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OECD
INSTITUTIONAL INVESTORS
IN THE NEW
FINANCIAL LANDSCAPE
OECD PROCEEDINGS
Institutional Investors
in the New
Financial Landscape
ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT
ORGANISATION FOR ECONOMIC CO-OPERATION
AND DEVELOPMENT
Pursuant to Article 1 of the Convention signed in Paris on 14th December 1960,
and which came into force on 30th September 1961, the Organisation for Economic
Co-operation and Development (OECD) shall promote policies designed:
– to achieve the highest sustainable economic growth and employment and a rising
standard of living in Member countries, while maintaining financial stability, and
thus to contribute to the development of the world economy;
– to contribute to sound economic expansion in Member as well as non-member
countries in the process of economic development; and
– to contribute to the expansion of world trade on a multilateral, non-discriminatory
basis in accordance with international obligations.
The original Member countries of the OECD are Austria, Belgium, Canada,
Denmark, France, Germany, Greece, Iceland, Ireland, Italy, Luxembourg, the
Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the
United Kingdom and the United States. The following countries became Members
subsequently through accession at the dates indicated hereafter: Japan (28th April 1964),
Finland (28th January 1969), Australia (7th June 1971), New Zealand (29th May 1973),
Mexico (18th May 1994), the Czech Republic (21st December 1995), Hungary
(7th May 1996), Poland (22nd November 1996) and Korea (12th December 1996). The
Commission of the European Communities takes part in the work of the OECD
(Article 13 of the OECD Convention).
 OECD 1998
Permission to reproduce a portion of this work for non-commercial purposes or classroom use
should be obtained through the Centre français d’exploitation du droit de copie (CFC),
20, rue des Grands-Augustins, 75006 Paris, France, Tel. (33-1) 44 07 47 70,
Fax (33-1) 46 34 67 19, for every country except the United States. In the United States permission
should be obtained through the Copyright Clearance Center, Customer Service, (508)750-8400,
222 Rosewood Drive, Danvers, MA 01923 USA, or CCC Online:
http://www.copyright.com/. All other applications for permission to reproduce or translate all or
part of this book should be made to OECD Publications, 2, rue Andr é-Pascal,
75775 Paris Cedex 16, France.
FOREWORD
The growing importance of institutional investors as large-scale
holders of financial assets and major players in national and international
financial markets is a key factor shaping the financial landscape in OECD
countries. The Committee on Financial Markets of the OECD keeps track of
these and other major structural changes in financial markets by regular
discussions among members of the Committee as well as meetings between the
Committee and representatives of the financial service industry. In addition the
Committee holds from time to time ad hoc expert meetings to analyse
particularly important financial market issues in greater depth. The last such
expert meeting in July 1994 focused on changes in the entire financial system
in OECD countries (see OECD, “The New Financial Landscape: Forces
Shaping the Revolution in Banking, Risk Management and Capital Markets”,
Paris, 1995). Against the backdrop of current demographic as well as general
financial market trends, the Committee held a second expert meeting on
7-8 July 1997 to consider a number of key policy issues and challenges related
to the development of the institutional sector.
This publication, which has been prepared and edited by Hans
Blommestein and Norbert Funke, Head of and economist in the OECD
Financial Affairs Division, brings together selected papers of the July expert
meeting on the growing importance of the institutional sector. It follows
another recent OECD publication which features international statistics of
institutional assets and liabilities [Institutional Investors: Statistical
Yearbook (1997)]. This book is divided into four main parts. The topic is
introduced with an executive summary and an overview paper of the financial
market implications of the growing clout of institutional investors. The second
part analyses past developments and future prospects of the institutional sector
in major OECD regions and non-OECD countries. Part three relates to
investment strategies and techniques of institutional investors. Part four
investigates the regulatory and supervisory challenges which result from an
increasing institutionalisation. The various analyses indicate that a further
institutionalisation of financial markets appears to be very likely. The growing
3
importance of the institutional sector will continue to have a profound impact
on the structure of financial markets. Regulatory and supervisory authorities
will have to address new challenges in a financial landscape shaped in large part
by the growing financial clout of institutional investors. Tentative policy
conclusions are offered.
The views expressed in this report do not necessarily reflect those of
the OECD or its member governments. It is published on the responsibility of
the Secretary-General of the OECD.
4
TABLE OF CONTENTS
Part I OVERVIEW AND KEY POLICY ISSUES
Chapter I
Introduction to Institutional Investors
and Institutional Investing
by Hans Blommestein and Norbert Funke ....................................... 15
Introduction........................................................................................................... 15
1. Institutional Investors Across Countries ............................................................. 17
2. Investment Pattern and Financial Market Behaviour of Institutional Investors ... 21
2.1 Overview ..................................................................................................... 21
2.2 Asset allocation ........................................................................................... 21
2.3 Investment strategies ................................................................................... 22
2.4 Future challenges ......................................................................................... 23
3. Risk Management and Regulatory and Supervisory Infrastructure ..................... 24
Chapter II
Impact of Institutional Investors on Financial Markets
by Hans Blommestein..................................................................... 29
Introduction........................................................................................................... 29
1. Overview of the Growth of the Institutional Sector ............................................ 30
1.1 The growing financial importance of institutional investors
in OECD countries..................................................................................... 30
1.2 Forces shaping the role, structure and modus operandi
of institutional investors ............................................................................. 34
1.3 The role of professional fund managers in portfolio management ................ 35
1.4 Regulation and supervision of the institutional sector .................................. 36
2. The Impact of Institutional Investors on Financial Markets ................................ 38
2.1 Market liquidity, financial system structure and new financial products ....... 40
2.2 The impact of fund management and trading and investment strategies ....... 44
2.3 Stability and volatility of financial markets ................................................. 49
2.4 International diversification of portfolios of institutional investors .............. 53
2.5 The supply of risk capital ............................................................................. 56
2.6 Institutional investors, corporate governance and financial markets ............. 59
Annex
Basic Characteristics and Information
on Institutional Investors in OECD Countries ............................................ 69
Notes....................................................................................................................... 100
5
Part II GROWING IMPORTANCE OF INSTITUTIONAL INVESTORS
ACROSS OECD REGIONS AND IN EMERGING MARKETS
A. NORTH AMERICA
Chapter III
Perspectives On The US Asset Management Business
by Milton R. Berlinski and Simon R. A. Western ......................... 109
Introduction......................................................................................................... 109
1. Demographics ................................................................................................. 112
2. Retail sector .................................................................................................... 116
3. Retirement sector ............................................................................................ 120
4. Regulation ....................................................................................................... 124
5. The Future of the US Asset Management Industry ........................................... 126
6. The Asset Management Industry In The Twenty First Century ........................ 128
Chapter IV
Institutionalisation, ‘Retailisation,’ and Shifting Responsibilities:
The Canadian Experience
by Thomas A. Hockin................................................................... 131
Introduction......................................................................................................... 131
1. Guaranteed Investment Products to Fluctuating Instruments,
Especially Equities .......................................................................................... 132
2. Bank Deposits to Money Market Mutual Funds or Other Products ................... 133
3. Domestic Investments to Global Diversification .............................................. 136
4. Defined Employer Pensions to Private Savings ................................................ 136
5. Registered Retirement Savings Plans in Canada .............................................. 137
6. Institutional Control of Individual Companies ................................................. 139
7. Conclusions ..................................................................................................... 140
B. ASIA PACIFIC
Chapter V
Japanese Financial Institutions and Their Challenge
Towards the 21st Century
by Takeo Sumino ......................................................................... 145
Introduction......................................................................................................... 145
1. Japanese Market Overview .............................................................................. 145
2. The Big Bang 2001.......................................................................................... 149
3. Conclusions ..................................................................................................... 151
Appendix I Japanese Financial Institutions ............................................................. 152
Appendix II Japanese Retail Investors .................................................................... 156
Chapter VI
The Growing Financial Market Importance of Institutional
Investors: The Case of Korea
by Yu-Kyung Kim ........................................................................ 159
Introduction......................................................................................................... 159
1. Historical Perspective of the Korean Economy
and Institutional Investors ................................................................................ 159
6
2. Means of Raising Capital in the Korean Economy ........................................... 160
3. Ownership Structure and Shareholder Activism
of institutional investors .................................................................................. 163
3.1. Insurance companies ................................................................................. 163
3.2 Investment trust companies ........................................................................ 163
3.3 Pension funds ............................................................................................ 164
3.4 Banks ........................................................................................................ 164
3.5 Securities companies ................................................................................. 164
4. Regulatory Aspects of Institutional Investors ................................................... 165
4.1 Insurance companies .................................................................................. 166
4.2 Investment trust companies ........................................................................ 166
4.3 Pension funds ............................................................................................ 166
4.4 Banks ........................................................................................................ 167
4.5 Securities companies ................................................................................. 167
4.6 Prudent man rule versus quantitative regulation of portfolio distribution ... 167
5. Current Status of Institutional Investors ........................................................... 168
5.1 Insurance companies .................................................................................. 168
5.2 Investment trust companies ........................................................................ 168
5.3 Pension funds ............................................................................................ 171
5.4 Banks ........................................................................................................ 172
5.5 Securities companies ................................................................................. 172
5.6 Composition of the Korean stock market ................................................... 172
6. Deregulation in the Korean financial system .................................................... 174
7. Growth Prospects of Institutional Investors ...................................................... 175
C. EUROPE
Chapter VII
Institutional Investors and Their Implications
for Financial Markets in Germany
by Bettina Nürk ............................................................................ 179
Introduction......................................................................................................... 179
1. The Limited Role Played by Institutional Investors in Germany ...................... 180
1.1 "Pay as you go" - Dominant form of financing the pension system ............ 180
1.2 Investment funds ....................................................................................... 185
2. Institutional Investors and the Capital Market in Germany .............................. 189
2.1 Investment regulations ............................................................................... 189
2.2 Strong focus on fixed-income securities ..................................................... 192
3. Future Developments ....................................................................................... 194
Chapter VIII
The Growing Financial Market Importance of Institutional
Investors: The Case of Belgium
by Marc Bayot.............................................................................. 197
Introduction......................................................................................................... 197
1. Social security Pension Schemes ..................................................................... 197
2. Supplementary Funded Schemes - Pension Funds ............................................ 200
7
3. Investment funds - Present Driving Force ........................................................ 200
4. Guaranteed Investment Products: Developments and Prospects ...................... 203
Chapter IX
The European Investment Funds Industry in 1997
by Patrick Zurstrassen .................................................................. 207
1. The World Investment Funds Market ............................................................... 207
2. Analysing the Asset Growth of Funds .............................................................. 212
3. Funds Investment Patterns ............................................................................... 214
4. Comparing Investment Funds With Other Savings and Investments ................. 221
5. Cross Border Distribution of Investment Funds ............................................... 225
6. Conclusion ...................................................................................................... 230
Notes....................................................................................................................... 231
D. EMERGING MARKETS
Chapter X
The Role of Contractual Savings Institutions
in Emerging Markets
by Bernhard Fischer ..................................................................... 235
Introduction......................................................................................................... 235
1. Benefits from Promoting Contractual Savings Institutions ............................... 236
1.1 Impact on saving and long-term savings .................................................... 236
1.2 Effects on capital markets .......................................................................... 238
1.3 Other benefits ............................................................................................ 240
2. The Evolution of Contractual Savings Institutions in Emerging Markets................ 241
2.1 Private pension funds in Latin America and Asia ....................................... 241
2.2 Performance of the life insurance industry in emerging economies ........... 242
3. Private Pension Funds and Capital Market Development in Chile .................... 248
4. Prerequisites for Strengthening the Institutional Investment Base .................... 254
4.1 Promotion of national savings .................................................................... 254
4.2 Deepening and widening of investment opportunities ................................ 255
4.3 Direct measures to promote contractual savings schemes ........................... 256
Notes....................................................................................................................... 258
References .............................................................................................................. 259
Part III INVESTMENT STRATEGIES AND TECHNIQUES
Chapter XI
Asset Allocation, Financial Market Behaviour and Impact of EU
Pension Funds on European Capital Markets
by Koen De Ryck ......................................................................... 267
1. The Importance of EU Pension Funds .............................................................. 267
2. Asset Allocation of Pension Funds................................................................... 269
3. Financial Market Behaviour of EU Pension Funds
and Their Impact on Capital Markets ............................................................... 271
4. Conclusion ...................................................................................................... 274
Notes....................................................................................................................... 276
8
Chapter XII
Institutional Investing in The Netherlands:
The Pension Plan for Dutch Civil Servants
by Jelle Mensonides ................................................................... 277
Introduction......................................................................................................... 277
1. Institutional Savings....................................................................................... 278
2. Position of Pension Funds .............................................................................. 279
3. Governance of a Pension Fund ....................................................................... 281
4. Liability of Pension Plan ................................................................................ 283
5. ABP Strategic Asset Allocation...................................................................... 285
6. Portfolio Composition .................................................................................... 286
7. Financial Markets .......................................................................................... 287
8. APB’s Investment Philosophy ........................................................................ 289
9. Active Styles.................................................................................................. 290
10. Internationally or Domestically Biased Investments ....................................... 293
11. Shareholders Value and Corporate Governance .............................................. 294
12. Future Developments ..................................................................................... 295
Notes....................................................................................................................... 295
Chapter XIII
Asset Allocations of Pension Funds:
Identification of Benchmarks
by Andrea Beltratti ...................................................................... 299
Introduction......................................................................................................... 299
1. Asset Allocation by Pension Funds .................................................................. 300
2. The Impact of Italian Pension Funds ................................................................ 302
3. The Benchmark ............................................................................................... 305
4. Implications..................................................................................................... 307
5. Conclusions ..................................................................................................... 310
Bibliography ........................................................................................................... 311
Chapter XIV
Institutional Investors, Capital Markets and EMU
by Karel Lannoo.......................................................................... 315
Introduction......................................................................................................... 315
1. Institutional Investors in Europe ...................................................................... 316
1.1 Insurance companies and pension funds ..................................................... 317
1.2 Investment funds ....................................................................................... 320
2. European Capital Markets: A Brief Overview .................................................. 321
2.1 Stock markets ............................................................................................ 321
2.2 Bond markets............................................................................................. 323
3. The Dynamic Effects of EMU ......................................................................... 325
3.1 Who becomes the benchmark issuer? ......................................................... 325
3.2 Portfolio shifts of institutional investors ..................................................... 327
3.3 Market restructuring .................................................................................. 328
4. Conclusions ..................................................................................................... 328
Notes....................................................................................................................... 330
Bibliography ........................................................................................................... 331
9
Chapter XV
Warning: Past Pension Fund Performance is No Guarantee
for Future Performance
by Helmut Reisen ......................................................................... 333
Introduction......................................................................................................... 333
1. Demographic Trends Inside and Outside The Ageing OECD Area .................. 333
2. The Demographic Impact on Capital Returns
in Neo-Classical Growth Models ..................................................................... 336
3. The Demographic Impact on Pension Fund Performance ................................. 338
4. The Scope for Emerging Markets to Improve Pension Returns ........................ 342
Notes....................................................................................................................... 345
Bibliography ........................................................................................................... 347
Chapter XVI
Ageing-Induced Capital Flows To Emerging Markets
Do Not Solve OECD’s Basic Pension Problem
by Hans Blommestein................................................................... 349
Introduction......................................................................................................... 349
1. Methodological Problems in Predicting Long-Term Trends ............................. 350
2. Funded Systems and Portfolio Diversification ................................................. 350
3. The Basic Pension Problem ............................................................................. 351
4. Demographic Pressures on Funded Pension Systems ....................................... 351
5. International Portfolio Diversification: Financial Market Implications
of Capital Exports to Emerging Markets .......................................................... 353
6. Conclusion ...................................................................................................... 357
Notes....................................................................................................................... 359
Bibliography ........................................................................................................... 361
PART IV
THE REGULATORY AND SUPERVISORY ENVIRONMENT
AND RISK MANAGEMENT
A. PENSIONS
Chapter XVII
Regulation of Pension Fund Assets
by E. Philip Davis......................................................................... 365
Introduction......................................................................................................... 365
1. Reasons for Regulation of Pension Funds ........................................................ 366
2. Regulation of Pension Fund Assets .................................................................. 368
2.1 Regulation of portfolio distributions .......................................................... 368
2.2 Regulation of funding ................................................................................ 373
2.3 Ownership of surpluses.............................................................................. 380
3. Costs of Asset Restrictions .............................................................................. 381
Conclusion .......................................................................................................... 387
Annex Regulatory Structures .................................................................................. 391
Notes....................................................................................................................... 394
Bibliography ........................................................................................................... 397
10
Chapter XVIII
Investment Rules and State Guarantees
for Mandatory Private Pension Funds
by Dimitri Vittas .......................................................................... 401
Introduction......................................................................................................... 401
1. Investment Limits ............................................................................................ 402
1.1 Minimum and maximum limits .................................................................. 403
1.2 The "Prudent person" rule .......................................................................... 404
1.3 Types of investment rules .......................................................................... 406
1.4 Limits on overseas investments .................................................................. 408
2. Valuation and Accounting Rules ..................................................................... 409
3. Minimum Profitability Rules and State Guarantees .......................................... 411
3.1 Types of minimum profitability rules ......................................................... 411
3.2 The Chilean approach ................................................................................ 412
3.3 SIPOs and benchmark portfolios ................................................................ 413
3.4 State guarantees ......................................................................................... 413
4. Concluding Remarks ....................................................................................... 414
Notes....................................................................................................................... 416
Bibliography ........................................................................................................... 417
B. INSURANCE COMPANIES
Chapter XIX
Issues in The Effective Regulation of the Asset Allocation
of Life Insurance Companies
by G. M. Dickinson ...................................................................... 421
Introduction......................................................................................................... 421
1. The Aims of Investment Regulation ................................................................ 422
1.1 Protection of policyholders ........................................................................ 422
1.2 Directing the flow of investable funds ....................................................... 423
1.3 Reducing potential concentration of power in the financial sector .............. 423
2. Assessing the Impact of Regulation ................................................................. 423
2.1 Authorised or permitted investments .......................................................... 423
2.2 Limits on classes of investment ................................................................. 425
2.3 Limits on a single investment .................................................................... 428
2.4 Maturity matching requirements ................................................................ 429
2.5 Currency matching requirements ............................................................... 432
2.6 Use of derivatives ...................................................................................... 433
3. Features of a Good Investment Regulatory System .......................................... 434
3.1 Differential treatment for investment of capital funds
and technical provisions ........................................................................... 434
3.2 A Broad view of admissible investments ................................................... 435
3.3 Flexible quantitative restrictions on investment choice .............................. 435
3.4 The need to rethink currency matching requirements ................................. 436
3.5 Reconsideration of the emphasis on capital certainty
in investment regulation ........................................................................... 437
3.6 Acceptance of financial derivatives ........................................................... 439
11
4. Conclusion ...................................................................................................... 439
Appendix ................................................................................................................. 441
Notes....................................................................................................................... 444
Selected Bibliography ............................................................................................. 445
C. INVESTMENT COMPANIES
Chapter XX
Regulation and Supervision of Investment Funds in The New
Financial Landscape - A Canadian Perspective
by Glorianne Stromberg ............................................................... 449
Introduction......................................................................................................... 449
1. The Stromberg Report A Review of the Investment Fund Industry in Canada ..................................... 449
1.1 Areas of concern ........................................................................................ 451
1.2 The Perspective underlying the Stromberg
Report Recommendations ........................................................................ 452
1.3 Strategic recommendations ........................................................................ 453
2. The Changing Face of the Institutional Investor ............................................... 457
3. The Needs of the Consumer/Investor
and the Implications Flowing Therefrom ......................................................... 459
4. Implications for the Regulatory and Supervisory Framework ........................... 462
5. Suggested Approaches to Regulatory and Supervisory Strategies ..................... 463
5.1 Regulatory structure .................................................................................. 464
5.2 Regulatory system ..................................................................................... 466
5.3 Expanding public access to the Internet ..................................................... 469
5.4 Fundamental laws ...................................................................................... 470
5.5 Performance information and indexing ...................................................... 470
5.6 Specific investment fund issues ................................................................. 470
6. Conclusion ...................................................................................................... 473
Notes....................................................................................................................... 475
Chapter XXI
Risk Standards for Institutional Investors
and Institutional Investment Managers
by Tanya Styblo Beder ................................................................ 481
Introduction......................................................................................................... 481
1. Risk Standards Working Group ....................................................................... 482
2. Overview of Potential Risks ............................................................................ 482
3. Risk controls and Risk Standards ..................................................................... 484
12
Part I
OVERVIEW AND KEY POLICY ISSUES
13
Chapter I
INTRODUCTION TO INSTITUTIONAL INVESTORS AND
INSTITUTIONAL INVESTING
by
Hans Blommestein and Norbert Funke*
Introduction
Institutional investors (insurance companies, investment companies
and pension funds) have been gaining in importance in both OECD and nonOECD countries. Total institutional assets in the main regions in the OECD
area amounted to more than $24.4 trillion in 1995 (106.7 per cent of GDP).
Average annual growth of holdings by all categories of institutional investors
reached 10.5 per cent in the 1990-1995 period.
A number of common factors have been of crucial importance in
driving the growth of institutional investors as a group. Among these factors
are:
− The ageing of the populations of the OECD area has produced a
rising need for retirement products by increasingly wealthy and
sophisticated individual investors. At the same time, the baby
boom cohort is causing looming fiscal problems in countries
relying predominantly on pay-as-you-go financed (PAYG) state
pension provision systems.
− Technological progress in communications and information
processing has enhanced the capacity of the financial services
industry to provide financial intermediation and risk management
services by handling vast information flows at very high speed
and at very low costs, giving rise to a new breed of sophisticated
investment products. This process has been supported by
*
Senior economist and economist at the OECD.
15
important methodological break-throughs in the pricing of
sophisticated financial instruments. The United States capital
market, which is characterised by innovation and creativity, has
had a powerful impact on the entire global financial services
sector.
− Deregulation of the banking and securities industries since the
beginning of the 1980s has heightened competition between and
among banks and other financial institutions. Abolition of
cross-border capital flow restrictions has further increased
competition. These forces together with the introduction of
international capital standards for banks, have in most countries
caused the latter to move massively into the fee and commission
business, thereby further blurring demarcation lines between
banks, insurance and fund management business.
− Disintermediation from banks occurring via reduced demand for
bank deposits and traditional savings vehicles has resulted in a
shift in favour of more performance-oriented instruments like
money market funds and equity mutual funds. This process is
particularly noticeable in the North American capital market,
where the percentage share of bank deposits in total financial
assets of the household sector has fallen markedly.
Apart from these broad trends, a number of other factors are
important, such as special tax treatment of retirement savings, the rate of return
on institutional savings products offered relative to those obtainable from other
financial products, the regulatory and supervisory infrastructure and changes in
that structure as well as existing attitudes of the private sector with respect to
the various means of savings (for example the differences in countries with an
"equity culture" versus those with a "banking culture"). In addition, many
countries have explicit policies that try to promote certain types of institutional
investors, notably private pension schemes.
The rising institutionalisation has a profound impact on the structure
and functioning of capital markets. Hans Blommestein shows in the next
chapter that a strong community of institutional investors has a number of
positive feed-back effects on financial markets. For example, countries with an
important institutional sector (e.g. the United Kingdom, United States, Canada)
tend to have highly developed securities markets. Also, the process of financial
innovation may be stimulated as sophisticated trading arrangements and trading
techniques are developed. The institutionalisation of savings has led to an
increased supply of long-term funds. Consequently, the growth of institutional
16
investors may also lead to an increase in the supply of risk capital. However,
despite the welcomed side-effects, a number of new policy challenges arise as
well. In particular, it will increasingly be necessary for policy makers to take a
closer look at the functioning and regulation of institutional investors, as they
have a growing influence on the structure and modus operandi of capital
markets, the role and importance of capital markets for the real economy,
corporate finance, and income security.
The remainder of this chapter gives an overview of the main
characteristics of institutional investors in major economies, analyses its impact
on financial markets and looks at the main challenges ahead. At the same time
it provides an executive summary of this conference volume and the discussion
that took place during the expert meeting. Section 1 reviews the growing
importance of institutional investors across OECD regions and non-OECD
countries, highlights similarities and differences among the various regions and
assesses the growth prospects of the institutional sector. Section 2 studies
investment patterns, strategies and techniques of the institutional sector.
Section 3 examines a number of financial problems related to regulatory and
supervisory issues, such as the importance of investment restrictions and the
need for internal risk management standards.
1.
Institutional investors across countries
The degree of institutionalisation differs markedly across countries
and regions and the importance of the three basic types of institutional investors
also varies substantially.
For the United States, Milton Berlinski and Simon Western
convincingly show that the four primary factors mentioned above
-- demographics,
technology
and
communication
improvements,
disintermediation and deregulation -- have been largely responsible for the
tremendous change in the asset management industry. In the retirement sector
the move from defined benefit retirement plans to defined contribution plans
has played an important role. The defined contribution programme, in the form
of 401(k) programmes, has developed particularly well. As of end 1996, an
estimated 83 per cent of companies with 1 000 to 500 employees had defined
contribution plans. This shift implies a change in investment risk bearing from
corporate sponsors to individual plan participants. This also means that the
availability of suitable investment choices for individuals becomes more
important than ever before.
17
Thomas A.M. Hockin identifies a number of major changes in
financial markets in Canada. Investors are increasingly willing to shift from
bank deposits and guaranteed investment products to fluctuating instruments
and money market mutual funds. In addition, a "retailisation" of retirement or
pension savings is occurring, i.e. a shift from defined employer pensions to
private savings. A retailisation of savings implies that while money is
becoming more institutionalised, it is at the same time more accessible and
freer flowing than before, when the topography of the financial landscape was
different. At the same time global diversification is increasing.
One similarity between the United States and Canadian asset
managers is their emphasis on equity investment, while asset managers in most
other countries (except the United Kingdom and Australia) traditionally focus
more on fixed-income markets. Rough comparisons between the European and
the United States markets show for the former a 3/3 rule, with a third each of
total assets under management going into money market instruments, bonds
and equities, while in the United States the relationship is half equities and the
other half roughly equally divided between money market and bonds.
In Japan, savings were traditionally held in deposit accounts and
insurance policies, with relatively small amounts held in other institutional
forms. The institutional fund market is segmented into several sectors, each of
which had in the past been highly regulated. Allowable investments were either
high quality, domestic, fixed income securities or fairly specific portfolio
allocation rules. A number of these institutions basically pursued "buy and
hold strategies". The market shows some symptoms of rigidity, including lack
of competition in the funds management market, lack of professionalism among
domestic fund managers, and a scarcity of suitable domestic investment
products.
Takeo Sumino argues that Japanese institutional investors are
currently facing a number of special challenges. In the current low-inflation
super-low yield environment they have to take some additional risk in order to
obtain a pick–up in yield. Big institutional investors that face stringent
investment criteria would generally prefer to undertake limited foreign
exchange risk instead of additional credit risk. However, Japan is presently
preparing for the forthcoming "Big Bang" deregulation that should heighten
competition in the financial sector and broaden investment opportunities.
Yu–Kyung Kim describes the growing financial market importance of
institutional investors in Korea. He uses a very broad definition of institutional
investors which also includes banks, securities companies and merchant
18
banking corporations. Since the mid–1980s, the Korean government has
gradually deregulated the investment activities of institutional investors.
Institutional investors now play an important role in the Korean securities
market. At the end of 1996, the equity ownership of institutional investors,
including banks and securities companies, accounted for 31 per cent of total
listed shares on the Korean stock exchange. The growing importance of
investors will bring fundamental changes in the landscape of the Korean
financial markets.
The fall–out of the 1997 financial crises in Asia is expected to speed
up the modernisation of Asian financial markets. This should also benefit the
further expansion and efficient functioning of the institutional sector in these
countries.
Turning to developments in Europe, Bettina Nürk shows that in sharp
contrast to Anglo-Saxon countries, institutional investors are less developed in
Germany. The dominance bank–based system, the size of the state pension
system which is operated on a pay–as–you–go basis, as well as the lack of an
equity culture, are among the reasons for the relatively modest role of
institutional investors. In the private system of old–age provisioning,
companies typically use pension reserves to finance occupational pension
schemes. The third Financial Market Promotion Act foresees, among other
things, the introduction of so–called Pensions-Sondervermögen, a special type
of investment fund targeted at old–age provisioning. Though this appears to be
a step in the right direction, these funds are not pension funds in the AngloSaxon sense, although legislation is being planned in this direction.
Marc Bayot demonstrates that traditional institutional investors, in
particular pension funds, are less important in Belgium. However, investment
funds reach the second highest rate of penetration in the European Union, after
France. Guaranteed funds represent the fastest growing sector. One of the
reasons for the success of "guaranteed" equity plans may be that Belgium has
one of the oldest populations in the world (21 per cent over 60 years old).
Towards the end of the life cycle, investor preferences tend to become more
risk averse as retirement approaches. In addition, guaranteed products may be
of particular interest for newcomers to the equity market and during periods of
high market volatility.
Patrick Zurstrassen analyses the world investment fund market. The
United States holds the lion’s share, with a 57 per cent market share at the end
of 1996. The average fund size in the United States is approximately five times
as large as in Europe. However, Europe takes a strong lead in terms of the
19
number of investment funds. The share of equity funds has not increased
significantly in major European countries. The investment patterns of funds
differ significantly across countries. While investments occur predominantly in
the domestic and fixed income sector in countries such as Spain, Greece,
Portugal, France and Italy, a high proportion of international and equity assets
can be found in countries such as the Netherlands, Switzerland and Hong Kong.
Bernhard Fischer investigates the expanding role of institutional
investors in emerging markets, arguing that institutional investors can help
promote capital market developments in these countries. In addition, they may
have an impact on domestic savings. Although the relationship between
institutional investors and the overall level of savings has remained somewhat
inconclusive so far, institutional investors may change the way in which agents
are saving and thus encourage the supply of productive capital. For example,
Chile’s capital market depth is often attributed to its pension fund system.
Following Chile’s success, privatisation of pension systems started to gain
momentum in Latin America during the 1990s. In the life insurance sector
developing countries continue to play a less important role, with a world market
share of net premium income of around 7 per cent.
The size of the institutional sector is likely to continue to grow in the
near future. Given current demographic trends, there is a growing recognition
in a number of OECD countries that PAYG financed public pension systems
will impose considerable budgetary challenges in the future. In many countries
authorities are therefore taking steps to introduce or expand pre-funded
retirement systems. The outcome of the various reform proposals will be an
increased concentration of significant amounts of savings under the control of
funded pension systems. At the same time, an increasing public awareness of
the need for additional savings for retirement purposes is also stimulating
growth in investments of life insurance companies and investment funds.
Ongoing regulatory reform in some countries, intended to develop capital
markets further, may also enhance the growth prospects of the institutional
sector. To the extent that these driving forces affect most countries, the
importance and structure of the institutional sector may converge to a certain
degree. Given the growth prospects of the institutional sector, the following
Section looks closer at the investment behaviour of the sector.
20
2.
Investment pattern and
institutional investors
2.1
Overview
financial
market
behaviour
of
The investment pattern and strategies being followed by institutional
investors remain highly differentiated, ranging from strong risk aversion to
fairly aggressive strategies using sophisticated techniques in making asset
allocation decisions. Some funds are actively managed while others use passive
investment strategies based on indexation techniques. So far, in almost all
countries, regulators of pension funds and insurance companies aim at limiting
the use of derivatives to hedging purposes. Funds may be managed in–house or
externally. There appears to be a tendency among institutional investors to
increasingly delegate the management of their portfolios to professional fund
managers. The role of the fund management profession is therefore a key factor
in analysing the relationship between institutional investors and financial
markets.
2.2
Asset allocation
The asset composition of institutional investors appears to be
characterised by two diversification puzzles. First, in many countries equity
holdings are fairly limited. Notable exceptions are the United Kingdom and the
United States. Second, there exists a considerable home bias in asset
allocation. Partly as a consequence of regulation, the bias tends to be stronger
for pension funds and life-insurance companies than for mutual funds.
Koen de Ryck analyses the asset allocation of pension funds focusing
on the European Union. The asset structure of EU pension funds differs
significantly across countries, with the highest percentage of investments in
equities prevailing in the United Kingdom, followed by Ireland and Belgium.
Germany and Spain are on the opposite side of the scale. Ignoring the United
Kingdom, about 30 per cent of European pension fund assets are invested in
equities. With a shift towards funded pension systems, investments in equity
may rise. In addition, an increasing participation in so-called alternative asset
classes such as investments in smaller capitalisation stocks and venture capital,
may be expected.
Jelle Mensonides describes the decision-making process in
determining asset allocation for ABP, the pension plan for Dutch civil servants
which ranks number three in the world on the basis of assets under
21
management. The starting point for the investment strategy of the pension fund
is the liability structure. In general, the younger the age of participants in a
fund, the greater is the potential for investment in equities. More mature funds,
on the other hand, have to ensure liquidity and can less afford the risk
associated with significant corrections in equity markets. With the lifting of
government regulations in the Netherlands in early 1996, the Board of Trustees
decided to shift the asset allocation from the traditional fixed income
investments towards a greater emphasis on equity investments.
The asset allocation may also be influenced by the type of fund. For
example it has been suggested that the allocation differs for defined benefit and
defined contribution pension funds. Since a large share of the responsibility of
the management of the defined contribution plan lies with the beneficiary,
portfolios may be excessively risk–averse, leading to sub-optimal results. Since
the management of defined benefit plans is handled to a larger degree by
professional asset managers, the risk of under–performance is reduced.
However, this may be just a transitory phenomenon. As individuals become
more accustomed to handling their own investments, it can be expected that
they will increasingly use the services of investment professionals.
2.3
Investment strategies
An important issue is whether a "passive or an active" fund
management strategy is more suitable. On the one hand, there is a large body
of evidence that most fund managers cannot out–perform their indexes.
Nevertheless, most institutional investors are still willing to pay for active
management. The greater an institution believes that it is worth paying for the
skills of a portfolio manager, the more the manager will be allowed to deviate
from the benchmark index.
While the least sophisticated investors simply measure the
performance of a manager with respect to an absolute benchmark, the trend is to
supplement this measure with measures of the amount of risk that a portfolio
manager has taken to achieve his return. Some United States institutions have
"custom benchmarks" which are tailored to their own liability structure and
which include their own tolerance for risk.
Andrea Beltratti looks at the asset allocation of pension funds and the
concept of dynamic benchmarks. As indicated above, empirical observations
show significant cross–country differences in asset allocation. His analysis
focuses on the formation of an optimal portfolio for a pension fund from a
22
theoretical perspective. It is shown that a fixed benchmark may represent an
optimal choice from the point of view of individual investors at a specific point
in time. However, over a longer term horizon theory suggests that the optimal
portfolio of pension funds should be time-varying. Theoretical elements which
are useful for identifying a benchmark for pension funds are discussed.
From an individual investor’s perspective, some problems of
measurement and transparency remain. In some countries securities are still
valued at historical cost. In addition, most countries do not have uniform
practices for measuring yields. Mutual fund prospectuses may also be written
in such a way that they allow the fund manager to have greater leeway in
investing than would appear to be the case. Furthermore, there is a risk that
mutual funds may try to engage in window dressing by shifting their portfolios
at reporting times to securities which they wish to display, while actually
investing in other assets at other times during the reporting period. In addition,
portfolio managers may not be completely transparent in disclosing their fees
and costs, especially to retail investors.
2.4
Future challenges
On-going changes in the micro and macroeconomic environment pose
a number of challenges for portfolio managers and may lead to substantial
portfolio adjustments. Among these challenges are the planned introduction of
a single currency in Europe, the development of new market sectors, for
example lesser-rated debt markets and instruments such as asset–backed
securities, which have hitherto only reached modest proportions in Europe. The
continued implementation of successful reforms in an increasing number of
emerging markets and the switch in the direction of defined-contribution
systems as opposed to defined-benefit systems are other examples of important
changes in the operating environment of fund management.
Karel Lannoo looks at the impact of European Monetary Union
(EMU) on institutional fund management. The introduction of a single
currency in Europe will most likely increase the liquidity of the European
capital market and stimulate European institutional investors to become more
competitive. EMU will ease asset allocation for institutional investors.
Currency-based investment restrictions will become almost meaningless. As it
will be less possible to "play" currencies, interest rates and yield curves,
sectoral investment strategies may become more important. The home bias
may weaken, as investors can now invest in all countries which use the euro in
order to meet currency matching requirements. EMU will make remaining
23
distortions at the EU level more visible and pressures for harmonising
withholding taxes in Europe may grow.
Population ageing constitutes another important challenge, namely the
risks associated with a decline in the prime savers ratio in around ten years’
time. This may potentially put downward pressure on stock market
developments and may also have negative implications for pension fund
performance. Helmut Reisen warns that past pension fund performance may not
be taken for granted in the coming decades. The major non–Member countries
will also be undergoing a similar process, but they will be several decades
behind the OECD countries. When the number of retirees rises in OECD
countries, the emerging market will have a large share of their population in the
"prime saver" category. Thus, fund performance may be improved by increased
diversification into younger emerging market economies.
Hans Blommestein also argues that further integration between OECD
and non-OECD financial markets may be beneficial for both regions. Asset
diversification by OECD institutional investors in non–OECD economies is
potentially a sensible strategy. However, empirical evidence shows that the
beneficial effects are modest. Moreover, the net benefits of investments by the
“ageing” OECD economies in the younger, non-OECD countries seem limited.
Hence, a simple international diversification strategy does not solve the basic
pension problem in the OECD area.
3.
Risk management and regulatory and supervisory infrastructure
Regulation of institutional investors’ activities differs both across
types of institutional investors and across countries. Typically, a number of
reasons are cited for public intervention in the operation of markets. They
concern potential market failures related to information asymmetry,
externalities and situations where some monopoly power prevails.
E. Philip Davis shows that actual regulation of pension funds differs
1
markedly across OECD countries . Quantitative regulation of portfolio
distributions is imposed in a number of OECD countries, whereas in other
countries, mainly Anglo–Saxon countries and the Netherlands, the prudent man
rule is dominant. The riskiness of funds is influenced by funding methods.
Internal funding tends to be more risky than external. For example, a particular
1.
“Institutional Investors, Statistical Yearbook, ” 1997.
24
feature of German private pensions is that pension liabilities are held directly
on the balance sheet of the sponsoring firm and are not fully funded. Such
book reserves are by nature highly undiversified, and hence require a
compulsory insurance system to be viable. There is some evidence that
countries with quantitative portfolio allocation regulations obtain lower returns
than those that apply the prudent man concept.
Portfolio and funding regulations may be binding, even if in some
countries the asset allocation appears on average not to touch the limit.
Regulations may be binding for individual funds.
In addition, other
restrictions, such as minimum annual performance requirements (e.g. 4 per cent
in Switzerland), may also have undesired side effects.
Although the prudent man concept is applied in a number of
countries, the precise meaning of the concept differs somewhat from country to
country and may change over time. In general, this principle requires managers
to follow high fiduciary standards in investing funds. It allows fund managers
to set their own investment guidelines and avoids the pitfalls of government
interference with market processes.
Dimitri Vittas argues that the appropriate regulatory framework might
well differ between developing countries and developed countries. A "relaxed"
regulatory regime would be more appropriate for countries with developed
capital markets and a long tradition of private pension funds. "Draconian"
regulatory regimes may appear more suitable for less developed countries that
have underdeveloped capital markets and little or no tradition in operating
private pension funds. There are several determinants of the appropriate
regulatory framework of private pension funds, including the country–specific
philosophy of regulation, the nature of private pension funds, as well as the
degree of individual choice. The emergence of the prudent man approach in
some countries might reflect the voluntary and gradual expansion of private
pension funds in countries with more sophisticated and better developed
financial markets.
Not only existing regulations may hinder the investment choice.
Current tax regimes can also introduce some distortions in the asset allocation
of pension funds. In many countries, earnings of retirement plans enjoy
exemption from tax in their residence country. However, retirement plans’
income from foreign investments is subject typically to source–country tax
withholding in the same manner as that of a taxable investor.
25
Turning to the regulation of insurance companies, Gerald Dickinson
shows that there have been significant changes in the investment regulation of
insurance companies in many OECD countries. The widening of the range of
permitted classes of investments, especially during the last five years, has
removed constraints in some countries. In most OECD countries, however,
there are limits on particular classes of investment in which life insurance
companies can invest. Although in many cases the maximum permitted in
these classes of investment has been set relatively high, this limit may have still
inhibited investment choice.
There is also some evidence that annual solvency assessments on the
basis of asset/liability valuations may have had a more significant effect on
asset allocation by insurance companies than the more obvious direct
restrictions that exist on financial asset choice. Annual solvency assessments
impact heavily on short-term investment positions, although the real investment
risks facing life insurance companies are essentially long–term. Currency
matching rules, which are part of a wider solvency assessment system, may also
impose restrictions on investment policy by inhibiting foreign investment. The
effect may be stronger in smaller countries. Actuarial valuation methods used
to determine the capital base of life insurance companies in most OECD
countries would often understate the value of the capital base. Such a
conservative valuation would already imply an implicit restriction. Therefore,
further calls for investment restrictions for the minimum capital required would
not necessarily be recommendable. Because of the complexity of setting-up
solvency systems based on asset-liability models, including risk-based
standards, the regulation of life insurance would be likely to move towards a
combined system of external and internal control.
Glorianne Stromberg gives an overview of recent changes in the
regulation of investment funds in Canada. A recent report concerning the
regulation of the investment fund industry in Canada centred around two core
concepts - "fairness and integrity" and "information and knowledge". The
recommendations envisage a strong self-regulatory role for the industry that is
supported by a strong regulatory structure that is founded on these core
concepts. The framework for the recommendations would be based upon
proposals for centralised, co-ordinated, streamlined and functional regulation.
This would, in particular, include a simplification of the Canadian regulatory
structure by combining provincial resources to create a single centralised unit to
regulate investment funds.
In light of recent regulatory changes in the United Kingdom and
Australia, an open issue is whether one "super authority", which regulates and
26
supervises all classes of institutional investors, would be desirable in the future.
On the one hand, it might be easier under such circumstances to keep
regulations of the various financial institutions in line. Such a system could
also facilitate co-operation. On the other hand, the regulatory authority could
become very large, and institution-specific aspects might be neglected. The
new financial landscape may, however, require that regulators and supervisors
should increasingly focus on the proper management of risk rather than on
instruments or legal entities.
In view of the many reports on surprises about losses of institutional
investors, many of the "old" risk controls (e.g. investment only in high-grade
securities, restriction of average maturity, currency risk, hedging guidelines,
etc.) seem to have failed in the recent past. Uni–dimensional risk measures
appear to be unsatisfactory. Guidelines on risk management measurement
systems and risk management practice appear to require updating. In particular,
there is no comprehensive set of standards covering the special problems facing
fiduciaries of multi-asset class, multi-manager portfolios. Issues specific to
institutional investors include: longer time horizons, multiple asset classes,
multiple portfolio managers/firms, distinct fiduciary responsibilities, heavy
reliance on outside data, historical focus on non–risk adjusted performance data
but a gradual shift to take risk into account, increasing dependence on
quantatitive models in allocating and evaluating investments.
Tanja Beder presents a set of risk standards that aims to provide
guidelines for institutional investors and their fund managers concerning risk
measurement and risk management practices. The standards were developed by
a Working Group of individuals from the United States institutional investment
community. The set of risk standards can be grouped into three categories:
management of risk (including identification), oversight and checks–and–
balances. Some of the standards are widely used, while others have only been
implemented by a few institutions.
A key policy issue is to what extent the development of risk
management standards for the institutional sector can be linked to a relaxation
of regulatory constraints concerning asset allocation. It has been argued that a
proper framework of risk management in the insurance sector would be able to
capture two key risks faced by life insurance companies: interest rate risk (in
conventional life insurance and annuity contracts) and inflation risk (in longterm savings vehicles, notably for retirement purposes). Similar arguments may
hold for the pension fund industry. Although portfolio and risk management
are separate activities and responsibilities, there may be some advantages or
even the necessity to agree - at some point - on a common course.
27
Chapter II
IMPACT OF INSTITUTIONAL INVESTORS
ON FINANCIAL MARKETS
by
Hans Blommestein*
Introduction
Institutional investors have been growing in size dramatically over the
past two decades or so. The increasing importance of institutional investors
(life insurance companies, pension funds and investment funds) as holders of
assets means that their impact on the functioning of financial markets is steadily
growing. In most OECD countries, institutional saving institutions now play a
key role in domestic financial systems.
The involvement of institutional investors in capital market
transactions is increasing in tandem with their growing financial clout. A
strong community of institutional investors seems to be a precondition for the
development of liquid securities markets with sophisticated financial vehicles.
In view of the growing influence that institutional investors exert on the
structure and modus operandi of capital markets, the importance of capital
markets for the real economy, corporate finance, and income security, it is
necessary for policy makers to take a closer look at the functioning and the
regulation of these institutions. A full analysis would include the functioning
of the fund management profession, the impact of changes in demography and
the regulation of pension schemes on the efficiency of the allocation of savings,
the influence of the international portfolio diversification of institutional
investors, and the impact of tax regimes on the behaviour of institutional
investors. Also the consequences of investment practices of institutional
investors for the functioning of financial markets need to be analysed.
*
Senior Financial Economist at the OECD.
29
1.
Overview of the growth of the institutional sector
1.1
The growing financial importance of institutional investors in
1
OECD countries
The importance of institutional investors is steadily increasing. Total
institutional assets of the main regions in the OECD area rose from $3.2 trillion
in 1981 (i.e. 38 per cent of GDP), to $16.3 trillion in 1991 (90 per cent of
GDP), to more than $24.4 trillion in 1995 (106.7 per cent of GDP). In the
period 1990-95, average annual growth of holding by all categories of
institutional investors has been spectacular (see Chart 1).
Chart 1. Average annual rate of growth of assets held by
Institutional investors in OECD regions, (1990-1995)
Insurance
Companies
11.4%
7.9%
9.2%
6.8%
Pension Funds
10.1%
11.1%
Investment
Companies
Europe (20
countries)
16.5%
North America
18.7%
7.6%
Asia and the
Pacific
11.3%
All investors
10.9%
8.3%
Source: OECD/DAFFE
Pension funds, insurance companies, and investment companies in the
Group of Seven countries had close to $18.5 trillion in assets under
management in 1995. In comparison, the global equity market in 1993
30
amounted to $14.1 trillion, and the total outstanding stock of government debt
in the Group of Seven countries was $9 trillion.2 In the period 1980 - 1993, the
aggregate assets of institutional investors in the United States, Japan, Germany,
United Kingdom and Canada increased more than 400 per cent and more than
doubled as a percent of GDP ; at the end of 1995, aggregate institutional assets
in the G-5 countries were around $20.5 trillion or 119 per cent of GDP. G-7
aggregate institutional assets stood at $21.3 trillion at the end of 1995 or
110.3 per cent of GDP, while recording strong growth for all categories of
institutional investors [see Chart 2]. Other OECD countries have recorded
similar changes in total assets under management.
Chart 2. Average annual rate of growth of assets held by
Institutional investors in G7 countries (1990-1995)
3%
19%
11%
Insurance Companies
13%
9%
10%
8%
6%
19%
5%
Pension Funds
11%
3%
6%
10%
29%
8%
22%
Investment Companies
5%
14%
14%
19%
Canada
France
8%
13%
13%
All investors
10%
9%
9%
11%
Source: OECD/DAFFE
Notes:
France: Pension Funds as mid-term reserves of the PAYG
Japan: Employee’s pension fund
31
Germany
Japan
Italy
United Kingdom
United States
Pension funds and insurance companies have traditionally been the
most important institutional investors in OECD capital markets. Although they
still control very sizeable (and still growing) asset portfolios, the asset growth
of investment companies has been even more spectacular. It is estimated that
mutual funds alone accounted for about $3.3 trillion in 1994.3 Investment
companies’ assets have increased at a much faster pace than have the assets of
other institutional investors. Assets of investment funds amounted to
$5.6 trillion in 1995, a growth rate of 16.1 per cent over the 1990-1995 period;
the total share of assets under management of investment funds increased from
18 per cent in 1990 to 23 per cent in 1995 (see Chart 3). Total assets under
management of hedge funds stood at an estimated $75-100 billion in 1994, a
4
doubling since 1991, and grew further to an estimated $236 billion in 1995.
Chart 3: Distribution of assets held by institutional investors.
1990 and 1995
Other forms
of
institutional
saving
16%
1990
Other forms
of
institutional
saving
14%
Insurance
Companies
37%
Investment
Companies
18%
1995
Insurance
Companies
35%
Investment
Companies
23%
Pension
Funds
29%
Pension
Funds
28%
Source: OECD/DAFFE
Another noteworthy trend is the changes in the share of foreign
securities in the portfolios of institutional investors. There is a gradual but
clear trend toward internationally diversified portfolios of pension funds. The
behaviour of life insurance companies and investment companies is less clear.
In fact, their international diversification shows some decrease in the 1990s.
The portfolios of insurance companies are less diversified than those of pension
funds. There are important differences in the share of foreign securities in the
portfolio of OECD investment companies: a) the portfolios of mutual funds in
Canada, Germany and the United Kingdom are more internationally diversified
32
than in the United States and Japan; b) possibly related to the previous point,
US mutual funds show a clear trend toward increased international
diversification, while in other countries this trend has levelled off or even
declined somewhat; c) mutual funds in the larger OECD countries are
significantly more diversified than insurance companies and pension funds.
The analysis of these general trends and developments is complicated
by the fact that increasingly there are a number of institutional and functional
overlaps between the different categories of institutional investors. World-wide
deregulation in the financial sector industry and revolutionary technological
developments have eroded the statutory and physical barriers between banks,
other financial intermediaries and the securities industry. The same forces that
are contributing to financial sector integration are also increasingly affecting
institutional investors. The process of integrating institutional investor
operations into the more “traditional” financial sector activities is being
strengthened by the growing influence of the professional fund managers.
Firstly, the links between banks and institutional investors have
grown stronger over time. Banks have moved on a wide scale into the
investment fund business, also in OECD countries with non-universal banking
systems. Secondly, deregulation and the liberalisation of the rules governing
the operation of financial institutions have encouraged the formation of
financial conglomerates in which banks and insurance companies offer the
5
widest possible array of services. This integrated financial activity is often
called bancassurance. This integrated activity is not allowed in all OECD
countries. For example, in the United States’ and Japan regulations separating
banks from insurance companies are still intact, although bank sales of
insurance products have expanded rapidly in recent years in the United States.
Thirdly, larger insurance companies that can afford the services of large
professional asset management teams are increasingly moving into the
investment fund business, either by developing "unit-linked" insurance products
or by launching investment fund companies that offer financial products also to
clients that are not necessarily insurance policy holders. Another development
is the so-called alternative risk transfer market, where insurance risk is
transferred on investment instruments such as catastrophe futures. Fourthly,
even insurance companies and pension funds that cannot afford a full-fledged
professional asset management team have usually strong links to the financial
sector because they are employing outside teams to invest and manage their
assets.
33
1.2
Forces shaping the role, structure and modus operandi of
institutional investors
The overview in the previous paragraph shows very clearly that
institutional investors as a group have vastly expanded their economic sphere of
influence. Yet, institutional investors are by no means a monolithic group,
since they have different investment objectives and fiduciary mandates, operate
under different regulatory and tax regimes, and have a different tolerance to
risk. The influence of the liabilities of the different types of institutional
investors is a key determinant of their behaviour, including their investment
activities. Nonetheless, it is possible to identify a number of structural factors
driving the growth of institutional investors as a group:
a) Deregulation of the banking and securities industries since the beginning
of the 1980s has heightened competition between and among banks and
other financial institutions. Abolishment of cross-border capital flow
restrictions has further increased competition. New capital standards for
banks were introduced in the same period. In response to these
pressures, banks have massively expanded, or moved into, the insurance
and investment fund business in search of new activities that generate
earnings in the form of commissions and fees, while they do not
necessarily absorb additional capital.
b) Liberalisation of the activities of institutional investors, both in terms of
the production and distribution of their respective products and the
investment of their assets. An important aspect of the liberalisation
process is the relaxation of regulatory constraints on cross-border
activities and investments.
c)
The rising needs for retirement benefits of a rapidly ageing population in
conjunction with more sophisticated and wealthier private investors
have had a significant impact on the growth of demand by private
households for retirement benefit products offered by the different types
of financial institutions -- banks, insurance companies, and investment
funds.
d) Spectacular technological advances in communications and information
technology enhanced the capacity of the financial sector, the
professional fund managers, and the institutional investor community to
use the opportunities offered by the liberalised environment. Advances
in technology have enabled funds to be managed at lower costs. More
reliable and efficient clearing and settlements systems for securities and
payments, the creation and use of complex new financial products for
risk management purposes, and the integration of capital markets have
34
been important factors underpinning the spectacular growth of the
managed assets of institutional investors, in particular, mutual fund
assets
e)
1.3
The increasingly active role of the fund or money management
profession has made important contributions to the transformation and
dramatic expansion of the institutional investor industry.
The
management of funds by these professionals has common, technical
features on the operational side, but the exact strategy and specific
objectives are adapted to the specific institutional set-up.
