models, their expected superior growth should not be accepted as an excuse for otherwise poor investment strategies. Given the above, there is a clear need for asset-liability profiling for pension funds. The provision of benefit promises needs to be safeguarded to ensure that above all, pension funds will be able to deliver benefit promises that meet Member expectations. There is also need to devise ways of determining what the Members expectations are, and consequently re-define overall fund risk as the failure to meet all aspects of such expectations. The call to develop well diversified investment strategies that focus on income, safety and avoidance of speculation can be reinforced by recognising that there is risk everywhere, no matter how promising an investment appears to be. We give two illustrations below:

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1. Botswana sobers up www.ft.com/intl/cms/s/2/dc6381e4-3e90-11de-9a6c00144feabdc0.html#axzz1Ts9U6uNR On the morning of Friday July 18 2009, Hloni Matsela, managing director of Botswanas biggest brewer, nearly fell off his chair. The radio was broadcasting a speech recorded the previous day by the new president, Ian Khama. Aghast, Matsela listened to the announcement that in two weeks the government would impose a 70 per cent levy on alcohol. I must caution you, Khama told his people, that if you adopt the we dont care attitude and continue drinking we are even going to hike it until whoever wants to buy alcohol fails to do so. The example above is meant to show the uncertainty in business as witnessed by Botswana Breweries, the largest brewer in that country which runs an oligopolistic business model. As if that was not enough, trading times for beer outlets were also severely curtailed to exclude sales after 8 pm as well as banning beer sales on Sundays. No single investment return projection model could predict the legislative impact on the prospects of this company, which went on to experience the following, quoted from the same article above: On November 1, the levy took effect. The brewer marked up its products by 30 per cent, later raising the price yet again to account for inflation. Within weeks, sales of western-style clear beer had fallen by a quarter, and traditional beer was down 12 per cent. By February, the serpentine conveyor belts that normally churn out Grolsch, Castle and SAB Millers other lagers stood idle. Already, the contents of the vast storage drums were close to going off; if the market didnt recover imminently, 3.5 million cans worth of lager would have to be poured down the drain. I can only imagine the look at the face of a Trustee who had say 35% invested in that companys counter, how he would begin to inform Members that the fund lost XX dollars due to exposure in one counter. More importantly, President Ian Khama recently indicated that he intends to increase the levy. Lets look at the second example below before proceeding to section 2: 2. Most widely read English paper in the world shut down due to a phone hacking scandal - http://www.bbc.co.uk/news/uk-11195407 I can imagine someone profiling News Corporation as follows, prior to the scandal: Worlds second largest multi-billion dollar media conglomerate; Operations in England, America, Australia and Asia; Been in existence for over one hundred years; Publisher of the largest English daily newspaper in the world; Owner of high profile companies like Dow Jones, 20th century Fox, New York times etc etc;
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A pitch like this could very easily lead to a unanimous agreement to invest everything in such a company based on dividend yields, price earnings ratios, return on equity and projected earnings. The company seems truly fantastic to any lay man. One can be forgiven for not being able to predict the phone hacking scandal at one of the subsidiaries (News of the world) which has led to damaging effects to the entire conglomerate. One can never however be forgiven for putting all eggs in one basket. There are some valuable lessons to be learnt from our two examples, which undoubtedly reiterate my sentiments regarding prudential investment management. In essence, no matter how great an investment prospect appears, conservatism should be applied when taking such opportunities to avoid undue hidden risk. Let us look at the international approach to investment management in the section below.

