Pension funds management

There is a heated political debate going on in India about pension reforms. Specifically, in recent months several state governments have reverted back to the defined benefit (DB) Old Pension Scheme (OPS), abandoning the defined contribution (DC) New Pension Scheme (NPS) which was introduced in 2004. I wrote about it yesterday.

There is another aspect of pension reform that is important. For a start, the reversion from NPS to OPS is a big blow to India's capital market development. In one stroke, it deprives the capital markets off the biggest source of long-term capital that's central to the broadening and deepening of capital markets, and that too at a time when economics and demographics dictate that pension fund assets should be ballooning. 

In this context, it's also appropriate to revisit the existing regulatory investment requirements for pension funds in India. 

FT has some interesting articles which examine UK's pension funds industry, which may have lessons for India. Like elsewhere, in the UK too the DB pensions have given way to DC pensions. But those DC pension funds are struggling,

Official numbers put defined contribution pensions membership, where the saver bears the risk of their eventual retirement income, about 55 per cent higher than defined benefit schemes. That doesn’t tell the whole story: thanks to the success of workplace auto-enrolment since 2012, there are more than 15 times the number of active savers in DC schemes compared with DB, according to the Pensions Regulator. Everyone knows that many of those pension pots will be inadequate. Average assets per member is low given the influx of new savers. But PwC in 2021 put the average pension pot for the first generation of DC workers to retire at about £50,000, compared with £400,000 for the average capital value of a DB member’s benefits. There are four to five times the assets in old-style pensions schemes as are held in the DC schemes typically offered to workers today. That is the first reason that DC pensions deserve more attention: a looming scandal of intergenerational inequity to rival what the housing market has to offer. Self-satisfaction about auto-enrolment, now set at 8 per cent of salary, of which just 3 per cent comes from the employer, is part justified and part premature. A 2017 review found that it should be expanded, to better cover younger or part-time workers, and that contributions should be higher... But the much-admired Australian system is moving towards 12 per cent employer contributions by 2025. “We need probably 25 per cent going into people’s pensions,” says Nico Aspinall, a DC specialist, who argues that contributions should be weighted towards employers.

In the UK, driven by regulatory restrictions, there has been a dramatic shift in the UK from equities towards fixed-income securities. 

First, private defined-benefit schemes — the dinosaurs of pensions past — have switched from equities into bonds as they closed and members approached retirement. That is the biggest factor behind the allocation of money from UK pensions to the UK stock market falling from 53 per cent in 1997 to 6 per cent in 2021, and it is not going to change. Defined-contribution schemes, with about £550bn of the pension market’s total £2.8tn in assets, still allocate more than half their assets to equities, according to think-tank New Financial, but everyone — including asset managers and insurers — has also shifted away from UK stocks seeking better opportunities overseas.

This FT long read has some excellent graphics on the UK and global pension markets. The share of equities in UK pension fund investments has dropped precipitously by £400 bn since 1997.

While their exposure to UK equities has fallen sharply, they've increased their investments in non-UK equities (primarily US equities).

This reduction in UK's exposure to equities contrasts with increased risk assumption globally among pension funds, though in the form of alternative assets.

In this context, there has been a debate among pension fund managers globally on the right level of exposure to private equity. There are those like Mikkel Svenstrup, Chief Investment Officer at Dutch Pension Fund ATP who have raised concern at private equity practices like continuation funds (where a PE firm passes investments between two funds it controls) starting to resemble ‘pyramid’ schemes. However, others like Marcie Frost at Calpers believe that the $442 billion fund’s 13% PE exposure limit is too small, and the fund may have lost $18 billion in returns between 2009-18 by avoiding PE. But this debate comes even as influential voices like Vincent Mortier, CIO of the $2 trillion Amundi Asset Management, Europe’s largest asset manager, have suggested that parts of PE resemble Ponzi Schemes. Just a couple of days back, Howard Marks of the $172 billion Oaktree Capital Management warned that the high-interest rate and economic weakness could strain the private credit market. 

The global leaders in pension funds management are the Canadian and Australian funds, the largest of whom manage funds internally and have got good returns over the last decade despite the ultra-low interest rates. 

The article points to the death of media tycoon Robert Maxwell in November 1991 which triggered risk aversion and regulatory over-kill in the UK pension funds industry,

His mysterious death triggered the swift collapse of his publishing empire as banks called in their loans. It emerged that Maxwell had used assets belonging to the Mirror group pension fund to prop up his companies. The episode contributed to a growing public clamour for tighter rules around pensions, particularly the so-called defined-benefit schemes that make payouts to members in retirement based on their salaries while in work. The result was a series of changes to tax, regulation and accounting rules that Sir John Kay, one of Britain’s leading economists, characterises as “one of the great avoidable catastrophes of British public policy”. “You had a system that worked pretty well, which was replaced by one that constrained investment strategies and effectively killed UK private sector defined-benefit schemes,” he says. 