The role of professional fund managers in portfolio management
When discussing the forces shaping the investment behaviour of
institutional investors it is conceptually important to make a distinction
between the legal and economic definition of the different types of
"institutional investors", on the one hand, and the professional fund managers
who develop asset allocation strategies and take investment decisions, on the
other. The fund management profession is an important driving force behind
the increasing sophistication of the investment strategies of institutional
investors. Individual and institutional investors have increasingly delegated the
management of their portfolios to professional fund managers. The role of the
fund management profession is therefore a key factor in analysing the
relationship between institutional investors and financial markets.
The following broad picture emerges from an analysis of the links
between institutional investors and professional fund managers:
− First, fund managers may work in four different basic types of
institutional set-up: 1) in the fund or trust departments of banks;
2) in separately capitalised fund (or money ) management
companies which may be owned by banks or insurance
companies; 3) independent money management companies (that
is, firms that or not affiliated with an insurance company or bank);
4) the in-house fund management departments of large insurance
companies and pension funds.
− Second, the total amount of professionally managed funds is
larger than the portfolios of the "classic" (regulated) institutional
investors. Fund management companies are also involved in the
management of portfolios of "high-net worth" individuals, the
non-pension fund money of non-financial enterprises, foundations
35
and endowment funds, and non-pension fund money managed by
banks, as well as the bank's and securities firm’s own portfolios
(proprietary trading by banks and securities firms have expanded
strongly).
− Third, the number of asset portfolio managers is smaller than the
number of institutional investors whose portfolios are
professionally managed. The smaller insurance companies and
pension funds usually give portfolio management mandates to
outside fund management teams.
In many cases, fund
management companies pool the funds of the smaller institutional
investors. There is also some evidence that the larger institutional
funds have reduced the number of managers investing their
6
assets. Institutional investors are increasingly indexing assets,
thereby reducing the need for a large number of asset portfolio
managers. Finally, to the extent that insurance companies and
pension funds invest directly in investment fund shares, they
reduce the amount of assets that would have to be invested by the
fund's own managers in the capital and money markets.
1.4
Regulation and supervision of the institutional sector
The different types of institutional investors are operating under
different regulatory and supervisory regimes (see Annex for details). An
important reason stems from differences in liability structures. On the other
hand, there are increasingly a number of institutional and functional overlaps
between the different categories of institutional investors. This raises the
general issue of a non-level playing field for the different institutional players
due to differences in the regulatory regime. For example, both life insurance
companies and pension funds offer "pension-type" products. One might argue
that, from this perspective, life insurance companies would face "unfair"
competition because the latter have to comply with strict "solvency" criteria,
whereas the pension funds do not. Another example concerns the difference in
the regulation of banks and mutual funds. Bankers complain that governments
are pursuing asymmetrical financial regulatory policies because banks have to
carry the costs of a higher regulatory burden (capital and liquidity adequacy),
while both mutual funds and banks compete for the same pool of savings. On
the other hand, a number of OECD countries allow the development of group
corporate structures so as to overcome some of these non-level playing field
problems. For example, some countries have banking groups with insurance
36
and mutual funds which observe the particular regulations of the market to
which they are addressed.
The supervisory structure of institutional investors, such as pension
funds and investment companies, differs considerably across OECD countries.
For example, Japanese pension funds are supervised by the Ministries of Health
and Welfare and Finance. In the United States, regulation of US pension plans
is divided by type of fund. Private pension plans are regulated by two, and in
some circumstances, by three agencies. The Treasury Department enforces the
rules relating to tax qualification for all public and private pension plans. The
Department of Labour has primary responsibility for regulating the
administration of private pension plans, the investment of their funds, and for
reporting and disclosure by private plans. The Pension Benefit Guaranty
Corporation guarantees the benefits provided by private defined benefit pension
plans up to a certain amount. Public pensions are regulated (except for tax
qualification) by the various states in which they are located. US mutual funds
are supervised by the SEC and the NASD; in the United Kingdom the
authorities have recently implemented a major reform of the supervisory
framework for the financial sector, including the institutional sector.
The complexity of the supervisory structure in many OECD countries
raises several questions, including the costs of regulation for financial market
participants and the desirability of co-operation and exchange of information
between the different supervisory organisations (including the securities
regulators and bank supervisors). Some analysts have therefore argued in
favour of a simpler supervisory structure, such as, for example, a Dutch-style
supervisory structure for pension funds and insurance companies (one regulator,
annual checks on funding and oversight of internal investment rules, occasional
on-site inspections).
An important analytical distinction needs to be made between “direct”
regulatory constraints on the investment activities of institutional investors and
compliance with regulations that do not intend to restrict asset allocations per
se, but which nonetheless lead de facto to a portfolio composition which is
different from the one that would prevail in the absence of the indirect
restrictions on asset allocation decisions. In this context, it could be argued that
although the regulation of institutional investors may be cumbersome (e.g. the
regulation of insurance companies and investment companies at the state level
in the USA), the regulatory regime may impose in practice no direct restrictions
on the investment activities of institutional investors. In this context, the key
questions in assessing the regulatory regime are: i) is the regulatory regime
significantly restricting the investment activities of institutional investors and,
37
if so, why? and ii) in cases where indirect restrictions constrain asset allocation
decisions, are they essential for achieving the stated objectives (e.g. investor
protection)?
2.
The impact of institutional investors on financial markets
In this section some aspects of the influence of institutional investors
on the functioning of financial markets will be examined. The proper starting
point for assessing the impact of institutional investors is to investigate which
of the economic functions of financial intermediation are being provided by the
different types of institutional investors.
Institutional investors as financial intermediaries?
Pension funds, insurance companies, and investment companies are
non-depository financial intermediaries that pool the funds of market
participants and use those funds to buy a portfolio of financial assets. These
institutional investors are engaged in three basic financial market activities,
whereby differences in activities across OECD countries are to a large extent
the result from differences in regulatory and tax regimes:
− as collectors of savings, in particular from households;
− as suppliers of funds in the market for securities and other financial assets;
− as participants in the i) primary and secondary market for bonds and
equities; ii) foreign exchange markets; iii) the money markets; and iv) and
the derivatives markets.
Thus, institutional investors may perform one or more of the
following economic functions of financial intermediaries:
1) maturity
intermediation; 2) risk reduction via pooling and diversification; 3) lowering
costs of contracting and information processing; and 4) the provision of
payment services. Maturity intermediation is generally not a function of
institutional investors. This is true even with mutual funds, because the net
asset value per share will fluctuate with changes in market conditions.
Consequently, an investor with a short-term investment horizon wishing to
invest in financial assets with a maturity greater than the planned horizon faces
the risk that the securities may have to be sold at a time when their market
value is less than the price paid. 7
38
On the other hand, institutional investors offer risk reduction through
diversification function. However, the degree of diversification is dependent on
the investment strategy of the institutional investor in question. Important
determinants of the investment strategy are the type of institutional investor and
the related fiduciary mandate and investment objectives, the associated
regulatory and tax regime, and the growing influence of professional fund
managers.
Beyond risk reduction via diversification, institutional investors lower
the costs of contracting and information processing because a retail investor
purchases the services of skilled financial advisors at less cost than if the
investor directly negotiated with such an advisor. The advisory fee is lower
because of the larger size of the assets managed, as well as the reduced costs of
searching for an investment fund manager and obtaining information about the
securities. Presumably, the costs of contracting and information processing
have been reduced by the more frequent use of professional fund managers by
institutional investors. In particular, institutional investors can reduce the costs
of transacting in securities by effectively mobilising their financial clout in
negotiating transaction costs and custodial fees.
Finally, institutional investors do not provide payment services with
the exception of those money market mutual funds which allow investors to
write checks drawn on the fund, although this facility is limited in various
ways.
The size of the institutional sector and the development of the capital market
It can be concluded that institutional investors are likely to have an
important impact on the functioning of the financial markets via different
financial intermediation functions. The strong rise in cross -border transactions
by institutional investors means that these intermediation functions are
increasingly performed on an international scale. Institutional investors can
have an overriding effect on the evolution of capital markets and corporate
finance: the larger the institutional sector, the greater the influence on the
development of the capital markets. At the same time, a dynamic community
of institutional investors seems to be a pre-condition for the development of
liquid securities markets with sophisticated financial vehicles. However, an
extensive debate about the question of which comes first is not relevant.
Institutional investors need well-developed securities markets for the efficient
execution of their investment strategies. Vice versa, a dynamic institutional
sector encourages the development of capital markets. For these reasons, the
39
impact of a dynamic institutional sector on: i) market and financial system
structure; ii) the role of fund management and trading strategies; iii) liquidity
and volatility of the market, and iv) demand for capital market instruments
(including innovations), warrants to be examined in some detail.
2.1
Market liquidity, financial system structure and new financial
products
The growth of the institutional sector has had a profound effect on
capital market structure. Institutional investors are very much interested in
market liquidity -- i.e. the ability to transact in large size without moving the
price against them and at low transaction costs. They demand therefore a
market infrastructure characterised by specialised wholesale markets which can
process large transactions very rapidly and contribute to liquidity. This in turn
requires the existence of well-capitalised market makers that are ready and able
to execute large transactions. Advanced communications and information
systems in conjunction with efficient and reliable clearing and settlement
systems8 and an efficient micro-structure for trading securities are also
important components of liquid capital markets because they provide the
ground for more efficient arbitrage activities and diversification of investment
portfolios. Both activities create additional liquidity in the market. Other
factors that are crucial for the development of a stable and liquid market
infrastructure include: adequate public disclosure standards, an adequate
(i.e. a market-oriented ) accounting system and a proper legal framework for the
9
institutional and financial sectors. Finally, a healthy banking sector is a sine
qua non for the emergence and development of capital markets, given its role as
an important intermediary of liquid longer-term funds.10
Market liquidity
Market liquidity is a key requirement of the larger institutional
investors. Institutional trading and investment strategies demand the existence
of sophisticated and liquid financial markets. Consequently, the quest for
liquidity has changed dramatically the micro-structure of financial markets.
Four dimensions of liquidity can be distinguished:
− width, determined by the bid-ask spread for a given number of securities;
− depth, the amount of securities that can be traded at given bid and ask
quotes;
40
− immediacy, the amount of time to carry out a transaction;
− resiliency, the time it takes before prices revert to former levels after a
large order has been absorbed by the market.
Through sophisticated trading and investment strategies, institutional
investors can create additional liquidity in the form of arbitrage activities and
diversification of investor portfolios. Liquidity might also be aided by
reduction in commissions and other transactions costs, that institutional
investors are well placed to press for. Increases in market liquidity should in
turn be beneficial more generally to the efficiency of financial markets, and lead
to a reduction in the cost of capital.
Liquidity is a form of economy of scale and therefore the larger
financial centres have a competitive edge, even with similar technology.
11
In some countries, the
Relative liquidity is reflected in transaction sizes.
growth of institutional investors -- in particular pension funds -- has encouraged
the development of off-exchange "block trading". This in turn may entail a
tiering of markets, with order-driven and heavily regulated domestic markets
dedicated to retail investors and small company stocks. Institutional investors
have more power than small investors to press for the lowest possible
12
transaction costs, thereby boosting liquidity. Total transaction costs consist of
indirect trading costs (determined by the liquidity of the market: the higher
market liquidity, the lower indirect trading costs) and direct trading costs
(determined by the structure of transaction fees ). Institutional investors will
13
seek to minimise total trading costs.
Financial system structure
Institutional investors have also had an impact on the overall structure
of financial markets. Countries with large funded pension schemes
(e.g. United Kingdom, United States) tend to have highly developed securities
markets, while capital markets are relatively underdeveloped (in particular the
equity market) in countries with small pension-fund sectors (e.g. Germany,
Italy). Given their focus on real returns, pension funds should be particularly
beneficial to the development of equity markets.14 Although pension funds
could in principle also develop by providing loans and investments in real
estate, their greatest comparative advantage is in the capital markets. Loans
require monitoring, so the customer relationship probably gives banks a
41
competitive edge. In contrast, trading and the pooling of risks are more
efficiently undertaken in capital markets, where transactions costs are lower.
The growth of a dynamic institutional sector may contribute to a
stronger role of capital market intermediation in so-called bank-based financial
systems (e.g. Germany, Japan, the Netherlands). In particular, pension funds
that are investing significant parts of their portfolios in equities would pressure
for changes in laws and regulations of companies that usually can be found in
"bank dominated" financial systems. In addition to a modernisation of the
capital market infrastructure, pension funds can be expected to push for a move
to laws and practices that would better protect the interests of equity holders.
These include take-over codes, insider information restrictions, limits on dual
classes of shares which seek to protect minority shareholders, as well as equal
treatment of creditors in bankruptcy to protect their holdings of corporate
bonds.
The resulting modernisation of the capital market might further
encourage the larger corporations to shift from bank financing to securities
markets. However, similar access to capital markets is not available for the
smaller enterprises. This in turn may re-enforce the development that bank
lending is being increasingly concentrated in the smaller and medium-size
enterprise sector, even in so-called bank dominated OECD countries.
Demand for capital market instruments and innovations
Institutional investors can influence the demand for capital market
instruments in several ways: i) by increasing the total supply of saving, ii) by
influencing the personal sector’s portfolio distribution between bank deposits
and securities, and iii) via the institutional sector’s own portfolio choices.
Most studies indicate that institutionalisation has a small impact on
total personal saving,15 although some studies suggest a larger effect.16 Most
authors have come to the conclusion that the growth of institutional investors
increases the total supply of long term funds, and may reduce bank deposits,
but that total savings do not increase or only marginally.
The personal sector tends to hold a much larger proportion of liquid
assets than the institutional sector. Institutional investors hold a greater
proportion of their assets in the form of long-term assets than households; also,
the personal sector’s foreign asset holdings are relatively minor. These
17
differences can partly be explained by the following factors:
42
a) Households have relatively short time horizons. Most institutional
investors (in particular, pension funds and life insurance companies) have
long-term liabilities. They tend therefore to concentrate portfolios on
long-term assets yielding higher returns such as equity and real property.
b) Institutional investors have a comparative advantage in compensating for
the increased risk of holding domestic and foreign equities, by pooling
across assets that are imperfectly correlated.
The institutionalisation of savings implies therefore a shift in
composition of the portfolios of the household sector. The demand for capital
market instruments by the institutional sector is the outcome of portfolio
optimisation -- seeking an optimal risk/return profile-- taking into account the
nature of its liabilities, tax factors and regulatory regimes. It has been
suggested that in recent years the biggest impulse to the supply of long-term
funds has come from pension funds (part of the growth of mutual funds is due
to investments by pension funds and/or the growth of personal pension plans).
These shifts in portfolios imply that securities are increasingly held by
large, informed investors. This in turn means that their behaviour should be
strongly influenced by relative asset returns, particularly when there are
relatively few regulations governing portfolio investments and transaction costs
are low. Adjustments to changes in relative returns are relatively rapid. This
implies that capital markets are allocating funds more efficiently and are
valuing securities more accurately and rapidly.
Studies confirm that
adjustments to a change in returns are rapid in countries with few regulations on
portfolio allocation and somewhat slower in countries with higher transaction
18
costs, more restrictions and poorer information disclosure. Also, adjustments
by households and non-financial companies tend to be slower due to higher
19
transaction costs and poorer information.
Analysts have also argued that the increased supply of long-term
capital market instruments, attributed mainly to the growth of pension funds
and increased comfort with securities investing by individuals, may be leading
to a compression of the yield differential between equities and bonds. It has
been suggested that this may have a structural impact on the capital market by
20
making the issuance of equities cheaper relative to bonds.
The process of financial innovation has been driven strongly by the
growth of the institutional sector. Sophisticated trading arrangements and
investment techniques have been developed in response to the needs of
institutional investors. The growing importance of institutional investors is
43
generating also an increasing demand for risk-transfer techniques, which enable
the investor to choose the desired combinations of return and risk. Such
techniques include both securitisation, which enables the investor to transfer the
credit risk as well as the market risk, and derivatives, whereby market or price
risk is reallocated among participants. A more recent development is credit
21
derivatives, which enable market participants to transfer credit risk separately.
The demand for risk-transfer techniques has been strongly driven by
the nature of the liabilities of the different types of institutional investors and
regulatory requirements. For example, defined-benefit schemes and strict
minimum-funding requirements have stimulated demand for hedging by
pension funds. In order to minimise the costs of hedging, pension funds and
life-insurance companies have an incentive to immunise their defined-benefit
liabilities via an investment strategy of duration matching.
The requirement of a fixed duration for investment instruments has
stimulated innovations such as zero coupon bonds, collateralised mortgage
obligations, strips in government securities markets and guaranteed income
contracts; immunisation strategies have also stimulated the development of
markets for index options and futures. Fixed-duration instruments have also
spurred the process of securitisation of mortgages in the case of collateralised
mortgage obligations and of loans and private placements in the case of GICs
(Guaranteed Income Contracts).
2.2
The impact of fund management and trading and investment
strategies
A broad picture of the links between institutional investors and
professional fund managers was sketched in section 1.3. In this section
attention is paid to the impact of fund management and trading strategies on the
structure and functioning of financial markets. Professional fund managers are
an integral part of the financial market infrastructure. They have a growing
influence on the structure and modus operandi of financial markets and
institutions.
The growing influence of fund management
Fund or money management constitutes an increasingly important
part of the new financial landscape. The technical and operational demands, in
conjunction with growing size, of the fund management industry has had, and
44
is having, a major influence on how financial institutions are operating. In its
most simple form, fund management can be seen as a service involving
management of an investment portfolio on behalf of institutional investors.
As mentioned above, fund management can be carried out internally
or externally. Delegation to an external fund management service -- e.g. a
bank, insurance company or independent money management company -- raises
principal-agent problems. Various features of money management can be seen
as responses to mitigate the consequences of principal-agent problems such as
short mandates to fund managers, frequent performance evaluation, and fees
related to performance of the funds under management. Ideally, the choice for
an internal or external fund management set-up should be based on
(risk-adjusted) performance criteria. Hard evidence on the relative performance
of internal and outside money managers is sparse. Exceptions include a recent
survey among eight hundred corporate and two hundred fifty public pension
plan sponsors in the United States that shows that internally managed
22
defined-benefit assets outperform those run by outside managers. Data for the
United Kingdom also seem to confirm that average returns are lowest for
external managers. This evidence seems to indicate that internal managers are
less susceptible than external ones to principal-agent problems. Although plan
sponsors bear the ultimate risk in defined-benefit schemes and, therefore, have a
greater incentive to monitor fund managers than in the case of
defined-contribution, in-house managers of defined-benefit assets are
performing better -- by significant margins -- than both their external
counterparts and various benchmarks such as the S&P 500 index. Yet, fewer
than 25 per cent of US plan sponsors do defined-benefit asset management
in-house. The most important reason seems to be that few pension funds can
afford the salaries that "high-calibre" in-house managers would demand.
Unfortunately, the "high-calibre" external managers do not deliver the same
results as their "brilliant" internal counter-parts.
Another noteworthy recent feature of the US fund management
industry is the consolidation trend. Thus far, there seems to be no basis for
concern about growing market concentration in the money management
industry. A recent survey by “Pensions and Investments “ among more than
two thousand money managers, including banks, trust companies, and
investment advisors, showed that the five largest fund managers have a market
share of 20 per cent, while the twenty largest have a market share of 40 per
cent. Some analysts predict that advances in information technology, the need
to make huge investments in the state-of-the-art information systems, and
fiercer competition will lead to a relatively small number of mega firms (assets
of $100 billion and higher) and a group of smaller specialist boutiques, thereby
45
eliminating the mid-sized firms.23 An important reason seems that pension fund
sponsors are reducing the number of outside managers. This trend, which is
24
particularly marked among the largest pension funds, reverses a fashion of the
1980s, when funds appointed more and more specialised managers to handle
different asset classes. It can be argued that pension fund sponsors were not
able to reduce effectively the inherent principal-agent problems associated with
a large number of "agents". Prima facie evidence consists of the fact that plan
sponsors discovered that running a large number of specialised external
managers did not bring the superior returns that they had expected. Another
reason for a reduction in the number of outside managers is related to the lack
of success of active portfolio management versus passive management
strategies.
The level of management fees depends on the competitive structure of
the market. The degree of competition among fund managers varies strongly
25
across OECD countries, with fund management highly competitive in the
Anglo-Saxon countries (in particular, in the United States and the
United Kingdom fees are in the range of 20-40 basis points on pension fund
assets) and much less so in Continental Europe (fees on assets from pension
funds can be above 100 basis points) and Japan (trust banks charge 60-80 basis
points and life insurance companies 2-5 per cent of the inflow from pension
schemes). The regulatory regimes of the various types of institutional investors
are likely to have an important impact on the efficiency of fund management.
For example, Japanese fund managers are subject to restrictions on
diversification, and until recently, only trust bank and life insurance companies
could manage the funds of pension schemes; German Pensionskassen may not
delegate fund management to an outside manager.
Fund management is becoming an important source of income for
26
many financial institutions. The growth of the fund management business is
driven by the same structural factors that are behind the expansion of the
institutional sector. Some analysts expect that when economies around the
world will have privatised their social security systems, fund management may
become the primary source of income for many financial institutions, including
banks.
The role of investment and trading strategies
Professional portfolio managers also have an important influence on
the operational aspects of financial institutions and markets through trading
strategies. In a competitive environment, fund management can be described as
46
a two-stage decision-making process: i) a strategic decision regarding the
allocation of funds to different assets (equity, bonds, derivatives, real estate,
cash) and countries; and ii) a tactical decision about the size of specific assets
within each category of assets determined at the strategic level.
The main factors influencing the strategic decisions are the investment
objectives of the institutional investor, fiduciary mandate, regulatory and tax
regime, and risk preference. The basic strategic decision concerns the desired
mix of return and risk, whereby portfolio diversification plays a key role. This
requires appropriate measures of risk-adjusted returns and the identification of
portfolio performance in order to evaluate fund managers’ performance.27
Performance measurement systems should be in line with the policy objectives
of the institutional investor. In other words, market exposure should be
consistent with the benchmarks appropriate to the investment policies of an
individual institutional investor. For example, proper asset allocation by
pension plan sponsors requires alignment with plans’ future liabilities. The next
step is to establish appropriate benchmarks and a measurement system that best
fits the actual portfolio.
At the tactical level, the different investing techniques and trading
strategies (stop-loss trading strategies, static hedging, dynamic hedging with
portfolio insurance, programme trading arbitrage, etc.) play a decisive role.
The choice of technique and trading strategy is partly dependent on the
objectives and basic strategic decisions of the institutional investors. From a
cash-flow perspective, pension funds, insurance companies or mutual funds
commit themselves to offer "deposit-like" liabilities to the owners of the assets.
By "deposit-like" is meant that a fund can guarantee a minimum capital value
on its liabilities deliverable in cash on short notice, regardless of the value of
the underlying risky assets. There are various trading strategies and techniques
for placing a floor under the portfolio value, including by hedging risky assets
with options and stop-loss techniques (static and dynamic hedges). The details
of these techniques do not concern us here, the focus of analysis being on the
impact of the growing influence of institutional investors on trading
arrangements and investment techniques, and financial markets more generally.
The impact of the institutional sector on trading arrangements and investment
techniques
First, sophisticated trading techniques, such as portfolio insurance,
place heavy demands on the liquidity in the securities markets. Institutional
investors have encouraged innovations in financial products and investment
47
techniques to provide deposit-like characteristics to their liabilities.
Institutional investors are able to offer bank - like deposits by following
sometimes complicated strategies of holding and trading appropriate
combination of assets, even when their asset composition is not itself
substantially liquid. To the extent that such strategies can be carried out with
transactions that are as low as bank operating costs, institutional investors
apparently can provide perfect substitutes for bank deposits.
If these techniques to bestow deposit-like characteristics to illiquid
securities, which include derivatives, could create liquidity in securities markets
without generating additional demands for bank credit lines, bank business
would decline sharply. However, access to liquidity through the banking
system is vital to the delivery of cash associated with the execution of the above
mentioned sophisticated trading techniques. This is an important reason why a
sound banking system is a sine qua non for the functioning of liquid capital
28
markets with a dynamic institutional sector.
Second, with the increase in trading by institutional investors, trading
arrangements more suitable to these investors had to be developed. This has
resulted in the evolution of special arrangements for the execution of certain
types of orders commonly sought by institutional investors: i) orders requiring
the execution of a trade of a large number of shares of a given stock
(block trades), and ii) orders requiring the execution of a large number of
different stocks at as near the same time as possible (programme trades).
The operational arrangement that has evolved to accommodate these
two types of institutional trades is the development of a network of trading
desks of the major securities firms and institutional investors that communicate
with each other by means of electronic display systems and telephones. This
network is called the “upstairs market.” This market plays an essential role in
the well-functioning of capital markets by a) providing liquidity to the market
so that such institutional trades can be executed smoothly, and b) by arbitraging
activities that help to integrate fragmented stock markets, thereby further
boosting liquidity.
Institutional investors’ needs are also a driving force behind a switch
from market maker systems with screen-based displays of quotes with all
trading conducted over the telephone, to electronic order book systems which
can automatically execute orders entered by or via exchange members. For
example, the London Stock Exchange is planning to introduce an order book
trading system for FT-SE 100 stocks, partly in response to institutional
investors’ demands.
48
Changes in the micro-structure of financial markets to improve the
one or more dimensions of market liquidity have lowered indirect trading costs.
The search for more efficient ways of trading is also fostering the growth of
alternative or non-traditional trading systems -- in particular proprietary trading
systems (PTSs). This has resulted in the bypassing of brokers by institutional
investors from securities transactions (disintermediation) and pressure on
transaction fees, thereby lowering direct transaction costs
Third, in practice, active asset management often lowers returns when
transaction costs are taken into account. This is consistent with the so-called
efficient markets hypothesis, that states that current securities prices incorporate
all available information. Consequently, no net benefit can be expected from
spending extra resources on active investment strategies in order to try to beat
the "market index". Thus, portfolio indexing can be the optimal investment
strategy in situations where securities markets are price-efficient. The amount
of institutional funds managed using an indexing strategy has grown
substantially. In particular the use of benchmarks tailored to individual pension
funds’ liabilities has increased. For example, the use of individual benchmarks
for UK pension funds has grown from less than 5 per cent in 1990 to more than
30 per cent of the total in 1996. Typically, the benchmarks consist of
guidelines for the proportions of a pension fund the manager can invest in
particular asset classes. Yet, despite the growing body of evidence that fund
managers are unable to outperform systematically the stock market, indexed
funds still account for a relatively small part of total institutional stock
investments.
2.3
Stability and volatility of financial markets
Financial market volatility is a fact of economic life. Price
fluctuations of varying intensity have always characterised the behaviour of
financial markets. Volatility becomes an acute matter of policy concern,
however, when financial markets face a systemic (liquidity) crisis. The key
question therefore is to what extent the growing importance of institutional
investors may threaten market stability and orderly markets. Higher volatility
raises the cost of capital and it may even trigger liquidity crises. But also when
higher financial market volatility manifests itself in the form of periods of
bubble-like booms and busts and asset price over(under)shooting, there may be
reasons for concern at the public policy level: individual financial institutions
may face liquidity squeezes and serious financial losses, non-financial
enterprises and governments may be confronted with significantly higher
49
borrowing costs, while higher volatility may lead to a general increase in
uncertainty with a depressing impact on economic activity.29
Evidence on the link between volatility and institutional holdings
There is no clear evidence of an increase in volatility over longer
periods in the larger OECD countries. Yet, although no clear trend can be
discerned in the longer-term volatility of bond yields, stock prices and
exchange rates, short periods of heightened price volatility seem to have
become more common, especially in the smaller and less liquid segments of the
capital markets. Moreover, asset price movements may now be more easily
transmitted from market to market and country to country. There is a growing
body of evidence that the increasing concentration of savings in the hands of
institutional investors, has contributed to this higher short-term price
volatility.30
The positive relationship between volatility and institutional holdings
31
is consistent with two basic hypotheses. The first one states that institutional
investors are attracted to more volatile securities because riskier securities are
more likely to outperform performance benchmarks. Similarly, riskier
securities may attract institutional investors if informed trading is easier to
conceal in more volatile markets. The second hypothesis argues that an
increase in institutional holdings induces an increase in (short-term) volatility.
The available evidence seems to support the latter hypothesis: an increase in
32
institutional holdings precede an increase in volatility.
Does an increase in institutional holdings lead to more volatility ?
Several explanations have been given why institutional investors have
contributed to increasing capital market volatility. A first explanation is based
on the reasoning that institutional trading and investment strategies can more
easily lead to a situation whereby selling or buying pressures may overwhelm
the available liquidity in the market, leading to price discontinuities and
cascading sales or purchases known as "market crashes". For example, some
commentators in the United States blamed the interaction between large
institutional investors’ portfolio insurance and index arbitrage strategies for
causing volatility at the time of the 1987 stock market crash. An initial
downward movement in stock prices was exacerbated by the existence of many
large institutional players using trigger-price strategies. In addition, margin
calls forced yet more sales. Together these actions created liquidity problems
50
that caused extreme price fluctuations in the stock markets at the time of the
crash. The second example supporting this example concerns the role of
institutional investors during the 1992 crisis in the Exchange Rate Mechanism
(ERM) of the European Monetary System (EMS). Hedge funds were accused
of triggering the crisis by taking positions consistent with an expected
realignment of currencies participating in the ERM. While the hedge funds
acted as market leaders, the real financial muscle was provided by mutual
funds, pension funds and insurance companies and by nonfinancial
33
corporations. Although the market generally worked well during the crisis,
liquidity problems surfaced in a number of currency markets.
Sophisticated trading and investment strategies using derivative
instruments have been identified as a second reason for the increase in shortterm volatility.
Derivatives create possibilities in which changes in
expectations may rapidly be translated into large price shifts and
correspondingly high market volatility. For example, the debt securities market
turmoil in 1994 highlighted the increase in volatility due to operations on the
futures markets. There is evidence that margin requirements for exchangetraded derivatives triggered the liquidation of sizeable positions (financed by
34
bank borrowing), thereby reinforcing price swings. On the other hand, futures
exchanges are generally characterised by high market liquidity, which tends to
35
have a dampening influence on market volatility.
Other sources of volatility are related to "herding" by institutional
investors. Frequently mentioned reasons for herding include:
− The regular performance checks of fund managers against the market.
This may induce similar behaviour by institutional investors to avoid
36
There is
performing significantly worse than the “average” fund.
evidence that pressure on fund managers from performance evaluation
37
may lead to similar approaches to investment.
− Institutions infer information from each others' trade, which may lead to
38
similar decisions.
− Institutional investors may react to news in a similar manner, which -- in
the aggregate -- may cause major portfolio shifts, if it induces funds to
change their views about the likely state of financial markets or the
economy. A recent example includes the world-wide bond market
turbulence in early 1994.
It has also been argued that situations with asymmetric information
where institutional investors are more professional and better informed than
51
other, mostly smaller, investors may lead to increased volatility.39 However,
other analysts have pointed out that the different types of institutional investors
may follow quite different investment strategies, thereby reducing the chances
that they may find themselves on the same side of the market. In particular, in
a situation when trading strategies caused a move of market values from
fundamental values, it is likely that other "speculators" in the market recognise
the opportunity and jump in to buy up or sell securities and move prices back.
It has also been argued that a large domestic institutional investor sector may
help to stabilise markets by offsetting the effects of wholesale moves in or out
40
of the market by foreign investors.
The institutional sector is increasingly investing internationally. The
resulting increase in financial market integration is reflected in the transmission
of short-term price movements in financial markets, in particular in debt
securities markets. The high volatility in the spring of 1994 provides an
example. There is also evidence that mutual funds and other institutional
investors play a crucial role at times in determining asset prices in emerging
financial markets, with shifts in institutional investor sentiment resulting in
41
periods of bubble-like booms and busts and highly volatile financial markets.
For example, the pressure on emerging stock prices in the wake of the Mexican
peso devaluation in December 1994 -- the so-called tequila effect -- was argued
to have been caused by a herd-like overreaction by domestic and foreign
42
institutional investors.
Assessment
Naturally, in situations with no liquidity problems, there is nothing
inherently wrong when the computerised portfolio insurance/ program trading
strategies and herding may move prices quicker to their fundamental (i.e.
equilibrium) values. If, in contrast, investment strategies are contrary to
fundamentals, herding and computerised trading strategies may cause a rise in
volatility. Other observers have argued that many of the institutional investors
are using the same models of the economy, the same sophisticated information
technology and are focusing on the same news, while they are employing
similar portfolio diversification and hedging strategies.43 The result could be
that, in particular, in periods of market tensions, they may find themselves all
on the same side of the market. This may lead to intrinsically more volatile
markets.
The task of the monetary authorities is to maintain price stability and
to ensure that liquidity problems do not result in a systemic crisis.. However,
52
this seemingly easy task is complicated by the fact that central banks have to
make sometimes very rapid decisions to determine whether a large price fall in
securities markets arises from liquidity problems or from a dramatic change in
underlying securities values.44 Clearly, if it is a liquidity problem, an
intervention will stabilise the markets and prevent needless bankruptcies. The
problem facing central bankers is that if it is not a liquidity problem,
interventions can lead to an undesirable expansion of liquidity in the economy,
and hence lead to inflation, if the monetary authorities attempt to prop
securities at too high a nominal level.
It can be concluded that institutional investors have the trading
technology and financial muscle to move markets rapidly, thereby inducing a
possible increase in short-term volatility. This increased volatility may be
desirable when new technology and trading strategies facilitate the moving of
asset prices to their fundamental (i.e. equilibrium) values. On the other hand,
increased financial instability would be welfare decreasing when institutional
investors engage in “noise” trading or herding behaviour. Moreover, recent
periods with market turbulence seem to suggest that even very large financial
institutions are not always willing or able to act as market makers in situations
of massive imbalances between supply and demand in some markets. In these
situations markets may become less liquid and more volatile, in particular the
smaller ones. Against this back-drop it can be argued that institutional
investors may find themselves exposed to a risk that is hard to quantify or
anticipate, namely the risk that by their own investment decisions they may
affect the direction of the markets in which they are operating and, thereby,
over(under)shooting fundamental values.
2.4
International diversification of portfolios of institutional investors
It was noted in section 1.1 that the evidence points to the
accumulation of a substantial amount of foreign assets by institutional
investors. Despite the general trend toward international diversification, it is
also evident that this trend is overshadowed by the relatively small share of
foreign securities in institutional portfolios, especially for insurance companies
and pension funds.
Several reasons have been advanced why insurance companies have a
relatively low share of foreign securities in their investment portfolios. First,
international diversification may be less useful to insurance companies then to
other institutional investors given the fact that their investment portfolios are
53
weighted heavily towards fixed-income securities.
Second, regulatory
restrictions may also play a role (e.g. rules concerning currency matching).
Pension fund investments in foreign securities are considerably higher
as a result of deregulation and the fact that they can benefit from international
diversification due to the relatively low correlations between stock returns
across countries.
Foreign investments by investment companies are largely driven by
customer demand. As a group, they benefit from international diversification
because foreign investment are concentrated in equity funds.
Reasons for the home bias of institutional investors
Modern portfolio theory suggests that pooling of securities in a
domestic market can eliminate unsystematic risk resulting from the different
performance of enterprises and sectors but not, in a national market, the
systematic risk resulting from the performance of the economy as a whole.45
Systematic risk would be minimised by holding the world market portfolio. 46
However, all the evidence points to the fact that all types of
institutional investors (including mutual funds) are much less internationally
diversified than the world market portfolio. In fact, the divergence between the
world portfolio and observed portfolios is even larger when one takes into
account the very high correlation between the returns to human and physical
47
capital. Reasons for this home bias include:
− Additional risks in the form of exchange-rate risk, transfer risk,
settlement risk, and liquidity risk;
− The benefits of international diversification are dependent on the
type of asset and the degree of financial market integration. Bond
markets are probably more internationally integrated than other
asset markets and hence there is less benefit from diversification
48
out of domestic markets. In contrast, equities can be expected to
yield higher benefits. Although real estate is a real asset similar to
equity, it is more risky because it is less liquid and its value is
dependent on sometimes hard-to-acquire and to assess local
information. Surveys of internal investment rules reflect this line
of argument (equity investments have the highest portfolio limit
for foreign assets and property the lowest);
54
− A third possible reason is that the argument for holding the world
portfolio is based on the efficiency of markets. If markets are
inefficient -- e.g. in the form of speculative bubbles -- then the
optimal level of diversification cannot be based on the global
49
portfolio. Instead, it needs to be calculated in a different way;
− A fourth reason is related to the fact that the investment behaviour
of institutional investors is partly determined by the nature of their
liabilities. For example, many pension schemes and life insurance
contracts have very precisely defined nominal liabilities. In these
cases, the preferred investment strategy may be to match domestic
liabilities with domestic assets;
− Regulatory constraints on foreign investments constitute another
reason for the home-bias of institutional investors;
− The "benchmark" orientation of fund managers may be an
important reason why domestic assets may be "over-represented"
in comparison to the predictions of modern portfolio theory;
− Finally, there is evidence that downside market movements occur
much more in parallel than upside ones. Unfortunately, downside
risk matters most to institutional investors who are adverse to
absolute risk.
Are the benefits of diversification declining?
By exploiting the fact that risks and returns on assets are not perfectly
correlated, a portfolio with international assets can achieve more stability in
returns without sacrificing the overall level of return. This insight has resulted
in the adoption of asset allocation rules based on international diversification.
More recently, however, analysts have pointed out that the benefits of
50
diversification are decreasing. It is argued that increasing financial integration
is leading to an increase in correlation of returns, in particular on the bond
markets. The increase of integration of bond market -- especially in Western
Europe -- has reduced the potential for reducing risk on a bond portfolio
through diversification. Moreover, the fact that an increasing amount of
institutional money is managed using the concept of diversification is causing
the benefits of diversification to get smaller. High correlation of returns
between countries has in some cases led to a restructuring of portfolios by
diversifying by sectors.
55
Another finding that is relevant in assessing the potential benefits of
diversification is that downside market movements occur much more in parallel
than upside ones. A recent study51 shows that shocks in volatility are closely
linked with rising correlations, in particular in the case of stock markets. An
increase in correlation is normally associated with sharp downside movements
of securities markets. Unfortunately, the fact that most assets seem to move
uniformly during market crash situations reduces the benefits of controlling
absolute (downside) risks using investment strategies based on diversified
benchmarks.
In sum, all types of institutional investors are much less
internationally diversified than the world market portfolio. There is evidence
that the risk-reducing benefits of international investments have become less
powerful. Nonetheless, studies show that they are still positive, also during
52
sharp downside moves of securities markets.
2.5
The supply of risk capital
The institutionalisation of savings has lead to an increased supply of
long-term funds. Consequently, the growth of institutional investors may also
lead to an increase in the supply of risk capital. Whether this happens or not
depends on various factors, including the internal and external investment rules
for the different types of institutional investors, the availability of "suitable"
projects, the quality of the market infrastructure, the degree of liquidity of the
capital market, the tax regime, etc. More generally, institutional investors -- in
particular funded pension schemes -- contribute to the development of an
"equity culture".
Institutional investors are playing an increasingly important role in
providing risk capital, even in “bank-dominated” countries such as Germany
and Switzerland. For example, since the mid-1980s German joint-stock
companies have tapped the German capital market for new equity capital
totalling more than DM 200 billion, more than double the amount in the 35
years up till then. Institutional investors have contributed strongly to this
development; for example, European institutional investors have shown a
growing interest in transactions involving initial public offerings.
Clearly, regulations in the form of quantitative constraints on how
much the various types of institutional investors are allowed to invest in risk
capital are an obvious obstacle to make institutional funds available. For that
reason, many analysts have argued in favour of abolishing or relaxing these
56
quantitative constraints. The challenge for regulators is to balance the fiduciary
responsibilities and risk factors, on the one hand, and return on investment, on
the other.
The participation of institutional investors in the US securities market
The regulation of pension funds in the United states provides a good
example. Regulation of pension schemes is based on the prudent man
concept.53 Pension funds are the largest component of institutional capital in
the United States, while a significant part of their funds is being invested in
equity. Moreover, pension funds, as a result of regulatory changes, have
54
become the largest source of venture capital funding in the United States.
Many analysts argue therefore that countries with quantitative portfolio
constraints should replace them by the prudent man standard because it would
boost the returns on investments and increase the supply of risk capital by
funded pension schemes.
However, even the prudent man standard has been criticised by some
analysts on the basis that it constitutes an obstacle for investing in risky, but
potentially highly profitable ventures. US pension funds legislation requires
fiduciaries to act as a careful professional, experienced and educated in trust
and financial matters. If a trustee follows an established, prudent process, no
court will argue with the investment results of the pension fund. Prudent
investment behaviour is reflected in two requirements of the prudent man rule.
First, the requirement to diversify. Second, the exhortation to favour
"seasoned" situations that similarly placed institutions find appropriate. The
combination of these two requirements has two major consequences: 1) it
encourages the "index" mode of investment, and 2) it leads to the
overwhelming preponderance of pension equity money being invested in the
limited number of listed securities of American corporations with large
capitalisations.
The role of US institutional investors in the private equity market
It is true that US pension funds provide the bulk (i.e. 47 per cent in
1994) of venture capital; pension funds account for just over half of private
equity investments, with public funds providing 30 per cent of total private
equity capital.55 On the other hand, this is just a very small fraction of their
total assets. From an analysis of the investment strategies of the largest 200
pension funds it was concluded that 0.3 per cent was invested in venture
57
capital, 0.5 per cent in LBOs and 1.5 per cent in private placements. In absolute
terms this amounts to the impressive sum of $32.2 billion, but as a percentage
of total holdings of $1.415 trillion it is barely 2.3 per cent. At year-end 1995,
corporate and public pension funds in the US held between $50 and $60 billion
in investments or commitments to invest in private equity. This represents
roughly 2 per cent of the $ 3 trillion in assets held by traditional defined benefit
pension plans. Among US pension plans that invest in private equity, the
average asset allocation is between 5 and 6 per cent.
The key policy question is whether these relatively small fractions of
total institutional assets are too small relative to the set of potentially profitable
projects. The increase in private equity commitments by pension funds, along
with most other institutional groups, has increased sharply over the last four
years and, if anything, there is concern that more funds have been raised than
can be profitably invested in LBOs, venture capital deals and other types of
private securities. A record $28 billion of private equity was raised in 1995 in
the United States, including $4.7 billion in venture funds and more than
$19 billion in buyout funds; analysts estimate that around $32 billion of private
56
equity was raised last year.
Asset flow in the period 1994-1996 has set new records, with a total
of more than $80 billion committed or handed over to “alternative asset”
managers (as much as was invested in the previous eight years combined).
Pension plans account for more than half of this flow, with the remainder
coming from other institutional investors, endowments and wealthy individuals.
Institutional investors are attracted to these investments by the possibility of
yield enhancement and diversification (low or negative correlation between
“alternative assets” and the public equity market). Most of these investments
concern LBOs and venture capital, with the rest going to distressed securities,
mezzanine financing, hedge funds and other investments outside the public
market. There is also a growing tendency among US funds to invest abroad.
Indexation and investments in listed securities of "blue chips" are the
epitomes of the "prudent" mode of investment. On the other hand, this has not
prevented US institutional investors from investing in the "non-investment
“(or alternative asset) grade" sector. In this context, it has even been suggested
by several commentators that there is a need for governments to create a special
category and to permit investment of the certain portion of the pension system
outside of the trustee mode and in the risk/reward mode of "traditional"
business investment.
58
The participation of Japanese and European institutional investors in the
private equity market
Institutional investors in Europe and Japan seem to be less willing (or
able) to provide equity investment in start-up companies than those in the
United States and Canada; pension funds and life insurance companies outside
the USA seem to prefer investments in bonds, property and blue chips
securities. European institutional investors are not very active in acquiring
equity holdings, notably in the form of making venture capital investments in
start-up technology companies. The exceptions are the United Kingdom and
the Netherlands.
A second key distinction between the United States and Canada and
other OECD countries is that, outside the first two countries, a large part of
what is classified as venture capital is dedicated to management buy-outs and
57
buy-ins, as opposed to start-ups or traditional funding of expansion.
The United Kingdom venture capital industry is the most developed
in Europe, representing 42 per cent of total venture capital investment in 1994;
58
it is second only to the USA in world importance. Venture capital funds in the
UK raise funds principally from institutional investors mainly through
independent (unquoted) funds with a limited partnership structure, and
investment trusts (closed-end funds) that are quoted on the London Stock
Exchange. Moreover, there are unregulated investment schemes for UK
pension funds which allow smaller pension funds to invest in the venture
capital sector whilst spreading the risk per pound. In contrast, the private
59
equity market in Germany is not very developed.
2.6
Institutional investors, corporate governance and financial markets
There is a growing perception in the last few years that managers have
become insufficiently accountable to shareholders. In other words, it is argued
that the conflict between owners and managers - a principal-agent problem - has
increased or at least has become more acute. At the same time, institutional
ownership has grown rapidly. The rise in institutional private securities
60
holdings and the decline of the market for corporate control have focused
attention on the role and importance of institutional investors as monitors of
61
corporate management.
In response, there is increased pressure on management of companies
to maximise shareholder value by institutional investors and other shareholders.
59
“Shareholder activism” by traditionally passive institutional investors has
increased. Shareholder activism includes monitoring and attempting to bring
about changes in the organisational control structure of enterprises (the
“targets”) not perceived to be pursuing share-holder-wealth-maximising goals. 62
In essence, the larger institutional investors are seeking to enhance the return on
capital through improvements in corporate governance systems so as to increase
the accountability of managers.
Corporate governance models in OECD countries
Corporate governance is, very broadly speaking, the process of
exercising power over the larger companies and the regulation of that power.
This process can be described in OECD countries by two stylised models: an
"insider" model and an "outsider" model.63 These two models in turn can be
used to analyse the role of financial markets in corporate governance [see box:
Corporate governance models and financial governance channels]. The two
models can also be used to characterise and describe the corporate governance
process in OECD countries. However, it should be kept in mind that the
"actual" process has many idiosyncrasies, making the corporate governance
process in individual countries in several important respects (e.g. the cultural
and political dimensions) "unique". The range of potential governance factors
which influence differences in economic performance across firms and
countries is considerable. There is no consensus among analysts how to
identify the effects of changes in governance on performance. Moreover,
evidence on the effects of different governance systems is very sparse. A final
complication is that in practice the corporate governance process in OECD
countries is changing and there are indications that some "convergence" in
governance has taken place, stimulated by the internationalisation of
product -- and factor (notably financial) markets as well as a more important
role in capital markets by institutional investors.
Financial governance channels
In sum, the financial importance of the institutional sector is
increasing while its influence on both the process of corporate governance and
financial markets is growing. A good starting-point for analysing this impact is
to distinguish the following financial governance channels: 1) market control
via equity, 2) market control via debt, 3) direct control via equity, and 4) direct
control via debt.
60
The first three financial governance channels are typical of the
outsider models largely used in Anglo-Saxon countries, which emphasise the
liquidity of share-holdings and adequate public disclosure of financial
information. The fourth channel is more common in the insider models of
Continental Europe and Japan, where liquidity is less emphasised and
information not so widely distributed.
The insider model is further
characterised by large share-holdings between non-financial companies and
between companies and banks since they often form the basis of long-term
business relationships. It is suggested that the role of institutional investors is
more central in the case of outsider systems with equity-based control than in
insider-systems relying on debt-based controls.
Evidence about which financial governance system leads to superior
results is inconclusive. What emerges from studies is that differences in such
systems are primarily concerned with the formulation, implementation and
adaptation of corporate strategy and not simply with incentives, disciplining,
64
finance and investment. Insider systems are superior at implementing policies
which require the development of relationships with several stakeholders; for
example, it has been argued that the Japanese insider system is better at
assuring the commitment to stability needed to ensure proper levels of
65
employee firm specific investment. Yet, it is not very clear that outsider
systems are clearly beneficial to shareholders. Outsider systems seem to be
superior at responding to change; for example, the US outsider system has been
66
credited with an excellent ability to adapt to technological change.
The growing corporate governance role of institutional investors
The relationship between the functioning of financial markets and
other governance channels needs to be further explored to get more conclusive
answers. In addition, the impact of structural changes in OECD financial
markets on governance needs to be taken into account, in particular the growing
role of institutional investors.
61
BOX : CORPORATE GOVERNANCE MODELS AND FINANCIAL
GOVERNANCE CHANNELS
Insider model
The "insider model" can be found in many OECD countries (e.g. Japan,
Germany, the Netherlands, Switzerland, Sweden). This model relies on the
direct representation of specific interests on the board of directors. Monitoring
and disciplining of management relies heavily on the accountability of board
members to the stakeholders they represent, including banks, non-financial
companies with close ties to the corporation, government representatives, and
workers. Management discipline via securities markets is not the rule. Insider
systems are also often characterised by concentrated shareholding, with
cross-holding among companies being fairly common. Markets in corporate
control (i.e. hostile take-overs) are weak. Banks play an important role in most
countries with insider models.
Outsider model
In the "outsider model" of the English-speaking countries, managers are
weakly controlled by the board of directors, which may be even allied with
management. Monitoring and disciplining of management is done via the
capital market. If the company is run badly and/or shareholder value is not
being maximised, investors may react by selling shares. This will depress the
share price, making the company vulnerable to a hostile take-over. This model
presumes market-oriented accounting rules, adequate public disclosure
standards, strict trading rules, and liquid stock markets.
ROLE OF CORPORATE FINANCE AND FINANCIAL MARKETS
The following four governance channels in financial markets can be
distinguished:
i) Market control via equity
This corporate governance channel relies on selling shares and/or
take-over activities. The principal advantage of take-over activity is that it can
reduce the conflict between management and shareholders. This assumes that
managers perceive take-overs as a personal cost. Institutional investors, both
directly and via non-executive directors, can play an important role, both in
62
complementing take-over pressure, and in evaluating take-over proposals. In
practice, however, take-overs are not always effective; they may be a weak
disciplinary tool because it is relatively easy for managers to protect themselves
against personal losses due to take-overs (e.g. through golden parachutes). It
has also been argued that the costs of a take-over may be high. Losses in
welfare to stakeholders such as employees may be higher than gains to
shareholders.
ii) Market control via debt
Debt issues can exert a disciplining effect on management since a
manager of a highly-indebted firm who wants to avoid bankruptcy (by failing
to make regular interest payments) will expend more effort in avoiding
low-profit outcomes. An increase in debt decreases the free cash flow, thereby
reducing the extent to which managers can appropriate earnings to increase
their own welfare. However, high leverage may also have negative economic
consequences in the form of a higher incidence of dead-weight bankruptcy
costs and increased financial fragility of the corporate sector which may lead to
a chain of bankruptcies during a recession.
iii) Direct control via equity
Boards of directors act as shareholders’ representatives in monitoring
management and ensuring that the business is run in their interest.
Shareholders’ influence is ensured by their right to vote on policy proposals of
management or shareholders (including the choice of directors). This
mechanism may be supplemented by direct links from investors such as
pension funds (see below) to management, either formally at annual meeting,
or informally at other times.
iv) Direct control via debt
Relationship banking along the lines of the German and Japanese
models give banks an incentive and the opportunity to monitor managers.
Bankers wish to ensure that loans are repaid and to avoid circumstances in
which they are forced to continue lending to large firms who threaten to default
on their obligations. The effectiveness of debt in controlling managerial
behaviour is limited however since the manger of a highly-indebted firm has an
incentive to engage in asset substitution. The influence of institutional
shareholders is often limited by voting restrictions and lack of detailed financial
information.
63
The growing corporate governance role of institutional investors
manifest itself in several ways:
− First, institutional investors have enhanced their corporate
governance role in the form of an increase in market control via
equity and debt. Institutional investors are major shareholders, so
that their role in take-overs is a central one. Regular performance
checks on fund managers against “the market” may induce
heightened willingness of institutional investors to sell shares in
take-over battles to maintain or improve performance. Market
control via debt has also been enhanced by the growing financial
clout of institutional investors. In some countries, institutional
investors (mainly banks and insurance companies) have been
important financiers of leveraged buy-outs (LBOs). In addition, if
pension funds are willing to accept cash for leveraged take-overs
and buy-outs, they can facilitate the process of gearing and, in this
way, are linked to the take-over mechanism.
− Second, an increase of de facto direct control via equity in the
form of an increase in share-holder activism by institutional
investors has been an important characteristic of the change in
corporate governance in the 1980s. There has been a growing
concentration of institutional assets in OECD countries. For
example, it has been estimated that institutions as a whole own an
average 50 per cent of the top fifty US companies, while the top
twenty US pension funds hold 8 per cent of the stock of the ten
largest companies. Thus, institutional investors as shareholders
are in a potentially strong position to exert pressure on the
67
management of enterprises. Although institutional ownership of
equities has increased sharply, institutional investors are, for the
most part, passive investors. Moreover, regulation may prohibit
some categories of institutional investors to acquire direct control
or dominant influence over the management of a company. For
example, European insurance companies are not allowed to
acquire a dominant influence in any business other than their own.
Thus, institutional ownership per se has no clear implications for
corporate governance. Institutional investors in several OECD
countries have a fiduciary responsibility to participate in a
nominal way in corporate governance activities, such as reading
proxy statements, making careful voting decisions, and so forth.