2.0 INTERNATIONAL APPROACH TO INSTITUTIONAL INVESTMENT

It is appropriate that in developing our own policy as a pensions industry, we benchmark ourselves against our international counterparts. We conducted regional and global surveys so that we could get an idea of the emerging international practice. Our findings are provided in summary form in the sub-sections that follow:

2.1

SOUTH AFRICA REGULATION 28

South Africans have developed regulatory guidelines through regulation 28 to govern pension fund investment. The stated objective of regulation 28 is to impose Limits relating to assets in which a registered fund may invest. The following is a summary of this piece of regulation: 1. The board of each registered fund shall invest the assets of the fund in accordance with an investment strategy. The investment strategy must be determined, monitored, reviewed and reported on in accordance with the following process: (a) The board shall establish an investment strategy; (i) This investment strategy must take due account of the objectives of stakeholders; the nature and term of the liabilities; the funding methods used in the fund, including, in the case of a defined contribution fund, any smoothing of investment returns accrued to individual member accounts, and; the risks to which the assets and the liabilities of the fund will be exposed.
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2.

(ii) The strategy must set out what percentages of the fair value of the total assets of the fund may be invested in various classes; (iii) The strategy should include the criteria with which investment managers shall be selected; etc (b) The actuary to the fund must confirm that he or she is satisfied that the strategy is consistent with the objectives of the fund and the management of the risks to which the fund is exposed, and will result in an appropriate relationship between the assets and the liabilities. .. ..etc Regulation 28 also sets maximum exposures to various asset classes, excluding government bonds and other approved assets for which theres no limit, as follows: max 75% may be invested in equities; max 25% may be invested in property; max 90% may be invested in a combination of equities and property; max 5% may be invested in the sponsoring employer; max 15% may be invested in a single large capitalisation listed equity, and 10% in any single other equity max 20% may be invested with any single bank; max 15% may be invested off-shore; max 2,5% may be invested in other assets.

2.2 MOZAMBIQUE - DECREE NO. 53/2007 OF 3 DECEMBER Mozambican legislation is not as detailed as the South African Regulation 28 but it however also imposes limits on certain asset classes a summary of which is given below: Maximum Equities exposure is 40%; Maximum Bonds exposure is 100%; Maximum Cash exposure is 100% ; Maximum foreign exposure is 10%; Maximum 5% to alternative assets such as property and private equity; Funds report to Reserve Bank on exposures on a quarterly basis.

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2.3 KENYA RETIREMENT BENEFITS AUTHORITY In Kenya, the Retirement Benefits Authority (RBA) sets investment guidelines that should be followed by the pension fund industry in that country. Currently, their asset allocation guidelines are as follows: Maximum Equities exposure is Maximum fixed property exposure is Maximum Government Bonds exposure Maximum other bonds Maximum Cash exposure is Maximum foreign exposure is Maximum private equity exposure Guaranteed Funds Maximum to alternative assets 70% 30% 70% 30% 5% 15% 5% 100% 5%

2.4 ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD COUNTRIES) The OECD is a grouping of 30 countries that, among other activities, developed guidelines on pension fund asset management for their participant countries. The guidelines propose to impose quantitative asset restrictions alongside qualitative supervision; and hence serve to establish boundaries that prevent or inhibit inappropriate or extreme investment management decisions. According to OECD, these guidelines are applied in order to ensure a minimum degree of diversification and asset-liability matching, promoting the prudential principles of security, profitability, and liquidity, pursuant to which pension fund assets should be invested. Asset allocation guidelines vary from one country to the other but the common denominator in the guidelines are: 1. 2. 3. 4. A limit of 5% in any single counter; A limit of 5% in self-investment; A requirement to match liabilities by term and currency and; A 10% limit on foreign investment.

The OECD guidelines also impose allocation floors to certain assets classes similar to the prescribed asset ratio regulatory requirement in Zimbabwe. The qualitative aspect is addressed in the OECD guidelines through a requirement to exercise due diligence in the investment process; which must be shown via an investment policy and internal controls for implementing and monitoring the investment process effectively. For example the guidelines state that, The investment process of a pension plan should be written, with

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clear investment objectives suitable for the fund (i.e. taking into account the liabilities and risk tolerance of the fund, liquidity needs etc.) as well as suitable diversification applied. The key highlight in this section is that pension fund investment regulation is a widespread phenomenon with globally accepted financial benefits. Further research into investment regulation in OECD countries indicates that there is need to strike a balance between enforcing a prescriptive regulatory regime and a liberalized one, which allows investment managers to adopt strategies that increase the Funds return subject to minimum diversification constraints. The transition from a prescriptive regulatory system to a more liberalized one should reflect enhanced risk management models to assess portfolio risks, improved experience and capability of pension regulators and fund managers as well as an aggregate improvement in pension fund performance.