Among the most significant changes was the introduction in 2000 of FRS17, an accounting standard that required companies to calculate the surplus or deficit on their defined-benefit pension schemes each year and disclose any deficit as a financial liability in their accounts just as they would a bank loan or a bond issue. Company boards, often shocked by both the magnitude and volatility of liabilities, rushed to close defined-benefit schemes, first to new members and then to further accruals. Trustees began shifting assets out of equities — the asset class that historically has delivered the highest inflation-adjusted returns — and into government bonds. The theory of this “liability-driven” investment strategy was that it was lower risk, but for many pension schemes it came unstuck last autumn when bond prices fell sharply following the UK government’s “mini-Budget”. The proportion of all UK pension fund assets invested in equities was 26.4 per cent in 2021, down from 55.7 per cent in 2001, according to the OECD. By contrast, Canadian funds had 40.6 per cent in equities and Australian schemes 47 per cent.

Canadian pension funds are the exemplars of global pension funds

Last year, global stocks and bonds lost more than $30tn after inflation, interest rate rises and the war in Ukraine triggered the heaviest losses in asset markets since the 2008 financial crisis. But the C$247.2bn Ontario Teachers’ Pension Plan, a defined-benefit scheme for 336,000 schoolteachers in the country’s most populous province, gained 4 per cent and maintained fully funded status for a 10th consecutive year... The scheme reduced its exposure to fixed income because of concerns about higher inflation, and boosted its holdings in infrastructure, private equity, and other more inflation-sensitive assets. OTPP’s ability to do this is the result of how the plan was designed when it was formed in 1990. Until then, Ontario teachers’ pensions had been invested solely in government bonds. But a new law that year set up OTPP’s investment board as an independent entity, gave it an exemption from public-sector pay caps so that it could hire people from the private sector, and reduced fees paid to external managers by dictating that most of its portfolio would be run internally...

The scheme’s ability to combine public market holdings along with direct investments in infrastructure, venture capital and property has helped it deliver average returns of 9.5 per cent a year since it was set up. Its model has been widely adopted across Canada’s public sector — CPP Investments, established in 1999 to oversee and invest the assets of the Canada Pension Plan, has grown from just C$12mn to C$536bn and is now one of the world’s largest investors in private equity.

Australia is another example,

The Australian superannuation system has almost A$3.5tn (£1.9tn) in assets after three decades in which contributions have been steadily raised, pots consolidated and investment diversified... One lesson from the Australian experience, argues Gregg McClymont of IFM Investors, is that the occupational schemes created their own vehicle (IFM) to pool resources and avoid leakage of fees to third parties... The Australian schemes have steadily consolidated over time, with IFM’s owners falling from 30 to 17. If the government wants to wield a big stick, pooled resources and consolidation is the place to do it. Another factor behind Australia’s success was that the system came together when its states were essentially privatising infrastructure. In other words, there was loads of good stuff to buy.

One of the important points discussed in the context of the UK's experience is the need to consolidate pension funds. For example, the UK has 86 regional funds that managed a combined £342 bn in assets as of March 2021. In fact, the UK has roughly 28,000 DC schemes. Since 2015, the UK Treasury has been, like in Australia, consolidating them. There is tension here between the increasing economies of scale from having larger assets under management and the increasing economies of return from smaller investment pools.

DC schemes are split between trust-based provisions and contract-based schemes offered through insurance companies. And while the financial markets focus on the latter, the former has had some impressive successes. Apart from the Canadian funds, this is about the corporate fund, Wellcome Trust, 

Observers point to the strong investment record of the Wellcome Trust, a charitable foundation whose health research is funded by a £37bn investment portfolio, as an example of how funds can thrive without the constraints of a corporate sponsor. It has generated annual returns averaging 11.7 per cent over the past two decades.

India has followed conservative regulatory restrictions on asset allocation for pension funds, compared to developed countries.  

Some questions in the context of the UK, Canadian, and Australian experience of relevance for India.

1. What should be the mandate for the appropriate mix between equities and fixed-income assets?

2. What should be the exposure to alternative assets and what conditions are associated with them?

3. How much exposure to foreign equities and bonds?

4. How to leverage pension funds to finance national and local infrastructure requirements?

The last point is of some importance in countries like India. The governments in developed countries benefited from being able to leverage their domestic patient capital sources like pension funds and insurance in an era of limited global financial integration to finance their infrastructure requirements. A UK government levelling-up white paper suggested that 5% of local government pension scheme assets should go towards local projects. 

For a country like India that's grappling with an acute deficiency of long-term capital to finance infrastructure, there is a strong case for figuring out ways to channel some of the pension fund investments into these. The political economy problem associated with going this way might be too daunting. But being deterred by this problem and not pursuing the available second-best approaches to leveraging this capital, even with their costs, might be a case of the best being the enemy of the good.