However, in most instances, they have not tried to participate
more actively.
64
− Third, direct control via debt is an important mechanism of
corporate control in Continental Europe and Japan. Pension funds’
role via this mechanism is a passive one in Germany and Japan;
most of the loans by pension funds are to the banks or arranged by
the banks, leaving banks in the controlling position to provide
monitoring of management on the part of all external financiers.
In other countries where bank loans are important, the nature of
the pension fund’s relation to the borrower differs. In the
Netherlands, loans to the government or semi-governmental
entities are the major component of pension funds’ portfolios. In
Sweden, many of the loans are retroverse loans to firms that are
major contributors to the various schemes -- implicitly a form of
self-investment. On the other hand, Anglo-Saxon countries tend
not to invest significant amounts in corporate debt. United States
pension funds, unlike life insurers, have not been significant
investors in private placements.
The fiduciary responsibilities of institutional investors
In tandem with the increase in institutional holdings of private
securities, pension funds and other institutional investors increasingly grapple
with the issues of corporate governance. In order to meet fiduciary
responsibilities, they are simultaneously seeking ways to improve systems of
corporate accountability. For example, it has been argued that fiduciary duty
may now include the duty to balance index fund strategies with active
68
Under the recently enacted “lead
monitoring and relationship investing.
69
plaintiff” provision of the US Private Securities Litigation Act of 1995, large
shareholders can now seek to be named controlling parties in class-action
shareholders suits. New forms of monitoring and collaboration between
corporations and institutional investors are required for both governance
activities. Both activities have the potential to increase the accountability of
corporations to owners and to reduce agency costs.
Thus far, corporate governance guidelines have mainly concerned
pension funds and insurance companies. Guidelines for mutual funds along the
same lines as for pension funds, making it explicit that exercise of ownership
rights, including proxy voting and evaluating more activist alternatives, must be
undertaken as a part of fiduciary obligation, seem not to exist in OECD
countries. For example, no provision of the US federal securities laws nor any
SEC rule thereunder specifically addresses the responsibilities of fund
investment advisers regarding the voting of proxies or shareholder activism.
65
However, in 1992, the SEC adopted new rules that have significantly lowered
the cost of proxy activism for institutional investors and have facilitated
increased activism by institutional investors. Under the new rules, a mutual
fund or other institutional investor, without making any filings with the SEC or
any mailings, may discuss voting issues with an unlimited number of other
shareholders as long as the fund does not solicit proxies from any of the other
shareholders.
The formalisation of the corporate governance process, through a
commitment to exercise fiduciary responsibilities (e.g. voting) in accordance
with published guidelines, represents a major change from situations in which
governance activities were exclusively conducted in an informal fashion
(e.g. private conversations between fund managers and the management of
companies). Corporate governance guidelines may or may not be mandatory.
In the US, governance guidelines tend to be compulsory. For example, under
the Employee Retirement Income Security Act (ERISA) a plan fiduciary is
required to discharge his or her duties with respect to a plan solely in the
interests of the participants and beneficiaries. This standard applies to all duties
charged to a fiduciary including the voting of proxies. In contrast, government
guidelines in the UK tend to be voluntary. For example, the National
Association of Pension Funds (NAPF) is opposed to compulsory voting. NAPF
argues that institutional investors should be allowed to exercise appropriate
judgement on corporate governance issues to take account of a company’s
individual circumstances. It has been argued by some that mandatory
guidelines may conflict with the institutions’ fiduciary and other legal
responsibilities to investors and beneficiaries. Nonetheless, NAPF and other
UK institutions have demanded better accounting and auditing procedures and
support the Cadbury and Greenbury Codes of Best Practice as well as the work
of the Financial Reporting Council.
As a general matter, it is necessary to strike a balance between
legitimate shareholder involvement and taking over management
responsibilities. An investment advisor to an investment fund has a fiduciary
responsibility to vote proxies of the fund’s portfolio companies and, perhaps, to
take additional actions with respect to those companies when it determines that
doing so would promote the best interests of the fund. The nature and extent of
an adviser’s duties with respect to voting proxies and taking other actions
regarding the corporate governance of portfolio companies, however, must be
determined by reference to the adviser’s contract with the fund, as well as the
fund’s specified investment objectives and policies, and an analysis of the
surrounding circumstances .
66
Many mutual funds have a stated investment policy that the fund will
not invest for the purpose of controlling or influencing the management of
portfolio companies. A fund that has such a policy has elected, in effect, to
remain a passive investor. Consequently, the ability of its investment adviser to
go beyond the simple voting of proxies and engage in shareholder activism on
the fund’s behalf may be quite limited. Other funds may have a stated policy
(disclosed in the fund’s prospectus) of attempting to control or influence the
management of portfolio companies. Many managers of venture capital funds
intend to become directly involved in the governance of portfolio companies.
If a fund has such a policy, its advisers would not be prohibited from engaging
in shareholder activism on its behalf.
Long-term versus short-term institutional investment strategies
It has been noted in section 2.1 that institutional investors demand
market liquidity. Consequently, many improvements in the financial market
infrastructure have been made to make it easier to trade. Critics have argued
that by placing a premium on liquidity, a "short-term bias" is being built into
the economic system. Similarly, institutional investors have been criticised for
70
their short term outlook.
The conclusion that institutional investors have a short-term
investment horizon has been questioned by several analysts. It is argued that
institutions own such a large percentage of the market that two of the factors
driving short-term orientation -- the need for liquidity and the competitive
advantages of active fund management -- are no longer important, or even
prudent. The massive size of some funds substantially removes the option of
full disinvestment from a company due to the potential adverse impact on share
price. In addition, the growth of indexed portfolios also means that funds are
obliged to follow the view of the market. In effect, the large institutional
71
investors are already “patient investors”.
In analysing the average holding period of institutional assets it is
important to distinguish the core portfolio -- representing the bulk of a fund’s
assets -- from the satellite portfolio (i.e. the remainder of the fund’s assets. The
core portfolio will normally be invested in a manner to provide stable returns
(possibly as an index fund), while the satellite portfolio can then be managed
more flexibly, in search of higher returns. The holding period of the core
portfolio is normally much longer than of the satellite portfolio.
67
Much of the turnover of institutional funds reflect tactical trading
activities, while strategic commitments to core holdings may be sustained for
many years. Active trading in smaller or marginal (i.e. non-core) companies
might be obscuring a more durable commitment to large, core holdings.
Moreover, not all institutions are alike: mutual fund portfolios are often traded
much more active than pension funds or insurance companies.
Shareholder activism and shareholder value
Shareholder activism by institutional investors is seen as a way of
restoring the balance in the direction of a longer-term perspective by restoring
the basis of "relationship investing". Advocates of this view point out that this
mode of ownership leads to superior returns over a longer time period because
relationship investors act as better informed and interested shareholders
insisting on competitiveness.
Several analysts have pointed out that large institutions can enhance
the value of their investments better through shareholder activism than through
trading. They argue that the evidence is clear enough that activism is a highly
competitive investment strategy and, therefore, governance activities should be
merged into the mainstream of asset management.
Several empirical studies of the impact of shareholder activism by
institutional investors demonstrate that institutional investor monitoring of
management is associated with statistically significant value gains, including
stock price appreciation and increased financial performance. The little
evidence that is available indicates that many target companies are poorly
managed and that resources spent on identifying and restructuring those
underperforming companies can create opportunities for earning higher-than72
average returns.
68
Annex
BASIC CHARACTERISTICS AND INFORMATION ON
INSTITUTIONAL INVESTORS IN OECD COUNTRIES
Introduction
Institutional investors are financial institutions that invest savings of
individuals and non-financial companies in the financial markets. This
definition is not very precise and, in dynamic financial markets, becomes
increasingly elusive1. The key is that the definition indicates that funds are
being professionally or institutionally managed, as distinct from money
managed by retail investors. Examples of institutional investors that are
generally found in OECD countries are pension funds, insurance companies,
open-end funds, hedge funds, closed-end funds, and the proprietary trading
activities of investment banks, commercial banks, and securities companies.
The shifting of the capital markets from dominance by retail investors to
financial institutions is often referred to as the “institutionalisation” of capital
markets.
Institutional investors operate on the basis of well-defined risk-return
criteria and may employ sophisticated investment strategies and methods. The
requirements of the institutional investor community have led to the
modernisation of capital markets and the development of sophisticated financial
instruments. Nonetheless, the behaviour of institutional investors is far from
uniform due to differences in objectives, tax treatment and regulatory regime.
These differences will be used to give an overview of the different types of
institutional investors. In this annex three basic types of institutional investors
will be distinguished: insurance companies, pension funds, and investment
companies.
1.
See "Institutional Investors and Capital markets: 1991 Update", Columbia
Institutional Investor Project, Columbia University School of Law,
September 1991.
69
A.1
Insurance companies
1
Insurance companies are financial intermediaries that undertake to
make payments if a certain event occurs. Their principal activity is to bear and
manage risk for a price (i.e., the insurance premium). Insurance activities
provide protection against the future consequences of: i) uncertain events that
may or may not occur; ii) certain, inevitable events whose date of occurrence is
unknown. There are two basic types of insurance activities: life insurance
activities and non-life (property and casualty) insurance activities.
The tax and regulatory aspects of insurance activities differ across
OECD countries and even within individual countries (e.g. in the USA rules
and regulations may vary from State to State). Harmonisation of a number of
regulations has taken place within the European Union in the form of EU
Directives.
A.1.1
Life insurance activities
Traditionally, the principal event that a life insurance company
insured against was death: after the death of the policy holder, the company
agrees to make a lump sum payment or a series of payments to the beneficiary
of the policy. However, the range of policies issued by life insurance
companies has evolved because of structural changes in the life insurance
business. The nature of life insurance activities has changed dramatically since
the 1970s2. High and variable inflation rates in the 1970s, increased
competitive pressures resulting from financial deregulation in the 1980s and
1990s, and a steady increase in investor sophistication, forced life insurance
companies to offer more diversified and attractive products.
Types of life insurance products
The following products are provided by life insurance companies:
1) pure insurance against risk of death; 2) a combination of life insurance and
an investment vehicle; 3) insurance against the risk of life (annuities), mainly
designed for pension plans; and 4) pure investment-oriented vehicles. Term
1.
This section relies heavily on the documents, publications and databases of
the OECD Insurance Committee.
2.
"Insurance and other financial services -- structural trends", OECD, 1992.
70
insurance falls in category 1) and the so-called universal life and variable life
insurance contracts fall in category 2) (Table A1). Under policies in category
(3), a life insurance company offers a fixed annuity for the remainder of the life
of the policyholder. These insurance vehicles are primarily used in connection
with a pension fund. For example, in a single-premium deferred annuity, the
sponsor of a pension plan pays a single premium to the life insurance company,
which in turn agrees to make payments for the remainder of the life of the
policyholder (the employee) when that employee retires. Policies from
category 4) typically are purchased by pension plan sponsors as an investment.
For example, in the United States so-called guaranteed investment contracts
(GICs) fall under this category. Under a GIC a life insurance company agrees,
for a single premium, to pay an amount (equal to the premium paid plus
accumulated interest) at the maturity of the GIC.
Investments
Investments made by life insurance companies are for the larger part
in longer-term debt instruments. A life insurance company’s investment
allocations are influenced mostly by the long-term nature of its liabilities.
Important asset classes are bonds and mortgage loans. However, in some
countries a large part of investments is made in shares1. Portfolio composition
is affected by tax concessions. Regulatory factors also influence investment
decisions, although some quantitative restrictions such as investment maxima
for asset classes seem not to be binding in many instances.
Tax and regulatory aspects of life insurance activities
All OECD countries provide some tax concessions for the purchase,
maintenance or execution of life insurance policies2. In most countries, tax
relief is provided for premiums paid. Policies that are primarily survivorship
contracts (e.g., endowments and annuities) are more likely to enjoy tax
preferences.
1.
The reason is that guaranteed surrender values are not a legal requirement in
some countries. Consequently investments by insurance companies does not
have to be concentrated in fixed-income securities, whose value is
predictable for matching purposes .
2.
"Policy issues in insurance -- investment, taxation, insolvency", OECD,
1996.
71
The regulatory regime concerning investments of technical provisions
is another determinant that influences life insurance investment activities. Each
OECD country has regulations with respect to i) the types of securities that are
eligible for investment, and ii) the valuation of these securities for regulatory
purposes. All OECD countries, and in the United States, the individual states,
have approved lists of investments which insurance companies are allowed to
hold. The rationale of these lists is to ensure that eligible investments possess
acceptable levels of investment risk. Most OECD countries impose maximum
limits on classes of investment: quoted and unquoted domestic shares, foreign
securities, real estate, mortgage loans and other loans (Table A2). The general
purpose of these maximum levels is to restrict the default and liquidity risks of
investments. Maxima are also applied to ensure that there is sufficient portfolio
diversification of investment holdings. Although regulatory investment
maxima vary widely across OECD countries, the actual investment portfolios of
insurance companies do not appear very much constrained by these maxima.
Apparently, in many instances the limits that have been set by the regulatory
authorities have been higher than what most insurance companies would
1
themselves view as prudent levels .
Another important area of investment regulation concerns the
matching of assets and liabilities in terms of maturity and currency. Only
5 OECD countries (Greece, Mexico, Norway, Sweden and Ireland) have
statutory requirements for maturity or duration matching. However, in most
OECD countries the regulatory authorities review on an informal basis the time
profiles of assets and liabilities as part of the wider assessment of the solvency
of an insurance company. A serious mismatch of assets and liabilities would
endanger the solvency of life insurance companies which tend to have
longer-term liabilities with often implicit interest guarantees. Life insurance
companies need therefore to ensure that the duration of their investments are
broadly in line with their mainly long-term liabilities, in order to minimise the
inherent interest rate risk. One of the main investment risks for a life insurance
company is that with many short-term assets it would face a reinvestment risk
in market situations with lower interest rates than warranted by the (often
implicit) interest guarantees on its long-term liabilities. Moreover, for life
contracts with a significant savings component, legal requirements and/or
competitive pressures demand that the rates of return on investment holdings
maintain their value in real terms.
1.
"Policy issues in insurance -- investment, taxation, insolvency", OECD,
1996.
72
In nearly all OECD countries there are statutory requirements for
some degree of currency matching. Currency matching requirements are
separate from restrictions on foreign investments (Table A3). The latter are
based on default and liquidity risk considerations.
In all OECD countries insurance companies are free to use derivatives
in connection with the investment of their capital funds. However, a number of
countries restrict their use in the investment of technical (mathematical)
reserves (Table A4). In almost all OECD countries the use of derivatives is
restricted to risk management purposes. In many countries the writing of
options is only allowed when they are covered.
A.1.2
Non-life insurance activities
Non-life insurance companies provide cover against the damage, loss
or destruction of property; the loss or impairment of income-producing ability;
claims for damages by third parties because of alleged negligence; loss
resulting from injury or death due to occupational accidents. Competitive
pressures in the non-life insurance sector result from intercompany competition
but also from large non-insurance companies that have established insurance
captives, often in off-shore tax havens or in countries or regions with lower
taxes. Additional pressure derived from industry initiatives to offer attractively
priced insurance contracts by pooling the liability risks of large corporations.
Investments
The liabilities of non-life insurance companies differ from those of
life insurance enterprises in the sense that they are mainly short-term and that
the size and timing of claim payments are much harder to predict. Investment
portfolios should therefore possess a high degree of liquidity. In most OECD
countries, non-life companies invest more heavily in equities and less so in
bonds than life insurance companies. Because of the increase in competition,
the investment and insurance sides of the non-life insurance business have been
prompted to co-ordinate better their respective activities, particularly when
pricing their policies. This is done in larger companies through actuaries and
investment managers sitting on asset/liability committees.
73
Non-life insurance products
In only three member countries -- Japan, Sweden and Germany -- can
one find examples of non-life insurance products with an in-built financial
component. Three reasons have been advanced to explain this1: i) non-life
insurance contracts are short-term, whereas saving is long-term in nature; ii) the
inclusion of a financial component could be considered as violating the
indemnity principle, which allows only the recovery of losses and not the
making of profits; and iii) non-life insurance products do not qualify for a
similar favourable tax treatment as life insurance products (because the latter
perform a long-term saving function).
Regulatory treatment of the non-life insurance business
Competitive pressures have made the need for price regulation less
desirable than in the past. Regulation of prices could even backfire when
imposed prices lead to the withdrawal of insurers offering insurance.
Regulations governing eligible investments have been imposed to reduce the
likelihood of insolvency. In most OECD countries, the same maximum
percentages in investment classes apply for non-life and life companies.
Differences between life insurance and non-life insurance can be found in
Canada, Ireland, Italy, Japan, Portugal, and some states (e.g., Delaware and
New Jersey) for the United States (Table A2). In view of the different nature of
investment risks in the two sectors, this degree of uniformity is surprising.
Practical problems regarding the enforceability of these rules seem to be the
main reason why there are no bigger differences2.
For non-life companies maturity matching is relatively unimportant,
because the duration of technical provisions is shorter than those of life
companies and there are no interest guarantees. On the other hand, currency
matching is of even greater importance for non-life companies since there is
uncertainty about the timing of claim payments.
1.
"Insurance and other financial services -- structural trends", OECD, 1992.
2
"Policy issues in insurance", OECD, 1996.
74
Table A1. Glossary: Insurance companies
Bancassurance:
Basket Provision:
Bullet-type guaranteed
investment contract:
Claim expenses:
Claim-adjustment expenses:
Combined ratio:
Convention statement:
Floating-rate guaranteed
investment contract:
Life insurance company:
Premium on an insurance
policy:
Property and casualty
insurance company:
Reinsurance:
Reserves of property and
casualty insurance company:
Single-premium deferred
annuity:
Surplus:
Term insurance:
Underwriting profit or loss:
Universal life policy:
Variable contract:
Whole life insurance:
Integrated financial conglomerates that offer both banking and insurance
products.
Feature of insurance company regulations that allows a company to
invest some small percentage of its assets in any type of vehicle that is
not explicitly prohibited by law.
A GIC, to which funds cannot be added, over the specified life of the
contract.
Funds that property and casualty insurance companies must add to their
reserves for new claims for policies written during a year.
Funds that property and casualty insurance firms must add to reserves
because of underestimates of actuarially projected claims from previous
years.
An important measure of a property and casualty firm’s underwriting
results, which is calculated by dividing the sum of claim expenses, claim
adjustment expenses, and administrative and marketing expenses by
annual premiums.
An insurance company’s annual statement of its financial condition.
A GIC in which the guaranteed interest rate is tied to some
predetermined market benchmark such as a specific-maturity Treasury
yield.
Financial intermediary that agrees to make a payment in the event of the
death of the person who holds the policy; a life insurance company may
also be active in the area of providing retirement benefits.
The price the policy holder pays for the insurance policy.
Financial intermediary that insures against a wide variety of losses to
personal or commercial property.
The action of one insurance company buying insurance on some of its
own policies from a second insurance company independent from the
first.
Funds available to satisfy the actuarially estimated claims.
Individual savings product that earns a fixed, or quasi-fixed, rate of
return over an indefinite period. Earnings are tax-defined, and funds can
be withdrawn at any time, subject to a surrender charge.
The difference between an insurance company’s assets and liabilities.
A form of insurance that has no value if the insured party does not die
before the end of the set policy period.
The difference between a property and casualty firm’s annual premiums
earned and the sum of the claim expenses incurred, claim adjustment
expenses, and administrative and marketing expenses.
A life insurance policy under which the policy holder may change the
death benefit and vary the amount and timing of premium payments.
Provides a death benefit that depends on the market value of invested
premiums at the time of the insurer’s death or, if the value of the
investment is low, pays a guaranteed minimum amount.
A form of insurance that pays a stated amount upon the death of the
insured, and that accumulates, over time, a cash value that the
policyholder can call on.
75
Table A2 Maximum percentage that can be invested in a given class of Investments
Domestic shares
(quoted)
Non-life
Life
30a
30e
25a
5-25e
40a
40e
20
20
65a
65e
30
30
30a
30e
40a
40e
50-60a
55e
20
20
30a
30e
10
10
30
30
20a
20e
25a
25e
25a
25e
30a
30e
15e
40a
(1)
Domestic shares
(unquoted)
Non-life
Life
5
5
10a
10e
25a
5-25e
10
10
0
0
65a
65e
10
10
30a
30e
10b
10f
20
2.5
20
20
30a
30e
5
5
30
30
10
10
20a
20e
10
10
25a
25e
30a
30e
10
10
10a
10e
15e
40a
(1)
Foreign shares
Foreign bonds and other
securities
Non-life
Life
10(3)
10(3)
0
0
0
5
5
10b
10f
30
50
30b
30f
10
10
30
30
30b
30f
60
60
20b
20f
h
i
5
5
Real Estate
Loans
Loans
(mortgage)
(non-mortgage)
Non-life
Life
Non-life
Life
Non-life
Life
Non-life
Life
Australia
Austria
30a
30e
30a
30e
0
0
Belgium
10a(2)
10e(2)
10(4)
10(4)
5(5)
5(5)
Canada
0
5-25e
10
5-25e
5
5
Denmark
40a,d
40d,e
10
10
Finland
0
0
France
65a
65e
40
40
10b
10f
10b
10f
Germany
6
6
25
25
50a
50e
50a
50e
Greece
30a
30e
40
50
10b
10f
10b
10f
Iceland
40a
40e
10b
10f
Ireland
50-60a
55e
60
25
15-30b
10
15-30b
45
Italy
10
20
35
50
20
50
0
0
Japan
30b
30f
20
20
55c
55c
10
Luxembourg
5
5
40
40
10a
10e
0
0
Mexico
30
30
40
40
40
40
40
40
Netherlands
10
10
5j
8j
Norway
20a
20e
30b
30f
30b
30f
30b
30f
Portugal
25a
25e
35
45
10
25
10
25
Spain
Sweden
25a
25e
25b
25f
25b
25e
10
10
Switzerland
25b
25f
0
0
Turkey
20
20
20
20
20
20
UK
10a
10e
10a
10e
USA(New Jersey)
h
i
5
10
40
60
USA (Delaware)
5
5
25
25
50
50
Notes: maxima in respect of foreign investments are separate from the currency matching requirements for foreign liabilities. 1. 250% (at market value) of the capital and surplus;
2. unquoted shares only; 3. only State and enterprises bonds outside of area A (see the Directive 89/647/EEC); 4. investments in a single real estate or in several real estate close to one another;
5. 5% with a maximum of 1% for one single loan. a) max. for these classes of investment combined (Non-life); b) maximum for these classes of investment combined (Non-life); c) maximum
for these classes of investment combined (Non-life); d) if unquoted then ten per cent; e) maximum for these classes of investment combined (Life)which would constitute one single investment;
f) maximum for these classes of investment combined (Life); g) max. for these classes of investment combined (Life); only for unqualified non-mortgage loans; h) investment must not exceed
the value of outstanding policies in the foreign country; i) 5% in the aggregate; 2% in foreign countries, except for "qualified foreign investment" defined in the statute; j) unsecured loans.
Source: OECD Policy Issues in Insurance, Paris 1996 and updates via OECD submissions.
Table A3 Currency matching requirements
Required percentage Does currency matching
of currency matching extend to equalisation
of technical provision
(claim fluctuation)
reserves?
Non-life
Life
Non-life
Life
n/a
n/a
80
80
Yes
n/a
80
80
Yes
n/a
100
100
n/a
n/a
80
80
Yes
Yes
100
95
n/a
n/a
80
80
Yes
Yes
80
80
Yes
n/a
80
80
n/a
n/a
80
80
Yes
Yes
80
80
Yes
n/a
80
80
Yes
n/a
No
No
No
No
80
80
n/a
n/a
80
80
Yes
80
80
Yes
Yes
80
80
Yes
Yes
80
80
Yes
n/a
80
80
n/a
n/a
80
80
n/a
n/a
100
100
n/a
n/a
80
80
No
n/a
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Mexico
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA
(New Jersey)
100
USA
(Delaware)
100
Source: Table A2
Extent to which ECU
denominated securities
can be used for
matching
Non-life
Life
n/a
n/a
100
100
100
100
n/a
n/a
50
50
n/a
n/a
0
0
50
50
100
100
50
50
50
50
100
100
n/a
No
0
0
n/a
n/a
100
100
80
80
50
50
0
0
80
80
n/a
n/a
0
0
100
n/a
n/a
n/a
n/a
100
n/a
n/a
n/a
n/a
77
Table A4 Use of financial derivatives
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Mexico
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New
Jersey)
USA
(Delaware)
Can they be used
in respect of the
investment of
technical
provisions?
Non-life
Life
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Yes
No
No
Yes
Yes
No
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Can they be used
in respect of the
investment of
capital funds?
Non-life
Life
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
* Also allowed to write covered call options
Source: Table A2
78
Purpose for which
they can be used
Non-life
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Life
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging*
Hedging
Hedging
Hedging
Hedging*
Hedging*
Hedging
Hedging*
Hedging*
Hedging
Hedging
Hedging*
Hedging*
Hedging
Hedging*
Hedging*
Hedging
Hedging*
Hedging
Hedging*
Hedging*
Hedging
Hedging*
Hedging*
Hedging
Hedging
Hedging*
Hedging*
Hedging
Hedging*
Hedging*
Hedging*
Hedging*
A.2
Pension funds
In all OECD countries pension funds have become major institutional
investors and important players in the capital markets due to the following
factors:
− income and wealth have grown steadily since World War II,
providing households with more funds for long-term savings;
− people are living longer and have larger financial needs during
longer retirement periods;
− pension claims are tax free until after workers retire and income
from employment ceases.
Pension fund schemes can be classified into the following three
categories (Table B1):
i) Public managed pension schemes with defined benefits and
pay-as-you-go finance, usually based on a payroll tax. They are
mandatory for covered workers. In most OECD countries
coverage is (near) universal.
ii) Occupational pension funds that are privately managed and offered
by employers to employees. Thanks to tax advantages not
available to personal pension plans, coverage grew in most OECD
countries. Currently more than one-third of the working age
population (or more than 40 per cent of the labour force) is covered
in OECD countries. Within this category of funds there is a trend
in OECD countries from defined benefit and partially funded
schemes toward defined contribution schemes.
iii) Personal pension plans in the form of saving and annuity schemes.
These schemes are normally voluntary and based on fully funded
defined contribution plans.
In some non-OECD countries
(e.g., Singapore and Malaysia) there exist publicly managed,
mandatory schemes that are fully funded and based on defined
contributions, known as provident funds.
Tax incentives
encourage the development of these plans, although at present their
share of total income in old age is relatively small.
An overview of the structure of pension provisions in a sample of
OECD countries is given in (Tables B2 and B3).
79
Pension plans
1
A pension plan is a fund that is established for the payment of
retirement benefits (Table B1). Plan sponsors are the entities that establish
pension plans such as private business entities acting for their employees,
governmental entities on behalf of their employees, unions on behalf of their
members, and individuals for themselves. There are two basic types of pension
plans: defined contribution plans and defined benefit plans. Designer pension
plans are a hybrid of both basic types. In a defined contribution plan, the plan
sponsor is responsible only for making specified contributions into the plan on
behalf of qualifying participants. The plan sponsor does not guarantee any
retirement payments. Payments are determined by the investment performance
of the assets in which the pension fund invests. In contrast, defined benefit
plan sponsor agrees to make specified payments to qualifying employees at
retirement. The pension obligations are effectively the debt obligations of the
plan sponsor, who assumes the risk of having insufficient funds in the plan to
satisfy the contractual payments to pensioners. Hybrid pension plans that
combine features of both basic types of pension plans have also been
developed. The appeal of these hybrids is that they can be designed to reduce
some of the inherent disadvantages in both types of plans: in defined
contribution plans the employee bears all the investment risk, while defined
benefit plans are expensive and hard to implement when workers are mobile.
"Hybrids" come in many forms but the so- called "floor-offset plan" is a
representative one. In this plan the employer contributes a certain amount each
year to a fund, as in a defined contribution system. In addition, the employer
guarantees a certain minimum level of cash benefits, depending on the
employee’s years of employment, as in a defined benefit plan.
Defined contributions are, by definition, fully funded, while defined
benefit plans can operate on either a partially funded or a pay-as-you-go basis.
Many public defined benefit plans are based on "pay-as-you-go" funding
policies, that is, when an employee retires, the necessary retirement benefits are
taken out of current contributions and/or budget transfers. For example, public
pension plans in Japan, Sweden, and the United States maintain partially
funded schemes, while Canada, France, Germany, Italy and the United
Kingdom rely on pay-as-you-go approaches.
1.
Reforming Public Pensions. Series OECD Social Policy Studies No. 5,
OECD, 1988; Private Pensions and Public Policy, OECD 1992.
80
Investments
Pension funds are important investors in equities and/or fixed-income
securities (Tables B4, B5, B6, B7, B8). The shift from pay-as-you-go systems
towards funded pension schemes (in particular, defined contribution plans) has
increased the potential of pension funds to channel longer-term savings into
financial markets. The investment policies of professional fund managers
increasingly influence the allocation and productivity of capital. Unlike most
public pension reserves, occupational and personal pension funds in OECD
countries have been invested strictly on the basis of commercial criteria, subject
to regulatory constraints.
Pension funds benefit from regular inflows of funds on a contractual
basis and from long-term liabilities. They face therefore little liquidity risk.
Underestimating mortality and lower-than-expected returns on assets constitute
the main risks. Given the general nature of their liabilities, pension funds are
likely to concentrate portfolios on long-term assets yielding the highest returns.
Pooling across assets whose returns are imperfectly correlated is done to offset
the associated extra risk. However, the actual liability structures of pension
funds differ because of differences in the "maturity structure" of the fund. The
conventional wisdom is to invest in equities to meet long-term liabilities for
younger workers, but in bonds for most of the liabilities which have to be met
immediately. Consequently, in order to avoid an asset-liability mismatch,
mature pension funds need to invest more heavily in bonds than immature
schemes. Surprisingly, however, studies seem to indicate that there is a striking
similarity of the asset allocation among UK and US pension schemes, despite
1
very different liability structures .
Tax treatment of pension schemes
Unlike other types of institutional investors, pension funds in most
OECD countries benefit from tax deferral: contributions and accumulated
interest and capital gains are tax free; tax is paid on receipt of a pension after
retirement. Reasons for the favourable tax treatment of pension schemes
include: i) the argument that there is a need to encourage people to save
enough to maintain post retirement living standards; ii) this in turn would mean
that when people save enough it would reduce the cost to the state to provide
means-tested social security benefits; and iii) it is also hoped that the general
1.
Financial Times, The fund manager as a herd animal, April 15, 1996.
81
level of saving would be raised. The tax treatment of pension schemes differ
widely across OECD countries (Tables B2-B3).
Regulatory aspects of pension fund activities
Quantitative regulation of portfolio holdings are in place in a number
of OECD countries. Reasons include the protection of pension fund
beneficiaries or benefit insurers and, in some countries, the creation of a steady
demand for government securities1. Limits are often imposed on holdings with
relatively volatile returns, such as equities, real estate and foreign assets,
although their mean return might be higher (e.g. on equity) than on assets with
so-called stable returns (e.g. government bonds with a fixed coupon). There are
often also limits on self investment, to protect against the associated
concentration of risk regarding insolvency of the plan sponsor.
A number of countries do not impose quantitative limits but impose
guidelines such as the so-called "prudent man rule". Under the prudent man
rule, fiduciaries, trustees, and bank trust departments are expected to behave as
careful professionals in making investment decisions. In the United States the
Employment Retirement Security Act (ERISA) stipulates that the fiduciary
must be knowledgeable enough to act as a careful professional, experienced and
educated in trust and financial matters. "Prudence" is a design standard, not a
performance standard. This is reflected in the two most significant elements of
the rule: i) the requirement to diversify; ii) the exhortation to favour "seasoned"
situations that similarly-placed institutions find appropriate. In the United
States, the application of this design standard to investment decisions has led to
the overwhelming preponderance of pension equity money being invested in the
limited number of listed securities of American corporations with large
capitalisation. It may also account for the increase in the "index mode" of
investments.
Prudential concerns are also often mentioned as the rationale for
regulatory constraints on portfolio holdings of foreign securities (Table B9).
Other motives (for example, the "benchmark" orientation of fund managers)
are, however, also mentioned in the literature.
1.
E. P. Davis, 1995, "Pension Funds", Clarendon Press, Oxford; see for
restrictions on "foreign assets" DAFFE/CMF(96)19 and DAFFE/INS(96)1.
82
Table B1 Glossary : Pension funds
Defined Benefit Plan:
Defined contribution plan:
U.S. Employee Retirement
Income Security Act of 1974
(or ERISA):
Hybrid pension plan:
Insured benefit Plan:
U.S. Pension Benefit Guaranty
Corporation (or PBGC):
Pension plan:
Pension plan sponsor:
Pensionkassen:
Personal Equity Plan (PEP):
Plan whose sponsor agrees to make specified
dollar payments to qualifying employees at
retirement, according to factors such as the length
of service and the earnings of the employee.
Plan whose sponsor is responsible only for making
specified contributions into the plan on behalf of
qualifying participants.
Comprehensive U.S. legislation regulating several
key features of corporate pension plans and
including the “prudent man” statutes and rules.
Plan that combines some features of the defined
benefit approach and some aspects of the defined
contribution method.
Plan whose defined benefits the sponsor insures
through an annuity policy with a life insurance
company.
The U.S. federal agency established in 1974 by
the ERISA legislation to insure the vested benefits
of pension plan participants.
A fund that is established for the payment of
retirement benefits.
The entity that establishes a pension plan for its
employees, which may be a private business or a
unit of state/local government. Sponsors may also
be a union acting on behalf of its members or
individuals acting for themselves.
German term for legally separate but actually
captive and in-house companies that manage
pension funds.
This policy of the British government encourages
individuals to increase their savings for retirement
through exemption from taxation of gains from
dividends and price appreciation in equity
accounts.
Funding rules are a key aspect of the regulation of defined benefit
pension funds. A defined contribution is by definition always funded.
However, with defined benefit schemes one needs to make a distinction
between the pension plan (i.e. the contractual rights of the parties) and the
83
pension fund (i.e. the pool of assets to provide cover for the promised benefits).
Under/over funding is the situation when the fund is worth less/more than the
present discounted value of the promised benefits. Minimum funding rules
seek to protect the beneficiaries against default risk by the company. Since
unfunded benefits are liabilities for the company, pensioners or pension insurers
(see below) may have no better claim than other creditors. Other regulatory
issues concern ownership of surpluses, portability, internal transfers, fraud,
disclosure, and the structure and mechanics of supervision (see Tables B2-B3,
for a summary).
Table B2 Summary of pension asset regulations
United
Kingdom
Germany
Netherlands
Sweden
Denmark
Portfolio regulations
Prudent man concept; 5 per cent
self investment limit, concentration
limit for defined contribution plans.
Guidelines: maximum 30 per cent
EU equity, 25 percent EU property,
6 Per cent non-EU shares, 6 per
cent non-EU bonds, 20 per cent
overall foreign assets, 10 per cent
self investment limit.
Prudent man concept; 5 per cent
self investment limit, whereby free
reserves can be added up to a total
limit of 10 per cent.
Majority to be in listed bonds,
debentures and retroverse loans to
contributors.
Property loans, shares and
investment trust holdings limited to
40 per cent, foreign assets to 20 per
cent; 60 per cent to be in domestic
debt. No self investment.
84
Regulation of funding (1)
Maximum 5 per cent overfund of
PBO or IBO. Funding only
obligatory for contracted out part of
social security.
Funding obligatory up to PBO.
Option of book-reserve funding.
Minimum funding requirement is
present value of ABO discounted at
4 per cent; percentage of
overfunding dependent on
composition of investment portfolio
and volatility of relevant investment
returns; maximum 15 per cent
overfund of ABO, minimum is
ABO itself.
For ATO, IBO is funded.
Contribution rate adjusted 5-yearly
to balance fund.
Irrelevant as defined contribution;
benefits must be funded externally.
Table B2 Summary of pension asset regulations (continued)
France
Italy
Ireland
Belgium
Spain
Portugal
Norway
Assets of supplementary funds
(ARRCO/AGIRC) to be invested
50 per cent in EU government
bonds and less than 33 per cent in
loans to sponsors. insured funds to
be at least 34 per cent state bonds,
maximum 40 per cent property and
15 per cent Treasury deposits. No
foreign assets.
No pension law for self
administered schemes. Most
schemes are insured investments
may be in state bonds (maximum 90
per cent), bank deposits, property,
mortgages, securities, investment
funds.
Funded company schemes
forbidden: book reserve funding
subject to tax discrimination.
Schemes must diversify prudently,
any self investment to be declared.
15 per cent to be invested in
government bonds, no more than 15
per cent in sponsor, 40 per cent limit
on real estate, 10 per cent deposits.
90 per cent in stocks, bonds,
mortgages, property, deposits.
Funding of ABO required; deferred
rights indexed.
Funding obligatory of ABO based on
current salary, interest rate 7 per cent.
30 per cent to be invested in
government bonds, maxima of 50 per
cent real estate, 15 per cent self
investment, 40 per cent equities and
bonds not listed in Portugal.
Maximum 20 per cent in shares;
maximum 30 per cent in loans that
are not issued or guaranteed by: the
government or municipalities;
financial institutions or EU credit
institutions; and investment in other
real estate than negotiable property.
No pension law for self
administered schemes; draft law
proposes payments equal to 7 per
sent of salary. Insured plans must
be fully funded on a 15 year
projection.
Funding obligatory of ABO plus 4 per
cent margin; maximum interest rate 6
per cent.
Funding obligatory of ABO.
Funds should, at least, cover the
difference between PBO and NPV of
future contributions, based on an
interest rate of 3 per cent.
1) ABO refers to the accrued benefit obligation; PBO the projected benefit obligation
Source: Davis (1995), EFRP, OECD.
85
Table B3 Features of funded pension systems
Nature of
benefits for
average member
UK
Largely defined
benefit based on final
salary.
US
Primary cover largely
defined benefit based on
final salary.
Supplementary defined
contribution plans
widespread.
Contributions and asset
returns tax free. Benefits
taxed.
Taxation of
funded schemes
Contributions and
asset returns tax free.
Benefits taxed, except
tax free lump sum.
Social Security
Low replacement
ratio. Scheme
members can contract
out of earnings related
social security.
Prudent man concept;
5 per cent self
investment limit;
concentration limit for
defined contribution
plans.
Maximum 5 per cent
overfund of IBO or
PBO. Funding only
obligatory for
contracted out part of
social security.
Low replacement ratio.
Mature.
50 per cent (company
schemes) 20 per cent
(personal pensions).
No (although state
guarantees payment of
minimum pension if
fund defaults).
Vesting in 2 years.
Indexation of accrued
benefits. Transfers
must be made to other
pension funds.
Discretionary (to date)
but total or partial
indexation common in
practice (75 per cent).
Regulation of
portfolios
Regulation of
funding
Maturity of
funds
Coverage of
workforce
(approx.)
Insurance of
benefits
Portability
features
Indexation
Germany
Largely defined benefit with
flat rate benefit based on
years of service.
Employers’ contributions
taxed as wages; employee
contributions and asset
returns tax free. Benefits
taxed at low rate.
High replacement ratio.
Prudent man concept; 10
per cent limit on self
investment for defined
benefit plans.
Guidelines; maximum 20 per
cent equity, 5 per cent
property, 4 per cent foreign;
10 per cent self investment
limit.
Maximum 50 per cent
overfund of ABO. Higher
insurance premia if
underfunded.
Mature.
Funding obligatory for
pension funds.
(Pensionskassen), albeit only
up to PBO. Option of
booking (tax exemptpensions taxed at normal
rate).
Immature.
46 per cent.
42 per cent.
Yes (special guarantee
corporation).
Yes (via insurance
supervisors). Booked
benefits insured by Pension
Guarantee Association.
Vesting in 10 years.
Indexation of accrued
benefits.
Vesting in 5 years. No
indexation of accrued
benefits. Lump sum
distribution permitted on
transfer.
Full indexation rare (5 per
cent of schemes).
Discretionary cost-ofliving increases common.
86
Mandatory.
Table B3 Features of funded pension systems (continued)
Nature of
benefits for
average member
Taxation of
funded schemes.
Social security
Regulation of
portfolios
Regulation of
funding
Maturity of
funds
Coverage of
workforce
(approx.)
Insurance of
benefits
Portability
features
Indexation
Denmark
Largely defined
contribution.
Sweden (ATP)
Defined benefit based on
best income years.
Contributions tax
deductible. Fund may
be taxed, including 40
per cent of lump sum.
High replacement
ratio.
Contributions tax free. Tax
on asset returns (1991)
benefits taxed at low rate.
Real estate, investment
trusts, shares limited to
40 per cent. 60 per
cent in domestic debt.
No self investment.
Only “small
proportion”
can be invested interna
tionally.
Irrelevant as defined
contribution.
Majority to be in listed
bonds, debentures and
retroverse loans to
contributors.
30 per cent (company
funds) 20 per cent
(personal pensions).
Immediate access to
own contributions, 5
years total vesting.
Transfer values can be
negotiated.
No.
Low replacement ratio;
only for basic needs.
Switzerland
Majority of schemes (60
per cent) defined
contribution but with targets
of 60 per cent replacement
rate which contributions
adjusted). 40 per cent defined
benefit.
Contributions and asset
returns tax free, benefits
taxed.
Low replacement
ratio; designed to be
supplemented by
mandatory private scheme.
30 per cent limit on domestic
shares; 50 per cent domestic
real estate; 20 per cent
foreign currency assets; 25
per cent foreign shares;
overlaps are possible.
Contribution rate adjusted
5-yearly to ensure IBO is
funded.
Mature.
Funding compulsory for PBO
or ABO.
90 per cent (compulsory).
Above a certain salary level
(SFr 23 280) 100 per cent.
State backup as national
scheme.
Yes; Government Safety
Fund. Small funds backed
by insurance companies.
Immediate access to
minimum contributions.
Complete vesting for
employees.
Vesting immediatenational scheme and
transferability perfect.
Yes.
Mature
Indexing not compulsory.
87
Table B3 Features of funded pension systems (continued)
Nature of
benefits for
average member
Taxation of
funded schemes.
Social security
Regulation of
portfolios
Regulation of
funding
Maturity of
funds
Coverage of
workforce
(approx.)
Insurance of
benefits
Portability
features
Indexation
Japan
Largely defined
benefit based on years
of service and career
earning or final basic
salary. Often taken as
a lump sum.
Contributions tax free.
Benefit taxed, except
tax free lump sum.
Canada
Largely defined benefit
based either on final salary
or flat rate benefit.
Netherlands
Almost exclusively defined
benefit, based for around 75
per cent of contributors on
final salary.
Contributions and asset
returns tax free. Benefits
taxed.
Contributions and asset
returns tax free. Benefits
taxed.
High replacement
ratio. Scheme
members can contract
out of earnings related
social security.
Guidelines; maximum
30 per cent equity,
20 per cent property,
30 per cent foreign,
10 per cent one
company. Minimum
50 per cent bonds.
Funding optional. Tax
exempt up to ABO
only. (Book reserves
tax exempt up to 40
per cent of liabilities).
Immature.
Low replacement ratio.
Low replacement ratio.
Prudent man (since 1987);
tax on foreign assets above
10 per cent; 7 per cent limit
on real estate.
See Table B2
Funding obligatory.
Maximum 5 per cent
overfund of PBO.
See Table B2
Mature.
Mature.
37 per cent (funded
plans only).
41 per cent.
90 per cent.
Yes (under wage
payment law). Mutual
guarantee scheme for
EPFs introduced 1988.
Vesting graded
between 5 and 30
years for voluntary
leavers. Low transfer
values for voluntary
early leavers.
Rare except for part
replacing social
security.
No (but social security
provides backup).
No
Vesting after 2 years.
Little indexation of
accrued benefits.
Vesting in one year.
Accrued benefits indexed.
Transferability within
extensive pension circuits
with same conditions.
Provisions rare (6 per
cent of private schemes);
some discretionary
increases.
Indexation almost universal
(albeit not mandatory).
88
Table B3 Features of funded pension systems (continued)
Nature of benefits for average
member
Taxation of funded schemes
Social security
Regulations of portfolios
Regulation of funding
Maturity of funds
Coverage of workforce (approx.)
Insurance of benefits
Portability features
Indexation
Norway
Largely defined benefit based on final salary. Most schemes
aim to provide a benefit which, together with the State scheme,
corresponds to 60-66 percent of the last income earned after a
contribution period of 30 years.
Contributions and asset returns tax free to a certain extent for
plans which comply with the regulations of the tax law.
Benefits taxed as income.
High replacement ratio for low income; designed to be
supplemented by mandatory private scheme.
See B2
See B2
Compulsory occupational pension in public sector. In the
private sector, 1/3 of the workforce have occupational pension
scheme and about 1/4 of the overall work force have a private
pension scheme.
Yes, via insurance supervision.
Vesting in 3 years.
Indexation follows social security index, which is set by the
government each year.
Source: Davis (1995) and OECD.
Table B4 Asset allocation of European pension funds, 1994 (%)
Germany
United Kingdom
Netherlands
Switzerland
Norway
Domestic
equities
6
56
11
8
14
Foreign
equities
3
26
12
5
0
Domestic
bonds
72
7
63
54
1
72
Foreign
bonds
4
5
4
5
2
Real
Estate
13
4
8
19
4
Cash
2
2
2
9
2
8
Note: Figures on investment in equities include calculated holdings through mixed funds
and equity funds.
1. Including bills.
2. Including deposits.
Source: Global Investor, February 1995, OECD
89
Table B5 Investments of German Pensionskassen (%)
Type of Investment
1993
1994
Real properties and equivalent titles
7.0
7.1
Mortgage, land charge and annuity land charge claims
Registered bonds
10.5
20.7
10.2
19.8
Claims backed by promissory notes and loans
10.4
10.8
0.7
0.6
0.1
0.1
0.2
25.7
0.2
26.7
2.3
2.5
20.1
2.1
20.9
1.0
Other
0.1
0.1
Total
100
100
Debt register claims on
governments
the
Federal
and
regional
Loans and prepayments on insurance policies
Corporate holdings
Fixed-income securities
Equities
Shares in security funds
Time deposits and savings deposits at credit institutions
Note: This figure includes investments in real estate funds, equity funds, bond funds,
and mixed funds.
Source: Federal Supervisory Office for Insurance Companies
Table B6 US pension funds portfolio (%)
Type of fund
Single-employer defined benefit
Single-employer defined contribution
Multi-employer defined benefit
Multi-employer defined contribution
Single-employer profit-sharing defined
contribution
Single-employer moneypurchase defined contribution
Source: Papke (1991)
90
Bonds
and
cash
50
41
63
73
39
Equities
Pooled
funds
Other
23
33
19
5
32
20
17
8
8
19
7
9
10
14
9
51
12
26
11
Table B7 Portfolios of pension funds (proportion of total)
Asset Category Year UK
USA Canada Japan
Germany Netherlands Sweden Denmark
Marketable
1970 0.85 0.90
0.82
0.21
0.23
0.20
0.76
0.72
1
1980 0.79 0.86
0.78
0.64
0.34
0.12
0.74
0.66
securities
1990 0.78 0.85
0.90
0.74
0.43
0.33
0.88
0.74
2
1970 0.61 0.45
0.28
0.37
0.17
0.17
0.00
0.00
Real assets
1980 0.70 0.41
0.25
0.16
0.18
0.13
0.00
0.03
1990 0.72 0.46
0.36
0.29
0.24
0.23
0.02
0.07
Capital1970 0.93 0.90
0.81
0.51
0.36
0.29
0.76
0.72
uncertain
3
1980 0.94 0.82
0.75
0.7
0.42
0.20
0.74
0.66
assets
1990 0.96 0.82
0.83
0.76
0.49
0.41
0.86
0.74
Long-term
1970 0.32 0.51
0.65
0.14
0.69
0.81
0.98
0.76
fixed-interest 1980 0.24 0.43
0.64
0.54
0.76
0.86
1.00
0.70
4
bearing assets 1990 0.14 0.38
0.51
0.47
0.70
0.75
0.94
0.74
Notes: Categories overlap, so they do not add up to unity
1. Equities, bonds and market paper
2. Equities and property
3. Equities, property and bonds
4. Bonds, mortgages (for Canada, the USA, the Netherlands, Norway, Denmark, Sweden, and Germany),
Denmark, Sweden, Switzerland and the Netherlands).
Source: Davis, 1995, OECD.
91
Switzerland
0.31
0.41
0.55
0.19
0.27
0.33
0.44
Australia
0.66
0.48
0.57
0.17
0.28
0.29
0.68
Norway
0.21
0.42
0.62
0.02
0.04
0.13
0.21
0.55
0.62
0.58
0.55
0.43
0.61
0.49
0.51
0.33
0.20
0.44
0.65
0.98
0.96
0.85
other loans (for Germany, Norway,
Table B8 Pension funds’ portfolio distribution, 1992
Percent
Equities
Fixed
Property
Liquidity and
Income
deposits
UK
80
11
6
3
Germany
6
80
13
1
Netherlands
24
60
14
2
Sweden
1
84
1
3
Denmark
19
67
12
2
Ireland
66
24
7
3
France
20
67
11
2
Italy
14
72
10
5
Belgium
31
50
8
11
Spain
3
94
2
1
Portugal
18
57
5
19
Norway
9
73
6
12
Note: Foreign assets are included in the categories to the left.
Source: EFRP/EU Committee, OECD.
Of which (1):
foreign assets
30
8
17
0
4
35
2
4
31
1
3
0
Table B9: Regulatory constraints on foreign investment by pension funds
in selected OECD countries, 1994
Country
Australia
Ireland
Luxembourg
Netherlands
Spain
United Kingdom
United States (a)
Belgium
Canada (a)
Japan
Portugal
Switzerland (b)
Ceiling
None
Matching requirements
None
None
None
Location in Belgium
Not applicable
20%
None
30%
None
40% (only EU)
None
30% (global)
None
25% (equities)
30% (debt instruments)
5% (real estate)
20% (foreign currency)
Denmark
“Small proportion” stipulated
80%
60% minimum in domestic debt
Finland
5% (foreign currency)
None
Germany
60%
100%
Sweden
5-10%
None
Norway
None
80%
a) Applies only to private pension funds. France and Italy are not included, because
private pension schemes are almost nil. b) Overlaps are possible.
Source: OECD
92
A.3
Investment companies (Institutions for collective investment in
securities)
Investment companies are financial intermediaries that sell shares to
the public and invest the proceeds in a diversified portfolio of securities. Each
share sold represents a proportionate interest in the portfolio of securities
managed by the investment company on behalf of the companies’ shareholders.
The type of securities purchased depends on the company’s investment strategy.
The different types of investment companies are based on a common
principle: individuals contribute savings to a large pool -- the mutual
fund --which is managed by a team of professional money managers. This
mutual fund operation is conceptually different from asset management services
offered by securities brokers (e.g. “SIMs” in Italy), banks and trust companies
to individual clients.
There are four distinct parties involved in any type of “mutual” fund
operation: 1) fund participants who contribute their savings; 2) the fund
management company that invests the pool of savings and executes the
necessary transactions within the framework of the rules specified in the
mandate of a given mutual fund and the existing regulatory and supervisory
regime; 3) the depository bank that is empowered to act as custodian for the
assets of the fund, and is charged with ensuring that all transactions executed by
the management company conform to the fund’s regulations; and 4) the sales
network that acts as a conduit for contributions to the fund. The network may
consist of the branches of the depository bank or other banks, a distribution unit
within the fund management company, a brokerage company or a combination.
By investing in a fund, an investor can effectively achieve the benefits
of diversification at lower cost even if the amount of money available is not
very large. Beyond risk reduction via diversification offered by the funds, there
are reduced costs of contracting and information processing. In addition,
money market mutual funds generally also provide payment services by
allowing investors to write checks drawn on the fund, although this payment
facility is limited in various ways.
Types of investment companies
Two basic types of investment companies can be distinguished:
open-end funds and closed-end funds (Table C1). Open-end funds (referred to
more often as mutual funds and in the United Kingdom as unit trusts)
93
continually stand ready to sell new shares and to redeem their outstanding
shares on demand at a price equal to an appropriate share of the value of their
portfolio, which is computed daily at the close of the market. The net asset
value (NAV) per share is equal to the market value of the portfolio minus the
liabilities of the fund divided by the outstanding number of mutual fund shares.
Load funds impose sales commissions, whereas no-load funds do not.
Back-end load funds charge investors only a fee to sell (redeem) shares.
Closed-end funds (referred to as investment trusts in the United
Kingdom) sell shares like any other corporation but, unlike mutual funds, they
usually do not redeem their shares. The closed-end fund is usually used for
financing high-risk projects by a relatively small number of investors; in the
United States closed-end funds invest mostly in publicly traded illiquid shares.
Venture capital funds are generally organised as closed-end funds, while for
real estate funds this is also often the case. Subscriptions to this type of funds
are generally closed after a short time. After that period, investors have only
access to such funds through purchases in the secondary market. Shares of
closed-end funds sell on either an organised exchange or in the over-the-counter
market. Supply and demand determine the price of a share in a closed-end
fund, so the price can fall below the NAV per share ("trading at a discount") or
rise above it ("trading at a premium").