3.0 REGULATORY REGIMES IN OTHER SECTORS

A cross court analysis of regulation in sister sectors such as banking and insurance provides immense insight into the framework of regulatory systems and what they are meant to achieve. It is possible to draw parallel lessons from the approach that these sectors have taken, particularly to focus on the challenges that have been faced in those sectors thus far. Regulation in banking is largely prescriptive through the Basel Accord, and driven by the Basel Committee on Banking Supervision of the Bank of International Settlement (BIS). The aim of Basel recommendations is to set international standards for bank regulators and legislators on the risk-based capital requirements for banks and the prudential management of banks. The insurance sector on the other hand, has an equivalent international regulatory body that develops standard recommendations for the global insurance sector known as the Solvency Accord. The main policy for the Solvency Accord is developed in Europe and communicated to member countries for adoption either in the original format or adapted to suit each countrys particular socio-economic environment. These two regulatory frameworks are shaped around the following pillars: 1. Quantification of risk exposures and regulatory capital requirements; 2. A supervisory framework and; 3. Comprehensive disclosure requirements. Regulation in these sectors has evolved over time to focus on rewarding institutions that have robust risk management systems in place, through a lower capital charge and hence
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releasing shareholder value. That being said, the chief aims of regulation in these two sectors are to protect beneficiaries, establish confidence in the financial system, maintain efficient and orderly markets, and also to ensure that the failure of one institution does not lead to a systematic financial collapse.

4.0 Tying up the strings

Asset management decisions are better informed by a well considered understanding of the scale of risk, investments and returns. This paper seeks to address the fundamental conflict in institutional investment, in particular defined contribution pension funds, which is about maximising the retirement benefits without running the risk of losing vested benefits. This conflict is practically resolved by developing a comprehensive investment risk management strategy which indeed must become a priority area for institutions; and must include: A detailed and effective risk analysis and management system; Regular monitoring and updating, and; A well-documented response strategy to combat excessive risk exposure.

Focusing on risk as a starting point in the process that seeks to produce investment guidelines should result in the development of policies that are confined to an institutions risk appetite. This gives birth to a new set of questions, about how best to assess an institutions risk appetite and how the assessment will be quantified into measurable investment guidelines. The initial reaction is often that investment risk is difficult if not impossible to quantify, and even if it were not, the range of incidents would be hard to categorise, and even harder to predict. Further, fund managers may view this proposal as a calculated move to undermine their professional responsibility and capacity to manage assets. However, we need to overturn such kind of thinking and start learning from international examples such as South Africa, Kenya, Mozambique and the UK amongst others. Sections 2 and 3 show that institutional investments are no alien to the need to develop a well-regulated system that will build confidence in the public and in international companies that participate in Zimbabwes occupational pensions sector. Many skills and types of expertise are required for this task and would include ideas from actuaries, administrators, asset managers, auditors and trustees. The proposed skills pool above would hopefully keep the right balance between numerically-based logical decisions and more intuitive qualitative thought, resulting in better thinking from all angles, and consequently increasing the chances of success. Consultations with other sectors will most be helpful, particularly in identifying critical paths of the process.
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5.0 Conclusions and Recommendations

