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Why pension, provident funds should invest in capital markets?

02 Dec 2012 - {{hitsCtrl.values.hits}}

Pension funds may be defined as institutional investors, which collect, pool and invest funds contributed by sponsors and beneficiaries to provide for future pension entitlements of beneficiaries (Davis 2000). Therefore, pension funds provide an opportunity for individuals to accumulate savings throughout their working life to finance their consumption needs during retirement.

The financing will be received either in a lump sum or by provision of an annuity. Further, pension funds will provide funds to end users such as corporations, other households or governments for investments or consumption. Therefore, we can assume in a border aspect that pension funds operate as financial intermediaries within capital markets.

Pension funds and capital market
Pension funds operate and are perceived as substitutes and complementary institutions to other financial institutions, specifically to commercial and investment banks. Therefore, as competitors for household savings and corporate financing, pension funds create competition and may aide towards improving the loans and primary securities market (Meng and Pfau, 2010).

The growth of pension funds will encourage financial innovation, improvements in financial regulations and corporate governance, which will aide in the overall improvement in financial market efficiency and transparency through increased penetration by pension funds. This will widespread the number of interest parties and thereby demanding more information symmetry, stimulating long-term economic growth.

Contribution to economic growth
Capital has the role as the storage device for saving some of the current income for future consumption. The accumulation of these savings represents the wealth of a nation. Therefore, the higher capital productivity could be achieved through investing savings more productively and generating higher capital income.

This is more applicable for a country like Sri Lanka which has relatively low national savings to the GDP ratio of 24.7%, compared to the other regional countries such as India, China, Taiwan and Singapore, which record more than 30% national savings to the GDP ratio. Therefore, these countries possess relatively high domestic investments than Sri Lanka to fuel the economic growth.

Sri Lanka’s pension funds as a key source of long-term financial savings, holding approximately 20% of the GDP have to play a key role in enhancing the capital productivity by investing in high yielding instruments, with a calculated risk, enabling to create new capital base for the reinvestment needs of the country, in order to achieve a sustainable economic growth.

Key drivers of capital market
Long-term investors can support sustainable growth and financial stability since the structure of their balance sheets provides the capacity to smooth their resources over the medium and long term. They are not prone to herd mentality and are able to retain assets in their portfolios in times of crisis and in this way play a counter cyclical role.

Professionally managed long-term institutional investors can make an important contribution to growth in various ways, most important by financing long-term projects, such as infrastructure and promoting venture capital, etc. Further, they reduce reliance on the banking system, acting as shock absorbers at times of financial distress.

Long-term investments can also provide higher returns for long-term savings and thus, alleviating some of the funding gap that is widening due to low interest rates and an increased demographic burden.
The presence of large institutional investors is crucial for the development of the capital market of the country. In many markets, institutional investors such as pension funds, play a critical role in the stock market. Unlike the retail investors, large institutions invest with a long-term focus and are not affected by the short-term price fluctuations.

Since their investment capacity is relatively high, institutional investors can correct the stock market inefficiencies such as speculative actions, thereby stabilizing the market in the long run. In addition, the presence of large local institutional investors in the equity market is critically important to build investor confidence amongst the retail and foreign investors.

Hence, large institutional investors, pension and provident funds by investing in equity and debt instruments create long-term stability and investor confidence in a capital market. It is also imperative that institutional investors such as pension funds are professionally managed and have proper governance structures by adaptingglobally accepted standards of best practice and Code of Conduct for the governing body (CFA Institute). More specifically, the governing body should:

Maintain confidentiality of scheme, participant and beneficiary information.
Take actions that are consistent with the established mission of the scheme and the policies that support that mission.
Abide by all applicable laws, rules and regulations, including the terms of the scheme documents.
Act with skill, competence and diligence.
Act in good faith the best interest of the scheme participants and beneficiaries.
Act with prudence and reasonable care.
Maintain independence and objectivity by, among other actions, avoiding conflicts of interest, refraining from self-dealing and refusing any gift that could reasonably be expected to affect their loyalty.
Deal fairly, objectively and impartially with all participants and beneficiaries.
Review on a regular basis the efficiency and effectiveness of the scheme’s success in meeting its goals, including assessing the performance and actions of scheme service providers, such as investment managers, consultants and actuaries.
Communicate with participants, beneficiaries and supervisory authorities in a timely, accurate and transparent manner.

Alternative investments
Sri Lanka’s pension and provident funds mainly consist of Employees’ Provident Fund (EPF), Employees’ Trust Fund (ETF), Approved Private Provident Funds and Public Service Provident Fund. The EPF, the largest fund in the country, which approximately records 13% of financial sector assets, has grown at a CAGR of 16% for the last five years, whilst the total pension and provident funds grew at a CAGR of over 14% for the last five years. Rapid growth of pension and provident funds will indicate the available investment opportunities need to be expanded to enhance the return to beneficiaries, while managing the associated risk factors of such investments. Hence, pension funds’ investments in the capital market enable their members to indirectly own a stake in some financially stable, fast growing companies and benefit from the country’s economic development.

Currently, the two largest pension funds, the EPF andthe ETF collectively account for 89% of the total pension and provident fund assets of the country, but have mainly invested 90% of their funds in government securities,while focusing less on listed equities, only accounting a share of approximately 8%.
The less resource allocation towards the equity market is really visible when we compare with the other regional countries such as Malaysia, South Korea and India, which have allocated over 30%, 30% and 20% respectively to equities.

Further, the government has planned to reduce the budget deficit to the GDP ratio from 6.2% in 2012 to 5.8% in 2013. One percentage point reduction in budget deficit will lower the government borrowing requirement by approximately Rs.60 billion.

Since the budget deficit will lower in the medium to long term, resulting in reduced borrowings by the government, shifting a part of the state-managed pension funds such as the EPF andthe ETF to other profitable investment avenues, such as listed and unlisted equities, debentures and mortgages backed securities, which is considered to be a prudent investment strategy in managing pension and provident funds.
On the other hand, this will lead to create sizable returns to their members especially in a period where the total returns of pension assets are continuously eroding.

Rapidly aging population
A main concern for both developed and developing countries is the aging population and the low birth rate due to couples consciously having fewer children or having children late in life. This has led to the insufficient contribution to pension funds through the working population to fund the elderly population. In response, most countries are moving towards private pension schemes (partial or full funded). Therefore, effective management of pension funds, generating healthy yields is a timely requirement due to the expected demographic shift of the population pyramid of the country by 2021, resulting 16.8% of the population surpassing the age of 60 and above from 12.5% at present.

(This article was written by Pasindu Perera and Ranuka De Silva of Asha Phillip Securities Ltd., with auspices of the Research Committee of the Colombo Stock Brokers Association)

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Why pension, provident funds should invest in capital markets?

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