A concept that has revolutionised the fund industry is a "family of
funds" or “group of funds". The term refers to a series of funds with different
investment characteristics that are being offered as a menu of options by the
fund management companies to investors. The funds in a family may include
choices ranging from money market funds to global funds. Investors usually
can move their assets from one fund to another within the family or group, with
little or no costs. This new organisational concept has transformed mutual
funds into a multi-service family of funds in response to the financial needs of
households and large institutional investors.
Hedge funds have become important institutional investors, although
it is difficult to get reliable data. Even though there is no universally accepted
definition of a "hedge" fund, they can be characterised in terms of two major
1
features: they are unregulated and often highly leveraged. Most hedge funds
can be found in the United States. On-shore U.S. hedge funds are structured as
investment partnerships and the minimum investment is in the range
1.
Even though hedge funds are not subject to specific securities regulations,
they still have to comply with general rules such as commercial codes.
94
$350 000-10 000 000. Off-shore hedge funds are usually structured as
open-end investment funds, albeit with higher minimum investments than most
retail mutual funds. Although total assets of all hedge funds (including
off-shore funds) are estimated to be around $ 236 billion1, their market
positions can be much higher due to leverage. This makes them important
players in the international capital markets, in particular in currency and bond
markets.
Investment objectives and strategy
A wide range of funds with different objectives are active in most
OECD countries. The investment objective is described in the fund’s
prospectus. Some funds focus exclusively on equities, others on bonds, yet
others in specified classes of financial assets (e.g. domestic or foreign securities
only, money market instruments, shares of enterprises in specific sectors, etc.).
However, within each asset class, funds may have different investment
strategies: stable returns, emphasis on volatile high growth industries or
countries, or a combination. Funds may also specialise in equities of small
firms, blue chip companies, emerging markets, high-tech firms, etc. Some
funds offer maximum diversification to investors in the form of "indexed
funds" that hold a portfolio replicating the composition of a broad index such as
the S&P 500.
Funds that specialise in bonds also have a broad range of investment
objectives and strategies. There are corporate bond funds, government
securities funds, high-quality corporate bond funds, low-quality (junk) bond
funds, convertible securities funds, etc. Money market mutual funds invest in
money market instruments. Funds may specialise in different types of
short-term securities (maturity of one year or less): treasury bills, commercial
paper, negotiable certificates of deposit, etc.
A so-called balanced fund is one that invests in both equity and
bonds. Although there may be limits as to how much a fund manager may
allocate to a certain class, there is normally room to change the asset mix to
take advantage of the expected better-performing asset class. It has already been
noted above, that many fund management companies offer investors a choice of
1.
Financial Times, Mighty
4 December 1995, p. 29.
humbled
95
but
they’re
here
to
stay,
numerous funds with different investment characteristics via family or group of
funds.
The investment objectives of hedge funds differ strongly. The
conventional hedge funds are chiefly interested in cross-security arbitrage
within an equity market, while others are active on commodity markets. The
big players are the so-called macro hedge funds who focus on currency and
bond markets. They typically take highly speculative and highly leveraged
positions through the use of bank loans, options, futures and other derivatives.
The regulation of investment companies
Extensive regulation by governmental authorities is a characteristic of
mutual fund activities in many OECD countries. A distinction needs to be
made between the restrictions on the "manufacture" of investment fund
products and services and restrictions on their "distribution". Although in
many respects (e.g. investor protection) investment companies are required to
operate under the regulatory and supervisory framework for securities markets,
there are many special provisions that regulate their activities. Regulations
cover usually the following key areas: self dealings and affiliated party
transactions; management fees of professional fund managers; capital
structures; investment objectives and policies; protection of physical integrity
of the asset pool; fair valuation of investor purchases and redemptions; and the
disclosure of reliable information to investors.
In the United States, all investment companies are regulated at the
federal level according to the Investment Company Act of 1940. This Act
established a comprehensive framework of federal regulation for the protection
of United States investors, including disclosure, accounting, pricing, the use of
leverage, transactions with affiliates, and the custody of fund assets. The
securities issued by investment companies must be registered with the SEC.
The Insider Trading and Securities Fraud Enforcement Act of 1988 requires
mutual funds investment advisors to institute and enforce procedures that
reduce the chances of insider trading. The purchases and sales of mutual fund
shares must meet the requirement of fair dealing that the SEC and the NASD, a
self-regulatory organisation, have established for all securities transactions in
the United States. Fees charged by mutual funds are also subject to United
States regulations. In addition to federal regulations, mutual funds are subject
to the “Blue Sky” laws of each state, which include, among other provisions,
restrictions on certain types of investments.
96
Regulation of the investment companies in Japan is conducted by the
Ministry of Finance (MOF) and a self-regulatory organisation, the Investment
Trust Association. Securities investment trusts (an investment vehicle in many
ways similar to a US mutual fund) are regulated along the lines of the
1
1951 Securities Investment Trust, as amended . A securities investment trust is
a contractual agreement among four parties: The investor who buys beneficiary
certificates; the management company that issues the certificates and decides on
the investments of the trust; the securities company that sells the certificates;
and the trustee, which is a trust bank that manages the assets at the direction of
the management company. If an investment trust is an open type trust,
investors can purchase new certificates, there is no specific maturity date, and
the size of the trust is not fixed. A unit type of trust is somewhat similar to a
closed-end fund: After it is issued at fixed cost per certificate, no new
certificates are sold and no new money is raised. The typical unit trust matures
5 years after issuing its certificates. The MOF must license securities firms (or
subsidiaries) before they may act as the manager of a securities investment
trust.
The regulatory situation in Western Europe has undergone important
changes since the adoption of the 1985 EU Directive on Undertakings for
Collective Investment in Transferable Securities (UCITS). The UCITS
Directive stipulates which types of investment companies are allowed and
which can advertise and market their products across the EU area. Moreover, it
contains the co-ordination of an agreed upon set of minimum standards for
investor protection, leaving considerable scope for EU countries to compete
with each other. Consequently, some EU countries have relatively liberal
investment fund regulations (e.g. Belgium, France, Ireland, Luxembourg and
The Netherlands) that are not in conflict with the minimum standards of the
UCITS Directive. The draft 1993 Directive amending the 1985 UCITS
Directive investment fund companies would allow (i.e. when adopted)
investment companies to advertise and market MMMFs and funds-of-funds
across the EU area.
The 1988 Luxembourg Investment Company Act provides
considerable freedom to investment companies regarding legal structure
(contractual form, the joint stock company with variable capital or SICAV
form, the common fund or FCP form, or any other form of collective
investment) and investment objectives of the investment fund.
The
Luxembourg law includes also regulation of funds that are not covered by the
1.
M. C. Whitener and E. Hiraki, Managing Money in Japan, International
Financial Law Review, Supplement (April 1990).
97
UCITS Directive, including venture capital funds, derivatives funds, index
funds, foreign currency funds, family or group of funds, government securities
funds, etc. These non-UCITS funds are not allowed to be advertised and
marketed across the EU area. Also, France has relatively liberal investment
fund rules. Money market mutual funds (MMMFs) have grown spectacularly.
But other funds have also grown steadily, including risk capital funds,
funds-of-funds, index funds, and financial futures, options and warrant funds.
More "conservative" European countries such as Germany and
Switzerland have reacted to these new initiatives and competition from other
European countries by giving more freedom to investment companies.
Germany allows now the operation of MMMF. Existing investment funds have
gained greater flexibility to engage in derivatives transactions for risk
management purposes; they may invest up to 10 per cent of total assets in
unquoted financial assets. The new Swiss Investment Fund Act of March 1994
has considerably widened the scope for new investment fund products. Both
German and Swiss investment funds have been expanding their presence in
Luxembourg in response to investment fund restrictions at home and, more
important, to tax factors.
Restrictions on the distribution of investment fund products
(including restrictions on cross-border sales of products and services) are
usually motivated by investor protection concerns. Most OECD countries other
than France, the United Kingdom, Italy, Switzerland and the United States,
seem not to have in place special regulations dealing with the sale and
marketing of investment products.
In the United States the sale of investment fund products has
traditionally been subject to tight and detailed regulations. The SEC is
currently undertaking a comprehensive review of current disclosure
requirements. In addition, the Commission is working on the development of a
“fund profile”. The profile contains the fund’s key features in a standardised
format designed to facilitate comparison among funds. Another noteworthy
development is that US legislators are currently considering a set of
amendments to the Investment Company Act designed to modernise certain
aspects of mutual fund regulation, including the authorisation to allow the SEC
to create a new, more investor-friendly fund “advertising prospectus. A final
point of regulatory attention for the authorities is the recent sharp surge in the
sale of investment products via the banking system.
The new Swiss Investment Fund Act covers the sale of investment
products. According to this Act, foreign investment funds will be allowed to be
98
marketed in Switzerland, provided that the fund management companies from
the home countries: i) have supervisory practices and investor protection rules
that are judged to be "equivalent" (not necessarily "identical" or "equal" ) to the
one in Switzerland; ii) have a legal presence in Switzerland; and iii) have sales
practices in compliance with the new Investment Act.
As noted above, the EU UCITS Directive allows the free distribution
of UCIT-defined investment fund products within the European Union.
However, many OECD countries have very detailed and complex investor
protection rules that inhibit at present the free cross-border sale of investment
products.
Direct regulation of portfolio holdings of investment funds are largely
in the form of constraints on outward portfolio investments. However, these
constraints are usually formulated in terms of limits on illiquid securities or in
the form of asset diversification rules. For example, in the United States a
mutual fund may not hold more than 15 per cent of its net assets in illiquid
assets.
Table C1 Glossary investment companies
Advisory fee:
Back-end load fund:
Closed-end fund:
U.S. Insider Trading and
Securities Fraud Enforcement
Act of 1988:
U.S. Investment Company Act
of 1940:
U.S. Investment Company
Institute:
Investment objective:
Load:
Load funds:
Net asset value per share
(or NAV):
No-load fund:
Offshore fund:
Open-end (or mutual) funds:
Fee charged by an investment advisory firm for managing the portfolio of
an investment company.
Fund that charges investors a fee to sell (redeem) shares. The formal name
for the back-end load is the contingent deferred sales charge or CDSC.
Fund that manages a pool of investments and that sells shares like any other
corporation and usually does not redeem its shares, which trade on either an
organised exchange or over the counter.
U.S. Federal law dealing with insider trading, which requires the fund
advisors to take precautions against it.
A major piece of U.S. legislation regarding the operations and regulations of
mutual funds and closed-end funds.
The national association for open-end or mutual funds in the U.S.
A fund’s stated goal, which determines the kinds of assets in invests in.
Sales commission that a mutual fund may charge.
Mutual funds that charge sales commissions.
The ratio of the market value of the portfolio less the mutual fund’s
liabilities to the number of mutual fund shares outstanding.
A mutual fund that charges no sales commission.
A fund managed by a firm in one country but sold to investors in another.
Funds that stand ready to sell new shares to the public and to redeem
outstanding shares on demand at a price equal to an appropriate share of
their portfolio’s value.
99
NOTES
1.
A statistical survey was conducted for supporting this study by the CMF
Group of Financial Statisticians, encompassing as categories of institutional
investors: insurance companies, pension funds, investment companies, and
other forms of institutional savings [“Institutional Investors, Statistical
Yearbook,” OECD, 1997]. The latter category was introduced in order to
allow for problems in giving a precise definition of "institutional investors"
and complications in demarcation of different categories of institutional
investors. These complications should be kept in mind when interpreting
the figures from the statistical survey, as well as data from other sources.
2.
International Capital Markets: developments, prospects and policy issues,
IMF, 1994.
3.
International Capital Markets: developments, prospects and policy issues,
IMF, 1995.
4.
International Capital Markets: developments, prospects and policy issues,
IMF, 1995.
5.
Financial conglomerates, OECD, 1993.
6.
Global Investment, Volume 2, Number 2, March 1996.
7.
When an investor with a short-term investment horizon invests in either
stocks or long-term debt obligations with a maturity greater than the
planned investment horizon, then there is the risk that the securities have to
be sold at a time when their market value is less than the price paid. The
same reasoning can be applied when short-term investors buy shares in
mutual funds, because the net asset value per share will fluctuate with
market conditions. Thus, mutual funds do not provide the economic
function of maturity intermediation. In contrast, depository institutions
acquire short-term funds and grant loans with longer maturities. This
satisfies investors with short-term horizons and borrowers who want
longer-term funds, while the depository institution bears the risk of this
maturity transformation.
100
8.
Efficiency in terms of costs and processing time. See for details H. J.
Blommestein and B. J. Summers, Banking and the Payment System, in:
Bruce J. Summers, ed., The Payment System -- Design, Management and
Supervision, IMF, 1994; and I. Sendrovic, Technology and the Payment
system, in: Bruce J. Summers, ed., The Payment System -- Design,
Management and Supervision, IMF, 1994.
9.
H. J. Blommestein, Comment on "Building Stability in Latin American
Financial Markets" by L. Rojas-Suarez and S. R. Weisbrod, in: R.
Hausmann and H. Reisen, eds., Securing Stability and Growth in Latin
America, OECD, 1996.
10.
H. J. Blommestein and M. G. Spencer, "Sound Finance and the Wealth of
Nations", North American Journal of Economics and Finance, 1996.
11.
E. P. Davis, 1995, "Pension Funds", Clarendon Press, Oxford, reports the
following average transaction sizes: $275 000 (London), $50 000
(Frankfurt), $25 000 (Paris).
12.
Lower transaction costs boost liquidity because it enables more frequent
trade transactions and it increases the number of potential market
participants.
13.
A Revolution in Securities Markets’ Structures?, Financial Market Trends
No. 65, November 1996.
14.
However, experience in countries such as the Netherlands suggest that there
is no one-to-one relation between pension funds and equity market
development, even with a favourable regulatory framework (Davis, 1995, p.
176).
15.
M. Feldstein, Do private pensions increase national savings? Journal of
Public Economics, 10:277-93, 1978; A. H. Munnell, Private pensions and
saving: New Evidence, Journal of Political Economy, 84:1013-31, 1986; R.
S. Smith, Factors affecting saving, policy tools and tax reform, IMF Staff
Papers, 37:1-70, 1990.
16.
R. G. Hubbard, Pension wealth and individual saving: some new evidence,
Journal of Money, Credit and Banking, 18:167-78, 1986; S. F. Venti and D.
Wise, The wealth of cohorts: retirement saving and the changing assets of
older Americans, NBER Working Paper no. 4600, 1993.
101
17.
E. Philip Davis, Pension Fund Investments, in: B. Steil et al., The European
Equity Markets, the state of the Union and an agenda for the Millennium,
The Royal Institute of International Affairs, London, 1996.
18.
E. P. Davis, Financial Market Activity of Life Insurance Companies and
Pension Funds, Economic Paper No. 21, BIS, 1988.
19.
E. P. Davis, Portfolio behaviour of the non-financial private sectors in the
major economies, Economic Paper No. 17, BIS, 1986.
20.
O. J. Blanchard, The vanishing equity premium, in R. O’Brien, ed, Finance
and the International Economy 7, Oxford University Press, 1993.
21.
The British Bankers’ Association (BBA) estimates in its “Credit Derivatives
Report 1996” that the size of the credit derivatives market is around $ 20
billion (i.e. notional outstanding), representing less than 0.1 per cent of the
global OTC market. The BBA expects the market to double in size within
the next two years and to reach $ 100 billion by the year 2000.
22.
Institutional Investor, "In-house Afire", April 1996.
23.
Global Investment, "Envisioning the Investment Management firm of the
21st Century, March, 1996.
24.
According to figures from Greenwich Associates, US corporate funds of
over $1 billion had an average of 17.2 managers in 1995, down from 19.3 in
1993, while public funds of $1 billion and higher cut back from 21.5 in
1993 to 17.9 in 1995.
25.
E. P. Davis, 1995 (footnote 11).
26.
Global Investment, Volume 2, Number 2.
27.
D. Blake, 1990, Financial Market Analysis, McGraw Hill, London; M.
Tamura, 1992, Improving Japan's Employee Pension Fund System, Nomura
Research Institute Quarterly, summer, pp. 66 -83; Davis, 1995, p. 154.
28.
H. J. Blommestein and M. G. Spencer, The role of financial markets in the
transition to a market economy, in: G. Caprio et al., eds., Building sound
finance in emerging market economies, IMF, 1994.
29.
Hu, Z., Stock Market Volatility and Corporate Investment, IMF Working
paper WP/95/102; Overcoming Volatility, Inter-American Development
bank, 1995.
102
30.
Deutsche Bundesbank, Financial Market Volatility and its Implications for
Monetary Policy, Monthly Report, April 1996; Sias, R. W., Volatility and
the Institutional Investor, Financial Analysts Journal: March/April 1996.
31.
Sias, R. W., Volatility and the Institutional Investor, Financial Analysts
Journal: march/April 1996.
32.
Deutsche Bundesbank, Financial Market Volatility and its Implications for
Monetary Policy, Monthly Report, April 1996; Sias, R. W., Volatility and
the Institutional Investor, Financial Analysts Journal: March/April 1996.
33.
International Capital Markets, Part I. Exchange Rate Management and
International Capital Flows, IMF, 1993.
34.
BIS, Annual Report 1994-95, Basle, 1995.
35.
Deutsche Bundesbank, Financial Market Volatility and its Implications for
Monetary Policy, Monthly Report, April 1996.
36.
D. S. Scharfstein and J. C. Stein, Herd Behaviour and Investment, American
Economic Review 80: 465 -79, 1990.
37.
E. P. Davis, Financial Market Activity of Life Insurance Companies and
Pension Funds, Economic Paper No. 21, BIS, 1988.
38.
R. J. Shiller and J. Pound, Survey Evidence of Diffusion of Interest and
Information among Institutional Investors, Journal of Economic Behaviour
and Organisation, 12: 47-66, 1989.
39.
See footnote (43).
40.
E. P. Davis, The Development of Pension Funds, an approaching financial
revolution for Continental Europe, in R. O’Brien, ed., Finance and the
International Economy 7, Oxford University Press, 1993.
41.
B. Aitken, Have institutional investors destabilised emerging markets?, IMF
Working Paper, WP/96/34, 1996 .
42.
B. Aitken, Have institutional investors destabilised emerging markets?, IMF
Working Paper, WP/96/34, 1996 .
43.
H. J. Blommestein and K. Biltoft, Trends, Structural Changes and Prospects
in OECD Capital Markets, in: The New Financial Landscape, OECD, Paris,
1995.
103
44.
The 1987 stock market crash provides an interesting example of the need of
speed in decision-making. The S&P 500 stock index dropped from 283 to
220 on October 19 (Black Monday). At 8:15 a.m. on October 20, the FED
announced, "The Federal Reserve affirms its readiness to serve as a source
of liquidity to support the economic and financial system." The same day
the S&P 500 index closed at 237, a bit more than 20 per cent above its low
for the day.
45.
B. H. Solnik, International Investments, Addisson Wesley, Reading Mass,
1991; C. Nowakowski, C. and P. Ralli, International investment,
diversification and global markets, in: E. I. Altman, ed., Handbook of
financial markets and institutions, John Wiley, New York. 1987; E. P.
Davis, 1995 (footnote 25).
46.
M. Adler and P. Jorion, Foreign portfolio investment, New Palgrave
Dictionary of Money and Finance, MacMillan, London, 1992.
47.
M. Baxter and U. J. Jermann, The international diversification puzzle is
worse than you think, American Economic Review, Vol. 87, No. 1, March
1997; P. Richardson, Outlook 95: The Rugged Singles Scene, Institutional
Investor, pp. 115-25, January 1995.
48.
To put it differently, the growing international integration of capital markets
raises the shadow costs of regulations that forces institutions to hold
domestic fixed-income securities.
49.
Various methods have been proposed in the literature to calculate optimal
portfolios. One of them takes into account the exposure of institutional
investors to output and inflation shocks by calculating measures of the
"openness" of the national economy M. Howell and A. Cozzini,
International Equity Flows, Salomon Bros., Edition 1990]. An alternative
method is based on the estimation of the so-called frontier of efficient
portfolios based on historical variances and covariances M. Howell and A.
Cozzini, International J. G. Greenwood, Portfolio investment in Asian and
Pacific economies: trends and prospects, Asian Development Review,
11:120-50, 1993].
50.
C. Kessler, Diversification -- Is It Still Alive? , Economic and Financial
Prospects, No. 6, December 1996, Swiss Bank Corporation.
51.
B. Solnik, C. Boucle and Y. Le Fur, International Market Correlation and
Volatility, Financial Analysts Journal, 9/10, 1996.
104
52.
C. Kessler, Diversification -- Is It Still Alive?, Economic and Financial
Prospects, No. 6, December 1996, Swiss Bank Corporation.
53.
See Annex, Tables B2-B5.
54.
In 1994, pension funds as a per cent of venture capital funding represented
47 per cent in the United States, 30 per cent in the United Kingdom, 36 per
cent in Ireland and 32 per cent in Denmark. OECD Financial market
Trends, No. 63, February 1996.
55.
Private equity’s split personality, Institutional Investor, December 1996.
56.
No alternative, Institutional Investor, April 1997.
57.
Financial Market Trends, No. 63, February 1996.
58.
To put it differently, the growing international integration of capital markets
raises the shadow costs of regulations that forces institutions to hold
domestic fixed-income securities.
59.
D. Brown, Managing Private Equity Investments, The Financier: ACMT,
Vol. 3, No. 2, May 1996.
60.
R. Comment and G. W. Schwert, 1993, Poison or Placebo ? Evidence on the
Deterrent and Wealth Effects of Modern Anti-take-over Measures, NBER
Working paper No. 4316, April 1993.
61.
M. P. Smith, 1996, Shareholder Activism by Institutional investors:
Evidence from CalPERS, the Journal of Finance, Vol. LI, No. 1, March.
62.
“Activism” refers to the involvement in monitoring the management of
portfolio firms as opposed to active selection of private securities (e.g. stock
picking) without taking an active role in monitoring.
63.
See for details DAFFE/CMF(95)24 and Financial market Trends, No 63,
February 1996.
64.
C. Mayer, 1996, Corporate Governance, Competition and Performance,
Economics Department Working Paper, No. 164, OCDE/(96)99.
65.
R. J. Gilson, 1994, in: M. Isaksson and R. Skog, eds., Aspects of Corporate
Governance, Juristfoerlaget, Stockholm, 1994.
105
66.
R. J. Gilson, 1994, in: M. Isaksson and R. Skog, eds., Aspects of Corporate
Governance, Juristfoerlaget, Stockholm, 1994.
67.
In the United States, pension funds were historically passive. This attitude
started to change in the 1980s during the take-over boom. The shift to a
more active stance was stimulated by three major events of developments:
first, the United States Department of labour (the supervisor of the pension
funds) stated in a 1988 ruling that decisions on voting were fiduciary acts of
plan asset management under ERISA; second, shareholder initiatives on
social issues (e.g. environment, South Africa) in the late 1980s, stimulated
increased interest by public pension funds in the importance of proxy issues
generally; third, the collapse of the take-over movement helped to boost
shareholder activism as an alternative mechanism of corporate control.
68.
R. H. Koppes and M. L. Reilly, An Ounce of prevention: meeting the
Fiduciary Duty to Monitor an Index Fund, Journal of Corporate Law,
University of Iowa, Summer, 1995.
69.
The U.S. Private Litigation Reform Act of 1995 provides for a courtappointed lead plaintiff. It stipulates that the most adequate plaintiff is the
person with the largest financial interest in class-action shareholder suits.
70.
For example, the UK Report of the Pension Law Review Committee argued
that the average period that a pension fund held a share in the period 19831987 declined from 7 years to 2.5 years; see The Pension Law Reform
Committee, Pension Law Reform, Volume I, 1993.
71.
Institute of Directors, Short-termism and the State We’re In, August 1996;
Jeremy Monk, The Dynamics of Institutional Share Ownership in Major
Quoted UK Companies, The Investor Relations Society, 1995; Barry Riley,
Short-termism Revisited and Recalculated, Financial Times, April 1997.
72.
Council of Institutional Investors, Does Ownership Add Value?
Washington D.C.; S. Nesbitt, Long-term Rewards from Corporate
Governance, Wilshire Associates, November 1993; Gordon Group, Active
Investing in the US Equity Market: Past Performance and Future Prospects,
1993; Stephen L. Nesbitt, The “Calpers Effect” on Targeted Company
Share Prices, Conference on the Power and Influence of Pension and Mutual
Funds, February 21, 1997, New York University Salomon Center and
Leonard N. Stern School of Business.
106
Part II
GROWING IMPORTANCE OF INSTITUTIONAL INVESTORS
ACROSS OECD REGIONS AND IN EMERGING MARKETS
A. NORTH AMERICA
107
Chapter III
PERSPECTIVES ON THE US ASSET MANAGEMENT BUSINESS
by
Milton R. Berlinski * and Simon R. A. Western **
Introduction
It is clear that the global financial system is undergoing a significant
restructuring, arguably driven in some degree by regulatory changes and
innovations in the United States. With these changes have come challenges and
opportunities for participants in the financial services industry. While these
changes have been costly for some, overall, the evolution of financial services
has implied vast wealth-creation for shareholders, the rapid development of
speciality finance businesses, millions of new jobs and a dramatically expanded
range of financial products and services for consumers. Nowhere has the
evolution of financial services been more evident than with the coming of age
of the US asset management industry -- and its powerful repercussions on the
entire global financial services sector.
Outside of the USA most of the asset management industry has
focused, usually for good historical reason, on the underlying domestic fixedincome markets. With the need for greater future provision of pensions for the
ageing population, the accelerated development of managed pension portfolios
and the move away from pay-as-you-go state systems, the world is looking
closely at the US model which has emphasised the management of equities.
The USA provides not only a well developed model for, and experience in, the
management of equities, but it also provides a wealth of experience in the
provision of the defined contribution type of pension plan. This has given rise
to the trend of global financial services companies following an asset
management strategy acquiring US asset managers. In many cases, US
*
**
Managing Director, Goldman, Sachs & Co.
Vice President, Goldman, Sachs & Co.
109
management that has been acquired goes on to manage the global asset
management operation that is then formed.
The management of portfolios of securities is becoming one of the
world’s important growth industries. The underlying securities markets are
expanding rapidly. Fuelled in part by the global bull market, worldwide stock
market capitalisation is approaching $20 trillion. The value of the world’s
fixed income markets add up to something close to that figure -- having been
augmented more by a flood of new issues rather than rising values. Net
issuance by the Group of Ten countries has been about $600 billion per annum
for the last few years. It was recently estimated by British Invisibles, a UK
organisation which promotes exports of financial and business services, that the
assets of the global asset management industry exceeded $22 trillion at the end
of 1995. This included $8.2 trillion of pension fund assets, approximately
$5.3 trillion in mutual fund assets and roughly $6.4 trillion in assets held by
insurance companies.
Although the vast majority of the ownership of securities and the
trading in them is domestic there has been a strong increase in cross-border
business. Portfolio flows into the USA have been running at more than
$200 billion a year, and foreign buying of Japanese stocks and bonds exceeded
$70 billion during 1996. Portfolio flows from the USA into international
securities has grown from $1 billion in 1970 to over $93 billion in 1995. Part
of this trend can be explained by the benefits of geographic risk diversification
within any given securities portfolio driving the desire for greater cross-border
asset allocation. Another reason is due to the increasing volumes of
international trade between the different economies of the world and the
resulting trade imbalances that occur e.g. US trade deficit with Japan. This
provides certain other countries with a large flow of investable dollars much of
which is invested in US financial assets.
When comparing the various economies in which to invest dollars
earned through trade the USA is attractive for a number of reasons:
− open economy with freely convertible currency;
− increasing productivity and structural flexibility in the labour
force;
− deep, liquid financial markets;
− increasing profitability and shareholder value focus of the
corporate sector;
− pro-market economy Government and regulatory systems.
110
In the USA, the asset management industry has seen a powerful shift
to prominence. While over the past ten years deposits held by banks, thrifts
and credit unions have grown at a modest rate of 2.75 per cent from
$3.0 trillion to $3.9 trillion and reserves held by life insurance companies have
also grown modestly at a rate of 8 per cent from $264 billion to $571 billion,
assets under management by asset managers have grown at a rate of 13 per cent
(compound annual growth rate, CAGR) from $2.2 trillion to $7.4 trillion.
Understanding the underlying economic drivers for these trends are critical to
managers and shareholders of financial service companies. Four primary
factors have been responsible for the tremendous change in asset management
and the US financial services sector overall:
− demographics;
− technology and communications improvements;
− disintermediation;
− deregulation.
The four factors are clearly interrelated, but the ageing of the babyboomer generation is exogenous, so we begin there.
It was maturing baby-boomers entering peak savings age in the
middle of a volatile macroeconomic environment that created heightened
demand for financial services in the early 1970s. Among the services which
experienced growing demand were brokerage services. This demand for
brokerage services in the midst of regulated (and inflated) fees prompted
efforts, and ultimately success, in deregulating the brokerage industry.
Deregulation gave way to the advent of discount brokerage, greater price
competition generally, and hence lower transaction costs. Lower transaction
costs gave rise to more direct retail investment in financial markets and
disintermediation away from the banks and insurance companies, the traditional
institutions for savings and financial planning. In the 1980’s, an improving
economy and a concomitant bull market, as well as the advent of favourable tax
legislation encouraging individual savings further fuelled interest in direct
investments in the financial markets.
At the same time, technology and communication improvements
created completely new ways of interfacing with consumers [e.g., Automatic
Teller Machines (ATMs), direct marketing, and more recently, the Internet] and
introduced significant economies of scale in back-office processing for financial
service firms of all types.
111
Increasingly sophisticated technology has also facilitated a new breed
of sophisticated investment products which has in turn fuelled increased size of
US institutional investors and demonstrates that the USA is a market
characterised by innovation and creativity. The ability to gather and analyse
vast quantities of data within a short time span has provided for efficient
pricing of risk that can be sold to investors in the form of innovative products.
This has rapidly expanded new markets and provided depth and liquidity e.g.
mortgage backed securities and collateralised mortgage obligations. The
increased utilisation of technology has also heightened sensitivity to the
financial markets at the individual level. A majority of US households now
own, or have direct access to, a personal computer. This allows individual
investors to easily track the value of their investments, make decisions as to
refinancing of liabilities e.g. refinancing of mortgages as interest rates fall, and
make investment decisions e.g. mutual fund purchases.
The benefits of technology, and the large fixed investments necessary
to realise them, yielded a compelling economic rationale for scale, and therefore
consolidation. Slowing growth in banking and insurance resulting from
disintermediation drove a growing need to rationalise overhead, creating yet
another reason to consolidate. The economic benefits of scale and broader
scope gradually prompted policy-makers to deregulate the financial services
industries, broaden their scope of activity and engender a regulatory climate
more favourable toward consolidation.
Interestingly, despite asset management’s emergence as a wellestablished business in the USA, generating an estimated $43 billion in annual
revenue, the structure of the industry continues to resemble a cottage industry
with a large number of small and medium-sized firms representing a substantial
portion of the total assets under management. We believe that great changes in
industry structure need to and will take place to accommodate the rapidly
developing business. Already over the past ten years, the asset management
industry has experienced a flurry of mergers and acquisitions (M&A) activity
which has begun the process of restructuring the industry. We believe M&A
activity will continue to grow because these business combinations are driven
largely by compelling fundamental economic considerations on the part of the
asset management entrepreneurs and the large diversified financial institutions.
1.
Demographics
One of the most important factors driving the growth of the asset
management industry worldwide is demographics. A recent paper published by
112
Goldman Sachs’ Global Research department entitled “The Global Pension
Time Bomb and Its Capital Market Impact” highlights the general ageing of the
populations of the world’s developed economies and the response required to
support that older population during retirement. The paper points out that due
in part to a decreasing fertility rate and increasing life expectancy, the support
ratio (population available to work divided by the population beyond retirement
age) is decreasing in a significant way.
As illustrated in Chart 1, for the OECD countries the support ratio has
decreased from 4.5 in 1960 to 3.5 in 1990 and is projected to decrease to 2.5
in 2020. In many countries the support ratio will approach one. Chart 2
demonstrates the estimated rise in the median age in the USA. The Bureau of
the Census estimates that the median age of the population in the USA will
peak at 38.6 years of age at around the year 2040. Driven in response to the
significant shifts in demographics Goldman Sachs believes that this should
increase assets managed by pension funds globally to $12.0 trillion from an
estimated $7.3 trillion over the next five years. Excluding organic growth of
existing funds, pension funds are projected to demand more than $2 trillion
Chart 1. Support ratios for OECD countries
(number of people aged 25-59 for each person aged 65+)
8
7
6
5
4
3
2
1
0
France
Germany
Italy
Japan
Netherlands
2020*
Spain
1990
Sweden
1960
* Projected
Source: United Nations, World Population Prospects, 1992.
113
UK
US
OECD
Chart 2 - Development of the median age of the US population
45
40
35.7
35
30
25
22.9
24.
25.3
29.0
30.2 29.5 28.0
194
195
30.0
38.5 38.6
37.2 37.6
38.1
32.8
26.5
20
1
190
191
192
193
196
197
198
199
2000 201
2020 2030 2040 2050
Source: Employed Benefits Research Institute.
worth of new investments over the same period. This is due to a number of
factors, some global in nature and some country specific. What is interesting is
that of the $2 trillion increase in pension securities demanded approximately
one-half of this net new investment demand is expected to be cross-border
equity investment and approximately one-third expected to be domestic equity
investment with the remainder going into non-equity securities. The paper goes
on to predict that the US market equity market can expect net inflows of
$250 billion over the next five years from international pension fund investors
and a $500 billion inflow from domestic US pension funds.
The US bull equity market conditions that have prevailed since 1980
have helped to fuel the unprecedented levels of direct and indirect equity
investment activity seen of late. Highlighting the increase in underlying equity
values the total market capitalisation of the major US stock exchanges overtook
US GDP during 1995 (see Charts 3 and 4). This helps provide evidence that
there is a strong equity culture in the USA. The strong equity culture in the
USA has been fuelled by a well developed institutional investment sector
consisting of pension fund money managers and life insurance companies and
increasingly significant participation by the retail sector principally through the
use of the mutual fund vehicle in addition to individual retirement
accounts (“IRAs”).
114
Chart 3. Total market capitalisation of combined
major US stock exchanges vs. US GDP
($ trillion )
14
12
10
8
6
4
2
0
1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
NYSE
AMEX
NASDAQ
GDP
Source: NYSE, AMEX, NASDAC and OECD.
Chart 4. Total market capitalisation of selected OECD member
(a)
stock exchanges vs. respective economy GDPs
($ trillion)
24.1
25
23.1
20
25
20
15
15
10.6
10
10
7.9
4.5
5
5
3.2
2.5
2.1
1.2
0.8
0.7
1.4
0
0
New York
London
Tokyo
Frankfurt
Mkt Cap
.
(a)
GDP
.
Market data as of June 20, 1997.
Source: Goldman, Sachs & Co.
115
Paris
OECD
The dynamics highlighted above have helped the major players in the
US asset management industry grow, and continue to grow, rapidly. Today,
there are over $7 trillion of assets in mutual funds, defined contribution and
traditional institutional accounts compared to $427 billion in 1975 (see
Chart 5). Total assets have grown at a compound annual growth rate of
(CAGR) 15 per cent over the past 20 years versus approximately 10 per cent for
the S&P 500 over the same period.
Chart 5. US pension and mutual fund assets
($ Billions)
12 000
CAGR (1981-1996E)
26.63%
(1)
Mutual Funds
10 000
Defined Contribution Plans
Defined Benefit Plans
10 956
14.31%
2 471
11.43%
8 000
7 404
2 165
1 623
6 000
1 375
3 778
4 000
472
2 000
0
198
1 101
47
869
185
1981
1 635
6 320
712
2 260
427
4 406
2 594
1985
1990
1996E
2001E
1) Mutual funds do not include defined contribution assets. Traditional institutional
includes defined benefit, endowment and foundation assets.
Source: Sanford Bernstein, Goldman Sachs estimates.
2.
Retail sector
The retail asset management sector in the USA consists principally of
mutual funds. This is also the sector of the US asset management industry that
has grown most rapidly in recent years.
As Chart 6 shows, US mutual fund industry assets have grown at a
compound rate of 26 per cent over the past 18 years. This aggressive growth
has been a result of a number of factors:
116
− the ageing of the “baby-boomers” has dramatically increased the
pool of likely savers;
− the general recognition that Social Security will not pay for a
comfortable retirement has led many to focus on increasing
returns from existing savings;
− the drop in relating attractiveness of traditional bank-sold savings
products (fixed-rate CD’s etc.);
− the understanding that mutual funds can provide diversified
exposure to various asset classes.
The net result has been a disintermediation out of traditional savings
vehicles and into more aggressive instruments like equity mutual funds. Of the
total $3.54 trillion invested in mutual funds at year-end 1996, $1.75 trillion, or
49 per cent, was invested in equity mutual funds, $886.5 billion, or 25 per cent,
was invested in bond and income funds, and $901.9 billion, 26 per cent, was
invested in money market funds. Chart 7 shows how financial assets of the
personal sector have increased during the 18 years beginning in 1979. The
interesting trend is the decrease in bank deposits as a percentage of total assets
as pension and mutual fund assets as a proportion of total assets increased.
Chart 6. US Mutual fund industry assets
7 000
($ billion)
6 239
6 000
Projected
5 000
CAGR
1996-2001 =
3 540
4 000
3 000
12
Historic
CAGR
2 162
1 646
2 000
1 000
56
135
297
371
197
198
198
198
716
810
198
198
1978 -96 =
26%
1 067
0
Source: ICI.
117
199
199
199
199
2001
Chart 7. Financial assets of the US personal sector
($ billions)
Assets ($ in trillions)
(% of total assets)
100%
$25 000
80%
20 000
60%
15 000
40%
10 000
20%
5 000
0%
1979 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
0
Time
Bank Deposits
Pension Assets
Open Market Investments
Miscellaneous Assets
Life Insurance
TOTAL ASSETS
Mutual Funds
Source: Federal Reserve, Flow of funds.
This has been caused, in part, by the retail market switching out of
relatively low yielding bank deposits and into higher risk -- higher reward
mutual funds. More recently the trends have been even more marked. Between
1990 and 1996 US household assets in bank deposits grew at an average annual
rate of 1.7 per cent compared to open-market debt securities which grew at
6.5 per cent, open-market equity assets which grew at 17.5 per cent, long-term
mutual fund asset grew at 21.3 per cent, defined contribution assets grew at
14.4 per cent and defined benefit plan assets grew at 9.2 per cent.
Not only has the assets under management represented by mutual
funds increased but so has the number of mutual funds on offer.
The rapid increase in the number of mutual funds on offer (Chart 8)
coupled with individual fund performance that, over time, converges to the
mean, has fuelled pressure for mutual fund companies to consolidate. We have
already seen significant M&A activity related to this area and consolidation
would appear to be increasing rather than decreasing.
With the increase in mutual fund activity has come an increase in the
ownership of public securities through the mutual fund vehicle. Chart 9 shows
that 14.5 per cent of US corporate equity as of 31 December 1996 was held
through mutual funds. US mutual funds have become an important source of
buying in the US primary equity market due to their significant participation in
IPOs -- many of these companies being in high growth industries, such as
technology and biotechnology. The chart also shows mutual funds as
118
significant owners of US Treasury and agency securities, corporate and foreign
bonds and municipal securities.
Such significant securities ownership
participation helps to demonstrate the important intermediation role that the
mutual fund institutions provide.
Chart 8. Number of mutual funds
1960 161
1970
361
1975
390
36
106
1980
458
1981
486
1982
539
179
421
820
1984
Stock and bond & income
373
653
1983
Money market funds
318
457
1 071
1985
485
1 355
1986
541
1 776
1987
605
2 110
1988
664
2 253
1989
743
2 362
1990
821
2 606
1991
865
2 985
1992
920
3 638
1993
963
4 394
1994
997
4 764
1995
988
5 305
1996
0
500
1 000
1 500
2 000
2 500
3 000
3 500
4 000
4 500
5 000
5 500
6 000
6 500
Source: ICI
Not only have fund balances been advancing rapidly, but growth has
been concentrated in higher fee equity funds. Equity funds represented just
under a quarter of all mutual funds in 1985, while they are projected to grow to
over 50 per cent of all funds by 1999. Conversely, money market funds are
projected to represent just 23 per cent of total funds in 1999, as opposed to
49 per cent in 1985. Logically, this trend has disproportionately benefited fund
firms which are heavily weighted to equity investments.
119
Chart 9 Mutual fund ownership of securities
($ trillions)
($ Trillions)
(in %)
100
14.5
8.2
8.3
10
27.6
80
91.8
12
91.7
8
60
85.5
6
72.4
40
4
20
2
0
0
Corporate
Equity
Other Investors
Treasury
Municipal
and
Securities
Corporate
and
Agency
Foreign
Securities
Bonds
Mutual Fund Ownership
Total Outstanding
Source: ICI.
Not only is the rapid growth in equity mutual funds apparent but also
the significant increase in international funds. As part of the move to increase
the diversification of investment portfolios an increasing proportion of US
mutual fund assets is being invested outside the United States. As of
31 December 1996 assets of international and global equity and bond funds
were $321 billion, up 40 per cent from $230 billion at year-end 1995. This
figure now represents 9 per cent of total mutual fund assets as of the end
of 1996 and is forecast to continue growing both in absolute terms and in terms
of percentage share of total mutual funds.
3.
Retirement sector
The US pension and retirement system is estimated at about
$7 trillion in size as at year-end 1996, having grown at an annual 14 per cent
rate over the past two decades (see Table 1). The majority of assets consist of
five types of plan: corporate defined-benefit plans ($1.5 trillion), corporate
defined-contribution plans ($1.4 trillion), insured assets ($1.2 trillion), state and
local pension plans ($1.4 trillion), and IRA assets ($1.3 trillion). The mutual
fund business also forms a cornerstone of the US retirement market. The
120
Investment Company Institute finds that pension and retirement plans and IRAs
held about $1 trillion of mutual fund assets at year-end 1995, about 15 per cent
of the retirement market’s total assets of $6.8 trillion as at that point in time.
All US retirement products are tax deferred. Defined benefit
programs are provided to employees and state a guaranteed pension, usually as
a percentage of final salary. The plan sponsor will fund the pension through
tax-deductible contributions that are subsequently invested. The resulting
portfolio accrues tax-free. The defined contribution program, in the form of a
401(k) program, enables employees to make pre-tax payments into a selfdirected investment vehicle that accrues tax-free over time until it is available at
retirement. The employee is subject to a maximum pre-tax contribution and the
plan sponsor may choose to supplement the plan with tax-deductible
contributions up to a certain limit.
In the corporate sector (excluding union plans), assets of definedcontribution plans now exceed assets of defined-benefit plans. Research by
Sanford Bernstein estimates that this shift, along with the over funding of
traditional plans, has led to a gradual reduction in the cost of pension and
retirement plans to corporations. In the mid 1970s, the aggregate cost nearly
equalled 5-6 per cent of employee compensation; recently it has averaged 44.5 per cent.
The growth of the pension market is the product of overall
employment gains, pension plan coverage and participation rates, the funding
status of defined benefit plans, contributions and disbursements, plan
terminations, and performance of the financial markets. Only about one quarter
of all private sector employees are now covered by defined-benefit plans. The
majority of growth has come from 401(k) plans, via newly formed plans and
raising employee participation at the large-end of the market, and increasing
new plan formation at the medium to small-end of the market.
As identified in Chart 10, most large US companies already have
existing defined-contribution plans. As of the end of 1996, Goldman Sachs
estimates that 83 per cent of companies with 1 000 to 5 000 employees and
96 per cent of companies with more than 5 000 employees had definedcontribution plans. But only 29 per cent of companies with 50-100 employees
and 13 per cent of companies with less than 50 employees had an existing plan.
Consequently plan providers will have to displace existing plans at large
companies or market themselves to smaller companies.
121
Table 1. Average annual growth rates of US pension assets
($ billion)
Private trusteed:
corporate, non-profits,
and union plans
Defined
benefit
Defined
contribution (a)
Private
trusteed
Insured
(primarily
group
Total
private
State &
Pension
assets (b)
& other
annuities)
pension
plan
local
gov’t
Total
pension &
Total
Federal
gov’t
pension
assets
IRA
assets
retirement
assets
1975-1985
16.1%
19.1%
17.0%
13.6%
16.4%
14.4%
13.5%
15.7%
—
16.8%
1985-1996E
5.5
11.2
7.8
14.9
9.4
12.4
9.2
10.0
18.7%
11.1
1991-1996E
6.2
10.5
8.1
12.7
9.4
10.4
7.2
9.5
14.9
10.3
9.5
7.3
9.5
7.9
5.5
6.3
8.0
11.9
8.7
1996E-2001E 5.0
Note:
a) 403 (b) plan assets held in other than annualised form are considered private defined contribution assets, but group annuities are
included in the insured category.
b) Excluded from this analysis are tax-exempt assets sponsored by endowments and foundations. At the end of 1995 endowment
assets totalled about $130 billion while foundation assets were an estimated $150 billion.
Source: US Department of Labor, Federal Reserve Board, Employee Benefit Research Institute, Investment Company Institute and
Bernstein estimates.
122
Chart 10. Estimated percentage of companies with 401(k) plans
31 December 1996
96%
%
100
90
83%
80
70
65%
60
50
38%
40
29%
30
20
13
1
0
<50
50 -100
100 - 500
500 - 1 000
1 000 - 5 000
5 000+
2 950
1 450
Number of employees
Total No. of companies
1 640 000
115 000
Source: Goldman, Sachs
75 000
6 000
The fastest growing segment of the retirement sector currently is the
mutual fund element of 401(k) assets. As can be seen in Chart 11 below,
401(k) mutual fund assets have grown 40 per cent per annum over the ten year
period ended December 1996. Mutual funds have also grown as a percentage
of overall 401(k) plan assets from 8 per cent in 1986 to an estimated 44 per cent
in 1996.
The corporate defined-benefit market used to be the core of the US
money management industry. It is large, fragmented, sophisticated,
performance-sensitive, and is the primary market for most money managers.
However, it is now the defined-contribution market that is exhibiting greater
momentum. This implies a shift in investment risk-bearing from corporate
sponsors to individual plan participants. Most of the growth in the definedcontribution market has been experienced during a strong bull equity market
period. It will be particularly interesting to observe trend behaviour if the
underlying equity markets enter a period of poor performance.
123
Chart 11. 401(k) Plan assets in mutual funds
900
830
800
Mutual Fund 401(k) Assets
700
600
364
531
261
475
500
410
345
400
300
300
230
155
200
13
100
675
Other 401(k)
A
190
18
270
37
31
24
172
239
142
206
263
1986
1987
1988
1989
1990
100
167
356
375
364
1992
1993
1994
54
47
298
1991
414
466
0
1995
1996 E
Source: ICI.
4.
Regulation
The US money management and mutual fund business is underpinned
by a robust regulatory framework that was borne out of the aftermath of the
1929 stock market crash. The Securities and Exchanges Commission (“SEC”)
was given life from the Securities Act 1933. The SEC regulates all entities that
offer securities to the US public. The Securities Exchange Act of 1934 made
mutual fund distributors subject to SEC regulations and placed them under the
jurisdiction of the National Association of Securities Dealers (“NASD”), which
established advertising and distribution rules.
The most important rules relating to mutual funds and investor
protection were adopted in 1940: the Investment Company Act and the
Investment Advisers Act. The former was adopted with strong industry support
and is considered to have been very effective. The Act’s core provisions include
that every fund price its assets based on market value every day; transactions
between a fund and its manager are prohibited; limits for leverage; and a
statutory system of independent directors. These provisions are unique to the
mutual fund industry.
Other regulations imposed by the 1940 Act impact on the investment
advisers as well as the mutual funds to which they are related. They also relate
124
to their principal underwriters, directors, officers and employees. It also states
that mutual funds should be able redeem their shares upon any shareholder
request and requires them to pay a price based on the next calculated net asset
value of the fund’s investment portfolio within seven days of receiving a
request for redemption. The Advisers Act requires the registration of all
investment advisers to mutual funds with the exception of banks. Such a
comprehensive regulatory framework to govern mutual funds has been one
factor that has made the mutual fund vehicle so successful.
The most important recent changes in the US regulatory structure for
financial markets and pension regulation occurred in the mid 1970s. The
Employee Retirement Income Security Act (ERISA) 1974 set minimum
funding levels for companies promising pensions to their workers, following
several major failures of firms with under-funded pensions. It also prompted
pension plans to diversify their assets and to use independent “master trustees”
to be responsible for them. Both provisions provided the catalyst for increased
employment of specialist managers. Specialist management involves a narrow
focus for particular managers on one or more defined asset classes where they
offer particular expertise. This could include the equities of a particular
industry segment or a municipal bond fund. These provisions gave rise to a
large number of relatively small specialist institutional asset managers.
The fragmented market in the US money management industry is
demonstrated by the following statistics. As of 31 March 1997 there were 3 373
companies managing pension, endowment, foundation, and mutual funds. As of
the same date there were at least 1 256 companies that managed $500 million or
more in discretionary pension and endowment assets. In addition, 533
th
companies offered more than 6 293 different mutual funds. The 200 -largest
investment management company had more than $16 billion in assets under
management.
The SEC ensures a rigorous level of disclosure of all information that
could prove to be material to investors of the company’s securities which is
presented in the form of a prospectus. In addition, securities are governed by a
well defined legal system that has in the past been favourable towards investors.
Financial disclosure is governed by a well established set of principles under
US GAAP which overseas issuers in addition to domestic issuers are obliged to
abide by. Unlike a majority of the European countries US pension regulation
permits pension funds unlimited ability to invest in US and non-US equities.
According to a recent survey by Pensions and Investments, an international
publication of money management, this has enabled US pension funds to
125
increase their holdings of equities to approximately 52 per cent of total assets
under management as at the beginning of 1997.
5.
The future of the US asset management industry
The trends of the recent past will help to shape the direction of the US
asset management industry in the future. One interesting observation is that of
the different growth rates of the major industry segments. Chart 12 shows that
the growth rates of cash flow between certain of the segments is diverging. The
traditional institutional segment, consisting of defined benefit plans,
foundations and endowments, has slowed dramatically due to the factors that
were discussed earlier in this paper. The estimated cash flow for this segment
of the industry has been negative over the past five years. Cash flow growth of
the defined contribution segment ex 401(k) assets has also been negative, while
the 401(K) and mutual fund segments have shown positive growth rates of
3 per cent and 5 per cent respectively.
Chart 12. Estimated cash flow growth rates by segment
6.0
per cent
5.4
5.0
4.0
3.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-5.0
-3.6
-4.4
Traditional Institutional
Defined Contribution
401 (k)
Mutual Funds
Notes: Mutual Funds do not include Defined Contribution Assets. Net cash flow
growth calculated by subtracting the growth rate of the 60 per cent S&P/40 per cent
LBGC index from the asset class’ absolute growth rate.
Source: EBRI, ICI, Access Research, Greenwich Associates, Goldman estimates
126
The combination of the highly fragmented nature of the traditional
institutional segment combined with negative cash flow growth over the past
five years is likely to produce change over the next few years. Structural
changes will be driven by several trends. First, plan sponsors are likely to
reduce the overall number of firms they use to manage their pension assets
without materially changing their investment diversification goals so as to
concentrate assets among a small number of core managers that offer broad
product lines and high calibre customer service. Second, as a consequence of
consolidation of assets, those companies that hope to serve as core managers
will need to create sophisticated and expensive sales forces and make
substantial investments in new product development. Finally, at the same time
that the costs of competing as a core manager will rise, average fees for most
products will fall since plan sponsors will be able to demand volume discounts
from their managers. As a result, the pursuit of scale will become essential to
the survival of many management companies.
The retail segment of the asset management industry continues to
enjoy a period of high growth. However, competition to grow assets under
management has become intense. The costs associated with succeeding in the
business are growing steeply. Retail customers expect a high level of service
which equates to significant expenditure associated with upgrading technology
and systems to provide regular performance reports, statements, automated
voice recognition systems, toll-free telephone service and Internet Web site. In
addition, the costs of competing in the intermediary, or load, channel are
increasing due to the requirement for experienced wholesaler sales professionals
and in the no-load, or direct, channel, the cost of advertising and brand
strengthening is climbing. Shelf space within the mutual fund supermarkets,
such as Charles Schwab’s One Source, is becoming ever more crowded
providing the supermarkets with ever more pricing power. Subject to these
pressures retail fund managers recognise considerable merit in broadening
distribution and product lines and achieving large scale to spread the increasing
fixed-costs.
Goldman Sachs believes there are three major changes that will drive
the overall evolution of the industry.
− Rising cost of gathering and retaining assets.
− Globalisation of investing will create a single worldwide market
for asset management.
− Access to capital will become a major success factor for asset
management companies.