Pension fund assets play a major role in the development of the socio-economic aspects of a nation and will most likely continue to do so. Against this background, how to invest such a large amount of assets should become an important issue, which must have policy implications. In Zimbabwe, the practice thus far, has been to leave asset managers with an open mandate on how to invest fund assets. In our view, this lack of checks and balances has resulted in some funds being exposed to excessive concentration risk from equities. Globally, pension funds have been subjected to two approaches: broad quantitative asset restrictions and personalised qualitative supervision as outlined in section 2.4. Most countries however realise that whilst the rationale behind sweeping quantitative guidelines is understood, there should be greater migration towards personalised qualitative supervision through the use of instruments such as a pension funds investment policy statements. An analysis of related sectors of banking and insurance regulation indicates that the focus has been on risk and how to provision for it. The obvious question is whether such an approach is suitable to pension fund investment. In this context, the question can be described as the dilemma of trying to decide on the fine balance between security versus adequacy; which has triggered raging debate globally. The key area of contention is how to judge between the amount of risky assets (and potential returns) versus less risky assets (and lower returns) to hold in a portfolio of pension fund assets. In addition, the right costbenefit ratio has to be achieved with the introduction of a regulatory policy to govern investments. Below is a set of recommendations to address the issues raised in this paper: 1. 2. Establish a regulatory framework targeted towards pension fund investment; Quantitative guidelines make sure the regulatory environment imposes quantitative guidelines that prohibit extreme investment decisions and encourage new investment instruments / practices e.g. overseas assets to improve diversification; Supervisory role make sure the supervisory authority and fund members can monitor investment management activity via the supply of adequate information within a risk-based approach; Governance framework supervisory authorities should ensure that the governance framework of pension funds is sufficiently robust to produce appropriate decision making (e.g. requiring an investment policy to be written etc.). Where pension funds set out a clear investment policy, fund managers should be assessed for compliance with their given investment mandates and explanation required where deviation surpasses some specified limits;

3.

4.

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5.

Education supervisory authorities should ensure that Trustees are competent to carry out their fiduciary duties and may require that Trustees training programs on investments be regularly conducted as part of Trustee development programs.

Having focused on institutional investment reform, complementary preconditions are needed in order to maximize the rewards of a well-supervised system. Some of these are a sound banking system, stable and liquid capital markets, many investment options, basic investor protection (e.g. national compensation schemes) and investor discipline. These are all elements that need to be considered alongside the recommendations tabled in this paper. Further research is required on the opportunity set in Zimbabwe in terms of efficient investment opportunities from a risk versus return perspective. There are some discussion points which need to be followed up, these are: Achieving a well-diversified portfolio in Zimbabwe (practice guide), cost - benefit analysis of introducing investment regulation. These examples provide us with a hint of the scale of the task at hand and opens up the debate for value addition.

5.1 Final remarks

It is important to realise that the introduction of prudential supervision of investments and subsequent adoption of risk management practices is not about funding rules and regulations; it is about better decision making. It is our hope that this proposal will be widely viewed as an opportunity for intermediaries, practitioners, regulators, advisors to take stock and to give prominence to the need to have good risk management information as an integral part of the investment decision making process. To cap it all, expressing this in a form of regulation acts as a sign of good faith by the industry, which would filter through to the public and possibly generate huge rewards in the form of high public confidence. Author: Tawanda Chituku is an actuarial Consultant (private pensions), and is the General Manager at Atchison Actuaries & Consultants, 118 Mchlery Avenue, Eastlea, Harare. Emails: tchituku@atchison.co.zw, tawchit1@gmail.com. The views expressed herein are those of the author and do not necessarily reflect those of Atchison or any member of Atchisons board. The author is solely responsible for any errors.

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References Yu-Wei Hu, Fiona Stewart and Juan Yermo. (2007) - Pension Fund Investment and Regulation: An International Perspective and Implications for Chinas Pension System South African Pensions Advisory sub-committee (2008) - South African Regulation 28 Blome, S. et al. (2007), Pension Fund Regulation and Risk Management: Results from an ALM Optimisation Exercise, OECD Working Papers on Insurance and Private Pensions, No. 8, OECD Publishing OECD (2007b). Survey of investment regulations of pension funds, July, OECD, Paris. OECD (2006). Guidelines on pension fund investment. Council on foundations Inc. (2008) Developing an asset allocation strategy

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