127
The cost of gathering and retaining assets is climbing. Access to
product and distribution channel additions are the likely strategic benefits from
combinations. Because of the competitive and high-growth nature of the
business, many managers have decided that the only way to add product is
through acquisition -- building a track record through organic growth is too
slow. Additionally, the competition to manage assets will continue to evolve
into more of a global market, requiring management companies to manufacture
and distribute products on a worldwide basis or establish themselves as niche
competitors. Thirdly, as a consequence of the first two factors, capital will
become critical for many investment management companies. The rising cost of
gathering and retaining assets combined with the globalisation of the business
will force many companies who want to remain competitive to make large
investments in personnel, systems and technology, and new product R&D.
Although in the past many companies have been able to fund their growth out
of current cash flow, the scale of these investments will place a great deal of
importance on access to capital.
6.
The asset management industry in the twenty first century
The combination of the factors outlined above will drive the desire to
achieve significant scale by providing a broad range of investment products
through multiple distribution channels. Demographic pressures are likely to
lead to deregulation of investment markets throughout most developed and
developing economies. This in turn will fuel consolidation of the industry on a
global basis. Taking this model to its ultimate limits would produce a global
asset management industry dominated by six to ten major global players.
128
Appendix 1. Composition and growth of US pension assets ($ billion)
Private trusteed: corporate,
non-profits, and union plans
Defined
benefit
1975
1980
1985
186
401
826
Private
trusteed
pension
assets (b)
Insured
Total private
(primarily group pension plan
& other
annuities)
State &
local
gov’t
Federal
gov’t
Total
pension
assets
42
76
149
478
1 008
2 058
IRA
assets
Total
pension &
retirement
assets
Defined
contribution (a)
74
162
427
260
564
1 253
72
172
258
332
736
1 511
104
197
399
—
—
478
1 008
2 258
200
895
488
1 383
331
1 714
477
170
2 360
277
2 638
877
525
1 402
355
1 757
524
188
2 470
333
2 803
912
592
1 504
439
1 943
609
208
2 760
390
3 149
988
688
1 676
504
2 180
767
229
3 176
454
3 630
962
712
1 674
595
2 269
820
251
3 340
529
3 869
1 102
834
1 936
656
2 592
879
276
3 747
657
4 404
1 147
947
2 094
745
2 839
998
304
4 140
746
4 886
1 245
1 050
2 344
854
3 198
1 088
331
4 617
868
5 484
1 155
1 100
2 255
900
3 155
1 146
359
4 659
941
5 600
1 428
1 325
2 753
1 086
3 839
1 387
375
5 601 1 169
6 769
1 488
1 375
2 863
1 195
4 058
1 440
390
5 888 1 315
7 203
1 900
2 165
4 065
1 880
5 945
2 165
530
8 641 2 305
10 946
403 (b) plan assets held in other than annualised form are considered private defined contribution assets, but group annuities are included in
the insured category.
(b) Excluded from this analysis are tax-exempt assets sponsored by endowments and foundations. At the end of 1995 endowment assets totalled
about $130 billion while foundation assets were an estimated $150billion.
Source: US Department of Labor, Federal Reserve Board, Employee Benefit Research Institute, Investment Company Institute and Bernstein estimates
.
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996E
2001E
Note: (a)
129
Chapter IV
INSTITUTIONALISATION, ‘RETAILISATION,’ AND SHIFTING
RESPONSIBILITIES: THE CANADIAN EXPERIENCE
by
Thomas A. Hockin*
Introduction
As you are aware, the growth of institutional investment has been a
major force at work in many countries. However, the degree and type of
institutional investment varies considerably. What we have seen in Canadian
financial markets in recent years has been a number of shifts or changes in
investing patterns. These shifts are interrelated and, in many instances,
complementary, but for heuristic purposes I shall attempt to separate the
connected strands and discuss four major shifts, their causes, particularly ones
distinct to Canada, and possible policy implications.
The major shifts I see are i) shifts from guaranteed investment
products to fluctuating instruments, ii) from bank deposits to money market
mutual funds, iii) from domestic investments to global diversification, and iv)
from defined employer pensions to private savings.
When we consider the growth of institutional investment or the term
institutionalisation, I think we need to look closely at definitions. If left
unexamined, ‘institutionalisation’ can suggest a concentration of money in
fewer hands, perhaps in more static organisations or institutions than it was
previously. The number of institutional investors and the assets they manage
have both increased, but I would argue that the final effect has been what I
would call for discussion purposes a ‘retailisation’ of retirement or pension
savings in Canada and the United States through mutual funds and other like
products. In some ways, while money is institutionalised, it is more accessible
*
President and CEO, The Investment Funds Institute of Canada
131
and freer flowing than in previous years when the topography of the financial
landscape was different. Let us now turn to the particular shifts in investing
patterns (most statistics date from 1994).
1.
Guaranteed investment products to fluctuating instruments,
especially equities
Vast numbers of Canadians have switched money from Guaranteed
Investment Certificates (GICs) or Canada Savings Bonds (CSBs) to fluctuating
market instruments, especially equity mutual funds. In effect, financial
institutions, in Canada largely the chartered banks, no longer ‘own’ the money
deposited by their clients as they once did. When Canadian interest rates were
above ten per cent, at times nearly double that in the 1980s, Canadians were
prepared to accept the loss of control over their money in return for the
guaranteed double-digit returns. Today, banks manage clients’ money, but
clients effectively still ‘own’ it when the money is in a mutual fund and can be
redeemed readily any day.
There has been a tremendous shift into mutual funds in Canada. At
the end of 1993, mutual fund assets accounted for over eight per cent of total
household financial assets, an astonishing eight-fold increase in relative
importance over the decade. At the same time, mutual funds accounted for
nearly 12 per cent of all discretionary financial assets owned by households, a
nine-fold increase from the 1.3 per cent share in 1984. This increase is
especially significant given that discretionary financial assets as a percentage of
the household balance sheet in fact declined during this period (they averaged
8.6 per cent in the 1980s and averaged 5.5 per cent from 1990–1993). By 1996,
mutual funds accounted for 16.4 per cent of discretionary financial assets.
As of December 1996, domestic equity mutual fund assets constituted
eight per cent of equity market capitalisation. Of Canada’s total mutual fund
assets, 65 per cent were equity, 20 per cent bond and 15 per cent money market.
When clients can readily take money out of bank-managed
investments, can you, strictly speaking, consider that money institutionalised?
If you do, then at least the nature of that institutionalisation has changed
substantially. It is here that I would emphasise again the idea of ‘retailisation.’
132
2.
Bank deposits to money market mutual funds or other products
Money market funds in Canada invest in treasury bills and other low
risk short-term investments which generally have maturity dates of one year or
less, and whose average maturity is no more than 180 days. Under Canadian
regulation, a money market fund’s portfolio may include federal or provincial
government treasury bills, chartered bank certificates of deposit, corporate
paper, bankers’ acceptances and other short-term securities.
Let us consider some statistics. In the 13-year period from 1982
through 1994, mutual funds in the United States captured an impressive
35.8 per cent of the net growth of households’ liquid financial assets. Recently
in the USA, about half of the net growth of households’ liquid financial assets
has found its way into mutual funds. More specifically, households have
increasingly turned away from bank deposits in favour of holding mutual fund
shares. From 1982 to 1994, Americans’ holdings of deposits as a percentage of
their total liquid financial assets declined from 36.9 per cent to 20.6 per cent,
while their mutual fund holdings increased from seven per cent to 14.5 per cent.
In Canada, money market mutual funds as a percentage of deposits increased
from zero per cent in 1984 and 0.4 per cent in 1985 to 6.4 per cent in 1993. To
use dollar figures, in 1985 assets in money market mutual funds in Canada were
C$ 259 million; by 1993, the amount had grown to C$ 15.55 billion. By 1996,
short-term funds constituted 8.8 per cent of deposits. This increase illustrates a
significant increase in consumer awareness of and confidence in the mutual
fund product.
In the USA, mutual funds have also become major suppliers of
transaction services. Money market mutual funds, most of which grant chequewriting privileges, have grown to almost 70 per cent of households’ checking
deposits in banks and thrifts. By providing households with low-risk, highly
liquid assets, which pay higher returns than competing bank deposits, money
market mutual funds have succeeded in attracting households’ transactions
balances, despite the absence of government-backed deposit insurance. Canada
has not yet seen comparable growth rates, but some large mutual fund managers
are beginning to grant cheque-cashing privileges.
The massive shift of liquid household financial assets from banks and
other depository institutions to mutual funds has raised a concern in the
Canadian Senate about whether that development may be increasing the
fragility of the financial system. If this trend were to continue, and it is
difficult to see why it will not (especially in the USA), in a short time the
majority of transactions balances may be held in money market and other
133
mutual funds. Note that, unlike bank deposits, mutual funds are neither insured
nor backed by a government guarantee.
Thus, in the future, the bulk of
transactions balances may be held in uninsured accounts, which would result in
the de facto elimination of (or at least a considerable reduction in) deposit
insurance coverage of households’ liquid balances. Deposit insurance has long
been considered an essential facet of a sound and stable financial system. Thus,
the media in Canada and some financial specialists in the USA ask if the
increasing reliance of households on mutual funds as a repository for their
liquid assets may make the financial system more vulnerable to “panics”
precipitated by bank-like runs on mutual funds.
Are mutual funds as susceptible to runs as say deposit-taking financial
institutions (F.I.s)? While mutual funds have characteristics that are similar to
F.I.s, they differ in important ways. First, no mutual fund, including money
market mutual funds, has a legal obligation to redeem its shares at par value, or
at 100 per cent of the price paid by shareholders. The value of mutual fund
shares is tied directly to the value of the fund’s assets, unlike deposits, which a
bank or trust company is obligated to redeem at par value. If a mutual fund
experiences losses or gains in its portfolio, those losses or gains are passed
through to shareholders, as either a reduction or an increase in the value of their
shares. When shareholders redeem shares, they receive their proportionate
share of the market value of the fund’s total assets. Thus, although mutual
funds, just as banks, fund their portfolios with demandable debt (actually
equity), they are not obligated to redeem that debt at par value, as are banks.
“There is, therefore, no discontinuity or ‘flashpoint’ as in banking -- no point at
which portfolio losses render mutual funds bankrupt or incapable of meeting
redemption requests,” writes American academic Franklin Edwards.
Indeed, as far as redemption values go, there is no difference between
an investment in mutual fund shares and a direct investment in the same assets
as those held by the mutual fund. An owner of a basket of corporate stocks is
in virtually the same position as an owner of a mutual fund that holds the same
basket of stocks. If the value of those stocks declines (or rises), the value of the
mutual fund shares declines (or rises) in lock step. The same is true for
investments in bonds or any other asset held by mutual funds.
Another important difference between mutual funds and deposittakers is that the assets held by mutual funds are generally more transparent
than those held by F.I.s. As a consequence, most assets held by mutual funds
are traded in active secondary markets, and market values for those assets are
easily attainable. Greater asset transparency, therefore, substantially mitigates
the information asymmetry that lies at the heart of F.I.s’ vulnerability to runs.
134
Thus, compared with the depositors of a bank, mutual fund
shareholders have more information about the composition of the portfolios
held by their mutual funds and about the values of their assets. Therefore, they
are in a better position to evaluate the credit and interest rate risk exposures of
the funds. In contrast, little is disclosed to depositors about the nature of the
assets held by most F.I.s and about their market values, so it is difficult for
depositors to evaluate the credit and interest rate risks to which banks are
exposed. For example, depositors and other bank creditors know little about
the characteristics of the bank’s borrowers, about the maturity composition of
the bank’s portfolio, and about its trading activities.
Furthermore, mutual fund assets are generally more liquid than
financial institution assets. Fund managers make their investment decisions on
the basis of publicly available information. For example, firms that issue
commercial paper held by money market mutual funds are publicly traded
firms, for which a considerable amount of easily obtainable information is
publicly available. The obligations of those firms also are “rated” by
professional rating companies on the basis of public information (and perhaps
additional information known to the rating companies). Thus, there is less of
an information gap between mutual fund managers and the potential buyers of
mutual fund assets in secondary markets, so that the “so called discount” that
exists because of lurking “lemons” in a portfolio should be considerably less
than for an insurance company’s, bank’s, or trust company’s assets.
Franklin Edwards eloquently concludes that the incentive for
shareholders to ‘run’ on mutual funds is much less than it is for depositors to
‘run’ on a bank, a trust company, or an insurance company. First, the
insolvency threat that exists in banking, and which can cause depositors to run
on banks to avoid insolvency losses, does not exist for mutual funds because of
the absence of an obligation to redeem shares at par value. Second, the
informational asymmetry that can cause failures by unsound banks to spread to
sound banks is considerably less for mutual funds because of the greater
transparency of assets held by mutual funds. Lastly, because mutual funds do
not possess unique or specialised information about the assets they hold, their
shareholders should not incur a substantial “lemons discount” in the event that a
mutual fund finds it necessary to sell assets in secondary markets.
As a result of the availability and benefits of alternatives, deposits are
likely to continue their decline in Canada. Investor Economics Inc. predicts
that by 2004, deposits will account for less than 36 per cent of all financial
assets. That would constitute a six percentage point reduction from 1994 levels
and an almost 10 per cent decline since the early 1980s.
135
3.
Domestic investments to global diversification
It is not suitable today for individuals to invest solely in their own
country. In order to maximise their returns, global investments are necessary.
Obviously many Canadians realise this point: assets under management in
foreign funds have grown from C$ 2.54 billion in 1984 to C$ 27.48 billion in
1993. By 1996, foreign investments constituted 10.5 per cent of discretionary
financial assets. However, such a maxim about global diversification is simpler
in theory than in practice. There is a need for common minimum standards in
global financial markets. Such standards should consider the role of
independent custodians, proper internal controls, the treatment of potential
conflicts of interest between related properties, management of risk,
diversification requirements, and investment objectives. This last matter is
important as investors must be assured of a correlation between the name or
1
nominal objective of a fund and its actual performance and behaviour.
My Canadian colleague is eminently qualified to discuss common
minimum standards and regulation, and I defer to her for further expansion on
this point.
4.
Defined employer pensions to private savings
Consider the total Canadian retirement market. In 1981, Defined
Benefit pensions accounted for 68.5 per cent, Defined Contribution a mere
6.5 per cent, and individual Registered Retirement Savings Plans (RRSP)
25.0 per cent of the total retirement market. By 1994, this snapshot had
changed dramatically. Defined Benefit plans, while still accounting for over
half of the total retirement market, had dropped to 53.8 per cent and Defined
Contribution plans had lowered to 6.1 per cent. The major increase is with
respect to RRSPs, which had risen to 40.0 per cent.
What I mean here is that today we find more individuals than in past
years investing directly in mutual funds and securities instead of defined benefit
pension vehicles. The effect of this change is ‘retailisation’ because this money
is registered in the individual worker’s name, and in many cases is
withdrawable at any time. It is fully vestable and portable. In contrast, under a
Defined Benefit Pension Plan (DBPP), the employer commits to providing a set
amount to retired employees. Where there is a shortfall, the employer tops up
1.
See for a discussion of minimum statutes and regulations, the paper of
Glorianne Stromberg in this volume.
136
as required; but where there is a surplus, the employer keeps it. In contrast,
workers who save through individual savings plans (I shall examine the specific
structure of savings plans in Canada below) keep all the money in the plan.
Concerning the responsibility for retirement investing shifting to
individuals, suitability of investments becomes more critical than ever before.
The investment goals for specific individuals will not necessarily or even
probably match those of a single central pension fund for all employees of a
single company. Instead, individuals will need with their advisors to devise the
correct mix of assets for their age, income, and other circumstances.
5.
Registered retirement savings plans in Canada
The Canadian federal government created RRSPs in 1957 to
encourage people to save for retirement. This encouragement takes the form of
tax deductions. Contributions to an RRSP are deductible from income for tax
purposes, so they have the effect of reducing tax for the year in which the
contribution is made. Moreover, the investment sheltered within an RRSP is
allowed to grow untaxed, so RRSP investments grow at a much faster rate than
investments held outside an RRSP and subjected each year to tax for interest,
dividends, or capital gains. When money is withdrawn from an RRSP, it is
taxed as income. The idea is that the money will be withdrawn during
retirement, when the tax rate is likely to be lower than during peak earnings
years.
RRSPs are good for a number of key reasons. They are simple,
universal, and portable. If an investor wishes to transfer money from, say, a
maturing guaranteed certificate to a mutual fund, he or she may do so with the
T2033 government form without incurring the tax bite normally associated with
withdrawing funds from the tax shelter.
In 1981, individual RRSPs comprised 25 per cent of the retirement
market. By 1994, they had risen to 40 per cent. In 1994, RRSPs accounted for
40 per cent of all investment fund assets.
Consider the shift of asset mix within individual RRSPs, and consider
the shift in investment culture away from guaranteed instruments. In 1981,
RRSP deposits and Guaranteed Interest Annuities comprised 83 per cent of
RRSP holdings. Individual investments, including mutual funds, segregated
funds, and direct securities, comprised 17 per cent. By 1993, RRSP deposits
and Guaranteed Interest Annuities had dropped to 68 per cent and individual
137
investments had risen dramatically to 32 per cent. Today we estimate that
mutual funds comprise 40 per cent of RRSP holdings, and this share continues
to grow.
I would submit that the specific rules or biases of RRSPs have
affected the development of institutional investment and Canadian markets.
What are some of these conditions?
1. 20 per cent Foreign Property Rule. The Canadian Income Tax
Act specifies that a maximum of 20 per cent of RRSP holdings
may be classified as “foreign” property. Investment products are
examined and classified either as RRSP eligible Canadian
property or foreign property. Let me note that at present a fund
may be RRSP eligible and itself contain 20 per cent foreign
content. It is possible, then, for a Canadian investor to have
36 per cent of his or her RRSP as foreign content (20 per cent
foreign plus the 20 per cent foreign content allowable in the
remaining 80 per cent).
This rule poses obvious problems in that it limits the investing
choices of Canadians saving for retirement. Considering that the
Canadian market constitutes perhaps two or three per cent of total
world markets, the foreign property rule is restrictive and
parochial and harms Canadians saving for retirement. When the
rule was first made, it was intended to protect Canadian markets
or to ensure adequate capitalisation of these markets. The effect
today, however, is that too much retirement savings chases too
few listed investments, possibly inflating some equity prices
artificially and requiring some small cap mutual funds to close
themselves because they cannot find value purchases for new
cash.
2. From a philosophical public policy perspective, the total Canadian
retirement system fails to coalesce fully. In the early days of its
social safety net, Canada developed universal programs to assist
seniors in retirement. In recent years, acknowledging that
prudence and public policy dictate assisting only those in need,
rather than all Canadians of a certain age, clawbacks have been
imposed which reduce the seniors’ benefits to seniors with
incomes above particular thresholds. However, a year ago the
federal government introduced a new Seniors’ Benefit which may
actually provide a disincentive for lower and middle income
138
Canadians to make personal efforts to save for their retirement. In
other words, many Canadians would be better off saving nothing
and receiving the full seniors’ benefit rather than taking initiative
and responsibility for themselves by contributing to RRSPs and
then having the benefits clawed back at high rates; that is, the tax
benefit from contributing to an RRSPs is more than balanced by
the higher clawback rates. It is obviously not in the best interest of
Canadian society to discourage self-reliance, but at present that is
one quirk of the total retirement system.
3. There is some concern that limits on contribution amounts for
RRSPs are still not equal with those applicable to workers saving
through defined benefit plans or with benefits enjoyed by
government employees.
The government has capped the
maximum contribution limit at C$ 13 500 and appears at times to
feel that private retirement savings are a readily accessible tax
target.
4. Special rules allow investors to use funds from their RRSP to
purchase their first home without incurring the tax bite of normal
withdrawals from the tax shelter.
However, this program
obviously withdraws funds from the RRSP and impedes the
normal growth of funds compounding tax-sheltered. Canadians
may be advised to avoid this route if possible.
5. The accessibility of savings in RRSPs is good in many ways, but
may provide the temptation to withdraw funds prematurely.
During the recession of 1989−1990, many Canadians withdrew
funds from their RRSPs. While such withdrawals may have been
necessary, they may also have incurred substantial tax payments.
6.
Institutional control of individual companies
Not long ago, a select group of private Canadian families dominated
Canadian equity markets. In fact, just over ten years ago, it was estimated that
one side of the Bronfman family controlled one in ten companies in the Toronto
Stock Exchange 300 composite index. Indeed, in the mid-1980s, three-quarters
of TSE 300 companies had a majority shareholder (that is, a control block
where a single entity owns 20 per cent or more of outstanding shares).
139
Today, Canadian exchanges show a different picture as institutions
have assumed a much larger role. Now two-thirds of the TSE 300 stocks have
no controlling shareholder. Indeed, Canadian financial institutions, including
pension funds, insurance companies, banks and trusts and mutual funds, own an
estimated 60 per cent of all stocks listed on the TSE. As for mutual funds,
National Policy 39 proscribes individual funds from holding more than 10 per
cent of any one company. However, when investments are accounted for on an
aggregate basis across several funds in the same fund family, many fund
families own more than 10 per cent of a single issuer, although ordinarily not
more than 20 per cent.
In corporate America, pension funds and other institutional investors
have become a powerful force. Institutions now control more than half the
shares in big American companies. To compare, in 1965 institutions controlled
just 16 per cent. A number of institutions use their clout to effect change, or to
attempt to do so, in the companies they own. Institutions may pressure
companies to curb high salaries, make boards more independent, or even to
cashier poorly performing managers. In the past, shareholders were too diffuse
and disorganised to have much impact on companies they owned; today,
institutions have both the time and the resources to affect poorly-performing
chief executives.
What is unclear is whether intervention by institutions owning large
chunks of stock improves funds’ performances in real terms in a meaningful
long term way. Catherine Dailey of Purdue University concluded in a study
that institutional activism, as it may be called, has no appreciable effect on firm
performance. Shareholder activism may be an exercise in muscle-flexing done
by institutions responsible to their individual pension plan beneficiaries or
investment fund unitholders.
7.
Conclusions
I have considered a number of shifts and trends; let me conclude by
looking at a couple of their implications and what I see happening in the future.
Retailisation leads almost inexorably to the development of a more
attentive investing public. The phenomenon of individuals assuming greater
control over their retirement savings leads to increased demand for vehicles to
help individuals monitor their investments and make prudent choices. Consider
the proliferation of chat lines, newsletters, CD-ROMs, radio and television
shows devoted to the subject, and the expansion of newspapers’ business pages
140
to cover mutual funds and other institutional investments in considerable depth.
Investors take greater care because there are decisions to be made. For many
people, it is no longer the case that their retirement money is locked up in some
institution’s hands and that there is nothing proactive for them as individuals to
do. In fact, wise action by the retail investor can now be taken.
This more attentive public leads to additional pressure on both the
manufacturing and distributing side of products such as mutual funds to meet
the needs of the informed investor. It creates what I would call a drive for
transparency, a need for fees, investment objectives, and other information to be
readily accessible and communicable to investors. In Canada, one impediment
to this drive for transparency is the foreign property limit for RRSPs, which
increasingly drives mutual fund managers to create artificial vehicles to
circumvent the restrictive limit. We see portfolio managers using derivatives
because they are unable to find value buys within the foreign property limits,
although such derivatives may confuse investors and may be out of line with
the fund managers’ fundamental philosophies.
It concerns me that the teaching profession and the educational system
in toto has failed to respond to or even to acknowledge the significant shifts I
have outlined above. What young people are now taught of economics, if
anything at all, does not prepare them effectively for the responsibilities and
opportunities which will be given to them as adults vis-à-vis saving for their
own retirements. Perhaps teachers have not made investment education a
priority because in most cases they enjoy defined benefit or employer-run
pension plans. Schools talk about job skills being required for the new
millennium; they rarely speak about financial skills.
Let me here forecast that issues around global investments will
assume ever greater importance in the near future. If Canadian investors are in
any way typical, then our fellow countries will find that investors will
increasingly be asking, on the retail side, some directed questions about foreign
and emerging markets, questions that have not often been asked before.
Investors are beginning to take an interest in the reporting standards, accounting
standards, settling and clearing capabilities, and custodianship protocols in
markets in which their money is invested. Such matters would have seemed
esoteric a decade ago; they will not seem so at all in a few years more. Indeed,
I predict that these issues will occupy the front pages of newspaper business
sections before too long. Consider how the Hong Kong Exchange required two
“Red Chip” stocks to make adjustments before they could resume trading.
Investors, perhaps organised through their institutions, are making their voices
141
heard and asking questions which it is up to industry officials to answer
meaningfully.
Finally, the impact of this ‘retailisation’ of institutional investing
hastens the privatisation of investing for retirement. Eighty per cent of crossborder flows to emerging and developing economies is now governed by
investment managers and not, as in the past, by banks and direct investment.
These investing managers are using collective vehicles (including mutual
funds) and these generally are based on long-term commitments, often with a
tax incentive (such as Canada’s RSP tax deduction). It is not ‘hot money,’
volatile and fickle. Franklin Edwards finds that with the exception of the
1970s, mutual fund flows since 1966 have not affected stock and bond prices.
Characteristically, mutual funds provide stable funding with a long time
horizon. This leads me to discount the fears one often hears about the so-called
‘dangers’ inherent in the gradual privatisation and retailisation of retirement
savings.
142
Part II (continued)
GROWING IMPORTANCE OF INSTITUTIONAL INVESTORS
ACROSS OECD REGIONS AND IN EMERGING MARKETS
B. ASIA PACIFIC
143
Chapter V
JAPANESE FINANCIAL INSTITUTIONS AND THEIR CHALLENGE
TOWARDS THE 21ST CENTURY
by
Takeo Sumino*
Introduction
The Japanese economy has been transformed from a high growth
phase to a stable, matured stage. Japanese financial institutions are required to
further enhance it capability to manage its asset’s growth successfully. (For an
overview of financial institutions in Japan see Appendix I, IA - ID).
Institutional investors are facing a difficult period. The Bank of Japan
has cut its Official Discount rate to 0.5 per cent in September 1995. Coupons
of 10-year Government Bond have been lowered from a historical high of
7.9 per cent in 1990 to 2 per cent in October 1997. Traditional institutional
investor’s behaviour was characterised by a “Buy and Hold” strategy until
maturity. In the prevailing interest rate scenario, this investment strategy will
not achieve satisfactory returns. It is becoming quite vital to evaluate return on
real time basis. This will require fund managers to conduct analysis on yield
curve, basis points, options, swaps, duration, convexity, and credit.
1.
Japanese market overview
Japanese investors of every sector are struggling to increase their
returns under the current super-low yield environment. In order to obtain
higher yields, they have no choice but to take on some additional risks.
*
Nomura International.
145
Chart 1
Official discount rate in Japan
Source: Nomura International.
Chart 2
Recent trades / Movement towards taking risks
Source: Nomura International.
146
Japanese investors seeking higher returns have a choice between two
kinds of risks: foreign exchange (forex) risk and credit risk. Depending on the
characteristics of the investors, the risk that they are willing or able to take
differs. Chart 2 illustrates which type of investors will purchase the various
kinds of products available. Investors, however, usually agree to take one of
the risks but not both.
Big institutional investors such as Life Insurance Companies, Trust
Banks, Trust Funds, as well as governmental investors have stringent
investment criteria and in general prefer not to undertake significant credit risk.
(The bulk of their investments is in double-A or better rated credits). Therefore,
the only way currently for them to achieve higher returns is to undertake limited
forex risk. Accordingly, their focus is on reverse dual currency bonds, as well
as government securities with sufficient liquidity.
A reverse dual currency bond is a bond with yen payment, foreign
currency coupon (i.e. A$, $, DM, £), and yen redemption.
A dual currency bond is a bond with yen payment, yen coupon and
with foreign currency redemption (A$, $, £).
During 1996, it is estimated that there was an increase of more than
¥10 trillion of investments by retail investors in foreign currency denominated
bonds, including dual currency Samurai issues. Chart 3 looks at Japanese
investors’ patterns. (The Japanese retail investor sector is portrayed in
Appendix II. A-D.)
Japanese investors appetite for foreign currency has increased
substantially when Japanese yen started to weaken as well as when the yen
yield started to drop. Short and long term yields in US, UK and Germany are at
or near all time high spreads versus Japanese yields. This provides added
incentive for Japanese investors to seek out foreign currency exposure.
While the interest for foreign currency, dual currency, reverse dual
currency has become the mainstream investment vehicle, the equity market has
been providing very little incentives for investors to increase exposure.
In Japan, stock prices have shown no growth during the 1990’s
whereas in the States, we have seen a steady growth of stock prices over the
same period. it has already been eight years since the bubble economy
collapsed, but the Japanese economy is still suffering from the after-effect of
the bubble economy.
147
Chart 3
Japanese investors’ investment patterns
Note: The Japanese retail investor sector is portrayed in Appendix II. A-D.
Source: Nomura International.
The upper half of Table 1 shows the annual stock performance and the
lower half shows the annual bond performance. In 1996, we saw most of the
major countries experience considerable rate of returns on stocks while Japan
experienced a negative rate. Japan alone was a loser. And this fact has been the
driving force behind the proclamation of the Japanese Big Bang.
After reaching its peak of 79 in 1995, the yen against the US dollar
has depreciated to the 126 level. Japanese investors are gaining confidence that
foreign currency assets will maintain their value versus the yen.
148
Table 1. Returns on Investment
Note: Based on Datastream. Total Return Index in local currencies.
Source: NRI.
2.
The Big Bang 2001
Japan is presently getting ready to carry out a variety of reforms.
There has been an ongoing discussion over the administrative reform,
particularly over the future of a number of government agencies and relations
between the central government and local governments. As for the budget
reform, the main theme is what to do in order to restore a sound fiscal balance
by reducing government debt issues. In the welfare reform, discussion is
focused around the way Japan’s system of public pensions should be structured
as the nation’s population grows older. Tax reform is concerned with what tax
system should be constructed in order to restore the government’s fiscal
soundness and at the same time revive the nation’s economy.
The financial market reform aims at revitalising the Tokyo
international financial market and strengthening functions of the securities
market at home, as described in the 2001 Big Bang proclamation.
149
The three keywords for this Japanese version of the Big Bang are
“free,” “fair,” and “global,” and they are defined as follows.
At present, the Japanese Big Bang is expected to consist of four parts.
A first part related to a revitalisation of Japanese corporate activities,
and for this the government is working on introduction of a U.S.-type stock
option and holding companies by abolishing the Anti-Monopoly Act. In fact,
the Act will be amended in the Diet in 1997.
A second part is revitalisation of the Tokyo stock market which has
shrunk to almost a tenth the size of the U.S. market. Loosening the restriction
on treasury stocks, abolition of the securities transaction tax, and promotion of
venture businesses are now under examination.
Another part is abolition of the legal separation among banking,
insurance and securities businesses. Possibilities for sales of insurance policies
and mutual funds by banks, sales of insurance policies by securities companies,
and sales of mutual funds by banks are expected to be permitted first, possibly
in 1998.
The last part is the abolition of the fixed commission system, and
there is a great possibility that this will be implemented in the latter half of
1998. The Japanese securities companies are now pleading for the introduction
of a U.S.-type CMA in this country, in compensation for giving up the fixed
commission system.
The most important issues concerning the Japanese securities market
are abolishing the system of fixed brokerage commissions and loosening up on
the market segmentation among banks, securities firms and life insurance
companies in the retail market. Securities companies will therefore need to find
a way to offset the reduction in commission income, and they hope to do so by
developing better products in the investment trust areas and by introducing the
U.S.-type CMA. In addition, securities firms will need to actively make
proposals that will enhance the value of the Japanese companies and to
implement them
150
3.
Conclusions
The biggest challenge of institutional investors going forward to 21st
Century can be summarised as follows:
− International competition for Fund Management - Overcome the
historical low interest rate environment;
− Arrival of Ageing Society in Japan;
− Lack of professional fund managers;
− Lack of variety of domestic products;
− Managing Foreign Exchange Risk;
− Sluggish Equity Market;
− Slow Decision Making on Portfolio Strategy.
The counterpart’s solution for Japanese institutional investors point in
the following directions:
− Big Bang 2001;
− Form Joint Venture / Strategic Alliance with Non-Japanese fund
managers;
− Introduce aggressive Incentive Scheme to create professional fund
managers;
− Establish Lean Organisation / quick decision making;
− Equity Market Reform - Tax System;
− Deregulation of Japanese Primary Bond Market;
− Create efficient secondary bond / equity market.
151
Appendix I
JAPANESE FINANCIAL INSTITUTIONS
IA. The category and size of Japanese financial institutions
Source: Nomura International.
152
IB. The comparison between Japan, the USA and the UK
Source: JOJ Statistics, at the end of September 1996.
153
IC. Features of Japanese financial institutions
Note: As of 30 September 1996.
Source: Nomura Research Institute.
154
ID. Investor group composition and investment guidelines
Note: As of 30 September 1996.
Source: Nomura Research Institute.
155
Appendix II
JAPANESE RETAIL INVESTORS
IIA. The Retail investor base: Breakdown of Japanese financial
assets by investor category (March 1996)
Source: BOJ Statistics.
IIB. International household savings ratios
(as a percentage of disposable household income)
Source: OECD Economic Outlook.
156
IIC. Personal financial assets in Japan and the United States
Source: FRB “Flow of Funds Accounts” (March 1996).
Figure 1. IID. Personal financial assets in Japan
(¥ trillion)
Mutual Funds
1200
Stocks
Bonds
1000
Insurance
800
Trust
600
Cash & Deposits
400
200
0
85
86
87
88
89
90
91
92
Source: Nomura International.
157
93
94
95
Chapter VI
THE GROWING FINANCIAL MARKET IMPORTANCE OF
INSTITUTIONAL INVESTORS: THE CASE OF KOREA
by
Yu-Kyung Kim*
Introduction
In Korea, the definition of institutional investors is broader in scope
than in other OECD member countries. For tax purposes, institutional
investors are prescribed in the Corporate Taxation Law. They include banks,
securities companies and merchant banking corporations, in addition to the
common definition of insurance companies, investment companies and pension
funds. The proprietary trading desks of banks and securities companies have
played a major role in the institutional investors market. In particular, banks
have rapidly moved into trust business and are competing with investment
companies and insurance companies for private pension products.
1.
Historical perspective of the Korean economy and institutional
investors
The roles and functions of institutional investors did not exist in any
meaningful way until the 1970s. For nearly a decade after the Korean War
(1950 - 1953), the Korean economy was basically at a standstill position and
did not begin to make a forward movement until the 1960s. With the
government-led Five-year Economic Planning, Korea started to industrialise
and modernise its production facilities and to push toward an export-driven
economy. Having had almost no natural resources except for a hardworking
*
Director, Securities Research, Korea Stock Exchange. The views expressed
in the paper are those of the author and not necessarily those of the
institution to which he is affiliated.
159
and determined group of the population, it was extremely difficult to jump start
the economy. Hard-currency funds had to be borrowed from international
agencies and institutions. If there were any funds in the domestic market, they
were invested in economic development. At that time, institutions which could
be characterised as institutional investors were basically banks and insurance
companies, and whatever funds they were accumulating were immediately
recycled back to the real economy. Given that there was a constant demand for
funds, banks and insurance companies had little room to think about how their
funds could be invested in financial markets. Moreover, the main priority was
to develop the real economy and not the financial system.
As Korea entered the 1970s, the National Assembly enacted a policy
law to foster the capital market. The government encouraged firms to go public
and to list their shares on the Korea Stock Exchange and started to create a
demand for stocks by selling shares, at a deep discount, of those firms which
had been owned by the government. At the same time, investment trust
companies were launched to help retail investors find a way to participate in the
stock market indirectly, without having to commit a large sum of money.
However, the results did not meet the expectations. Inflation was still a big
concern of the government and investors were more inclined to put their money
in real assets such as real estate. As the Korean economy expanded at a very
rapid pace in the 1980s accompanied by much subdued inflationary pressure,
real income per capita started to take off and a variety of new financial products
were introduced. As investors were looking for places to invest, they began to
discover the stock market which was also rising in parallel with the growing
economy. This was the period when the basic infrastructure of the Korean
capital market was laid out as securities companies and investment trust
companies became more important.
Even in the 1990s the Korean economy was growing at a healthy pace
in comparison to other emerging countries. Until 1997, it grew at a rate of just
below 10 per cent. However, the economy is currently faced with cyclical
difficulties as its growth rate is forecast to be just below 6 per cent (Chart 1).
2.
Means of Raising Capital in the Korean Economy
Currently the Korean financial system is not based on a universal
banking system but on the specialised banking system that clearly defines the
securities market on one side and banking on the other side. However, as the
universal banking system along with a financial holding company concept are
160
about to be introduced, the days of the Chinese wall between the securities and
banking industries will be numbered.
Chart 1 Capital markets vs. GNP
400 000
350 000
300 000
250 000
200 000
150 000
100 000
50 000
0
1 990 1 991 1 992 1 993 1 994 1 995 1 996
GNP
Stock Market
Bond Market(Amount Listed)
Source: National Statistical Office, Securities Supervisory Board.
As the Korean economic development was planned and implemented
by the government, financial resources of firms relied predominantly on such
indirect sources as banks and overseas loans instead of the capital market. As
mentioned above, the government started to nurture the capital market in the
1970s to mobilise funds that were outside the structured financial system. The
wave of securitisation in the United States in the 1980s had partially influenced
the financing method of Korean firms to change from indirect financing to
raising capital through direct financing by issuing new or seasoned equity, or
bonds.
In 1985, the amount of direct financing by listed companies through
capital market amounted to 3.4 trillion won, which consisted of 300 billion won
161
in equities and 3 100 billion won in debt. The amount increased to 35 trillion
won in 1996 where 5 trillion won and 30 trillion won were from stock and bond
issuances, respectively. Out of the total financing by Korean firms, the
proportion of direct financing increased from around 20 per cent in 1975 to
close to 50 per cent in 1996. As new securities issuances proliferated,
investment in securities became a big part of individual investors’ portfolio
investment (Charts 2 and 3).
Moreover, as financial market deregulation was phased in to all areas
including product development, financial business entry barriers and scope of
business activities, the separation between banking and securities has become
blurred. Many financial institutions now offer similar products to their
customers. As a result, for example, business activities of a securities company
will no longer be confined to brokering, underwriting and proprietary trading.
Eventually securities companies will offer a similar broad line of business as
investment companies in the US.
Chart 2 Corporate financing
120
100
80
Overseas
Indirect
60
Direct
40
20
0
1990
1991
1992
1993
Source: Bank of Korea.
162
1994
1995
1996
Chart 3 Proceeds from corporate securities offerings
Bonds
Stocks
Source : Securities Supervisory Board.
3.
Ownership structure and shareholder activism of institutional
investors
3.1.
Insurance companies
Most insurance companies are affiliated with either large
conglomerates or financial institutions.
There are seven joint-venture
companies with foreign counterparts and five foreign companies. In terms of
shareholder activism, there is no restriction on how ballots should be cast by
insurance companies.
3.2
Investment trust companies
The big three investment trust companies in Seoul are owned by
banks and other financial institutions with a maximum individual limit of
15 per cent. The maximum individual ownership limit on investment trust
companies registered outside Seoul is 30 per cent. The sum of ownership of a
single investment trust company by affiliated companies of the ten largest
163
conglomerates cannot exceed the 30 per cent level.
Moreover, if a
conglomerate owns stocks of more than two investment trust companies and
owns more than 10 per cent in one of the investment trust companies, it cannot
own more than 10 per cent in the other investment trust companies.
Their voting in general shareholders meeting is passive unless the
ballots are involved with asset sales or mergers and acquisitions which can
bring a result that may not be in the best interest of trust account holders.
3.3
Pension funds
Since pension funds are established by a special law and have
characteristics of public enterprises, the organisation structure of pension funds
are in essence not too different from government owned enterprises.
There are no clear-cut guidelines or regulations, concerning pension
funds voicing their rights in the management of corporations in which they
have partial ownership. The voting decision is made by the management but
they are usually neutral in casting their ballots.
3.4
Banks
A single investor cannot own more than 4 per cent of a bank.
Exceptions are government-owned banks, joint-venture banks with foreign
partners and banks registered outside Seoul, in which case up to 15 per cent
could be owned. Also, institutional investors who invest for the purpose of
portfolio investment may own up to 8 per cent of common stocks outstanding.
There is a strict separation of ownership and management but corporate
executives and institutional investors may participate in the management of
banks indirectly as non-standing directors at the board of directors meetings.
As far as shareholder activism by banks is concerned, banks cast their
ballots neutrally in the general shareholders meetings unless the result of an
election may not be in the best interest of the owners of their trust accounts.
3.5
Securities companies
Securities companies are typically part of large conglomerates in
Korea, subsidiaries of financial institutions, or owned by individuals. Since the
164
social responsibility of securities companies is not as great as that of banks,
there is no upper limit on how much an individual or an institution can own.
In the area of shareholder activism, securities companies rarely cast
votes in the general shareholders meeting as they are passive portfolio
investors.
4.
Regulatory aspects of institutional investors
In Korea, all types of institutional investors, except pension funds, are
regulated by the Ministry of Finance and Economy (MOFE). Pension funds are
operated under a different regulatory and supervisory regime. For example, the
National Pension Corporation (NPC), the largest pension fund in Korea, is
regulated by both the Ministry of Health and Welfare and the MOFE. The
Ministry of Government Administration and the Ministry of Education have
primary responsibility for regulating the pension funds for government
employees and teachers. Military pensions are administered by the Ministry of
Defense. Given the diversity of regulatory bodies for different funds, the
MOFE is in the process of drafting a set of guidelines in order to make the
operation and management of pension funds transparent and to standardise their
performances measures.
In order to make sure that the funds are managed prudentially with
due care, different laws and regulations are set in place to restrain institutional
investors’ investment activities. Some of the investment constraints concern
the total amount that could be invested in the equity market, the maximum
amount that could be invested in a single company and affiliated companies
within the same conglomerate group, and the maximum amount that could be
invested in companies which are affiliated with the group that the institutional
investor belongs to.
The purposes of these regulations are to make sure that the investment
behaviour of institutional investors is healthy and prudent. Therefore, the goals
are to make sure that institutional investors have well-diversified portfolios and
have only portfolio investments instead of disguised direct investment. The
latter part is a big concern for market regulators since over-expansion by
conglomerates may result in too much concentration of economic power in the
hands of a few chaebol.
165
4.1
Insurance companies
The Insurance Business Law sets the maximum limits on classes of
investment vehicles, namely equities and real estate. Insurance companies are
permitted to invest up to 30 per cent of their aggregate assets in equities and
15 per cent in real estate. Investment in foreign equities, including foreign real
estate, is limited to 10 per cent of total assets. To ensure a portfolio
diversification of investment holdings, the Law prohibits insurance companies
from lending more than 3 per cent of their assets to a single customer and from
investing more than 10 per cent of the shares outstanding in a company.
However, if an insurance company is affiliated with a large conglomerate, a
5 per cent investment in equity of a company is the maximum.
4.2
Investment trust companies
The Securities Investment Trust Business Law establishes a set of
guidelines for managing their own assets for the purpose of proprietary trading.
Investment trust companies may invest in the equity market up to 50 per cent of
their respective shareholders equity, but in a single company they cannot invest
more than 5 per cent of its shares outstanding. There is no stock investment
limit for the assets of trust accounts, but the maximum investment that
investment trust companies can invest in a single company must be less than
either 20 per cent of shares outstanding or 10 per cent of the trust account
assets.
4.3
Pension funds
The laws regulating pension funds do not prescribe the guidelines
concerning their investment activities. Therefore, most pension funds manage
their assets according to their own internal rules or decisions by their
management committees.
It should be noted that pension funds have been a reluctant player in
the stock market since participation in the equity market is viewed as a very
risky investment decision. Moreover, in contrast to pension funds of other
countries, portfolio management of Korean pension funds is not delegated to
outside professionals but is done in-house. Recently, the MOFE has strongly
encouraged pension funds to actively participate in the securities market by
relaxing conservative fund management rules and reducing accountability for
their investment performance.
166
4.4
Banks
For the purpose of proprietary trading, banks may invest in stocks and
bonds up to the amount of shareholder equity. In terms of investing on behalf
of trust accounts, the maximum amount that can be invested in equity cannot
exceed 25 per cent of the preceding month’s trust account assets. In either case,
the amount that can be invested in a single company is up to 10 per cent of the
shares outstanding.
4.5
Securities companies
There is no specific regulation on the investment behaviour of
securities companies as long as it is done prudently. Instead, in order to set a
system of check and balances, a monthly report on the ratio of shareholders
equity to expected losses from such risks as market risk, interest rate risk,
counter-party default risk, and operational risk within the securities company,
must be filed with the Securities and Exchange Commission. If the ratio
changes by more than 10 per cent from the preceding month, the SEC may
request more frequent filing. If a securities company’s ratio is over 120 per
cent, it is assumed to be investing prudently. If the ratio is between 120 per
cent to 100 per cent, the firm’s direct investment in other corporations or
acquisition of real estate may be restricted. If the ratio is less than 100 per cent,
the firm will be ordered to safeguard its shareholders interest.
4.6
Prudent man rule versus quantitative regulation of portfolio
distribution
As illustrated, institutional investors in Korea are regulated by the
quantitative regulations convening portfolio distribution. Given the special
circumstances that have arisen from developing its economy in a short period of
time, adoption of the prudent man rule does not fit to the Korean regulatory
framework. One of the by-products of rapid economic growth is that the
Korean economy is concentrated in the hands of a few conglomerates which
dominate not only manufacturing firms but also such service industry firms as
insurance companies and securities companies. If the prudent man rule
prevailed the market, it could be abused in an unintended way and the degree of
economic concentration could be heightened in the hands of those few. A
country must decide whether to adopt either quantitative regulations of
portfolio allocation or the prudent man rule according to the stage of its
economic development and country specific circumstances.
167
5.
Current Status of Institutional Investors
Over the past few years, the stature of institutional investors in the
Korean financial industry has grown remarkably. The three basic types of
institutional investors - insurance companies, pension funds and investment
companies - have experienced a sizeable growth in their assets under
management. Their combined assets rose from 75 trillion won in 1990 to 212
trillion won in 1996, accounting for 54.3 per cent of GDP. Also, the assets of
banks totalled 587 trillion won.
The value of equities and fixed-income securities held by the three
major institutional investors amounted to 103 trillion won at the end of 1996,
which is composed of 27 trillion won in stocks and 76 trillion won in bonds.
These figures represent 49 per cent of total assets under management (Chart 4).
5.1
Insurance companies
Before entry barriers were relaxed in 1989, there were six domestic
life insurance companies registered in Seoul. Now there are 12 in Seoul, nine
outside the capital city, seven joint ventures and five foreign companies.
However, the big three, Samsung, Kyobo and Daehan, dominate the industry
with a 66 per cent market share.
In the non-life insurance market, there are 11 domestic firms and three
foreign firms. In addition, two credit guarantee companies and one reinsurance
company make up the industry. The size of the industry is around 20 per cent
of that of the life insurance industry. Insurance companies invested 12.3 per
cent of their assets in equities, which is equivalent to a 6.5 per cent shareownership in the Korean stock market. They invested 12.1 per cent in fixedincome securities in 1996.
5.2
Investment trust companies
Prior to 1996, there were three firms in Seoul and five outside Seoul.
20 more new investment trust companies started their business in 1996, but
they are only allowed to sell their products indirectly through securities
companies. Additionally, there are two joint venture companies and several
foreign investment companies which have been selling their funds through
domestic securities companies, starting in 1997. The original three firms have a
market share of close to 80 per cent.
168
Chart 4 Assets of investment companies, insurance companies
and pension funds
Billion Won
100 000
90 000
80 000
70 000
60 000
50 000
Investment
Insurance
40 000
Pension
30 000
20 000
10 000
0
1990 1991 1992 1993 1994 1995 1996
4.1 Investment companies
Billion Won
70 000
60 000
50 000
Bonds
Stocks
40 000
30 000
20 000
10 000
0
1990
1991
1992
1993
169
1994
1995
1996
Chart 4 Assets of investment companies, insurance companies
and pension funds (continued)
4.2 Insurance companies
Billion Won
25 000
20 000
Bonds
15 000
Stocks
10 000
5 000
0
1990
1991
1992
1993
1994
1995
1996
4.3 Pension fund
Billion Won
14 000
12 000
10 000
Bonds
Stocks
8 000
6 000
4 000
2 000
0
1990
1991
1992
1993
1994
1995
1996
Source : Bank of Korea, Securities Supervisory Board, Insurance supervisory
board, Korea securities finance Corp.
170
Investment companies held 15.3 per cent of their assets in equities,
which is equivalent to a 5.8 per cent share-ownership in the Korean stock
market; 65.0 per cent were invested in fixed-income securities in 1996.
5.3
Pension funds
There are five main public pension funds; National Pension,
Government Employee’s Pension, Korea Teachers Pension, Military Pension
and the Korean Teachers’ Mutual Fund. The biggest, National Pension, was
created in 1988 and it is mandatory to join the pension for a firm which
employs more than five people. Given the short history of Korean economic
development, pension savings have been a relatively new concept. Given their
social and cultural backgrounds most elderly Koreans rely on their children
after retirement. However, as baby boomers move into their 40s, the idea of
being independent in their silver age has become the predominant thought of
many people. In turn, the government, allowed 1994 financial institutions to
introduce tax exempt individual retirement accounts. Though it is a growing
market it will take a while before the instrument will be as important as in some
advanced markets.
Current practice of retirement funds in Korea is that a worker receives
a lump sum retirement fund from his company The amount is usually the
monthly income of the month preceding the retirement times the number of
years of employment. The source of fund usually comes from current capital
and not from a separate fund that is designated for such purpose. Therefore, it
is somewhat close to a pay-as-you-go system. As far as corporate sponsored
pension funds are concerned, they have not been introduced as of yet.
However, the government is taking a hard look at the feasibility of introducing
them at the moment. Once they are introduced, they are expected to have a
major impact on the stock and bond markets.
Pension funds which are less exposed to the securities market than
their foreign counterparts, invested 7.3 per cent and 30.9 per cent in stock and
bond markets, respectively, in 1996. Their investment in equity is equivalent to
a 5.2 per cent share-ownership in the Korean stock market,
171
5.4
Banks
Currently, there are 15 Seoul-based and ten other domestic banks as
well as 67 foreign bank branches and 24 foreign bank offices. Banks invested
215 trillion won in securities in 1996, which were comprised of 131 trillion
won in equities and fixed-income securities, and 84 trillion won in other
securities. Their investment in equities is equivalent to a 10.6 per cent shareownership in the Korean stock market.
5.5
Securities companies
There are 33 domestic companies, three joint ventures, 22 foreign
branches and 18 foreign securities companies’ offices. 32 domestic companies
and joint ventures and four foreign branches are members of the Korea Stock
Exchange.
In 1996 securities companies held 10 trillion won worth of securities
with 4 trillion won in equities. Their investment in stocks is equivalent to a
2.2 per cent share-ownership in the Korean stock market,
5.6
Composition of the Korean stock market
At the end of 1996, the equity ownership of institutional investors,
including banks and securities companies, accounted for 31.2 per cent of total
listed shares on the Korean Stock Exchange (KSE). This figure can be further
broken down to the following: 10.5 per cent were held by banks; 6.5 per cent
by insurance companies; 5.8 per cent by investment trust companies; 5.1 per
cent by pension funds; 2.2 per cent by securities companies; and 1.1 per cent by
other financial institutions. Foreign investors owned 11.6 per cent of listed
shares on the KSE (Chart 5).
Similar to the securities markets in other OECD countries, the Korean
securities market has become dominated by institutional investors. The
proportional ownership of institutional investors increased from 20 per cent in
1986 to 31 per cent in 1996. In contrast, individual ownership of shares
decreased from 52 per cent in 1986 to 34 per cent in 1996. Since participating
foreigners are mostly institutional investors and they account for around 12 per
cent of the market share, including them would increase the institutional
ownership to 43 per cent at the 1996 year-ending (Chart 6).
172
Chart 5 Ownership of the Korean stock market
Foreigners
12%
Government &
Public Bodies
7%
Others
16%
Institutional
Investors
31%
Individuals
34%
Source : Korea Stock Exchange.
Chart 5 Ownership of the Korean stock market (continued)
Foreigners
12%
Government
7%
Banks
11% Securities
2%
Investment Trust
6%
Insurance
6%
Individuals
34%
Others
16%
Source: Korea Stock Exchange
173
Pension
5%
Other
Finance
1%
Chart 6 Institutionalisation
(%)
90
80
70
60
50
40
30
20
10
0
1982
1984
1986
1988
1990
1992
1994
Institutional Investors
1996
Individuals
Source: Korea Stock Exchange
6.
Deregulation in the Korean financial system
Since the mid 1980s, the Korean government has gradually
deregulated the investment activities of institutional investors. For one, prior to
this year there was a quota system which designated how the assets of securities
companies should be allocated into different groups of securities. This system
was abolished in the first quarter of this year and now securities companies can
invest their assets according to their internal rules. Secondly, the government
completely lifted the investment restrictions in overseas securities markets in
1995. This deregulatory step was implemented gradually starting in 1988. As
of March 1997, Korean institutional investors have acquired US$ 2.8 billion
worth of foreign equities and bonds. Securities companies are the largest
investors with $1.2 billion and investment trust companies are the second
largest with $1.1 billion. In addition, institutional investors’ maximum
ownership limit on different securities has been gradually expanded. For
example, insurance companies are now permitted to invest up to 30 per cent of
their total assets in equities, up from the previous 20 per cent.
174
As Korea became the newest member of the OECD in 1996, it was
natural for its member countries to expect that the Korean financial system
change its rules and regulations to be more comparable to the standards of the
group in due time. It was also one of the key reasons why Korea applied for
membership. Korea recognised that its financial system was lagging behind its
competitors with similar economic backgrounds, even though it already had its
own plans of how the financial system would be deregulated. In some ways,
the challenges that were brought up while discussing the requirements of the
Committee on Capital Movements and Invisible Transactions (CMIT) and the
Committee on International Investment and Multilateral Enterprise (CMIE)
have become a force in accelerating the ongoing deregulation process.
7.
Growth prospects of institutional investors
Like other OECD countries, there will be a significant change in
demography in Korea due to the ageing population. For example, the cohort of
65 years old or over, is expected to increase to 13 per cent in 2020 from 5 per
cent in 1990. Against this backdrop, different types of pension products were
introduced in the last few years and it is expected that there will be a steady
increase in assets under management of institutional investors.
As mentioned before, institutional investors, and particularly, pension
funds have been reluctant to be highly exposed to riskier investments as
equities. The conservative allocation can in part, be attributed to relatively high
returns on fixed-income securities. Due to falling interest rates in the domestic
financial market, however, institutional investors are forced to increase their
investments in equities which yield higher returns on a long-term basis, and
invest in international securities. The introduction of derivatives products, such
as stock index futures and options, will help institutional investors in managing
systemic risk associated with stock investment.
Another development which will have a significant impact on the
investment behaviour of institutional investors is the growth of the fund
management business. As part of the financial liberalisation process, a number
of professional fund management companies have been established and foreign
fund management companies have expanded their presence.
The growing importance of institutional investors will lead to
fundamental changes in the landscape of the Korean financial market. One of
the by-products is the liberalisation of brokerage commission. Brokerage
income makes up around 55 per cent of securities companies’ total income.
175
Currently, there is an upper limit on charges for brokerage services, of 0.6 per
cent of the trading value. However, the going rate in the market is 0.5 per cent.
With a complete deregulation of the brokerage commission rate, there will be
an intense competition among securities houses. Initially, people are expecting
that the brokerage fee on block trades by institutional investors will be lowered
without any change in the retail brokerage commission structure. However,
before long it is expected that there will be a Korean version of Charles Schwab
in the near future, which will break up the cordial relationship in the securities
industry.
Stock exchanges will be faced with challenges of changing its market
structure and introducing new products to accommodate the diverse needs of
institutional investors. One of the near term projects is to improve the market
infrastructure so that more institutional investors participate in the stock
market. Institutional investors who strive to fulfil their fiduciary duties will, in
turn, demand listed companies to improve corporate governance and disclosure
practices, as well as to focus on maximising shareholder value. The result will
be a financial market and a financial industry that are efficient and sophisticated
as well as effective to end-users.
176
Part II (continued)
GROWING IMPORTANCE OF INSTITUTIONAL INVESTORS
ACROSS OECD REGIONS AND IN EMERGING MARKETS
C. EUROPE
177
Chapter VII
INSTITUTIONAL INVESTORS AND THEIR IMPLICATIONS FOR
FINANCIAL MARKETS IN GERMANY
by
Bettina Nürk*
Introduction
In Germany, institutional investors do not enjoy the same significance
as, for instance, in the UK or the USA. Correspondingly, they are less active in
the capital market. Table 1 shows the percentage of total shares in circulation
held by insurance companies and pension funds as well as investment funds and
other financial institutions (excluding banks). This percentage is about 44 per
cent in the USA and 50 per cent in the United Kingdom, but only 20 per cent in
Germany. In Germany, companies are the most important investors in shares
(42 per cent). The same is true, to an even larger extent, in France (58 per cent)
where institutional investors play an even less important role than in Germany.
Also, banks are rather important share holders in Germany (roughly 10 per
cent). This is in stark contrast to the USA and the UK, where banks have next
to no share holdings.
This paper analyses the reasons why institutional investors in
Germany have so far been less important. Moreover, it will take a closer look
at the investment behaviour of these institutions. It can be said even at this
point that private investors' conduct is clearly reflected in the investment
strategy pursued by institutional investors. Finally, it is particularly interesting
to look ahead and try to assess expected developments in the coming years and
decades.
*
Economist, Deutsche Bank Research
179
Table 1. International comparison of share ownership profiles
United
States
Japan
Germany
France
United
Kingdom
Households
Enterprises
Public sector
Non-financial sectors
Banks
Insurance enterprises and
pension funds
Investment funds and other
financial institutions
Financial sectors
Rest of the world
36.4
15.0
0.0
51.4
0.2
22.2
31.2
0.5
53.9
13.3
14.6
42.1
4.3
61.0
10.3
19.4
58.0
3.4
80.8
4.0
29.6
4.1
0.2
33.9
2.3
31.3
10.8
12.4
1.9
39.7
13.0
44.5
4.2
11.7
35.8
10.3
7.6
30.3
8.7
2.0
8.0
11.2
10.4
52.4
13.7
Total
100
100
100
100
100
Source: Deutsche Bundesbank.
1.
The limited role played by institutional investors in Germany
1.1
"Pay as you go" as the dominant form of financing the pension
system
1.1.1
Low degree of funding
One of the main reasons why there is a lack of institutional investors
in Germany is the structure of the old-age provision system. It is dominated by
the state pension system operating on a pay-as-you-go basis. 70 per cent of
total pension payments in 1995 (DM 515 bn) were accounted for by the state
pension scheme and 14 per cent by civil-service pensions and additional
benefits, while the share of privately organised, funded old-age provision
amounts to a mere 16 per cent. Of the latter, just over 4 per cent are corporate
pension schemes and just under 12 per cent life assurance contracts. However,
it is not always possible to clearly differentiate between corporate and private
old-age provisioning. In addition, this calculation is based on the assumption
that all funds paid out from private life assurance contracts are used for old-age
provisioning. In a different calculation, the EU Commission concluded that
11 per cent of all pensions paid out in Germany in 1993 stemmed from
corporate pension schemes. In any case, all calculations reveal a pronounced
predominance of the state pension scheme and pay-as-you-go financing.
180
Pension funds and other forms of funding via external institutions thus play an
only minor role in the financing of old-age provision.
This is particularly obvious in the case of pension funds if
international statistics are used for a comparison of pension fund assets.
Pension fund assets come to only around 6 per cent of GDP in Germany but to
almost 60 per cent in the US and to 80 per cent and more in the United
Kingdom, Switzerland and the Netherlands (Table 2). The total of US$131 bn
quoted for German pension funds comprises assets held by so-called
"Pensionskassen" and "Unterstützungskassen" (support funds), but do not
include funds held as pension reserves.
The small capital resources of pensions funds or similar institutions in
Germany is not compensated by higher assets held by insurance companies,
either. According to the EU Commission, assets held by life assurance
companies in Germany accounted for 20.5 per cent of GDP in 1995. Even
though this figure is even lower in certain countries (e.g. Italy: 3.7 per cent), it
is markedly higher in others. Apart from France (30 per cent) this applies
especially to the group of countries where old-age provision is increasingly
funded, i.e. the UK (67.1 per cent), the Netherlands (45.6 per cent), Sweden
(36.9 per cent), Denmark (49 per cent) and the non-EU member Switzerland
(roughly 51.5 per cent). Even though these figures are not automatically
comparable, as they are based on different national valuations, they nonetheless
highlight the different degrees of significance attached to funded pension
systems even within Europe.
Table 2.
Germany
France
UK
Italy
Netherlands
Sweden
Switzerland
Japan
United States
Assets of pension funds in 1996
Total (US$ billion)
131
74
1 056
80
350
109
257
1 142
4.352
Source: InterSec Research Corp., OECD, own calculations.
181
per cent of GDP
5.6
4.8
93.2
6.7
88.9
43.0
87.2
24.9
57.5
1.1.2
State pension system
As mentioned earlier, the German state pension system is funded on a
pay-as-you-go basis. The government has so far rejected even a partly funded
system. There are several initiatives regarding civil service pensions which aim
to limit the growing burden of pensions to be paid or at least to ensure that they
can be financed.
Firstly, two German states have started to build up capital to at least
partially fund pension commitments to civil servants. The state of SchleswigHolstein allocated an initial instalment of DM 100 m to a fund in 1995. This
money came from the proceeds from privatisations. Further contributions are
to be paid from the current budget. The aim is to restrict pension expenditures
to 9 per cent of the state’s net spending over the coming years and decades and
thus avoid an expenditure peak around the year 2020.
The state of Rhineland-Palatinate established a kind of "pension fund"
in October 1996. Unlike in the case of Schleswig-Holstein, the aim here is to
fully fund future pension liabilities to newly hired civil servants. Allocations to
the fund are to be financed from savings in the state budget. In both SchleswigHolstein and Rhineland-Palatinate, the funds are to be invested in bonds of the
1
state in question.
Secondly, it is planned that from 1999 to 2013 civil servants – both
the working generation and retirees – shall contribute towards their own
pensions by paying 0.2 per cent of the increase in salaries or benefits into a
compulsory pension reserve. This also seeks to avoid the expenditure peak
around the year 2020.
1.1.3
Occupational and private pension schemes
The German system of corporate pensions is still clearly dominated
by pension reserves, even though their share in funding capital has declined
over the last few years (see charts 1 and 2). Pension reserves offer the
possibility to defer tax and enjoy liquidity advantages. Apart from that,
pension schemes financed by pension reserves are subject to deferred taxation
from the point of view of the employee. This means that contributions (or in
this case the forming of pension reserves) are in principle tax-deductible
expenses for the employer, while the employee does not have to pay tax on
1.
The fund in Schleswig Holstein has recently been liquidated.
182
them. Investment income is not taxed (at least not with the employee). Only
the pensions paid out later are in principle taxable income.
Chart 1: Cover for occupational pension schemes in Germany
1995 (in per cent)
total DEM 490 bn
Support funds
Direct insurance
8.4%
12.2%
57.2%
22.2%
Pensionskassen
Pension reserves
Source: Arbeitsgemeinschaft für betriebliche Altersversorgung
On the other hand, if Pensionskassen or insurance companies are used
to finance occupational pension schemes, the contributions themselves are
already being taxed. Employees pay their contributions from taxed income. As
regards employer contributions, it is possible that these are not taxed at the
employee’s individual tax rate as a part of his/her wage or salary. This is the
case if the tax is paid by the employer rather than the employee, with a reduced
flat tax rate of currently 20 per cent (plus solidarity surcharge and church tax)
being applied. However, this is only allowed up to a maximum of DM 3 408
on average for all employees p.a. (in individual cases payments must not
exceed DM 4,200). For all other payments exceeding this maximum the
employee’s individual tax rate is applied.
Levying taxes on contributions to old-age provision is in contrast to
the international taxation practice and puts external funding forms at a
disadvantage. It is in particular the different tax regulations that prevent
companies from switching to another form of financing. Employers wishing to
change from internal financing via pension reserves to an external source of
financing are usually put off by the amount of tax to be paid.
183
Chart 2: Occupational pension schemes: Capital cover 1981
(in per cent)
Pensionskassen
(20.0%)
Direct
insurance
(4.8%)
Pension reserves
(67%)
Support
funds
(8.2%)
Source: Arbeitsgemeinschaft für betriebliche
Altersversorgung
It should be mentioned in this context that a deferred taxation system
is in fact applied to "Unterstützungskassen" (support funds), which are also
external financing institutions. However, financing pension liabilities through a
support fund has the disadvantage that, for tax reasons, pre-financing is only
possible to a limited amount. Thus, as long as an employee has not yet reached
retirement age, a full funding of pension obligations is not possible. This
implies that support funds are only used to a limited extent in corporate pension
schemes.
External forms of financing will probably continue to play a rather
minor role in old-age provision if there is no change to taxation. This is all the
more true as corporate pension schemes have been on the decline for some
years now due to the generally unfavourable tax and legal regulations. Moving
away from a system of deferred taxation will initially lead to temporary revenue
losses on the part of the state. Over the longer term, however, this will change
as higher tax revenues from pensions will compensate lower or even nonexisting tax revenues from premiums and contributions. The temporary loss of
revenues can be alleviated by a step-by-step introduction of the reformed tax
system. This could mean that the tax-exempt amount will initially be limited
and then gradually raised, while at the same time a growing share of pension
payments would be subject to taxation.
184
So far, life assurance schemes have been the predominant form of
private old-age provision as part of monetary capital formation. Besides,
investment in real estate has also served this purpose. Investment funds are
also increasingly gaining in importance in this context.
1.2
Investment funds
The fact that investment funds, like other institutional investors, were
off to a slow start can be explained partly by the structure of old-age provision
in Germany and the low significance of private schemes. Another important
aspect is the investment behaviour of private households in Germany. It was
only in the 1970s and even more so in the 1980s that investment funds gained
in importance with German investors as a form of saving. This is in sharp
contrast to the USA, for instance, where the foundations for an investment
sector were laid early, and that sector registered high growth rates from the
1940s onward.
At the end of 1996 there were 3,989 investment funds of which 1,058
were so-called Publikumsfonds and 2,931 so-called Spezialfonds.
Publikumsfonds are retail funds which offer their units for sale to the public.
Spezialfonds are institutional funds for non-natural investors. The number of
investors per institutional fund is limited to ten. Of all assets (about DM 822
bn at the end of 1996), 52 per cent were accounted for by retail funds and
48 per cent by institutional funds. Looking solely at domestic funds, however,
the institutional sector accounted for a larger share with 58 per cent of total
assets.
1.2.1
Retail funds
Investment funds have become ever more important as a form of
private savings over the last few years. Today investment funds account for
about 7.5 per cent of private monetary assets in Germany, and only 2 per cent
in 1980.
In 1996 there were 655 domestic retail funds and another 403 foreign
funds. Domestic funds accounted for DM 285 bn of the total assets of DM 429
bn, while foreign funds held DM 144 bn. However, foreign funds also included
those offered by German companies operating abroad, especially in
Luxembourg. At an early stage, Luxembourg had created a very liberal
environment for funds. Taxation in Germany, particularly the introduction of
185
the tax on investment income in 1993, also helped boost Luxembourg as a
location for investment funds over the last few years.
The asset structure of retail funds clearly reflects the typical
investment approach of private investors in Germany. Bond funds dominate,
with a 54 per cent share in total assets at the end of 1996. Equity funds make
up around 15 per cent of all assets, money market funds 12 per cent and others
account for the rest (among them real estate funds with a 17 per cent share).
This reveals that equity funds are still lagging far behind bond funds. However,
for some years now they have met with increasing interest. The total amount of
money invested in equity funds came to DM 65 at the end of 1996, compared
with only DM 17 bn at the end of 1991. This means that assets have
quadrupled, helped in part by rising share prices. The DAX rose from 1577.98
points at the end of 1991 to 2888.69 at end-1996, thus boasting an increase of
about 83 per cent.
Investor interest in equity funds remained strong also in the first few
months of 1997. According to the Bundesbank, approximately DM 22 bn
flowed to domestic equity funds between January and May 1997, while foreign
bond funds only absorbed DM 19 bn. Surely, this must be seen against the
background of a particularly favourable general environment (such as booming
equity markets and a low interest rate environment). However, it cannot be
assumed that the current change in private individuals’ investment behaviour
will prove short-lived. This is unlikely as, among other things, there is a
growing need to bridge the gap in state pension schemes by making private
provisions. The positive role played by shares in this context – due to their
great potential for high returns – is increasingly recognised.
An international comparison of investment per head of the population
(see Chart 3 where only domestic retail funds are considered) confirms that
there is still considerable potential for growth of the German investment
industry in general. While France is Europe's No 1 investment nation with
investment in excess of DM 14 000 per capita, Germany boasts roughly
DM 3 500 per capita (including Luxembourg and other foreign funds of
German origin, per-capita investment is approx. DM 5 240). World-wide, the
US ranks first regarding investment savings, not only in absolute figures but
also per head of the population, with the per-capita figure amounting to roughly
DM 21 000.
186
Chart 3: Investment fund assets per capita 1996
GER
FRA
UK
ITA
3480
in DM
14238
5314
3503
NETH
6762
AS
SWZ
SPN
USA
7666
10600
5602
21130
0
10000
20000
Source: Bundesverband deutscher Investment- Gesellschaften
Especially with a view to private old-age provision, certain
investment funds are to be introduced in 1998. The Third Financial Market
Promotion Act foresees, among other things, the introduction of so-called
Pensions-Sondervermögen. They are a special type of investment fund aimed
solely at old-age provision. In light of the long-term orientation, returns are to
be reinvested. The investment focus is on net asset value, i.e. mostly property
and equities. Their share of the portfolio should be no less than 51 per cent but
no more than 75 per cent. A new aspect of Pensions-Sondervermögen is that a
portfolio mix would be made possible by simultaneous investment in securities
and property in one single fund. Besides savings schemes into which deposits
are paid at regular intervals, German fund managers are to offer investors
additional insurance schemes to cover risks like disability or death.
Without doubt, Pensions-Sondervermögen are a useful complement to
the existing range of provision schemes. They will help to strengthen the role
of equities in old-age provision. However, it remains to be seen to what extent
this will be incorporated into German legislation on occupational pension
schemes. An important aspect is the tax treatment of contributions to the fund's
assets and the resultant payouts. There is a lot to suggest that the introduction
187
of Pensions-Sondervermögen will not trigger a change from immediate to
deferred taxation because it is not planned to exempt contributions to these
investment funds from tax, along Anglo-Saxon lines. This means that there
will be no changes to tax rules.
Apart from a number of other aspects, taxation is among the most
important characteristics that allow differentiation between PensionsSondervermögen and the kind of pensions funds that is common in other
countries. This implies that the introduction of Pensions-Sondervermögen is a
step in the right direction. It will not solve the problems besetting the German
system of old-age provision with its current structure and regulations, however.
In order to create the same environment for pensions funds and old-age
provisions as in other countries, a number of other, essential steps will have to
be taken, particularly as regards changes to tax regulations.
1.2.2
Institutional funds
It is intended that Pensions-Sondervermögen will also be used as
institutional funds in the framework of corporate pension schemes. They would
thus provide an instrument for asset funding, with direct commitments and
financing via pensions reserves still existing alongside these funds.
Commitments would then be financed by investments in institutional funds.
This is already done by German companies today. According to estimates,
roughly 20 per cent of total investments in institutional funds are designed to
provide the capital for corporate pension schemes. To avoid confusion, it
should be mentioned that these funds do not constitute assets that are legally
independent of the respective company.
Total assets invested in institutional funds were approximately
DM 400 bn at the end of 1996. At just under DM 63 bn, assets invested in
institutional funds reached a record high in that year. This amount corresponds
to about 80 per cent of the funds that flowed to the entire German (domestic)
investment sector in 1996.
At roughly 30 per cent of total assets, the share of equity funds was
considerably higher at the end of 1996 than that of Publikumsfonds, even
though it was still relatively small compared with investment habits of
institutional investors in other countries, such as pension funds along AngloSaxon lines. With a share of 62 per cent, however, bond funds carried an even
greater weight than in the retail investment sector. In the first few months of
1997 the percentage of equities in the German institutional funds industry rose
188
further. In May 1997 – due to share price increases and new funds being
invested – the share of equity funds was about one-third of total assets.
Table 3 provides an overview of the investor structure of German
institutional funds.
It shows that German insurance companies (incl.
Pensionskassen) are by far the most important investors in institutional funds.
Table 3. Investors in “Spezialfonds”
Investors
Assets
DM million
per cent
86 143
200 913
75 808
7 937
21.7
50.5
19.1
2.0
22 563
4 150
397 514
5.7
1.0
100
Residents
Banks
Insurance companies
Other companies
Social security institutions
Private non-commercial
organisations
Non-residents
Total
Source: Deutsche Bundesbank/Bundesverband deutscher Investment-Gesellschaften e;V.
2.
Institutional investors and the capital market in Germany
2.1
Investment regulations
2.1.1
Pensionskassen and insurance companies
Pensionskassen and insurance companies are subject to the same
investment regulations, laid down in the Insurance Supervision Act
(Versicherungsaufsichtsgesetz).
These are based on the principle of
diversification, i.e. the assets must be distributed over at least three different
kinds of investment, with no form of investment accounting for more than
50 per cent of total assets. Investments with one debtor must not exceed 5 per
cent of total assets.
189
A much-discussed issue is the investment regulations for shares and
similar risk capital such as corporate holdings and equity funds (including
mixed funds). In July 1994 an upper limit of 30 per cent was imposed for
investment in the countries belonging to the European Economic Area, which
may be raised to 35 per cent by means of an exceptional clause. A further
increase in the ratio of shares as a percentage of total investments is only
possible if a special individual permit is granted.
The average ratio of shares held by German Pensionskassen and life
assurance companies is 10 per cent at most. Therefore, for the average
Pensionskasse there are, on principle, no restrictions resulting from the
investment regulations (which have been liberalised over the past few years).
However, this may apply to large Pensionskassen. Thus, it would make sense
to further raise the ratio of shares permitted.
This also affects the rule that shares and participations held by an
insurance company or a Pensionskasse in any one company may not exceed
10 per cent of that company’s capital. Smaller companies could thus be put at a
disadvantage, as the cost of researching and managing small stakes often
exceeds expected returns. Thus, investments in small companies are often not
worthwhile.
Apart from particular regulations for foreign equities or bonds, the
proportion of foreign securities can be restricted by the principle that 80 per
cent of the assets must be invested in the currencies of the obligations they
cover, i.e. usually in DEM. Before the law was amended in 1994 this rule was
even stricter. Until then, 95 per cent of the assets had to be invested in the
currencies of the obligations they covered. However, even a percentage of
80 per cent is much too restrictive with regard to the spirit of the single
European market. Moreover, the insistence of Germany and some other EU
member states on an 80 per cent cover was a sizeable obstacle to passing a
common EU directive for pension funds. The scope for investment abroad will
be increased substantially by the creation of European Monetary Union.
2.1.2
Investment funds
Guidelines for capital investment are laid down in the law on capital
investment companies. These regulations have been amended several times
over the last few years, with the Second Financial Market Promotion Act
marking the last move in 1994. Money market funds were introduced in
190
Germany in August 1994. At the end of 1996 they amounted to approx.
DM 50 bn (of which DM 34 bn were invested in domestic funds).
Institutional and retail funds may invest in all listed securities and in
paper traded on a domestic or foreign organised market. Unlisted securities (or
paper that is not traded on an organised market) must not account for more than
10 per cent of a fund’s total assets. This limit also applies to note loans
("Schuldscheindarlehen") and investments in other funds. The latter must not
exceed 5 per cent of the fund’s assets.
In order to minimise the risk, securities and note loans by the same
issuer must not account for more than 5 per cent of the fund’s assets, or 10 per
cent if certain conditions are met. There are exceptions to this rule. For
instance, bonds issued by the federal government, a federal state or an OECD
member state may account for 100 per cent of the assets, if the funds are
invested in at least six different issues.
The Third Financial Market Promotion Act is to replace the current
regulations regarding investment in order to strengthen the competitive position
of German investment funds in an international environment. Apart from
Pensions-Sondervermögen, which have already been discussed, it is also
intended to introduce so-called pyramiding funds, which may also invest in
other funds ("Dachfonds"). The shares of one single fund may amount to at
most 20 per cent of the pyramiding fund's assets and no more than 10 per cent
of issued shares. This is to offer a standardised form of asset management for
private investors.
It is also planned to introduced mixed securities and real estate funds
(which may invest in both securities and real estate). Moreover, closed-end
funds are to be introduced in the form of listed joint-stock companies. The
shares in these funds will be traded on the stock exchange and must not be
repurchased by the investment company.
In addition, by loosening existing regulations for institutional
investors, the types of funds existing currently are to be enabled to track a
recognised share index. Equity index funds enjoy the advantage of not having
to engage in costly research so that their administrative costs are lower than for
actively managed portfolios. Finally, there will also be new regulations on the
use of derivative financial instruments. Interest and currency swaps, for
instance, will be permitted. Moreover, fund managers will in the future be able
to make OTC deals with derivatives.
191
2.2
Strong focus on fixed-income securities
A strong focus on fixed-income securities has been registered with all
institutional investors, and particularly with the traditional providers of old-age
provisioning (Pensionskassen and insurance companies). As mentioned above,
equities usually play only a minor role.
There are several reasons for this reluctant attitude towards equities.
It is a well-known fact that there is a general lack of an equity culture in
Germany. This is reflected by the small proportion of shares (around 5 per
cent) in the monetary assets of German households. In Germany, there is a sort
of hen-and-egg problem as, on the one hand, large institutional investors stay
away from the equity market because of low liquidity in most shares. On the
other hand, especially smaller companies are reluctant to use the equity market
as a source of financing as they fear a lack of capital on the part of investors.
There are, of course, other reasons for this behaviour of investors and
companies. One is the small size of the German equity market, an important
factor in the investment decisions of big institutional investors in Germany.
Between July 1996 and June 1997, the ten shares with the largest turnover
listed on the German stock exchange accounted for 51 per cent of total
turnover. The thirty shares making up the DAX accounted for 85 per cent of
turnover. Large investors tend to stay away from shares of smaller companies
for fear of a lack of liquidity. In this context, EMU should boost German
institutional investors’ commitments in the equity market, as the range of
equities listed will become broader with the single currency.
Pensionskassen and life insurance companies can apply a maximum
discount rate of 4 per cent in the calculation the necessary capital cover. This is
also the rate they have to guarantee. In addition, accounting rules for securities
follow the principle of prudence which means that share price losses must be
shown on the balance sheet at once while price gains must not be disclosed
prior to realisation, i.e. only when the shares are sold. Opposing movements in
individual share prices cannot balance each other out. As long as shares are not
sold, only price losses have an impact on performance. In addition, the
performance of Pensionskassen (or insurance companies) is measured at a fixed
date (usually at the end of December) every year. Thus, even very short-term
movements in the equity markets could have a substantial effect on the results
of these institutions. There is no roll-over valuation in the sense that the
average of several years is considered in assessing performance.
192
In addition there are tax obstacles for Pensionskassen, which as a rule
are tax-exempt as they are considered to be social institutions. This has the
effect that some taxes which are deducted at source can not be offset against
any tax due. This is true of the corporation tax credit which is received on
dividends against tax and investment income tax. However, as a consequence
of their tax-exempt status, Pensionskassen do not have to pay withholding tax
when they invest in fixed-income securities. Thus, investment in equities is
discriminated against.
Apart from that, the private investors’ reluctant attitude towards
equities naturally leads to a rather conservative investment policy also on the
part of Pensionskassen. They are expected to make regular payments of
previously known dimensions. What is more, Pensionskassen – as social
institutions - are not only exempt from tax but also subject to co-determination.
Therefore, employees are usually represented on the basis of full parity - either
at management board or supervisory board level.
There are obviously several obstacles to higher equity investment by
Pensionskassen in Germany. In contrast to German Pensionskassen, however,
pension funds in other countries have a considerably higher percentage of
shares in their portfolios and carry much greater weight in the capital markets in
general and the equity market in particular (see Table 4). A rising number of
institutional investors such as pension funds could therefore enable the German
capital market to gain in breadth and depth. As a general rule, market
capitalisation reflects the importance of pension funds or similar institutional
investors in a country (see Table 5).
Table 4. Pension fund ownership of listed shares in 1993
(in per cent)
United Kingdom
Ireland
United States
The Netherlands
Denmark
Germany
Belgium
Source: EFRP.
34.2
29.0
28.0
13.2
10.5
1.6
1.3
193
Stock exchange
London
Dublin
New York
Amsterdam
Copenhagen
Frankfurt
Brussels
Table 5: Market capitalisation in selected OECD countries
Shares in circulation
in DM billion
Country
United States
Japan
United Kingdom
Germany
France
Canada
Switzerland
Netherlands
Italy
Sweden
Spain
Belgium
Denmark
Finland
Norway
Austria
13 354
4 881
2 544
1 002
892
756
624
555
386
357
332
180
105
90
85
48
Market capitalisation
coefficient
122
63
152
27
38
88
135
93
23
103
39
44
40
47
38
14
Source: Deutsche Bundesbank.
3.
Future developments
EMU will likely have a significant effect on the asset allocation of
German institutional investors. After the introduction of the common currency
the matching regulations mentioned above for Pensionskassen and insurance
companies in Germany (80 per cent cover) will apply to a much larger currency
area than today. The same rules will hold for investment in euros and DEM.
This means greater possibilities for diversification for institutions acting
according to the principle of matching cover. At the moment only about 67 per cent of total assets of German Pensionskassen are invested abroad.
Diversifying a portfolio by investing in other countries can boost revenues and
thus increase pensions. However, higher capital gains and returns in the local
currency which can be achieved in foreign capital markets, may be wiped out
by a depreciation of the local currency against the DEM. A common European
currency will remove this risk at least for the countries taking part in EMU.
194
EMU should thus lead to higher investments in foreign securities by German
institutional investors.
The pan-European capital market will be considerably more liquid
than the national markets. This should benefit the equity market in particular.
Under certain circumstances, large investors in the German equity market
currently run the risk of causing an unfavourable impact on prices by shifting
larger amounts of money. This will be much less of a problem in a larger
European stock market.
Higher liquidity, better opportunities for diversification, the end of
exchange-rate risks for capital investments, direct investment and in the export
sector as well as lower trading costs are considered some of the reasons why
equity investments in Europe will receive a boost from EMU. There are other
factors, too, such as further privatisations in the countries of Europe and a shift
in old-age provision towards a system of funded pensions.
It is especially the latter that offers a long-term basis for a dynamic
development of institutional investors in Germany. However, in view of the
existing tax rates and the high ratio of levies it will be very difficult for many
private households and companies to close the growing gap in the state pension
system and finance private old-age provision. An important precondition for a
broad upswing of private, funded old age provision is therefore the creation of
an adequate framework by the state.
195
Chapter VIII
THE GROWING FINANCIAL MARKET IMPORTANCE OF
INSTITUTIONAL INVESTORS: THE CASE OF BELGIUM
by
Marc Bayot*
Introduction
In many respects, the Belgian savings and capital market differs
significantly from other countries. In particular, three points, which will be
addressed in greater depth are the following:
− Public (social security) pension schemes are more vulnerable than
in most European countries. The necessary corrective measures
imply a dramatic change of the Belgian capital market.
− Traditional institutional investors are relatively weak, particularly
pension funds.
− Investment funds, on the other hand, are very strong, reaching one
of the highest rates of penetration of the world. Guaranteed funds
are the fastest growing sector, in which Belgium assumes the
leadership in the world. There is also a rather unique legal
structure (“fonds d’épargne-pension”) for individual retirement
savings.
1.
Social security pension schemes
Total pension spending is high. It exceeds 10 per cent of GDP. If no
action is taken, annual spending will reach at least 15 per cent of GDP in 2040.
*
Strategic Advisor, Investment Management, Generale Bank. Professor, Free
University of Brussels.
197
Whereas the gross replacement ratio of legal retirement schemes in
Belgium is somewhat lower than the average in the European Union (at least
for the private sector), the present deficit of these schemes is one of the highest
in the European Union, with around 3.5 per cent of GDP. This deficit has been
adversely affected by demographic and economic-social trends: First, Belgium
has one of the oldest populations in the world, 21 per cent of total population is
aged 60+. Secondly, the actual age of retirement or pre-retirement is one of the
lowest in Europe. In 1995 only 53 per cent of the male population between 5559 years was still working, against an average of 67.5 per cent (Chart 1) in the
European Union. Thirdly, and as a result, the average ratio “workers per
retiree”, presently standing at 3.7 will deteriorate sharply to reach the level of 2
in the years 2030-2040 (Chart 2).
Chart 1. Activity ratio male population 55-59 years (1995)
average E.U.: 6.75
100
90
87
85
80
78
75
75
71
% of population
70
72
60
75
60
63
60
58
59
53
50
40
30
20
10
Finland
Austria
Sweden
U.K.
Portugal
Netherlands
Italy
Ireland
France
Spain
Greece
Germany
Denmark
Belgium
0
Source: The Active Population of the Union.
As a result of demographic developments, the public pension deficit is
expected to increase dramatically especially during the period 2010-2030, when
the baby-boom generation will reach retirement. Numerous projections have
been done by Belgian and international organisations. Under the assumption
that no corrective measures will be taken, these studies project a
198
Chart 2. Average ratio “workers per retiree” (2030-2040)
average E.U.: 47%
Number of workers per retiree
3.5
3
3
2.9
2.8
2.5
2.4
2
1.9
1.8
1.5
2.3
2.2
2.1
1.6
1.5
1
0.5
Netherlands
Ireland
Denmark
U.K.
Finland
Portugal
Belgium
Greece
Germany
France
Italy
0
Source : European Commission, 1996
deficit of around 10 per cent of GDP in the year 2040. An alternative
method to assess the evolution of the deficit is to calculate a net present value
of future pensions deficits. Again, different calculations have been made.
Using median assumptions concerning factors such as productivity growth and
interest rates trends, the result is a negative net present value of 153 per cent of
GDP, which ranks Belgium at the second worst position in the European Union
(Chart 3).
These trends clearly suggest that Belgium -- as it is the case for most
of continental European countries -- will not be able to absorb deficits of the
magnitude described. Two different types of measures will have to be
simultaneously introduced: the first will be the introduction (or strengthening)
of structural reforms aiming at slowing down the explosion of global
retirement legal schemes. The second is the introduction of systems or
instruments with the aim of offsetting the inevitable reduction in most
individual legal schemes. These new systems or instruments will all be based
on the funded (capitalisation) principle. This implies a dramatic change of the
Belgian capital market, where up to now institutional investors such as pension
funds were relatively under-developed. All institutional investors, namely
pension funds, insurance companies and investment funds will grow
substantially as a result of increased retirement savings. This trend is likely to
induce a more efficient allocation of savings.
199
2.
Supplementary funded schemes - pension funds
Present supplementary funded schemes remain of subordinate
importance in Belgium. The following stylised facts are worth mentioning:
− The second pillar, organised almost entirely under the defined
benefits pattern, is not particularly developed. All capitalised
reserves do not exceed 10 per cent of GDP. This places Belgium
in a median position on the continent: better than southern
countries, including France, weaker than most Scandinavian
countries, Germany and the Netherlands.
− Only one third of the working population in the private sector is
participating to the second pillar. This percentage is lower than in
most countries, with the exception of the Mediterranean markets.
− Since 1986 internal reserves have been forbidden in Belgium.
Assets are lodged mainly within (group) insurance companies
(70 per cent) and pension funds have therefore no more than a
30 per cent share of the market. Only in a few other European
countries do insurance companies play such a dominant role
(Norway and Sweden). The predominance of insurance schemes
in Belgium is mainly due to the fiscal disadvantage faced by
pension funds (taxation of investment income).
− Investments of Belgian pension funds are strongly oriented
towards equities (41 per cent). On the other hand, their exposure
to foreign investments, both equities and fixed income, reaches a
hefty 36 per cent while the equity exposure is among the highest
in the world (not including the United Kingdom, the USA, HongKong and South Africa), international diversification is probably
the highest in the world.
3.
Investment funds - Present driving force
Investment funds are highly developed in Belgium. Total assets of
funds increased by 132.7 per cent between 1991 and 1996. As of 30 June 1997,
total assets of funds sold on the Belgian market reached BF 2 863 billion
(Table 1).
200
Table 1. Evolution of the Belgian investment fund market
(BF billion)
1991
1992
1993
1994
1995
1996
1 080
1 481
2 095
2 051
2 206
2 513
1997 (30 June)
2 863
Source: Author.
Chart 3. Net present value of future pensions deficits
(per cent GDP 1994)
300
250
235
200
153
150
132
124
109
93
100
109
102
66
65
62
97
101
70
60
53
50
24
18
23
USA
Japan
Canada
Australia
Sweden
U.K.
Portugal
Netherlands
Norway
Italy
Island
Ireland
France
Finland
Spain
Denmark
Belgium
Austria
Germany
0
Hypothesis : - average annual increase of the rate of productivity : 1.5 %
- actuariel rate : 5 %
Source : Ageing populations, pension systems and government budgets : simulations for 18 OECD countries - OECD 1996
The rate of penetration of investment funds in Belgium is the second
largest in the E.U., after France. This is illustrated by Charts 4 and 5.
The official figures for each country have been adjusted to take into
account funds which are domiciled in Luxembourg and which have been
“reimported” by their sponsors to their home country.
201
Chart 4. Rate of penetration of investment funds
in the E.U., USA and Japan (per cent of GDP)
2
Finland
Denmark
5
Japan
9
10
Germany
Italy
13
Ireland
12
14
Greece
Portugal
15
Netherlands
17
Austria
17
U.K.
19
Sweden
21
Spain
24
Belgium
30
France
36
U.S.A.
50
0
5
10
15
20
25
30
35
40
45
50
%
55
60
Assets managed in percentage of GDP
Chart 5. Rate of penetration of investment funds
in the E.U., USA and Japan ($ per inhabitant)
494
Finland
1505
Greece
1587
Portugal
1799
Denmark
2185
Ireland
Italy
2418
Germany
2864
Japan
3360
Spain
3446
U.K.
3582
Netherlands
4337
Austria
4974
Sweden
5389
Belgium
7986
France
9569
202
15000
14500
14000
13500
13000
12500
12000
11500
11000
10500
9500
Assets managed per inhabitant
10000
9000
8500
8000
7500
7000
6500
6000
5500
5000
4500
4000
3500
3000
2500
2000
1500
1000
0
13700
500
U.S.A.
Investment funds sold in Belgium represent 30 per cent of GDP or, as
an average per inhabitant, $8 000. These figures are close to those recorded in
France and much larger than those prevailing for the countries ranked third in
these classifications (Spain and Sweden). As a matter of reference, the
corresponding numbers for the USA are : 50 per cent of GDP and $13 700 per
inhabitant and for Japan 9 per cent of GDP and $3 360 per inhabitant.
The high rate of penetration of investment funds in Belgium is the
result of the two following elements :
− investment funds have a very long tradition in Belgium. The first
unit trusts were launched in the late forties and the first legal
structure establishing the “fonds commun de placement” were
introduced as early as in 1957. Furthermore a rather unique legal
structure has been created in 1986 (“fonds d’épargne-pension”)
with the aim of encouraging individual retirement savings in a tax
efficient way.
− investment companies of the roll-over type (capitalisation) offer
an interesting fiscal advantage for individuals as well as for
pension funds. Investment income earned by these roll-over
SICAVs is not taxed at all, avoiding thus the standard 15 per cent
withholding tax on investment income paid out by individual
securities. This advantage has been partially compensated by the
introduction in 1995 of a special stamp duty (taxe sur opérations
de bourse) of 1 per cent and 0.5 per cent on the subscription and
redemption of roll-over SICAVs.
4.
Guaranteed investment products: Developments and prospects
Guaranteed funds have experienced a dramatic growth on the Belgian
market in the last six years. Guaranteed fixed income products were the first
driving force from 1991 to 1995. These funds reached a peak in early 1996.
However, a change in taxation which occurred in March 1996 put an end to this
growth so that guaranteed fixed income funds have stabilised since then at
around 10 per cent of total assets or 30 per cent of all traditional bond funds.
Guaranteed equity products began to be promoted in 1993. They have
experienced a dramatic and uninterrupted growth, particularly in the last
eighteen months. As of 30 June 1997 their assets amounted to BF 286 billion,
or 10.0 per cent of all investment funds assets in Belgium. It is interesting to
note that guaranteed equity funds represent already 75 per cent of the assets of
all traditional equity funds in Belgium.
203
Table 2. Assets of guaranteed bond funds
(1)
Year
BF billion
1993
1994
1995
1996
1997 (2)
% of total assets
74
104
214
249
281
3.5
5.1
9.7
9.9
9.8
% of traditional
bond funds
29
14
29
28
31
Notes:
(1) End of year; (2) 30 June 1997.
Source: Author.
Table 3. Assets of guaranteed equity funds
Year
(1)
1994
1995
(2)
1996
1996
(2)
1997
BF billion
% of total assets
29
42
111
162
286
1.6
2.2
5.3
6.4
10.0
% of traditional
equity funds
14
20
46
61
75
(1) End of year.
(2) End of June.
Source: Author.
The spectacular growth of guaranteed equity funds in Belgium is, in
our opinion, not a temporary phenomenon. In Belgium, and broadly speaking
in Continental Europe, four categories of individuals are potential customers for
these products: newcomers, long-term investors near retirement, investors in
highly volatile markets or in markets which could become vulnerable.
Today, there are still many individuals in continental Europe who
have never invested in equities. This is, of course, completely different from
the situation in the US, where close to 50 per cent of households own shares or
mutual funds and invest in shares. Guaranteed equity funds could give these
European savers the opportunity to "try" the equity market, without putting
their capital at risk, which has obviously been the main reason for their
reluctance up to now.
204
Long-term investors near retirement are probably one of the key
growth areas for guaranteed equity products. After many years of saving in
equities during most of their active life in order to supplement ailing state
pension schemes, workers in their mid-fifties will have a natural wish to
consolidate the returns achieved in equities in order to protect them from a
significant market correction.
During most of any working life, the time horizon of retirement
savings is very long and justifies a large percentage of investments in
internationally diversified equities. But obviously, during the last years of
active life, this time horizon shortens substantially.
At this time, a
repositioning of the whole portfolio is necessary. In shorter periods of time,
e.g. five years, financial history shows that returns on equities may be
disadvantageous compared with investment strategies.
Therefore, the risk of direct investments in equities becomes too high
for this last period which could be defined as the pre-retirement period. So,
when individuals reach their mid to late fifties, they should completely
reshuffle their portfolios and significantly reduce or even eliminate their equity
exposure. With the aim of protecting the attractive returns generated by equity
investments during much of their working lives, they should switch from
equities to less volatile investments. Traditionally, these were relatively shortterm fixed income investments. Until recently this was the only sensible
solution.
Now, guaranteed equity funds offer a very attractive alternative,
perfectly tailored to the needs of the "pre-retirement era". While protecting the
initial capital at maturity date, they still offer the upside potential of stock
markets.
The recent past brilliantly illustrates the merits of guaranteed
products. Let us assume that in 1993, a worker in his mid-fifties has decided
-- quite rightly -- to protect his accumulated capital by eliminating the equity
exposure and going short-term (he envisages retiring at the age of 60). The
annual return on these investments would probably be in the vicinity of 5 per
cent, at best. But he would have completely lost the robust bull markets which
continued in 1995 and are still underway in most countries. Guaranteed equity
funds would have been the ideal solution. Investors in highly volatile markets,
such as emerging markets (South-East Asia, Latin America, Eastern Europe)
will also find guaranteed equity products particularly attractive. Finally,
guaranteed products after a prolonged and important bull market are very
appealing. Again, the example of most markets since 1995 is very illustrative.
205
On the other hand, guaranteed equity products are not very cyclical
(although when interest rates are low, the upside potential offered to investors
will be somewhat reduced). It may be argued that in the long run, newcomers
to equities in continental Europe will progressively disappear. This may be
true, but it must not be forgotten that the guarantee to recover the invested
capital will always remain a major preoccupation in the pre-retirement era, as
well as for highly volatile markets and for markets considered to be very risky
after a prolonged rise.
These guaranteed equity products therefore constitute, in my
judgement, a major driving force in the mutual fund industry, not only in
Europe but world-wide.
206
Chapter IX
THE EUROPEAN INVESTMENT FUNDS INDUSTRY IN 1997
by
Patrick Zurstrassen*
1.
The world investment funds market
At the end of 1996, total world assets have reached US$6 193 billion.1
The United States has strengthened its lead and reached a 57 per cent world
2
market share. Europe’s market share has declined to 28 per cent and the Rest
of the World (mainly Japan and Canada) has kept its 15 per cent market share.
Chart 1. World investment funds
funds assets
4 000 000
FUNDS ASSETS
3 539 billion
(US$ million)
3 500 000
3 000 000
2 500 000
2 000 000
USA
1 732 billion
1 500 000
EUROPE
908 billion
1 000 000
500 000
Rest of the World
0
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Source: FEFSI & ICI
*
Professor at the Université Catholique de Louvain. Managing Director of
Crédit Agricole Indosuez, Luxembourg.
207
In sharp contrast to the size of assets, Europe takes a strong lead in
terms of numbers of investment funds totalling 14 907 different units of funds
or of compartments3 while there were 6 293 mutual funds in the United States
at the end of 1996. This difference may be explained by the multiplicity of
national markets of investment as well as by the large number of distribution
channels among the 17 European countries.
As illustrated in Chart 2, the average size of investment funds in
Europe has not grown significantly during the last ten years, except during the
short period of 1990-1993. Over the last ten years the average size was in the
order of $100 million. This contrasts with the situation in the Unites States,
where product and company concentration as well as market evolution have
allowed the average size of the United States mutual funds to almost double in
8 years, rising from US$300 million to US$562 million at present.
Chart 2. World investment funds
The average funds size
600
AVERAGE FUNDS SIZE
(USD Mio)
USA
500
400
USA Average 1987-96: USD 401 mio
300
200
EUROPE
100
EUROPE Average 1987-96: USD 90 mio
0
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Source: FEFSI & ICI.
The average size of investment funds differs considerably from one
country to the next as shown in Chart 3. In Europe, only countries such as the
208
Netherlands, Italy, Germany and Switzerland seem to have reached higher
levels of average funds size, while the average funds size still remained smaller
in France, Luxembourg, the United Kingdom and Spain.
Chart 3. World investment funds
Comparison between selected countries
USD Mio
600
1996 AVERAGE FUNDS SIZE
500
(USD Mio)
400
300
200
100
0
Source: FEFSI & ICI.
Looking at individual countries, Table 1 confirms the dominant
position of the United States as world leader in investment funds assets,
followed by France, Japan, Luxembourg and the United Kingdom.
th
The 4 rank awarded to Luxembourg reflects the dynamic role played
by this country that has become the incontestable European centre for
international distribution and management. But this hides the effective position
of other countries such as Germany, Switzerland and Belgium which often
domicile funds in Luxembourg and re-export them mainly or partly to their
4
home market. Table 2 is based on the crude assumption that all Luxembourg
funds promoted by a home country are entirely sold back to such home
markets. Germany becomes the second most important country (Table 2).
209
Table 1. World investment funds
The assets league country table
THE LARGEST
96
1
2
3
4
5
6
7
8
9
10
11
12
13
14
95
1
2
3
4
5
8
7
6
10
na
9
11
12
13
1996 ASSETS
(USD mio)
USD
UNITED STATES
3,539,204
FRANCE
529,289
JAPAN
420,103
LUXEMBURG
351,643
UNITED KINGDOM
188,374
CANADA
154,529
SPAIN
136,287
GERMANY
133,894
ITALY
128,683
BRAZIL
103,787
KOREA
92,406
NETHERLANDS
66,748
SWITZERLAND
48,050
HONG KONG
41,018
96
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
THE OTHERS
95
17
14
15
16
19
20
18
21
25
22
26
24
23
27
28
AUSTRALIA
AUSTRIA
SWEDEN
BELGIUM
TAIWAN
GREECE
PORTUGAL
INDIA
NORWAY
SOUTH AFRICA
DENMARK
MEXICO
IRELAND
NEW ZEALAND
FINLAND
Source: FEFSI & ICI.
Table 2. European investment funds
The Luxembourg effect
1996 E.U. TOP TEN
(US$ billion)
1 FRANCE
2 LUXEMBOURG
3 U.KINGDOM
4 SPAIN
5 GERMANY
6 ITALY
7 NETHERLANDS
8 SWITZERLAND
9 AUSTRIA
10 SWEDEN
1996 E.U. TOP TEN
(US$ billion)
* After adjustement for
Luxembourg domicile
530,516
352,379
198,641
142,335
137,071
129,304
67,179
47,813
39,565
35,187
11
Source: FEFSI & ALFI.
210
1 FRANCE
2 GERMANY
3 U.KINGDOM
4 SWITZERLAND
5 SPAIN
6 ITALY
7 BELGIUM
8 NETHERLANDS
9 SWEDEN
10 AUSTRIA
553,083
233,295
217,917
170,450
142,335
138,598
78,081
67,179
46,867
39,565
USD
40,745
39,397
35,093
27,356
19,945
15,666
15,605
10,107
9,549
9,352
9,300
8,815
7,735
7,685
2,510
The relative importance of investment funds can be assessed by
different ratios, such as the investment funds asset per capita and funds asset as
a per cent of GDP (Charts 4 and 5). These graphs illustrate the economic
importance of investment funds in France and, chiefly, in the United States.
Chart 4. World investment funds. Funds asset per capita
ITALY
2,426
GERMANY
2,868
JAPAN
3,362
SPAIN
3,639
U.KINGDOM
3,739
AVER. EUROPE
4,633
CANADA
5,283
SWEDEN
5,359
FRANCE
9,572
U.S.A.
13,578
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
USD per capita
Source: FEFSI-1996 assets amounts adjusted for Luxembourg domiciled funds.
Chart 5. World investment funds. Funds asset as per cent of GDP
JAPAN
9.6%
GERMANY
10.1%
ITALY
11.7%
SWEDEN
19.1%
UNITED KINGDOM
19.8%
AVER. EUROPE
20.0%
SPAIN
24.7%
CANADA
26.4%
FRANCE
36.5%
USA
0.0%
46.3%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
Funds assets as % of GDP
Source: FEFSI - 1996 assets amounts adjusted for Luxembourg domiciled funds.
211
2.
Analysing the asset growth of funds
Investment funds belong to one of the fastest, strongest and most
reliable elements of the world financial industry. Between 19875 and 1996, the
average annual compounded growth rate of assets (AAGR; expressed in United
States dollars) amounted to 18.5 per cent for Europe and to 18.9 per cent for the
United States.
As illustrated in Table 3, the fastest growing region in Europe has
been Mediterranean Europe, with countries such as Greece, Spain, Italy and
Portugal. Some Nordic countries have also experienced high rates of growth
(Finland and Norway) but started developing from a lower asset basis than
Spain or Italy.
Table 3. European investment funds: Assets,
number & growth
GREECE
SPAIN
ITALY
FINLAND
PORTUGAL
NORWAY
LUXEMBOURG
BELGIUM
AUSTRIA
NETHERLANDS
GERMANY
UNITED KINGDOM
SWITZERLAND
SWEDEN
FRANCE
DENMARK
IRELAND
TOTAL
ASSETS
XEU Mio
12,612
114,325
103,859
2,020
12,562
8,309
283,035
22,042
31,779
53,959
110,097
159,551
38,404
28,263
426,117
7,500
5,967
1,420,401
Source: Source: FEFSI.
212
NUMBER
148
958
531
62
182
188
3,380
340
517
179
641
1,532
251
316
5,379
189
260
15,053
AAGR
96/87
86.59%
47.85%
43.97%
41.47%
40.52%
39.25%
30.49%
25.34%
23.54%
18.55%
14.55%
13.21%
12.88%
12.69%
11.77%
11.41%
4.34%
18.54%
The average asset growth rate in the major mature markets - Germany,
United Kingdom and France - was in the order of 12 to 15 per cent.
Between 1995 and 1996, the fastest growing countries in Europe have
been Finland (130 per cent), Italy (66 per cent), Norway (57 per cent), Greece
(56 per cent) and Denmark (49 per cent).
In order to better understand growth, the industry associations and
some consultants have tried to gather reliable world statistics on
subscription/redemption investment funds flows. So far, these efforts have not
yet been fully successful.
Here, a simulation method has been used to start to distinguish
between the relative contribution of net subscription flows on the one hand and
the effect of the market on the other. To do so we have assumed that all the
asset classes that existed in 1991 have been invested in the respective index of
their classes until 1996. We have used the MSCI indexes for equity asset
classes, the J.P. Morgan indexes for bonds asset classes and the 3 month money
market indexes for monetary classes. We also assumed that United States funds
were only invested in United States dollars, and that all European funds were
invested in ECU.
As can be seen from Table 4, this method leads to a clear
confirmation of many observations from practitioners. The market performance
only accounts for 20 to 30 per cent of funds assets growth, while the rest is
caused by net subscription. This is a refreshing fact to marketing and sales
people.
Other findings of this simulation are :
− In the United States, close to 70 per cent of net subscriptions have
been flowing into equity funds, thus raising year after year the
6
percentage of equity funds assets .
− In Europe, the percentage of net subscription in equity funds has
only been 21 per cent, thus explaining why the current average
levels are not bound to grow significantly.
− In Europe, bond funds have attracted close to half of net new
subscription.
213
Table 4. World investment funds. Index portfolio model
USA
In USD
EUROPE
In ECU
91-96 ASSET EVOLUTION
Increase from performance
Increase from net subscriptions
TOTAL
30%
70%
100.00%
22%
78%
100.00%
INVESTMENT OF NET SUBSCRIPTIONS
Equity funds
Balanced funds
Bonds funds
Money Market funds
TOTAL
68%
7%
12%
14%
100.00%
21%
9%
50%
19%
100.00%
3.
Funds investment patterns
In previous years, the pattern of investment of “Europe Consolidated”
was not too surprising: the rule of the three third was applicable, i.e. equity and
balanced, bonds and money market funds had an equal share of the assets
(Chart 6).
Chart 6. European investment funds - Investment patterns
1 800 000
US$ mln
1 600 000
29 %
1 400 000
1 200 000
MONEY MARKET
1 000 000
36 %
800 000
BONDS
600 000
9%
400 000
BALANCED
200 000
27 %
EQUITY
0
1991
1992
1993
1994
214
1995
1996
Until 1994, these proportions were not too dissimilar from investment
patterns prevailing in the United States. However, starting in 1995 and
particularly since 1996, the proportion of equity funds has grown very
significantly in the United States, now reaching 50 per cent (see Chart 7) while
money market and bond funds were about equally sharing the balance.
Chart 7. American investment funds
Investment patterns
USD mio
4,000,000
3,500,000
25 %
3,000,000
2,500,000
22 %
2,000,000
MONEY MARKET
3%
1,500,000
BONDS
1,000,000
49 %
BALANCED
500,000
EQUITY
0
1991
1992
1993
1994
1995
1996
The understanding of the market changes enormously when individual
countries rather than regions are examined. For example, the share of equity
funds is illustrated for 13 selected countries in Chart 8. There are considerable
differences within Europe. In the United Kingdom the share of equity funds
amounts to almost 90 per cent, while the share in Spain is below 5 per cent.
215
Chart 8. World investment funds
Proportion of equity funds in selected countries
90.0%
PROPORTION OF EQUITY FUNDS
80.0%
(AS % OF TOTAL ASSETS)
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Source: Author.
Chart 9. World investment funds. 1993-96: change in the
proportion of equity funds in selected countries
20.0%
15.0%
INCREASE FROM 1993 TO 1996
OF THE PROPORTION
OF EQUITY FUNDS ASSETS
(AS % OF TOTAL ASSETS)
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
Source: Author.
216
On a global basis the share of equity funds as a percentage of total
investment assets has increased from 32 per cent in 1993 to 40 per cent in 1996.
However the bulk of this growth came from North America with significant
increases coming from both the United States and Canada (see Chart 9). On the
other hand, the proportion of equity funds has remained stable in France and
Germany and declined by an important percentage in Japan.
It may be somewhat disappointing that the contribution of investment
funds to the European market capitalisation has neither increased nor decreased
over the last three years of research. In fact, the percentage of European
domestic equity funds as a proportion of domestic equity market capitalisation
remains at 4.5 to 4.8 per cent. As shown on Table 5, the highest percentages
are to be found in Sweden and Norway and the lowest in Denmark, Finland and
Austria.
Table 5. European investment funds
Domestic equity funds as a proportion of domestic
equity market capitalisation (in per cent)
1
2
3
4
5
Sweden
Norway
France
United Kingdom
Italy
Average Europe
6
Belgium
7
Germany
8
Portugal
9
Ireland
10
Spain
11
Netherlands
12
Greece
13
Denmark
14
Finland
15
Austria
Source: FEFSI, FESE
9.9
5.2
7.0
5.8
6.5
4.8
2.6
3.8
2.0
3.1
na
0.6
3.3
1.3
1.5
0.9
217
9.1
5.2
6.5
6.0
4.6
4.6
3.3
3.7
1.6
3.0
na
0.6
2.7
1.3
1.2
0.5
8.3
7.5
6.3
6.0
4.8
4.5
3.9
3.4
2.7
2.0
1.6
1.6
1.3
1.2
1.0
0.5
A comparison with the American situation shows that the gap
between the two regions is widening year after year. In the United States the
share of domestic equity funds in the domestic equity market capitalisation had
increased significantly during the 1990s, reaching 14.5 per cent in 1996. It kept
growing strongly in 1997. The topic definitely deserves some further research.
Chart 10. Domestic equity funds as a proportion
of domestic equity market capitalisation
16.0%
14.50%
DOMESTIC EQUITY INVESTMENT FUNDS
AS PERCENTAGE OF
DOMESTIC EQUITY CAPITALIZATION
14.0%
12.0%
10.0%
8.0%
USA
6.0%
4.50%
EUROPE
4.0%
2.0%
0.0%
85
86
87
88
89
90
91
92
93
94
95
96
Source: FEFSI, FESE, ICI, Federal Reserve Board of the United States
European investment funds also contribute around 5 per cent to the
European bond market capitalisation (see Table 6). France has a clear lead with
12.67 per cent of bond market capitalisation. In bond markets the difference
between Europe and America is much less pronounced than in equity markets.
218
Table 6. European investment funds
Domestic bonds funds as a proportion of domestic
bonds market capitalisation (in per cent)
France
12.7
United States
7.74
European Union
5.14
Italy
2.41
Canada
2.33
Germany
1.57
United Kingdom
0.71
Source: FEFSI, Salomon Brothers 96, OECD 97.
Chart 11 addresses the issue of investment globalisation i.e. the
proportion of international assets funds as a percentage of all funds. Hong
Kong and Switzerland still have a clear lead, being the most internationally
invested countries, while Spain and, to a lesser extent, the United States and
France are well below others.
Chart 11. World investment funds
Proportion of international assets of selected countries
100.0%
90.0%
PROPORTION OF INTERNATIONAL ASSETS
(AS % OF TOTAL FUNDS ASSETS)
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Source: Author.
219
Combining these elements, for the third year in a row one can derive
the Investment Pattern Matrix illustrated in Chart 12 showing horizontally the
domestic to international dimension and showing vertically the fixed income to
equity dimension.
Chart 12. World investment funds. The investment pattern matrix
DOMESTIC
INTERNATIONAL
SPAIN XX GREECE
X AUSTRIA
X PORTUGALX INDIA
X FRANCE
BONDS
X ITALY
X AUSTRALIA
X EUROPEX GERMANY
X FINLAND
USA X X NORWAY
X BELGIUM
X DENMARK
X CANADA
X NETHERLANDS
SWITZERLAND X
HONG-KONG X
EQUITY
X SWEDEN
X UNITED KINGDOM
Source: Author.
Regions of investment patterns definitely emerge. In the Union
Latine with countries such as Spain, Greece, Portugal, France and Italy
investment funds belong mostly to the category “fixed income and domestic”.
Another region surrounds Germany with countries like Austria, Belgium,
Denmark and the Netherlands. There, the proportion of international assets is
increasing significantly but less than the proportion of equity funds.
The reverse is true for a group of three Nordic countries: In Finland,
Norway and Sweden the share of equity is getting stronger but the international
exposure is still below standard. Switzerland and Hong Kong have a high
proportion of international and equity assets. This is likely to stem from the
maturity of those two markets and the international nature of their investing
clientele.
The United States position is, as expected, strong on equity and weak
on international investments. The classification of Norway is similar. Finally,
220
the United Kingdom is certainly the most equity oriented market with still
below average international exposure.
4.
Comparing investment funds with other savings and investments
In this section, we compare investment funds with other forms of
savings and investments. In the absence of a cohesive body of statistics at the
European Union level, we have had to compile individual statistics coming
from the European associative bodies such as the European Banking
Federation, the Co-operative Bank European Group, the Savings Bank
European Federation, the European Federation of Stock Exchange, the
European Confederation of Insurance, the European Federation of Retirement
of Pension Funds. Some inaccuracies are inherent to such research; indeed,
double counting seems inevitable, for instance, between the “bank deposits” of
investment funds and the “customer deposits” of banks. One could hope that
with the efforts of the European Monetary Institute efforts, finer and fresher
statistics could soon be available.
As can be seen from Chart 13, the proportion of mutual funds among
selected financial assets amounts to 15 per cent in Europe versus 37 per cent in
the United States. The reciprocal difference between Europe and America is to
be found in the much higher proportion of deposits with savings and cooperative banks in Europe.
If private pension funds are added to those selected financial assets,
one would find that the total assets of those two forms are almost equal. Total
European assets of private pension funds amount to about the same as the total
assets of European investment funds.
But looking at the way pension and investment funds are being
invested, one observes a much larger proportion of equity in pension funds and
the appearance of real estate assets (See Chart 14). This observation can be
partly explained by the fact that the United Kingdom itself represented 54 per
cent of the European Union private pension market and that the United
Kingdom pension funds invest around 77 per cent in equity.
221
Chart 13. World investment trends. Proportion of selected assets
60%
54%
50%
49%
EEC USA
40%
37%
31%
30%
20%
15%
14%
10%
0%
Commercial
Banks Deposits
Savings &
Cooperative
Mutual Funds
Source: FEFSI, FBE, GEBC & ERP.
Chart 14. European investment trends
Comparing investment with pension investments
Pension funds
Other & real estate
Money Market
10 %
5 %
Bonds
32 %
Equity
Investment funds
31 %
Money Market
53 %
36 %
Bonds
8%
Balanced
24 %
Equity
Source: FEFSI & Pension funds rapport IIF, M. Bayot, 11/96
222
Between 1991 and 1996, investment funds have definitely been the
fastest growing category of selected European financial assets. Chart 15
illustrates that the average annual growth rate of investment funds was close to
15 per cent i.e. almost twice the rate of growth of commercial, savings and co–
operative bank deposits.
Chart 15. European investment trends
COMPARING GROWTH
16.0%
14.5%
EUROPEAN UNION
SELECTED FINANCIAL ASSETS GROWTH RATE
(AVERAGE ANNUAL GROWTH RATE FROM 91 TO 96)
14.0%
11.9%
12.0%
10.0%
8.7%
7.8%
8.0%
7.1%
5.4%
6.0%
4.0%
2.0%
0.0%
Investment
Funds
Private
pension
funds
Average
Commercial
Banks
deposits
Savings
banks
deposits
Cooperative
banks
deposits
Source: FEFSI, FBE, GEBC & GECE.
Again, there are major differences between European member states.
As illustrated in Table 7, the average share of investment funds as a percentage
of selected financial assets is about the same as the share of pension funds.
However, leading countries in investment funds are seldom leading countries in
pension funds and vice versa. The universe of pension funds countries is well
known around the Netherlands, Ireland, Sweden and the United Kingdom.
223
Table 7. European investment trends:
differences between countries (in per cent)
Investment funds
1
2
3
4
5
6
7
8
9
10
11
12
13
France
Sweden
Spain
Greece
Average Europe
Belgium
Austria
Germany
Italy
Portugal
Netherlands
United Kingdom
Denmark
Finland
Pension funds
34.7
15.0
14.0
13.5
13.2
13.1
12.9
10.8
9.1
8.2
6.2
5.8
4.0
1.4
1
2
3
4
5
6
7
8
9
10
11
12
13
Netherlands
Ireland
Sweden
United Kingdom
Denmark
Finland
Average Europe
Germany
Portugal
Greece
France
Italy
Spain
Belgium
34.0
31.2
29.2
28.0
19.0
18.7
13.8
5.8
4.9
4.3
4.2
3.1
2.5
1.8
Source: FEFSI, FBE, GEBC & GECE.
One could be misled by the percentage of investment funds in France
that is standing at 35 per cent. This represents the sum of private, corporate and
institutional assets invested in investment funds. In order to isolate the private
wealth, we have had to invite all central banks of Europe to provide us with
economical statistics relating to households’ national savings. We derived from
it the interesting Table 8 which is clearly confirming previous measures. In the
7
portfolio of the average European household, investment funds represent about
12 per cent of financial assets. Quite a few countries have not yet reached that
norm. Not surprisingly, Italy and Germany, but more surprisingly the United
Kingdom, have still a long way to go to reach 12 per cent. This is without
speaking about reaching the United States norm which, at 36 per cent, is three
times larger than the European one.
224
Table 8. European investment funds
as per cent of financial assets of households
Portugal
Netherlands
Spain
France
Denmark
Austria
Sweden
Germany
Belgium
Italy
Norway
United Kingdom
Finland
12.7
12.6
12.1
11.5
10.8
9.0
7.6
7.5
5.6
4.4
2.8
2.5
1.3
Source: Central banks of all countries.
5.
Cross border distribution of investment funds
The field of cross border flows of investment funds in Europe is one
of the hardest to research since many distributors are logically secretive on their
international sales. In addition this is not part of regulatory statistical reports.
Yet we have used a few methods that are reliable and able to project some
interesting trends.
Chart 16 shows the percentage of the number of investment funds that
are registered for sales in more than 2 countries. The analysis of the author is
based for the 1990 to 1993 period on research carried out by the French
Investment Funds Association (ASSFI) and from 1994 on, by the works done
by Lipper Analytical.
As expected, Luxembourg has the lion’s share of the true cross border
investment funds in Europe. It stands at about 10 times the UCITS level
communicated by Ireland that seems to have specialised in non-UCITS and
offshore funds.
225
Chart 16. European investment funds distribution
Percentage of number of UCITS registred for sales in more than 2 countries
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
1990
1991
1992
1993
1994
1995
1996
Source: P. Zurstrassen research from SFFI (90-93) and Lipper Analytical (94-96).
The 1985 UCITS Directive certainly has been successful since the
number of true cross border distributed funds has gone from almost nothing
before 1990 to a current level of 20 per cent. The detailed method of
calculation is illustrated in the following Table 9 for the year 1996.
Table 9. European investment funds distribution.
Countries of sales registration
Country
of domicile
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
UK
TOTAL EU
%
1994
15.5%
TOTAL
UCITS
DOMESTIC
UCITS
225
248
121
52
1,173
483
126
309
505
2,513
12
88
680
234
1,315
8,084
100.0%
FOREIGN UCITS
2 countries 3 countries
only
only
1
22
14
2
8
199
192
89
52
1,124
273
124
60
505
302
1
87
679
225
1,233
Total
Foreign
26
56
32
0
49
210
2
249
0
2,211
11
1
1
9
82
1 country
only
25
9
22
66
74
872
3
1
1
9
69
349
5
377
2
3
5,145
63.6%
2,939
36.4%
1,297
16.0%
483
6.0%
495
6.1%
1995
20.7%
40
155
2
89
1996
20.4%
Source: Lipper European Fund Directory 1995.
226
8
28
1
18
4 country
only
5 countries
or more
8
3
3
6
290
3
323
7
311
3.8%
1
333
4.1%
Chart 17 European investment funds distribution
90.0%
80.0%
83.7%
82.6%
77.9%
FUNDS REGISTERED
IN TWO OR MORE FOREIGN COUNTRIES
1994
70.0%
1995
60.0%
1996
50.0%
40.0%
30.0%
20.0%
14.7%
8.3% 7.4% 8.6%
10.0%
8.0%
8.8%
0.0%
Luxembourg
Ireland
Miscelleanous
Source: LIPPER : EFID 96.
Chart 18 may demonstrate that the European market has reached an
equilibrium between purely domestic investment funds and international
products domiciled in Luxembourg or in Ireland. Indeed, their combined
market share now appears to stabilise between 20 and 25 per cent.
Another distinctive difference between countries in Europe is to be
found in market concentration. As can be seen from Chart 19, the five largest
promoters of countries like Germany, Switzerland and Belgium represent about
75 per cent of their national market while this proportion is much lower in
France, Italy and, as expected, in the United Kingdom. The current
concentration in the banking sector is certainly bound to reinforce this situation.
Table 10 lists the 10 largest funds promoters, highlighting their
German, French and Swiss origin.
Finally, one should not close this statistical report without praising the
most active European distributors, namely: Flemings Flagship with 15
countries, Fidelity Funds with 13 countries and Templeton Funds and Groupe
Indosuez Funds with 12 countries of registration for distribution.
227
Chart 18. European investment funds distribution
MARKET SHARE OF
LUXEMBOURG AND IRISH UCITS
25.0%
(as percent of EU UCITS)
20.0%
15.0%
IRELAND
10.0%
LUXEMBOURG
5.0%
0.0%
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
Source: Author.
Chart 19. European investment funds distribution
Market concentration
United Kingdom
25%
1995 MARKET SHARE OF
THE FIVE LARGEST PROMOTERS
Italy
45%
France
56%
Germany
76%
Switzerland
77%
Belgium
77%
0%
10%
20%
30%
40%
Source: Lipper : EFID 96.
228
50%
60%
70%
80%
90%
100%
Table 10. European investment funds distribution
The 10 largest funds promoters
1
2
3
4
5
6
7
8
9
10
Promoters
Number US$ Mil
Deutsche Bank
245 85 094
Caisse des Dépôts et Consignations
173 58 053
Swiss Bank Corporation
117 52 979
Société Générale
294 47 703
Dresdner Bank
176 46 475
Crédit Agricole - France
302 46 150
Die Sparkassen Finanzgruppe DEKA
131 44 991
Union Bank of Switzerland
95 44 952
Crédit Suisse
162 43 501
Genossenschaftlicher V.- Union Invest
91 37 999
The Ten Largest Funds Promoters
1 786 507 897
Market share
12.1%
28.5%
Source: Author.
Table 11. European investment funds distribution
The most internationally distributed funds
Fidelity
Funds (13)
Austria
France
Germany
Ireland
Luxembourg
Netherlands
Sweden
United Kingdom
Iceland
Norway
Switzerland
Hong Kong
Japan
Fleming
Flagship Funds (15)
Austria
Belgium
Finland
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Spain
Sweden
Switzerland
United Kingdom
Hong Kong
Japan
Source: Author.
229
Groupe Indosuez
Funds (12)
Austria
Belgium
Finland
France
Germany
Italy
Luxembourg
Spain
United Kingdom
Iceland
Switzerland
Hong Kong
Templeton
Funds (12)
Austria
Belgium
France
Germany
Ireland
Italy
Luxembourg
Netherlands
Sweden
United Kingdom
Hong Kong
Japan
6.
Conclusion
Despite the many colourful charts illustrating this paper, one needs to
identify a few reasons for disappointment. Among them:
− The average size of European investment funds still stands at a
smallish US$100 million per fund, versus more than
US$500 million in the United States.
− There are very large differences in investment patterns among
European countries.
− The proportion of equity funds has not increased significantly in
any major European country. At 4.5 to 4.8 per cent, the share of
equity market capitalisation held by investment funds has not
increased in Europe while it keeps growing above 15 per cent in
the United States. The bond market capitalisation share also
stands at around 5.0 per cent.
− The proportion of international assets funds is not growing, either
in Europe, or in the United States.
− At 20 per cent, the proportion of true European cross border funds
has stopped growing. The European market share of Luxembourg
and Ireland seems to have reached an equilibrium with the
domestic market.
Yet the several years of research demonstrate that the European
investment funds industry is now much more mature than it was with a set of
norms emerging such as:
− Despite critics, cross-border funds do represent 20 per cent of both
number and assets of European funds evidencing the success of
the 1985 UCITS Directive.
− Funds start to represent a significant proportion of household
financial assets with an European norm of between 10 and 15 per
cent.
− Asset growth rates of 15 to 20 per cent or above have been
sustained for many years.
230
Notes
1.
The following figures have been gathered thanks to the contribution of the
29 countries that are participating in the International Funds Conference
statistical programme managed by ICI and FEFSI. These countries are:
USA, Canada, Brazil and Mexico in the Americas, all European Union
member states as well as Norway and Switzerland in Europe, Australia,
Hong Kong, India, Japan, Korea and Taiwan in the Asia-Pacific area and
finally South Africa.
2.
Except otherwise mentioned, Europe is meant to include all European
Union member states as well as Norway and Switzerland.
3.
In the case of umbrella funds in countries such as Luxembourg, Belgium or
Ireland.
4.
In the absence of detailed statistics on true cross-border funds flows, we
were forced to neglect the growing importance of European distributors,
many of them are of Anglo-Saxon origin.
5.
The first comparable statistics from both USA and Europe were produced
by ICI and FEFSI in 1987.
6.
See next section: Investment patterns
7.
Excluding real estate investment and the present value of life insurance.
231
Part II (continued)
GROWING IMPORTANCE OF INSTITUTIONAL INVESTORS
ACROSS OECD REGIONS AND IN EMERGING MARKETS
D. EMERGING MARKETS
233
Chapter X
THE ROLE OF CONTRACTUAL SAVINGS INSTITUTIONS
IN EMERGING MARKETS
by
Bernhard Fischer*
Introduction
The relatively low domestic saving ratios in many emerging
economies, in particular in Latin American countries,1 together with the need
2
for long-term capital point to the continued challenge to promote long-term
savings and sustainable foreign capital inflows. The large capital inflows some
emerging markets witnessed in the early 1990s were a mixed blessing, in
particular for some Latin American countries. First, the massive portfolio
investments have widened the trade-off between disinflation at home and
competitiveness abroad (Reisen 1995). Second, as experienced by Mexico and
Argentina in early 1995, the macroeconomic adjustment to a sudden reversal of
foreign capital flows has proven to be extremely painful (IMF 1995). However,
it can be argued that global investment by pension funds and life insurers
promises less macroeconomic problems and more microeconomic benefits than
other portfolio investments (Fischer, Reisen 1995).
An important ingredient for emerging economies to top these flows
will be a further widening and deepening of domestic capital markets in general
and of stock markets in particular. How can this be achieved? This article
argues that institutional investors such as pension funds and life insurance
companies can have an important impact on capital market development and
potentially on domestic saving. The discussion concentrates on these types of
institutions. Excluded are unfunded pension schemes which do not directly
affect capital markets, and mutual funds, in which liabilities have a different
pattern of behaviour.
*
HWWA-Institute for Economic Research-Hamburg.
235
The benefits from promoting “long-term” savings institutions are
discussed in Section 1 focusing in particular on their impact on saving and
long-term financial savings as well as on their effects on stock markets. The
evolution of private pension funds and of the insurance industry in emerging
markets is described in Section 2. A more detailed analysis of how private
pension funds can contribute to capital market development is provided for the
case of Chile (Section 3). Section 5 identifies important prerequisites for a
strengthening of the institutional investment base in these markets.
1.
Benefits from promoting contractual savings institutions
1.1
Impact on saving and long-term savings
Policies to promote the growth of institutional investors, notably
pension funds and life insurance companies, may be guided partly by the
assumption of a positive impact of institutional investors on the level of
macroeconomic saving or household sector saving. Saving rates may rise if, for
instance, the minimum contribution a worker must pay to his pension fund is
more than he would voluntarily save or if the higher return earned by these
funds prompt him to save more. In this context the question arises whether it
makes any difference for the saving ratio whether pension systems are based on
the redistribution principle (pay-as-you-go) or on the capitalisation principle.
While these issues are far from being settled there seems to be a broad
agreement that the growth of institutional investors has a favourable impact on
the structure of financial saving of households by increasing the ratio of longterm forms of savings.
The debate about the relationship between institutional investors and
the overall saving level so far seems to have remained inconclusive.
Internationally, there is no clear correlation between pension funding and
saving ratios (Vittas 1992): Singapore and Switzerland, two countries with
compulsory participation in funded systems, have very high saving rates, but
the United States, the United Kingdom and Sweden, all countries with large
funded systems, have very low saving rates. Several countries with underdeveloped contractual sectors, such as Korea and China, have high saving
ratios. In Chile, private saving went up sharply in the decade after the
mandatory saving scheme was introduced. But as many other factors were at
work, it is difficult to judge how much of the high saving was due to the
mandatory scheme.
236
The relationship between institutional investors and the household
sector saving ratio is largely determined by three factors: i) the organisation and
scope of the social security system, ii) the level of wealth, including housing,
accumulated or inherited by households, and, iii) the age structure of the
population and related trends. There is also a clear relationship between
generous state schemes and lower private savings (Edwards 1995). In countries
with well developed social security systems providing relatively generous
benefits there is obviously less need for households to save for their old age
through institutional investors than in countries with less developed social
security systems. To the extent that old-age income is produced in the form of
return on existing financial or real assets (such as owner-occupied housing
facilities), the need for securing old-age income through retirement benefits is
reduced. Finally, in countries with a relative young and fast-growing population
the operation of retirement benefit schemes tend to imply an increase in the
household sector’s saving ratio. In countries with a stagnant or "ageing"
population (OECD countries) with old-age dependency increasing, the
operation of retirement benefit schemes tends to imply a decline in the
household sector saving ratio.
Whether it makes any difference for the saving ratio if retirement
benefit schemes are organised on the capitalisation principle or on the pay-asyou-go principle has been a subject of considerable controversy. As a study by
the World Bank (1994b) is suggesting, partly funded public plans may have
more positive effects on long-term saving and capital accumulation than pure
pay-as-you-go schemes. This effect would crucially depend on the way funds
are managed and how they affect public expenditure. For example, national
saving would not rise even if private savings do in case the funds are used to
increase current government spending and deficits. The potential of pension
funds to increase household savings and productive capital formation would
only be realised if their resources are competitively channelled through the
financial system with incentives for productive investment.
A difficulty in judging the impact of contractual savings institutions
on saving is the crucial role of credibility (Vittas 1992). Contributions to a noncredible system will be treated as taxes rather than forced savings. Credibility in
turn critically depends on the extent to which the system accumulates reserves,
who are the recipients of current benefits and how old pension schemes are.
Holzmann (1996) has studied the impact of Chile’s pension reform on
savings in more detail and found a mixed result. He calculated how much
private saving the new funds directly generated by adding up the flow of money
into pension funds and the returns they earned. From this he subtracted the
237
direct loss of savings due to reform. The loss includes the public spending
involved in providing pensions to people who retired under the old system, as
the government no longer receives new contributions from current workers to
pay pensioners. In addition those costs are considered which arise from
compensating workers who switched to private funds for the payments they had
previously made into the old system. As a result the overall net impact of
pension funds on saving was actually negative between 1981 and 1988.
Obviously, Chile’s national savings rate rose at that time despite, rather than
because of, the new pension scheme. According to the calculations made by
Holzmann, pension funds did cause the saving rate to rise only after pension
reform had been in effect for eight years.
While the quantitative impact of contractual savings on aggregate
saving is ambiguous, the qualitative effects on the composition of national
saving are well settled. In countries, where opportunities to save for retirement
via pension funds or long-term assets are not available, people invest in assets
which assure the maintenance of their real value in the long-run (e.g. real estate
or consumer durable). In contrast, with the existence of contractual savings
institutions, savings can be channelled into stocks, corporate bonds, and longterm government securities. Pension funds and life insurance companies
therefore act as vehicles to change the wealth composition in favour of financial
funds that can be intermediated, thereby increasing the supply of productive
capital. Contractual savings institutions can also make the management of
domestic public debt easier by expanding the demand for long-term government
securities. Contractual savings therefore cause a shift in favour of long-term
financial savings that can be used to promote the development of equity and
bond markets. This could help to fill the gap in the supply of long-term finance
that exists, for example, in most of Latin America’s emerging markets.
1.2
Effects on capital markets
Because of their long-term view of investment and professional
management of a collective portfolio institutional investors can make a
significant contribution to the securities market. Although institutional
investors could develop on the basis of loans and property investment, their
greatest comparative advantage is in the capital market (Davis 1993a).
Institutional investors' main contribution to a market is that they are large and
reliable sources of financial resources (Castillo 1993). In particular pension
funds and life insurance companies provide a constant demand for securities
and provide the market with liquidity and stability, thereby reducing the
transaction costs for investors (Aggarwal 1993). Another important effect
238
which is linked to these investors is their need for timely, reliable and adequate
information on the operations, investment and dividend policies of the
corporation in which they invest (Castillo 1993). Institutional investors
establish high standards for compliance, disclosure and oversight of
information, particularly on corporate financial statements. Furthermore, they
give incentives for innovation in developing new instruments and encourage the
entrance of market participants such as risk taking agencies, advisors or
consultants and custodians (Vittas 1994).
Given their focus on real returns, pension funds are in particular
beneficial to developing emerging stock markets by providing incentives for
smooth, stable and less volatile stock exchange trading and by taking care of
shareholders’ rights. In developing equity markets institutional investors are
beneficial in providing risk capital for growing enterprises and by giving an
opportunity to diminish dependence on bank finance. The financial sector may
also benefit from competition between pension funds thereby contributing to
more efficient capital markets. However, some of these positive effects on
private capital market development are lost if pension funds are exclusively
allocated to public investment which might be the case in young countries with
immature systems where accumulated reserves are required to be invested in
government securities or the securities of state enterprises. Experiences in
OECD countries concerning the role of contractual savings institutions in the
securities markets differ from country to country, reflecting historical traditions
and investment regulations. With this traditional emphasis on conservative
investment policies contractual savings institutions place the largest part of
their funds in government, corporate and mortgage bonds, and in long-term
loans (Davis 1993b).
In industrial countries -- notably in the United States and in Canada -the invention and marketing of new financial instruments which allow new risk
or return streams has been closely related to the expansion of pension funds
(Davis 1995). Derivative securities, indexation and portfolio insurance
strategies are examples of such financial innovations. In particular the
requirement of a fixed duration for investment instruments in the frame of
immunisation strategies has stimulated innovations tailored to funds’ need,
such as zero coupon bonds, collateralised mortgage obligations and guaranteed
income contracts.
One may argue that institutionalisation may increase the volatility of
national and international capital markets which is a matter of concern if it
raises the cost of capital and/or discourages retail investors. Capital market
volatility can be induced by herding among funds to avoid performing
239
significantly worse than the mean (Davis 1995). Reasons for herding by
institutions could include regular performance checks against the market which
may stimulate similar behaviour; institutions inferring information from each
others’ trades, about which they are relatively well informed; and reacting to
news, which they all receive at the same time, in similar manner. Herding may
accelerate the market’s adjustment to a new equilibrium price. But combination
of herding with strategies such as trend chasing or positive feedback trading
could also drive prices further away from fundamentals. In addition, it was
argued, that situations with asymmetric information where institutional
investors are more professional and better informed than other, mostly smaller
investors, may lead to increased volatility (Blommestein and Biltoft 1995).
More controversially discussed issues related to pension funds’
impact on capital markets are their tendency toward short-termism and
negligence of small-firm finance (Davis 1995). The underpinnings of the shorttermist hypothesis is based on the regular performance evaluation of pension
fund managers by trustees which may lead to an undervaluation of firms with
good profit prospects in the long run, and willingness of funds to sell shares in
take-over processes. Such a behaviour would result in a rapid turnover of
shares, rather than in long-term holdings. There are also indications that
pension funds and other institutional investors may not invest in small business.
Obvious reasons are illiquidity or lack of rentability of their shares,
diversification problems given the level of risk, high monitoring and control
cost for firms without trade records and in the hands of the owner, and lack of
business expertise to supply risk-taking venture capital.
1.3
Other benefits
Institutional investors cannot only encourage the development of
capital markets but also facilitate privatisation playing a key role in the
economic liberalisation programs undertaken by Latin American countries such
as Mexico, Chile and Argentina. Efforts to sell a large number of state-owned
enterprises is possible only due to the major role played by institutional
investors.
While it is difficult for small, fragmented individual investors to
monitor the management of a company, institutional investors may have an
advantage through their involvement in business operations (Aggarwal 1993).
As long as their holdings of corporate equities are small, institutional investors
will probably play a passive role in corporate governance. But when
institutional investors become a dominant group of shareholders they will take
240
a more active interest in corporate management. As a consequence they will
invest in information gathering and processing and will develop the required
expertise to ensure that their interventions in corporate affairs have beneficial
aspects (Vittas 1994).
An issue related to systemic risk is the question of whether and to
what extent institutional investors can become victims of a broadly based run.
In this respect one can argue that a potential run on institutional investors
largely concerns investment funds. Pension funds and life insurance companies
are prevented from becoming the victims of a run thanks to their very nature as
collectors of contractual savings.
2.
The evolution of contractual savings institutions in emerging markets
2.1
Private pension funds in Latin America and Asia
During the debt and fiscal crises of the 1980s Latin America’s social
security systems widely collapsed. Underfunding, falling real pensions,
increasing evasion, large social security deficits, and depleted reserves have
seriously undermined the credibility of traditional pension schemes (World
Bank 1994b). For example, Argentina’s and Peru’s implicit social security debts
were estimated at about two-thirds of GDP at the end of the 1980s. At the same
time there was a general re-orientation in Latin America towards a reduced role
of the government, privatisation and a strong desire to build up domestic capital
markets. Stimulated by Chile’s success, the movement to privatise pensions
gained momentum as the region entered the 1990s (see Appendix I in
Fischer 1995b).
In 1992, governments in Argentina and Peru proposed to privatise a
large share of pension programs. Colombia is about to introduce a new
privatised pension system. All three countries have set-up schemes similar to
Chile’s and largely adopted Chile’s regulatory structures. Mexico also instituted
a small compulsory mandatory saving scheme, and Bolivia is linking pension
reform to state enterprise reform. Brazil, Costa Rica, Uruguay, and Venezuela
are still contemplating the future of their pension systems. While many of the
reformed pension schemes were designed along the Chilean approach the new
schemes also differ from Chile’s in certain important aspects as a consequence
of distinct political climates and institutions. Table 1 summarises the main
characteristics of private pension systems in selected Latin American countries.
241
With the exception of Chile (Fischer 1995a) only scattered statistical
evidence is available in the portfolio composition of private pensions funds.
Data for 1994/95 suggest that in Chile, Peru and Brazil pension funds have a
significant share of their assets invested in equities and bonds of enterprises,
although the bulk of investments is in government bonds, fixed income
accounts and bank notes (Table 2).
Information on the existence of occupational pension funds in Latin
American countries is practically not available. However, they are probably
more developed than the paucity of data may suggest. Those that exist mostly
cover civil servants, military personnel and privileged employees of large
public sector corporations and financial institutions. They may also play a more
important role in larger countries where multinational corporations have a
relatively strong presence, such as in Brazil and Mexico. In Mexico, for
example, estimates for the late 1980s suggest that there were over 2 000 private
pension plans covering up to 4 million people (Vittas, Skully 1991). Little
information is available on their size and operations which may be explained by
their ineffective regulation and supervision. Correspondingly, it is unknown
how funds are invested. Thus it is impossible to judge their impact on capital
markets.
2.2
Performance of the life insurance industry in emerging economies
The insurance business is divided in two main sectors: general and life
insurance, having very different impact on financial markets (Vittas 1994). As
result of the short-term nature of the policies of general insurance companies
their technical reserves are only a small fraction of annual premiums and make
therefore little contribution to the generation of long-term savings. However, as
general insurance reserves must be kept in liquid form they are ideally suited
for investment in marketable securities such as treasury bills and commercial
papers. Thus, general insurance companies can play an active part in supporting
the development of money markets. Most types of life insurers contribute
significantly to the accumulation of long-term funds. Their investable funds,
arising from both, the creation of technical reserves and the reinvestment of
profits to the benefit of policy holders, can be several times the annual
premiums.
242
Table 1. Characteristics of private pension schemes in selected Latin American countries
Argentina
Started
July 1994
Pension contribution (% of gross salary)
Current size (bn US$)
Government guarantee
Minimum pension (US$ per month)
11
Brazil
(a)
mandatory system
under discussion
varies
(b)
Chile
Mexico
Peru
July 1981
May 1992
July 1993
10
2
5
1
(1994)
23.5
(mid 1992)
22
(1994)
1.5
(1994)
yes
150
(c)
n.a.
n.a.
yesc
100
n.a.
n.a.
0.56
(October
1995)
none
none
50
to be decided
30
to be decided
to be decided
10
50
to be decided
to be decided
10
45
to be decided
to be decided
to be decided
to be decided
(d)
Limits of investment in :
Domestic equities
Foreign equities
Government bonds
a) Voluntarily established;
b) Private pension system supplements social security;
c)
On minimum pension and minimum return of fund;
d) In per cent of total investment.
Source: Fischer (1995b); Euromoney (September 1993); World Bank (1994 a).
243
Table 2.
Portfolio structure of pension funds in Chile,
Peru and Brazil 1994/95 (%)
Assets
Chile
Peru
Brazil
(May 1995) (August 1995) (Sept. 1994)
Government bonds
39.0
28.0
2.9
Fixed income accounts
6.8
27.5
12.8
Bank notes
14.7
21.9
19.7
Equities and bonds of enterprises 38.8
22.3
43.0
Real estate
0.0
0.0
14.5
Others
0.7
0.3
7.1
Total
100.0
100.0
100.0
Source: Banco Central de Reserva del Perú (1995); Banco Central de Chile (1996);
Gazeta Mercantil (1994).
Table 3. World market shares of life insurance business 1993 (%)
Industrialised
countries
93.14
Developing
countries
6.79
North America
USA
Canada
24.96
23.32
1.64
Asia
South Korea
Taiwan
India
5.11
2.95
0.75
0.32
Europe
United Kingdom
France
Germany
24.42
7.05
5.67
4.54
Latin America
Mexico
Chile
Argentina
Brazil
0.48
0.19
0.08
0.07
0.06
Asia
Japan
42.61
42.61
Africa
South Africa
Zimbabwe
1.20
1.13
0.02
Oceania
Australia
1.15
1.04
a) Net premium income. Not attributable to nations: 0.07 per cent.
Source: Schweizerische Rückversicherungs-Gesellschaft (1995); own calculation.
244
The world market of the life insurance business is clearly dominated
by life insurance companies in industrialised countries (Table 3). Their
accumulated world market share of net premium income accounts to over
93 per cent. Within the developing region countries in Asia have a share of
about 5 per cent, whereby South Korea, Taiwan and India contribute with
80 per cent to this result. Latin American countries play a minor role in the
world wide life insurance market which is also the case for the African region.
An outstanding exception in South Africa, with a market share slightly higher
than Australia (1.04 per cent).
For reasons which can be attributed to the demand and supply side the
insurance industry seems most expansive in East Asian economies but rather
sluggish in Latin American countries (Table 4), although more recent data on
3
the scope and structure of this sector are difficult to collect.
Table 4. Insurance premium development in selected regions
1971-1990 (Average annual real growth (a) in per cent)
East Asia
Latin America
OECD
1971-1980
13.9
9.3
3.7
1981-1990
19.3
3.9
6.1
1971-1990
16.6
6.6
4.9
Note: a) 1985 prices and exchange rates.
Source: Schweizerische Rückversicherungs-Gesellschaft (1992).
Among the emerging economies insurance diffusion, i.e. the share of
life insurance premium income to gross domestic product in 1994, is the
highest in South Africa (10.3 per cent) and South Korea (9.1 per cent)
(Table 5). With the exception of these countries and Taiwan insurance diffusion
is lower than three per cent. Compared to 1980 the most rapid expansion of the
life insurance industry in emerging economies took place in Chile, South Korea
and Taiwan, followed by Singapore, Thailand and Malaysia. Correlating
between the average annual real growth rates of the gross domestic product in
the periods 1970 to 1990 and 1990 to 1993 with the changes of the insurance
diffusion ratios for the respective periods suggests that real income growth is a
significant determinant of the expansion of the insurance industry.
245
Table 5. Life insurance diffusion (a) in selected emerging economies
1980, 1987 and 1994
Country
1980
Country
Country
1994
South Africa
South Africa
South Korea
Philippines
Taiwan
India
3.18b
1.59
0.85
0.84
0.76b
8.26
South Africa
10.32
South Korea
Taiwan
Malaysia
Singapore
7.31
2.34
1.49
1.29
South Korea
Taiwan
Singapore
Malaysia
9.10
3.64
2.73
2.30
Singapore
Malaysia
Thailand
Venezuela
Colombia
Morocco
0.65
0.63
0.42
0.35
0.26
0.25b
Chile
Philippines
India
Thailand
Morocco
Mexico
1.13
1.06
0.81
0.73
0.36
0.33
Chile
Thailand
India
Philippines
Mexico
Morocco
1.95
1.36
1.29
0.63
0.56
0.56
Mexico
Chile
Indonesia
Argentina
Brazil
0.24
0.18
0.16
0.15
0.14
Colombia
Venezuela
Indonesia
Argentina
Brazil
0.28
0.22
0.21
0.14
0.13
Indonesia
Argentina
Brazil
Colombia
Venezuela
0.43
0.33
0.27
0.24
0.04
Memo:
Japan
6.43
Memo:
Japan
United Kingdom
5.25
United Kingdom 7.31
Switzerland
4.45
Switzerland
5.99
United States
2.96b
2.47b
United States
3.69
United States
3.63
Germany
2.19b
Germany
2.83
Germany
2.80
Memo:
Japan
United Kingdom
Switzerland
3.48b
2.98b
1987
10.10
Notes: a) Share of life insurance premium income to gross domestic product;
b) Premiums in per cent of GNP.
Source: Schweizerische Rückversicherungs-Gesellschaft (various issues) and own
calculations.
246
The outstanding growth of the life insurance industry in South Africa
can be explained not only by fiscal incentives but also by the achievements of
high rates of return over longer periods (Munro, Snyman, 1994). A feature of
the life insurance industry in South Africa is its very high concentration and the
existence of two long standing and very efficient mutual organisations (Old
Mutual and Salam). Both are heavily engaged in the financial sector and have
large holdings in numerous industrial companies. Nevertheless competition
with the other 29 life insurance companies seems to be quite strong: Premiums
are frequently adjusted in response to market conditions on investment yields
and competitive offerings.
The development of the life insurance industry depends on a number
of factors such as the level and distribution of income and wealth of a country,
its social culture and family structure, the efficiency, solvency and public image
of insurance companies, the tax treatment of insurance premiums and benefits,
the availability of social security benefits, the degree of macroeconomic and
political stability, and the regulatory framework (World Bank 1990). Results of
regression analysis for estimating life insurance demand functions for Mexico
stress age, education, and level of income as factors affecting the demand for
life insurance (Truett, Truett 1990). In a cross section regression analysis
covering 45 developing countries Outreville (1994) provides empirical evidence
that life insurance development is significantly related to personal disposable
income and to the level of development in the country. He further found that
life premium per capita is markedly affected by the level of anticipated inflation
and that monopolistic markets are significantly less developed than competitive
markets.
The insurance business in Latin America suffered in particular from
the high and volatile inflation rates of the 1980s. Inflation causes poor
investment returns on insurance reserves and reduces the real value of insurance
policies unless indexed policies and investment are used. Political instability
has certainly also undermined the credibility of insurance contracts. In countries
with high inequality there is on the one side little effective demand from the
poorer segments of the society and on the other side the rich people may have
been able to take advantage of more efficient policies in foreign markets.
While East Asia’s average annual real growth rate of insurance
premiums was 16.6 per cent between 1971 and 1990, Latin America grew in the
same period by only 6.6 per cent with a heavy plunge in the 1980s. Premiums
experienced sharp fluctuations during that decade and were at a lower level in
real terms in 1990 than in 1970, with the notable exception of Chile, whose
insurance industry developed dynamically as a side effect of reforms of the
247
social security system (Table 6). The insurance sector in most other Latin
American countries has suffered in addition to inflation from low capitalisation
ratios, bad public image, a state monopoly in reinsurance, protracted disputes,
delays in settlement and widespread mistrust. Additionally, discrimination took
place by high taxes imposed on the insurance business, by high legal fees, and
by high commission rates and indifferent service offered by insurance agents.
A case study on Mexico’s insurance industry at the end of the 1980s
has shown that policy-induced distortions have played a major role for the poor
performance (World Bank 1990). Over-regulation has resulted in low
competition, insufficient operations, and limited product innovation. The
development of the industry has also been hindered by the absence of adequate
disclosure of financial information on the solvency and performance of
individual companies and the failure to establish an effective system of
consumer and investor protection. Given that Mexico’s insurance law
-- introduced in 1990 -- states as objectives to be fulfilled by the regulating
authorities, that insurers should contribute to finance high priority government
programs one must have doubt that the life insurance industry in Mexico has
contributed significantly to the development of capital markets.
Given the relative small size of the life insurance industry in most of
the emerging markets their impact on the evolution of the financial systems
might have been negligible. The scattered empirical evidence available hints to
very restrictive legal investment prescription leading to a heavy bias towards
domestic investment, mostly in government bonds.
3.
Private pension funds and capital market development in Chile
Chile is recognised for having an emerged, mature, stable, efficient,
transparent and well regulated domestic capital market providing long-term
finance for the country’s rapidly expanding companies. In 1993, stock market
capitalisation stood at US$35 billion more than 90 per cent of the country’s
GDP and double the size of that in Mexico. Corporate bond issues of seven,
nine and 12 years are common.
The main reason for Chile’s deep capital markets is attributed to its
powerful institutional base, particularly the pension funds or Administradores
de Fondos de Pensiones (AFPs). As the result of a comprehensive social
4
security reform they were set-up in 1981 as a mandatory savings pillar and
have proven to be a very suitable vehicle to accumulate long-term resources at a
very fast pace (Table 6).
248
After ten years of operation, resources of the AFP-system totalled
already 35 per cent of GDP (1992). Investments made by the AFPs have
dramatically changed the structure of Chile’s financial markets. By the end of
1995, pension funds assets were composed as follows: 40.7 per cent were
invested in treasury bonds issued by the Central Bank, 36.9 per cent in firm
bonds and debentures and 16.0 per cent in mortgage securities (Table 7).
Mainly because of the imposition of tight investment restrictions, investments
in corporate equities were only 23.3 per cent (in 1991).
In the first years after the foundation of the pension funds those were
not ready to hold long-term securities. There was no official obligation to invest
a certain percentage of their assets in government securities. On the contrary,
there were maximum ceilings for the holdings of public bonds. The bulk of the
funds were invested in short-term bank deposits with maturities from 30 days
up to 12 months. Lack of confidence in the financial system may have been a
major reason for this portfolio allocation strategy. The share of funds invested
in long-term financial investments was only raised slowly, with a preference
given to public and private corporate bonds.
The impact of private funds on the dispersion of corporate ownership
and development of the Chilean equity market was very limited at the
beginning, to a large extent because of the strict investment rules applied on
their equity investments. Reisen (1996) has shown empirically that equity
holdings of the Chilean pension funds did not contribute to the liquidity of the
stock market, reflecting a buy and hold strategy, while investment in credit
notes has significantly stimulated the supply of credits from private banks.
Both, the liquidity of the stock market, measured as value added in per cent of
the market capitalisation (and not the size of stock market capitalisation) and
the credit supply by private banks have been stressed as the most important
channels through which the financial system has an impact on economic
development. Liquid stock markets reduce the risk of investments in profitable
projects, the initial investor can sell quickly and at a relative favourable price.
At the same time enterprises have easier and more permanent access to the
stocks issued. Banks are interested in long-term relationships with enterprises
to receive improved informed about projects and managers as well as a better
control over enterprises in case of higher credits.
249
Table 6. Capital market developments in Chile
1980-1992
Year
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
Stocks
Fixed
income
instruments
(percentage of GDP)
1.8
0.2
1.1
0.3
0.6
3.3
0.3
5.6
0.2
5.8
0.3
10.7
1.7
25.5
2.6
31.1
2.8
37.3
3.3
48.8
2.8
50.5
6.0
38.6
5.5
60.4
Stock market
capitalisation
30.0
20.7
22.7
13.3
12.7
13.2
23.9
27.5
30.2
37.6
40.5
88.6
87.6
Corporate
bonds
51
96
415
266
203
101
64
149
440
906
1 349
1 889
2 064
Source: Arrau, Valdés-Prieto and Schmidt-Hebbel (1993).
250
Mutual
funds
714
681
611
188
104
125
215
295
375
364
479
908
910
Foreign
capital
country
funds
(US$ million)
106
502
1 023
1 244
Insurance
company
reserves
Pension
funds
n.a.
n.a.
584
454
515
427
458
566
753
1 031
1 313
1 834
2 665
294
876
1 265
1 653
1 743
2 254
2 936
3 643
4 998
7 364
10 773
12 243
Table 7. Portfolio composition of Chilean pension funds
1981-1995 (%)
Year
Central Bank and Bank deposits
treasury bonds
and bonds
Mortgage Firm bonds and Common
securities
debentures
stocks
(a)
Others
Total assets
(US$ million)
1981
28.1
61.9
9.4
0.6
0
n.a.
219
% of
GDP
0.9
1983
44.5
2.7
50.6
2.2
0
n.a.
1 223
6.4
1985
42.6
20.9
35.3
1.1
0
n.a.
2 228
10.9
1987
41.5
28.2
21.3
3.0
6.0
n.a.
3 570
15.5
1989
41.6
21.5
17.7
9.2
10.0
n.a.
5 388
19.7
1991
38.3
13.3
12.0
13.0
23.3
n.a.
10 078
34.4
n.a.
0.7
14 864
35.0
n.a.
n.a.
23 113
41.2
1993
39.4
7.5
13.1
39.5
(b)
1995
40.7
6.0
16.0
36.9
(b)
a) Includes available assets and since May 1993 investments in foreign countries;
b) Includes firm bonds, debentures and stocks;
c) Per cent of GNP;
d) Estimation.p
Source: Arrau (1992), Uthoff (1993), Banco Central de Chile (1996).
251
(c)
(d)
Rojas-Suarez and Weisbrod (1996) have recently also stressed the
importance of a reliable banking system for capital markets to develop from the
particular view of institutional investors. They first have to develop faith into
the short-term segment of the financial system before they invest in long-term
securities. The authors rightly point to the Chilean case where pension funds
largely invested in short-term deposits; subsequently, pension funds’
willingness to invest in long-term central bank liabilities was still directly tied
to the quality of the banking system because these central bank liabilities were
exposed to bank risk; from the early 1990s when Chile’s pension funds
increasingly invested in corporate bonds, liquid bank deposits still remained a
save haven for the pension system to be used when conditions in the corporate
bond market were not favourable for investing.
The Chilean pension funds have also played a very significant role in
the privatisation of several state-owned companies. The total holdings of all
pension funds range from 10 per cent to 35 per cent of the equity capital of
these companies (Vittas, Iglesias 1992). Holding in privatised companies still
represent the lion's share of pension fund equity holdings, accounting for nearly
90 per cent of their total investments in corporate equities in 1990. In addition,
pension funds may have contributed to increase domestic and foreign
confidence in the domestic stock market and stimulated the development of
insurance companies.
The most important factors for the positive dynamic interaction
between pension funds and securities markets are the following (Vittas,
Iglesias 1992):
− AFPs have been -- and still are -- subject to very strict investment
regulation guided by safety and profitability as the main operating
principles. Limits were expressed as shares of the value of the
fund, of particular instruments, of each fund in the total resources
of all funds and of each issues in the total liabilities of all issuers
in the same sector.
− The control and supervision of AFP operations is very effective.
It is based on daily reports on investment transactions and
monthly reports on their financial position and overall
performance. Compliance of investment limits is under constant
monitoring. Correspondingly, the companies from which AFPs
are eligible to buy stocks must also meet rigorous information
disclosure requirements.
5
252
− Pension funds achieved very high real rates of return on their
investments, averaging 13 per cent per year between 1981 and
1993 (Alloway 1994). Their high rates of return reflect the high
level of real interest rates that prevailed in the Chilean economy
for most of the 1980s and the downward trend of real rates that
resulted in very large capital gains. Since 1991 a booming stock
market has helped to maintain high real returns.
− Balances accumulated in individual capitalisation accounts are not
legally indexed, but in practice the value of pension funds is
protected by the fact that 95 per cent of pension fund assets are
invested in indexed assets or in assets that provide effective
hedges against inflation, such as corporate equities. Chile’s strong
performance of stock markets in the early 1990s has caused a
further substantial increase in return.
Although Chile’s capital market is said to be the most developed in
Latin America, it is also the most regulated and transparent, but it is by no
means the most open or diversified. Their equity holdings in privatised firms
accounted for nearly 90 per cent of their total equity investment in 1990. In the
following years concentration has fallen due to steps towards liberalising
investment rules. Currently the AFPs are restricted to investing 30 per cent of
their assets in stocks belonging to the top 40 blue chip groups. A capital market
reform bill intends to extend the coverage to more than 200 companies with
smaller capitalisation and other financial instruments (debt-in-project financing,
securitised bonds, venture capital) and to broadening investment abroad. AFPs
will potentially be able to invest up to 12 per cent of their portfolio abroad (the
current limit is 3 per cent).
A further structural weakness may be seen in the potential AFPs to
form a cartel in a highly concentrated market with a handful of shares
accounting for over half of the turnover. The daily market activity of about
US$10 million is exceptionally small for the size of the market (Euromoney,
September 1993). The loyalty of the AFPs to the shares and bonds to successful
groups may be helpful for the companies as long as they continue to perform
but may raise conflicts of interest if their performance deteriorates. As the
relationship between Chile’s large companies and its institutional investors are
pretty close (for example, they often share directors), the problem of insider
trading may be or become a real issue.
In comparison with other Latin American countries such as Argentina
and Mexico, Chile’s stock market is still relatively restricted to foreign
253
investors. For example, foreign investors must leave their money in the country
for at least one year (formerly three years) and the level of combined
corporation and withholding tax with more than 30 per cent of profits is high
(Euromoney, September 1994). However, as long as investment continues to
come in there will be little incentive for the government to free exchange
controls. Despite these caveats, the Chilean experience demonstrates the
possibility of a dynamic interaction that can evolve between growing pension
funds and emerging capital markets and the contributions that privately funded
and managed pension funds can make to the development of financial markets.
Domestic institutionalisation of Latin America’s capital markets is
expected to gather pace as pension funds grow. There is a widespread tendency
to increase the role of private pensions in Latin America as a supplement to the
state-run social security system (Mesa-Lago 1993 and World Bank 1994b).
However, it is questionable whether other reforming governments in
Latin America have the regulatory capacity and an adequate capital market to
run successfully mandatory savings plans (World Bank 1994b). In addition,
poverty would make a Chilean style system almost impossible in countries such
6
as Brazil. Nevertheless, even incremental change can be significant. For
example, the Brazilian Association of Closed Pension Funds estimated that
there were about 7 000 companies in Brazil that could establish their own funds
which would more than quadruple the total funds assets to US$100 billion
(quoted by Hansell 1991).
It is further unlikely, that the spectacular returns of Chile’s pension
funds in the 1980s can be repeated easily. Chile experienced -- starting together
with the implementation of the new pension schemes -- a nine year long period
of extraordinary growth. Although such a growth performance is not likely to
be repeated by other Latin American countries continued reform efforts may
result in a robust growth record also allowing a further expansion of pension
funds. In the following chapter the prerequisites for a strengthening of the
institutional investment base in emerging markets countries are discussed in
more detail.
4.
Prerequisites for strengthening the institutional investment base
4.1
Promotion of national savings
Increasing the national saving ratios particularly in Latin America
would certainly help to channel more savings towards institutional investors.
254
Based on a comprehensive empirical analysis of the determinants of savings in
the world economy, Edwards (1995) has recently suggested a number of
possible (new) avenues for raising national savings: While a deepening of the
financial sector and a reduction of government-provided social security benefits
would help to push private savings, government savings would be positively
affected by the creation of social and political institutions that reduce the degree
of political instability. Edwards reconfirms that higher real growth would
benefit both private and government savings.
For lengthening savings and investment horizons it is essential to lay
the ground (and the reputation) for durable macroeconomic stability and to
establish an adequate institutional framework to cope with systemic risks of
financial systems (Fischer, Reisen 1993). To raise the confidence of global
investors in the permanency of a policy regime that will respect their property
rights, countries may join a rich country club, as Mexico did when it joined
NAFTA and the OECD. However, such an arrangement will not necessarily
prevent a confidence crisis if the fundamentals or the exchange rate regime are
out of balance.
4.2
Deepening and widening of investment opportunities
Foreign and domestic institutional investors usually face an acute
shortage of equity supply in emerging markets. Encouraging companies that are
already listed to issue more stocks and firms to be listed at the stock market, is
-- at least in the short-run -- a difficult task. A review of the tax system on the
equity supply may lead to measures by authorities to reduce the cost of equity
issues and to reduce distortions (such as interest subsidies and exchange rate
risk guarantees) that enhance the attractiveness of borrowing relative to the
further issuance of equity. A more active trade in stock markets may provide an
incentive for companies to issue more stocks; reducing capital gains taxes and
avoiding double taxation of capital gains may make equity purchases and
therefore issues more attractive.
Important sources to increase the supply of new stocks are privatising
public sector companies and bringing privately held companies to the market.
Privatisation of state-owned enterprises was indeed the major source of new
equity supply in emerging markets in recent years. In many of these countries
the scope for privatisation is far from being exhausted. With more companies
listed and their share holdings disbursed among the local population, stock
markets will gain in depth and breadth and become more attractive also for
foreign investors. With buoyant market conditions where prices stand at a
255
significant premium to book values, it might also be easier to persuade family
owned companies to issue stocks although this advantage has to be weighted
against the loss of management autonomy and the implications on tax issues.
Due to the manifold interlinkages with other financial market segments the
widening and deepening of securities markets cannot be achieved without a
comprehensive approach to the financial system as a whole. For example,
securities market participants rely heavily on bank credit to ensure liquidity in
these markets. Actors in the primary and secondary markets need access to bank
credit lines to support prices immediately after the initial issue, to hold
undistributed securities and to manage settlement delays or failures. Therefore,
the creation of securities markets in an economy with a weak banking sector
will unduly increase systematic risk. Furthermore, an active government
securities market is a possible precursor of corporate fixed-income markets and
the development of a functioning market for equities. Finally, broader financial
system reforms may also create new sets of institutional investors such as
private pension funds and life insurance companies which are likely to create
demand for securities issues of all types on their preferred investment assets.
4.3
Direct measures to promote contractual savings schemes
In industrial countries the role of government in promoting pension
funds has been shown to be a crucial one (Davis 1988, 1994). In particular, the
level of state benefits and the ability of employees to opt out of the state
scheme and personal pensions, changes in taxation of pensions and alternative
assets, legislation on the nature of benefits and legislation on provisioning all
played a crucial role in setting up funds attractive to firms. The cost of
providing funded pensions critically depends on the returns on capital market
instruments which are heavily influenced by the degree of macroeconomic
stability and economic growth. Company-based schemes have in general
proven to be superior to personal pensions because of lower transaction costs
and avoidance of market failures.
As regulatory preconditions to develop pension funds Davis (1994)
suggests: a degree of mandatory indexation of pensions; prudent man rules on
asset allocation, with a ban on self investment; minimum and maximum
funding rules tailored to the nature of the obligations, but that do not discourage
equity holding by penalising temporary shortfalls; independence of the fund
from the employer; insurance against fraud; indexation of accrued benefits for
early leaders; and vesting periods of around five years. An adequate supervisory
structure should contain one regulator, annual checks on funding, oversight of
rules and occasional on-site inspections.
256
The establishment of pension funds could also stimulate the growth of
the insurance industry. While tax incentives can support the expansion of the
life insurance market, adequate legislation is needed to protect policy holder
interests without hindering profitable operations of the insurance companies.
Regulation must ensure institutional soundness and preclude excessive charges
and monopoly pricing (Skully 1988). This can be achieved by allowing the
entry of new competitors and by giving the insurance companies freedom to
develop new products and to pursue their own pricing and marketing policies.
At the same time regulations should not force them to invest their reserves, for
example, in low return government bonds or other captive markets.
Most governments in industrial countries encourage the growth of
contractual and collective savings institutions through tax incentives. The most
common incentives include allowing investors to deduct premium payments or
pension contributions from tax; allowing contributions to accumulate tax free;
exempting from tax any income received from savings; and deferring any tax
liability until savers retire, when their incomes and tax rates are lower.
257
NOTES
1.
The average saving ratio for Latin America in the period 1990-94 was 18.3
per cent compared to 31.4 per cent for Asia (IMF 1995).
2.
According to World Bank calculations, approximately US$60 billion will
have to be invested alone in infrastructure every year between now and the
year 2000 to provide the region with the infrastructure stock needed for an
export-led growth strategy (World Bank 1994a).
3.
There are no fully satisfactory indicators for the development of the
insurance industry. International comparisons are complicated by
differences in practice and data coverage. For a discussion of various
indicators see Vittas (1994).
4.
For details of the private pension system in Chile see Vittas, Iglesias (1992),
Myers (1992), Marcel, Arenas (1992), Gillion, Borrilla (1992), Büchi Buc
(1993), and Mesa-Lago (1993).
5.
The control and supervision of AFPs is entrusted with the Superintendencia
de Administradores de Fondos de Pensiones (SAFP), a specialized
supervisory authority that was established by the same law that created the
pension Superintendencia scheme.
6.
According to Hansell (1991) only three or four million people -- out of a
population of 150 million -- earn over US$700 a month. In Chile the
government spends the equivalent of 4 per cent of GDP to pay the portion
of worker's pensions that was earned under the previous social security
system. In Brazil, for 30 to 40 years one would be paying 8 per cent of GDP
to cover the past costs.
258
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263
Part III
INVESTMENT STRATEGIES AND TECHNIQUES
265
Chapter XI
ASSET ALLOCATION, FINANCIAL MARKET BEHAVIOUR AND
IMPACT OF EU PENSION FUNDS ON
EUROPEAN CAPITAL MARKETS
by
Koen De Ryck*
1.
The importance of EU pension funds
Pension fund assets in the EU are highly concentrated in two
countries: the United Kingdom and the Netherlands. Taken together these two
countries represent 74 per cent of total EU-wide pension fund assets. Major
differences can be noticed between the EU member states. These are, in part,
related to the impact of the second funded pillar. In general, pension funds are
much less important in the European Union than in the United States. Pension
fund assets amount to 18.3 per cent of GDP in the EU compared with 57.1 per
cent in the United States). One exception in Europe is the Netherlands - where
pension funds represented over 87 per cent of GDP at the end of 1995.
Pension fund assets exceed total stock market capitalisation in the
Netherlands and Ireland (which is a small market) and equal 61 per cent of the
huge London Stock Exchange market capitalisation. Relative to stock market
capitalisation, they are also important in Denmark, Portugal, Sweden and
Finland. In this respect pension funds are smaller in Italy, France, Belgium,
Spain, Austria and Luxembourg. The correlation coefficient between pension
funds assets and the stock market capitalisation is 0.897. This may be seen as
one indication that in countries where pension funds are important, listed equity
capital is also important.
*
Managing Director, Pragma Consulting NV/SA
267
Table 1. Total pension fund assets
EU (15) - end 1995 - in US$ billion
Total assets
United Kingdom
The Netherlands
Germany
Sweden
France
Denmark
Italy
Ireland
Spain
Finland
Belgium
Portugal
Greece
Austria
Luxembourg
Total
As %
of total
As %
of GDP
810.00
344.26
126.67
70.66
66.15
30.50
28.69
26.16
17.56
16.50
10.24
7.96
3.33
2.03
0.03
51.9
22.1
8.1
4.5
4.2
2.0
1.8
1.7
1.1
1.1
0.7
0.5
0.2
0.1
0.0
74.5
87.2
5.2
28.5
4.2
17.4
2.6
42.3
3.1
13.1
3.8
7.2
3.0
0.9
0.2
1560.74
100.0
18.3
As % of stock
market
capitalisation
60.9
120.0
22.5
41.1
13.3
54.3
13.6
102.3
9.2
37.7
10.1
43.4
20.2
6.6
0.1
43.7
Source: EFRP, Central bank of Belgium, FESE.
Table 2. Pension fund ownership of domestic equities
in per cent of stock market capitalisation
United Kingdom
Ireland
The Netherlands
Denmark
Sweden
Finland
Portugal
Greece
1995
33.3
23.9
13.2
11.2
7.6
2.9
2.6
2.1
Source: PRAGMA Consulting.
268
Belgium
France
Germany
Italy
Spain
Austria
Luxembourg
1995
1.7
1.5
1.3
0.9
0.4
0.2
0.0
United States
25.0
Pension fund ownership of domestic equity is very high in the United
Kingdom (33.3 per cent) and in Ireland (24 per cent) versus 25 per cent in the
United States. The Dutch and Danish pension funds follow with over 10 per
cent1. In the other EU countries the positions are very small, mostly due to the
fact that pension funds do not invest a lot in equities and to the minor
importance of pension funds.
2.
Asset allocation of pension funds
Pension funds are excellent transformers of savings into long term
investments. Almost 98 per cent of their aggregate assets are currently invested
for the longer term. No other investor category, whether institutional or private,
matches these figures in volume and duration (table 3).
Table 3. Pension funds are efficient investors
Average asset allocation in per cent (end 1995)
Equity
Fixed income
Real estate
Total long term investments
Short term placements/Other
Sources: EFRP, FEFSI.
European pension
funds
54.6
36.6
6.3
97.4
2.6
European mutual
funds
23.0
34.8
3.6
61.3
38.7
Retail investors tend to hold a much larger proportion of short term
assets than pension funds. These differences can partly be explained by
differing time horizons of investors. Typically, the time horizon for individuals
is relatively short, whereas, given the long-term nature of liabilities, pension
funds may concentrate portfolios on long-term assets that yield the highest
2
returns. When freedom of investment and professionalism prevail, pension
funds are less risk averse, i.e. they take more equity risk and invest in new asset
classes. The time horizon of investments has tended to increase in recent years
and turnover is slightly decreasing (more passive core; less trading and pension
funds hold positions in excellent companies quasi forever).
269
Notwithstanding this excellent overall transformation, the optimal
allocation of pension funds is severely handicapped in several member states
such as Germany, Italy, Denmark, by investment restrictions, the investment
culture, taxation and sometimes also by inadequate supervision which
encourages short-termism. As a result the asset structure of EU pension funds
differs: a high percentage is invested in equities in the United Kingdom (with
77.6 per cent one of the highest in the world), Ireland (58.4 per cent) and
Belgium (almost 40 per cent), whereas Germany and Spain are nearly the
mirror image to the United Kingdom. On an EU-wide basis pension funds
held 54.6 per cent of their total assets in equities and 36.6 per cent in bonds.
These figures are heavily influenced by United Kingdom pension funds.
Ignoring the United Kingdom, only about 30 per cent of European pension fund
assets are invested in equities and more than 60 per cent in bonds (table 4).
Table 4. Asset structure EU pension funds
in per cent end 1995
Equity
United Kingdom
Ireland
Belgium
Sweden
Denmark
Netherlands***
Luxembourg
France
Austria
Greece
Portugal
Finland
Italy
Germany**
Spain
77.6
58.4
39.5
27.6
26.9
26.0
21.2
13.6
13.0
10.2
9.4
9.2
7.7
7.7
5.0
Fixed
income
13.9
29.6
46.4
62.1
62.9
63.0
60.5
38.0
70.6
53.0
26.8
60.5
63.0
74.1
76.0
Real
estate
4.8
6.8
5.8
5.5
7.1
8.0
0.0
8.1
0.8
12.7
4.3
13.2
21.0
6.5
1.0
Notes: *
Short Term Placements
**
Incl. parts of SPECIAL FUNDS applicable to pensions
*** Incl. ABP
Source: EFRP.
270
STP*
& other
3.7
5.1
8.3
4.8
3.1
3.0
18.3
40.3
15.7
24.1
59.5
17.1
8.3
11.7
18.0
Where freedom of investment exists, pension funds can flourish: the
United Kingdom, Ireland and the Netherlands provide good examples.
Investment restrictions may have a negative impact on pension funds growth
and performance. It is in the interest of all (employers, employees and
pensioners and not in the least of tax authorities) that restrictions are abolished
and that pension funds can optimally invest on a world-wide scale.
It is essential that pension funds and their investment managers be
able to operate in an environment where freedom of investment prevails. "Risk
is risk, it cannot be legislated away" despite what many supervisory authorities
seem to think; "it can only be diversified away", as George Russell, the
Chairman of F. Russell & Co. once said. Risk needs to be managed and
controlled and it is only by doing so that the opportunities offered by the
markets can be fully enjoyed.
In the recent past pension funds showed excellent returns, far above
3
expectations, but there was a high price to restrictions . Most hurt were
Switzerland (restrictions and risk aversion); Denmark (restrictions; risk
aversion and excessive taxation) and Germany (restrictions and risk aversion),
whereas Ireland, the United Kingdom and Belgium did better (table 5).
Table 5. Real above inflation national average
pension fund returns p.a. (1984-1996) (E) in per cent
Ireland
United Kingdom
United States
Belgium
The Netherlands
11
10
9
9
8
Germany
Denmark
Switzerland
Japan
7
6
4
0
Sources: EFRP Report, June 1996: updating; PRAGMA Consulting.
3.
Financial market behaviour of EU pension funds and their
impact on capital markets
The shift to funding and to higher coverage will offer major
opportunities. EU pension fund assets are expected to reach US$15 trillion at
the end of 2020 (one generation) compared with US$1 560 billion at the end
271
of 1995 (an increase of almost ten times). The impact of this on European
capital markets will be enormous. The following trends can be anticipated:
1. Much more capital will be available for investment in equities.
Equity financing -still the cheapest of all- will be more attractive,
relatively speaking. This will improve the balance sheets of
companies, which will be less dependent on bank credit. The two
largest Dutch pension funds ABP4 and PGGM5, for example, are
currently increasing their equity positions of which the bigger part
will be invested abroad. Compared with these two funds many
large company pension funds in the Netherlands, but also in
Belgium for example, held much larger percentages in equity for a
long time.
The more sophisticated pension funds have anticipated EU-wide
capital markets and European Monetary Union (EMU) and have
generally overweighted positions in Europe. Others (insurance
companies etc..) will follow. Unified capital markets and
currencies will increase correlations and hence increase the need
6
for investments outside the EMU zone as Prof. B. Solnik stated :
"The eventual convergence of currencies [and markets] within the
EU means that this element of diversification can only be
provided by non-EU currencies". Because the internal market will
be very large, we expect investments outside the EMU zone not to
surpass, on average 20 per cent (that is, say, 30 per cent for
equities and 10 per cent for bonds).
2. We expect an increasing participation in new asset classes (large,
mid-and small capitalisation stocks; private equity; venture
capital; emerging markets; passive and active quantitative; more
use of derivatives etc.). That is happening already and it will
accelerate. No doubt, this may lead to an increasing volatility of
returns and therefore an increasing need for risk control. Real
estate will reappear possibly much more in a securitised form
(e.g., Reits in the United States). Real estate as an asset class had
rapidly declined in percentage of total pension fund assets over
the last 10 years due to weak performance and lack of liquidity
combined with high costs and high specific risk.
3. More capital will be available for debt financing and this can
hopefully lead to a decrease of real interest rates. Government
debt financing will be easier but we expect that there will also be
more room for private/corporate debt. This market is likely to
expand after the introduction of the EMU. Also, we expect more
272
"securitisation of everything" and more below investment grade
debt financing. As a result credit ratings will increase in
importance, both for public and for private debt.
4. There may be more passive core asset allocation for larger funds
combined with active specialised mandates and a move away
from balanced mandates. This currently is the case in the
Netherlands and Belgium, but less so in the United Kingdom up
to now although it happens there as well. Also in Germany,
Switzerland and in the Nordic countries specialised management
is on the rise. There will be a move towards increased external
asset management and increasing competition between external
managers.
5. There will be more shareholder activism; as a result of the current
and expected shift to investments in equities and more indexation
of core portfolios for large pension funds. Adequate corporate
governance as a countervailing power to company management
will be encountered more frequently and increasing attention will
be paid to "shareholder value". Corporate governance can have
positive or negative effects. Usually the effects are positive; it
changes attitudes; it detects and corrects excesses. Corporate
governance is now well developed in the United States and in the
United Kingdom (Cadbury and Greenbury Codes; Hampel
Committee) and will soon emerge in The Netherlands. The Dutch
Committee on Corporate Governance recently issued
40 recommendations and a specific Institute is now being created
of which the initial drivers will be large public and private sectorwide pension funds; and in Belgium where a Code of Conduct is
now being written.
6. It is clear that pension funds can only play a role in corporate
governance if they are important in the local equity market
(table 1).
7. Professional asset management, freedom of investment, adequate
stock selection, increasing pressure for return and the fact that
pension funds are collectively long term shareholders lead to
investment concentration in excellent companies. Those that are
competitive, innovative and expand employment and/or offer a
better future to their workforce will be supported in this natural
selective process. Poorly managed companies will not receive a
lot of pension fund investments and will therefore become
273
relatively cheaper; they will hopefully be encouraged to perform
better or could otherwise become vulnerable to take-overs.
8. Pension funds are currently the most sought after shareholders of
any listed company in view of their size and the long term nature
of their investments.
9. The trend away from defined benefit plans (overregulation kills
defined benefit plans) in favour of defined contribution plans
could lead to sub-optimal portfolios due to shorter investment
horizons if the plan participants make the investment decision.
Employers may not be as strongly motivated -as with defined
benefit plans- to optimise return. They incur a fixed cost,
whatever the return is, and the investment risk is shifted to the
employee who will, in general, not go very far on the risk curve.
This can be avoided if -as is the case of the United Statesappropriate education programs on asset allocation, risk and
return are offered to participants and if optimal diversification and
the long-term time horizon of funded pensions are taken
advantage of. The cost of defined contribution plans will normally
be higher per unit managed. Increasing competition between
providers of defined contribution plans (usually by means of
investment funds) may, however, lead to higher efficiency and
decreasing costs.
4.
Conclusion
The effect of the shift towards funded pensions systems will give
strong support to higher economic growth (including job creation), for
shareholder value and for successful companies i.e. those that have excellent
earnings growth and offer better perspectives to their employees. The
institutionalisation of capital and higher professionalism driven by fierce
competition will lead to optimised portfolios; greater efficiency; higher returns
and better risk control/understanding of risk. In defined benefit plans this will,
and does already, result in better pensions, usually fully protected against
inflation, and in labour cost reduction (contribution holidays) and for defined
contribution plans to more individual responsibility and better pensions at the
same cost.
These trends will result in pressure on social security pensions and to
less public subsidising of these systems; to much higher tax receipts during the
ageing wave for countries that already have and will have substantial pension
274
fund assets (The Netherlands, the United Kingdom, Ireland, Switzerland and
Denmark are already major beneficiaries of increasing tax receipts and this can
only grow over time).
Pension funds are social funds; they have no shareholders to satisfy;
all investment income and capital gains benefit their members and sponsors.
They have in recent years obtained excellent real returns, driven by outstanding
capital markets, in which they play an important role. They are increasingly
professionally managed and the fierce competition for their assets among
external managers will reinforce this. They are almost too good to be true
because they combine a social objective (better pensions for more people at the
least possible cost) with an increasingly important economic and financial role
directly applied to capital markets.
275
NOTES
1.
EFRP Report "European Pension Funds: Their Impact on European Capital
Markets and Competitiveness", June 1996, pages 26-27 (update).
2.
E. Ph. Davis "Pension Funds: Retirement-Income Security and Capital
Markets", 1995, page 161.
3.
Op cit. EFRP Report: Return and Risk Analysis, pages 56-76 and The Effect
of Restrictions on Benefits, Labour Costs and Tax Receipts, pages 76-88.
4.
The Dutch civil servants fund, the largest European pension fund and the
second largest in the world.
5.
The largest private sector pension fund in The Netherlands (health care
sector).
6.
Prof. B. Solnik "Fundamental Considerations in Cross-Border Investment:
The European View", The Research Foundation of the Institute of Chartered
Financial Analysts, April 1994, pages 8, 14, and 15.
276
Chapter XII
INSTITUTIONAL INVESTING IN THE NETHERLANDS: THE
PENSION PLAN FOR DUTCH CIVIL SERVANTS
by
Jelle Mensonides*
Introduction
In many countries there is a clear demographic shift to ageing
populations. This raises a number of serious questions, such as how to fund
retirement plans, and what would be the appropriate level for these plans?
Closely related to these issues is the overall structure and organisation of
retirement income systems, including the role of public policy and the role of
individual self-directed pension schemes. Clearly, the structure of retirement
systems depends to an important degree on social-political preferences.
This paper describes the Dutch situation. Generally speaking, the
Netherlands has a tradition of relatively high individual and collective savings,
underpinned by a well-developed pension industry. A major part of the
retirement system is governed by employers and trade unions.
This paper will focus in particular on the pension plan for Dutch civil
1
servants, called the Algemeen Burgerlijk Pension Funds (ABP). Various
aspects of the pension plan, the way retirement pension plans are organised in
the Netherlands, the status of pension funds and their governance, will be
outlined. Against this backdrop, the paper will analyse the concept of Asset
Liability Management (ALM) and ABP’s investment activities.
*
Director of Equity Investments, ABP.
277
1.
Institutional savings
Financial assets of institutional investors have been growing strongly.
This is the result of population ageing, as well as the steady decrease in the role
of the government in providing social security in many countries. These factors
have raised the awareness of households of the need to save for retirement.
Notably in recent years, part of the strong growth in pension funds’
holdings of financial assets has been the result of increased equity prices.
Financial assets as a percentage of GDP are given in Chart 1. This shows that
the USA, UK and The Netherlands are in the lead, while the emerging
economies at the bottom. German and Italy are special cases: Italy has virtually
no pension fund industry, while in Germany the pension liability is carried in
the form of book reserves on the sponsor company’s balance sheet. (In
comparison with Anglo-Saxon pension plans, these book reserve plans
completely lack autonomy.)
The financial services industry plays a major role in investing
retirement savings. The size of the Pension Fund industry is around $8.5
trillion, of which 50 per cent of this amount generated by the biggest 300
2
funds.
Chart 1. Financial assets as per cent of GDP
170,8
USA
UK
Netherlands
Germany
France
Belgium
Italy
Sweden
Japan
Korea
Mexico
Hungary
162,3
158,4
46,1
75,3
53,6
20,6
114,8
77,4
57,7
3,9
4,5
0
Notes:
Source:
1995
1992
1990
50
100
150
a) Mexico: 1995 excluding pension funds.
OECD Institutional Investor, Statistical Yearbook, 1997.
278
Chart
Chart 2.
2. Ranking
Ranking countries
countries with
with pension
pension assets
assets (%
(% of
of world
world total)
total)
France
France
New
NewZealand
Zealand
Chile
Chile
Norway
Norway
South
SouthAfrica
Africa
South
SouthKorea
Korea
Brazil
Brazil
Australia
Australia
Denmark
Denmark
Malaysia
Malaysia
Singapore
Singapore
Germany
Germany
Switzerland
Switzerland
Sweden
Sweden
Canada
Canada
Netherlands
Netherlands
UK
UK
Japan
Japan
0,2%
0,2%
0,4%
0,4%
0,4%
0,4%
0,4%
0,4%
0,5%
0,5%
0,5%
0,5%
0,7%
0,7%
1,0%
1,0%
1,0%
1,0%
1,1%
1,1%
1,2%
1,2%
1,3%
1,3%
1,5%
1,5%
2,3%
2,3%
3,9%
3,9%
6,4%
6,4%
8,6%
8,6%
9,9%
9,9%
58,6%
58,6%
USA
USA
0,0%
0,0%
10,0%
10,0%
20,0%
20,0%
30,0%
30,0%
40,0%
40,0%
50,0%
50,0%
60,0%
60,0%
Source: Pensions Investments,
&
.
Sept.
Source: Pensions & Investments, September 1997.
Pension funds have a traditionally strong position as retirement plan
providers in the Netherlands. The funds come in two types: corporate funds and
funds linked to a given branch of industry.
The ABP is the biggest pension fund in the Netherlands, comprising
some 40 per cent of all Dutch pension fund assets. Globally, ABP ranks in the
top three with US funds as its peers.
2.
Position of pension funds
Dutch pension funds provide supplementary benefits to retirement
3
plans (second pillar ). The first pillar operates as a pay-as-you-go system,
financed by premium contributions collected directly by the tax authorities. The
actual level of retirement benefits is only fixed after parliamentary debate, with
4
annual discretionary adjustments in line with wage and price developments.
279
A more recent development are plans more closely tailored to
individual needs; these are additional to the first and second pillars. At present,
these “third pillar” plans do not compete with the first and second pillars. But if
US developments with 401K plans are any guidance, they might become more
important in the near future.
There are two factors behind this shift:
− Families are giving higher priority to tailored individual products;
− Increased focus on cost reduction in second pillar plans by
employers.
Table 1. Retirement schemes
Scheme
Third pillar Individual plans
provided by life
and other insurers
Second
pillar
First pillar
Remarks
Defined Contribution plans. Investment Risk
with the participant, not the provider.
New trend towards individualisation creates
potential for third pillar (Employee benefit
plans).
Traditional life insurers see major potential.
Pension Funds create separate operations to
provide the same products.
Supplementary
Defined Benefit system, capital funded.
plans provided by Two types:
plan sponsors
1. Plan on top of the first pillar; adjustments
to the first pillar do not impact on height of
second pillar;
2. The first pillar has been integrated,
whereby adjustments in the first pillar
influence liability of the plan sponsor.
General
Pay as You Go System.
retirement plan,
Ageing population causes a future burden in
as from 65 years the form of higher premium contributions.
Source: Author.
280
3.
Governance of a pension fund
The pension plan in the second pillar is the responsibility of the
employers’ federations and bodies representing the employees - often the
unions; together they govern as plan sponsors, on occasion with an independent
chairman. Management and control of the pension services and organisation is
the task of a dedicated management organisation. There are two models:
− The management organisation delivers all services to the Board of
Trustees on the basis of a commercial contract covering
investments and the servicing of pension benefits;
− The management contract is mandated by the Board of Trustees.
There is no formal contract as the management organisation forms
part of the overall pension fund (delegation model).
This delegation model is the one used in most Dutch funds. An
independent Council acts in a supervisory capacity to monitor the funds’
financial position in relation to its liabilities. The ‘prudent man’ rule applies
here and the Council’s task is comparable to that of a central bank vis-à-vis
commercial banks.
Dutch law requires a separation of the second and third pillar
activities within a pension plan.
Figure 1 shows the ABP organogram (second model), reflecting the
various levels of responsibility. This is a recent structure and it remains to be
seen how it will function in practice.
The role of the Board of Trustees in relation to the Executive Board is
currently a hot issue within the delegation model. According to the present law,
the Board of Trustees has the ultimate responsibility for the pension plan. The
Board of Trustees (Pension Board) and the Executive Board have separate
responsibilities. The Pension Board has delegated the operational activities to
the Executive Board. A mechanism is needed to balance both sets of
responsibilities, without the Pension Board being forced to deal with these dayto-day activities.
In my opinion, the Pension Board should confine itself to appointing
the members of the Executive Board, which is responsible for all results
(pension services plus investment performance). In addition, the Pension Board
can implement internal or external auditing procedures, while avoiding
conflicts-of-responsibility. Under this model, expertise about the operational
281
activities of the pension plan (e.g. investments) is not necessarily concentrated
in the Pension Board. The two boards need to discuss strategic issues such as
strategic asset allocation arising from the Asset Liability Model (ALM), welldefined risk preferences for investments, level of pension services, and naturally - the budget. But, when it comes to operational activities,
responsibility lies with the Executive Board.
Figure 1. ABP organogram with an insurance operation
Regulators
(National
government)
Employers‘
Representatives
Trade Unions
Representatives
Independent
persons with
proven track
record
a)
a)
Independent
Supervisory
Council
Board of Trustees
b)
a)
PENSION PLAN
Executive
Board
Pension Services
Notes:
Non Executive Board
INSURANCE
OPERATIONS
Executive
Board
Asset
management
Employee benefit
Products
a) At present delegates of employer/employee organisations and an
executive board member of the Pension Group are non-executives of the
insurance operations.
b) In Holland the Executive and Non-executive Boards are separated.
Each board has its own chairman.
282
Recently, the Independent Supervisory Council stated that
appointments of members of the Board of Trustees should be conditional on
them having expertise of the various aspects of the pension industry. Without
this in-depth expertise, they could face complex issues which they are unable to
address. However, in my view this stipulation goes too far in that it is
unreasonable to expect that members of Board of Trustees possess this in-depth
expertise.
4.
Liability of pension plan
The liability structure is the starting point for the investment strategy
of a pension plan. The liability of a defined contribution (DC) plan differs
significantly from a defined benefit (DB) plan. Under the DC system a
participant pays a contribution in exchange for a given amount of money in the
future; the amount of the pay-out depends on the realised investment results.
The policy holder (and not the pension plan sponsor) bears the investment risk.
In a DB plan the pension plan sponsor accepts liability for future pension
payments. In principle, the participant’s contribution during his/her working
life must be sufficient to meet all future liabilities and risks. However, the plan
sponsor bears all risks5 and these risks must, therefore, be reflected in the level
of the premium contribution.
DB covers several different types of pension plans. One of the most
attractive for a participant is the final pay plan, which is also the most
expensive one. Typically, the benefit on the moment of retirement is calculated
on the basis of the most recent salary, or the average salary for the last two to
five years. In general, the pension benefit averages between 60 and 70 per cent
of the last salary, depending on the number of years worked. A less expensive
option is the average pay system, whereby a sum of money is assigned to every
working year.
The method of indexing is crucial to ultimate financial result6. The
pension can be indexed to prices or wages. Funded pension plans are highly
vulnerable to inflation; this makes hedging inflation a major factor in
7
determining asset composition.
The liability structure is further determined by specific actuarial
requirements. For example:
− Present and future ratio of active to inactive participants;
− Mortality rate;
283
− Salary distribution: salary differences and imbalance of salary
spread are factors determining the level of premium contribution.
The final pay systems mean redistribution of life-time income
within and across generations.
− total working-age of employees leaving the system and whether or
not they take accrued reserves or stay in the fund; this determines
future liabilities, particularly when they are indexed.
− Level and adjustment of state retirement pension (pillar 1). In
some cases, the supplementary pension is integrated in the first
pillar. In other cases, the supplementary pension is in addition to
pillar 1; in the former case, all positive and negative adjustments
are part of the cost of the plan sponsor.
− The assumed actuarial return.
8
Figure 2. Diagram of ALM
Type of
pension
scheme
Actuarial
conditions
Economic
scenarios
Financial
conditions:
Liability
structure
•
Return
•
Solvency
•
Volatility
•
Liquidity
•
Global allocation
Asset Liability Management
Asset composition:
• Fixed Income
• Real Estate
• Stocks
284
Asset characteristics
Using the “asset only approach”, one can calculate an efficient frontier
for the various asset mixes. An optimal asset mix with the highest yield can be
determined on the basis of a pre-determined risk profile. ALM helps to clarify
the liability structure. Hence, one gets a better asset mix to match with shorterand longer-term premiums and reserves (often used via the so-called coverage
ratio: assets related to liabilities). The younger the age of the participants, the
greater the potential for equity investment in the sense that short-term
obligations are negligible and, therefore, a higher degree of short-term volatility
can be accepted. In contrast, a mature fund must carefully monitor solvency
conditions and the short-term liquidity of its investments. Consequently, greater
emphasis on fixed income investments is called for. Arrangements must also be
made to prevent under-funding risks. To this end, the supervisory authorities
require an adequate level of reserves, particularly where more volatile
investments are involved. The higher level of reserves vis-à-vis the liabilities,
the more acceptable these risks for the Pension Board. From the shorter-term
angle, investment contributions are part of salary costs. Therefore, there will
always be pressure to reduce them, thereby creating a potential conflict between
short- and long-term objectives.
ALM is not a forecasting model and no precise estimates should be
expected. However, it is a powerful tool for putting into perspective the
strategic decisions with respect to composition, the impact on short- and longterm premium contributions, and the coverage ratio.
5.
ABP strategic asset allocation
Until January 1996, prevailing investment rules meant that fixed
income instruments made up a high percentage of ABP’s portfolio. With the
abolishment of these government regulations, ABP acquired the same status as
9
any other Dutch pension plan, and the Board of Trustees took the decision to
give a greater emphasis to equity. Higher investment returns can be earned on
equity, but at the cost of higher risk.
Several economic scenarios were developed using the ALM-model
with the aim of checking robustness of results under various circumstances; so10
called “what-if scenarios”. The basic assumption underlying this idea is that
economic developments are uncertain, particularly in the longer term. In this
uncertain climate, information on the risks associated with the various strategies
is preferable to supposedly “accurate” forecasts.
285
Starting with a low equity exposure and relatively low coverage, ABP
took the decision to increase its equity weighting to between 30 and 40 per cent
within a period of around 5 years. Given the low reserves, this increase had to
be gradual. To avoid a direct impact on the premium by market volatility, it
was decided to build-up a buffer; this buffer is fed by a part of the yield on
11
securities. Under this policy, the speed at which the desired buffer level is
reached, depends on the willingness to accept short-term premium increases,
12
with the potential to lower these in the future.
6.
Portfolio composition
Notwithstanding a strong emphasis on increasing the equity portfolio,
fixed income investment remains the anchor of the portfolio as a whole, i.e. a
stable cash flow with a relatively low risk profile.
The real estate holdings used to be viewed as a degree of hedging
against inflation in a more or less balanced supply-and-demand environment.
However, real estate is increasingly becoming a liquid investment due to its
securitisation. Hence, real estate is becoming more like a cyclical stock, i.e.
high volatility and added value depending on timing.
Equity investments help diversification and result in a higher portfolio
return, but they also create higher volatility. They give the institutional investor
access to other national and regional economies in various stages of
development. This corresponds to the way institutional investors are
channelling savings to destinations with the best potential.
Strategic asset allocation is by far the most important decision for an
institutional investor; this decision makes the largest contribution to the value
of the total portfolio. To a lesser extent, added value also comes from tactical
and country allocation. In fact, contrary to popular belief, stock selection only
accounts for a small part of the overall return.13 The next chart sets out five
years risk and return for several US equity managers and documents the
difficulty of outperforming the benchmark permanently. Each money manager
is represented by a dot; their median is well below the benchmark and it is safe
to conclude that many of them perform below the median and with a generally
higher risk level.
286
Chart 3. Five years average Return and Risk
of US money managers
Source: Pensions & Investments, Piper Information.
7.
Financial markets
Broadly speaking, financial markets can be divided into efficient and
less efficient ones. In an efficient market, the price of the asset is determined
rapidly within a transparent environment. Liquidity constitutes no problem and
assets can be bought and sold at low transaction costs, with little market
impact. Transparency will cause the advantages of market intelligence to
disappear rapidly. In less efficient markets, the factors underlying price
adjustments are less easy to determine, transaction costs are higher, and
liquidity lower. Sometimes the market is dominated by just a few players. The
sales of illiquid assets can be fairly problematic. Indeed, a major part of the
final return will depend on constructing an exit strategy precisely at the moment
of purchase. Less liquid markets include real estate, structured finance in fixed
income and private equity.14
287
Table 2. Types of investment
Efficient markets
Listed Investments
− Stocks
− Fixed Income
− Real estate
Less efficient markets
Non listed
Listed Investments
Investments
− Emerging Markets a)
− Private Equity
− Holding Interests
in Real Estate
− Structured
Finance with
Fixed Income
How are the activities organised?
Discretionary
Selection of countries by
Portfolios:
approach
focusing on:
− Index
− Social and Political
− Enhanced index Deal oriented
stability;
− Active
− Macro and Monetary
Benchmarks
Policy
− Style, local and
Portfolios:
/or global
− Active
− Developments are going
fast; portfolio structure in
the near future the same as
in the efficient markets
Benchmark:
Country specific
a)
Note: each emerging market is at a different stage of development; development is
fast but unequal; several countries are shifting to ‘efficient’ status.
However, markets are rapidly changing due to the securitisation of
formerly illiquid assets. Examples of these include: Real Estate Investment
Trust (REITS), Mortgaged backed Securities (MBS) and other asset-backed
securities. They have been pioneered in the USA but can now also be bought in
15
other developed markets.
The majority of institutional investors are end investors and they are
mainly interested in publicly traded liquid assets. In general, only a small part
of their investments are in the ‘less efficient’ markets. However, they show a
growing interest in these markets. Risks are diminishing due to enhanced
288
information facilities, while the returns are generally higher than in the listed
market. All the same time, they offer diversification benefits. Table 2 gives an
overview of the range of investments.
8.
APB’s investment philosophy
Investment products are increasing becoming standardised. The
market focus on short-term performance is pushing all asset managers’ results
in the same direction, i.e. towards the index.16 A feature of a standardised
product is that it can be offered by a large number of suppliers. In this situation,
the criteria for selecting asset managers are very much based on cost
considerations, a stable organisation, and style return enhancements.
Underlying ABP’s investment philosophy is a differentiation between
efficient and less efficient markets. Each type of market requires a separate
investment approach, in terms of strategic policy, management, and monitoring.
ABP’s approach to the efficient market sector is asset-management based.
Meanwhile, less efficient markets require a different approach, which more
closely resembles that of an investment bank: corporate finance, dealstructuring, due diligence, analysis of tax factors. ABP’s operates on the basis
of a very long-term investment horizon, making it attractive to invest in lessefficient markets and in unlisted activities, provided that they are wellmanaged.
ABP differentiates between three broad investment categories in the
efficient market: index, enhanced index, and active portfolios. This applies to
17
equity, fixed income investments and real estate. The advantages of an index
portfolio are: its exposure to a broad liquid market; use of well-known
benchmarks low management fees and low transaction costs. Enhanced index
portfolios aim to generate excess return on a benchmark by implementing an
active, strictly risk-controlled, limited position. In this context, risk is defined
18
as the standard deviation of the portfolio to the benchmark (tracking error).
Table 3 gives an example of the criteria for constructing a portfolio.
289
Table 3. Example of portfolio management for equity
Investment
choice
Percentage of total
portfolio
Tactical asset
allocation
Underlying
percentages are
dependent on the
risk profile of other
assets and on the
total risk profile of
the plan sponsor.
Several
combinations are
possible.
Tactical country
allocation
Higher risk active
portfolios
Medium risk
active portfolios
Enhanced index
portfolio
Index portfolio
Expected
Tracking
Return
excess return error b) contribution to
(basis points)
the total
a)
portfolio
200
4
Dependent on
the underlying
weights of the
different
portfolios and
tracking error
defined for the
total portfolio.
150
3
400
8
200
4
100
2
0
(=
benchmark)
0
Notes: a) one basis point is 0.01 per cent
b) excess return is used as an example here, the information ratio being 0.5;
a minimum of a half point excess return is required for every additional risk
point.
9.
Active styles
Style investments started to spread across the US investor community
back in the 1980s. The background to this development was that plan sponsors
were seeking asset managers with a strong focus on specific segments of the
equity market. Given ABP’s portfolio approach, the active style can contribute
to a transparent investment process. Two approaches need to be distinguished
here: top-down and bottom-up. The top-down approach starts with the macro
economy and its impact on various economic sectors. These effects are
290
analysed for specific companies, with the objective of identifying cyclical
stocks, i.e., defensive or offensive stocks vis-à-vis the economic cycle.
The bottom-up approach starts by analysing a given company, in
order to select companies with similar technical characteristics regarding priceto-book, E/P ratio, price-to-sales, etc., for the various business cycles.
Style investment is an attempt to exploit market anomalies.19
Although advocates of the efficient market hypothesis claim that all available
information is incorporated in prices as rapidly as possible, it is clear that
market anomalies can create an extra return. This key question is how to
allocate funds in such a way as to achieve outperformance on a durable basis. In
practice this is difficult, given the fact that in many cases the most important
variable for obtaining added value when buying or selling a stock is timing.
This point is illustrated in Chart 4: discrepancies between the various styles
fade away after around five years!
Chart 4. Style performances (per cent) in the USA 1987 - 1997
40
35
RogersCasey Large
Growth
30
RogersCasey Large Value
25
RogersCasey Small Growth
20
15
RogersCasey Small Value
10
5
RogersCasey Midcap
Growth
0
RogersCasey Midcap Value
1 Yr
2 Yrs
3 Yrs
5 Yrs
Source: Author.
291
10 Yrs
In creating a transparent, active portfolio, ABP makes a distinction
between size, value and growth companies. Large, -mid - and small-cap
companies are categorised on the basis of market capitalisation. This is a useful
approach given the ease of implementation. Another distinction is that between
value and growth companies. Value managers target undervalued companies,
while growth managers are looking for companies with high growth - or
potential high growth - in earnings. Growth managers accept high current prices
20
because they expect compensation from future earnings growth.
Table 4. Example of style matrix for active stock investments
Large-cap
Mid-cap
Small-cap
a)
Micro-cap
Weight (%) Value (%)
70- 90
25 – 35
5 - 10
25 – 35
5 - 20
5 – 15
Very limited
-
Coreb) (%)
50 - 70
50 - 70
50 - 70
-
Growth (%)
5 – 15
5 – 15
25 – 35
100
Notes:
a) Micro-cap is a more specific sub-division of the small-cap.
Generally, these are recently floated companies.
b) Generally, all core portfolios have a tilt (to value).
Source: Author.
Lack of adequate information means that this matrix cannot be used as
easily around the world as it can be in the USA. Given the timing problems
between value and growth, the lion’s share of the active portfolio will be
invested in the core portfolio. Moreover, according to research, the differences
in style risks diminish over a long period of time, so that asset allocation may
21
simply be a function of the return for true long-term time horizons. However,
the size variable remains a significant factor for explaining differences in
22
return.
Defining market segments in terms of style investment, requires
painstaking style control and performance attribution. By definition - to prevent
shifting and slipping - a style manager should stick to his style. Indeed,
performance of a manager’s stock selection for a given style will be evaluated
according to its style benchmark, while the allocation of funds on the basis of
the different styles is the responsibility of the plan sponsor.
292
Using portfolios with different return and risk characteristics for every
world region, makes it possible to allocate pension money in a highly
transparent and structured manner.
10.
Internationally or domestically biased investments
As early as 1974 Solnik pointed out the risk-reduction potential of
international diversification23. At that time, most institutional investors had a
very strong home bias. However, much has changed since then. World trade
expanded dramatically, and emerging economies/new markets joined the
developed economies. New trade zones were established in Europe and the
Americas. And in this new world order, international equity investments create
potential for achieving exposures to national and regional economies at
different stages of development.
Chart 5. Correlation between countries
Equity return correlation between the
Netherlands and other countries
0,80
0,70
0,60
0,50
0,40
0,30
0,76
0,75
0,69
0,59
0,61
0,69
0,62
0,61
0,55
0,48
0,50
0,50
0,37
Japan
Spain Switzerland USA
Australia
France HongKong
Italy
Canada
Singapore
UK
Sweden
Germany
local currency 1982-1989
NL currency 1990-1997
Source: Author.
293
local currency 1990-1997
Internationalisation of security investments can reduce risks as
evidenced by less than complete correlation between equity returns of the
various countries. The lower the correlation coefficient, the better the
diversification benefits; this is clear from Chart 5, which shows this correlation
for Dutch equity returns with other countries for two different periods.
Traditionally, the Dutch equity market has strong ties with US,
British and Swiss market returns. From the early 1990s onwards there has been
a marked increase in convergence with the European Union, and there is a
remarkable rise in the correlation coefficient between the Netherlands and
Germany, France and Spain, and - to a lesser extent - Sweden. At the same
time, this means a diminishing country effect on the portfolio. This trend also
dictates that greater attention must be paid to developments in the various
economic sectors. Hence, globalisation (leading to an increase in correlation of
returns) implies that a stronger emphasis needs to be given to the competitive
edge of companies with domestic and global sectors. And for the equity
investor it means focusing on companies that generate attractive shareholder
values in their particular sectors.
When the currency effect is taken into account, there is a slight
change in correlation (Chart 5). Correlation of returns for the period 1990 to
1997 is shown in both local and Dutch currency. For the Dutch investor, the
developments leading to a single EU currency mean virtually no currency
contribution to portfolio diversification (see the positions of Germany and
France). However, with the exception of Switzerland, investing in other areas
implies a higher correlation coefficient, and hence currency compensates for
part of the diversification of equity in the various countries.
Traditionally our main market has always been the Netherlands. The
single EU market is changing that, making Europe our domestic investment
market, notably in the fixed income category. On the equity and real estate side,
ABP, already takes a global and European investment perspective.
11.
Shareholders value and corporate governance
For two decades, institutional investors in the USA have put
shareholder value of equity investment and their role in corporate governance
high on their priority list. The same started to happen in Europe a few years
ago. In the United Kingdom, the debate on corporate governance and
shareholder value was sparked by the Cadbury Report, in France by the Vienot
Report and in the Netherlands by the Peters Report.
294
There are a number of reasons why institutional investors should take
corporate governance issues associated with their equity investments seriously:
− good corporate performance boosts discipline on the board and
hence generates better market value;
− an index investment approach means that overall performance is
determined by average (market weighted) performance of all
companies on the index. Increased focus on shareholders value
can be a significant factor in increasing the average result,
particularly where a company is performing below sector average.
− the larger the equity position in a company, the closer the
shareholder needs to monitor their operations and plans.
At ABP we make a sharp distinction between the role of our
shareholders’ position and the responsibilities of executive and non-executive
company directors. In general, we disapprove of shareholders on the board as
this can create conflicts-of-interest.
12.
Future developments
Competition between providers of financial services is expected to
increase. While life insurers are moving into the market for pension products,
the pension funds are penetrating the insurance market. Both types of
institutional investors are offering similar products. This will continue because
it is becoming increasingly attractive to provide the entire package of employee
benefits.
Against the backdrop of increased global competition between
providers of financial services, the pension industry is heading for greater
concentration, with smaller operations merging or being acquired. Also in
Continental Europe with its relatively low level of private retirement pensions,
major structural changes can be expected to take place.
This process will be driven by the desire to offer competitive
comprehensive pension products because plan sponsors increasingly demand a
24
high quality of services and investment performance.
295
NOTES
1.
ABP is the pension plan for Dutch civil servants in local and central
government and teaching. There are 878,000 active participants, and
540,000 inactive. Assets are around US$ 135 billion. The plan is fully
funded. ABP became independent from the government in January 1996. It
is now governed by a board of trustees comprising an equal number of
representatives for the employers and employees sides, with an independent
chairperson. Day-to-day operations are the responsibility of the Executive
Board.
2.
Pensions & Investments, 15 Sept 1997.
3.
First pillar plans are state (sponsored) pension plans; second pillar plans are
supplementary to these plans and provided by pension funds and life
insurers. Third pillar plans are individual schemes often defined
contribution ones.
4.
In the past, adjustments were in the form automatic indexation formulas
based on developments in wages. Today, adjustments are made on a more
discretionary basis.
5.
Extreme situations, e.g. armed conflict, are not covered.
6.
Index costs for final pay or average pay systems do not differ.
7.
Inflation erodes accummulated capital. This necessitates either an increase
in contribution rates or a lowering of the liabilities.
8.
The Dutch discount liability rate is usually 4 per cent; in the UK and USA it
is often higher at around 6 to 8 per cent. The discount rate pre-supposes a
fixed return on investments. This could become problematic where the
return does not exceed the sum of the discount rate and inflation. For
example, this is the case in Japan because institutional investors guarantee a
minimum 5 per cent of return; to be sustainable this guarantee requires very
high reserves.
296
9.
Prior to 1996, the responsibility for ABP’s financial results resided with the
Dutch Ministries of Finance and the Interior. Hence, restrictions on
investments were imposed by the finance ministry; up to 1987, these
included restrictions on investing abroad. However, since becoming an
independent foundation, full and final responsibility for the financial results
resides with APB’s Board of Trustees.
10.
Sensitivity scenarios were carried out under different circumstances:
1) reduced economic growth with slower growth in company earnings, and
low interest rates, 2) rapid economic growth, ongoing corporate
restructuring, high earning growth, 3) global inflation.
11.
Assets are valued at market value.
12.
This policy was complicated by too low premium contributions, which was
the outcome of government policy in the 1980s of seeking to balance part of
the government budget by lowering employers’ contributions to the ABP.
Bringing the contribution up to the appropriate level before the millennium
was one key condition in ABP’s privatisation process.
13.
Strategic asset allocation contributes to some 60 per cent of the overall
portfolio return, and active stock selection only about 5 per cent.
14.
Private equity comprises venture capital, management buy-out/in
participation or development capital via equity investments, often combined
with mezzanine financing.
15.
REITS are publicly traded real estate investments whereby a real estate
cluster package is offered on the open market.
16.
Sustained outperformance of active portfolios (e.g. 10 year) is extremely
difficult and many managers only realise excess performance for a short
period, say one or two years. (See graph 3).
17.
An index approach can be applied to real estate, because of the introduction
of listed funds in the mid-1990s, and the publication of benchmarks.
18.
Risks must be differentiated from uncertainty. Risk is an uncertain event
where the possible distribution of outcomes is known. Uncertainty relates to
events where the distribution of outcomes is totally unknown. The standard
deviation is often used for risk. Another measure of risk is the number of
times a stock does not exceed a threshold return in a given period, (say one
year). This is a less frequently used yardstick.
297
19.
Richard Bernstein, Style Investing, 1995
20.
Nominal earning growth will affect performance of market segments and
investing style. (Bernstein, 1995 p 19).
21.
Return differences between size segmentation are quite substantial, while
these differences for value and growth are rather small. (Bernstein, 1995,
p. 186)
22.
See also: R.A. Haugen, "The New Finance, The case against Efficient
Markets’". 1995
23.
B. Solnik, "Why not diversify internationally rather than domestically",
Financial Analysts Journal, July/ August 1974.
24.
While greater disclosure of investment performance would eventually lead
to better results, the downside is that the investment focus would shift to the
short-term. Monthly and quarterly comparisons in the mutual funds industry
have certainly meant a shift towards short-termism. In contrast, the pension
fund industry with its long-term outlook is particularly well-situated to
channel savings into longer-term investments.
298
Chapter XIII
ASSET ALLOCATIONS OF PENSION FUNDS:
IDENTIFICATION OF BENCHMARKS
by
Andrea Beltratti*
Introduction
Even within the context of countries with roughly similar degrees of
development, European financial markets are very heterogeneous both in terms
of regulations and in terms of relevance of institutional investors. In the UK,
markets have a central place in the financing of productive activity, while in
Germany and Italy banks intermediate most of the funds. Also, stock markets
are developed in very different ways both in terms of quantitative importance
and in terms of qualitative efficiency, e.g. compare Italy and the UK. The
various aspects are strongly interrelated: a market oriented system favours the
development of non-bank financial intermediaries and provides more occasions
for direct contacts between final savers and final investors.
Differences in financial structures are often associated with
differences in average asset returns. It is then perhaps not surprising that
existing empirical evidence suggests that asset allocation of pension funds
differs substantially across countries. Such differences may be also due to
regulations and taxation structures. However, before concluding that different
asset allocations can be explained largely by different country and institutional
characteristics, one may want to look at economic theory in order to understand
whether some differences may be connected with economic and financial
factors. Are there elements suggesting that pension funds based in different
countries should systematically construct different portfolios?
*
Professor, University of Turin. I am grateful to BSI Gamma Foundation for
financial support. Also, I thank Onorato Castellino for useful comments on
a previous version of this paper.
299
The issue can be reformulated as an identification of the proper
strategic benchmark. The strategic benchmark is used to identify the long run
structure of the optimal portfolio. It represents a reference point around which
the actual portfolio gravitates in the short run due to tactical decisions which
react to specific and temporary situations of various financial markets. As such,
the strategic benchmark may be used for the interpretation of the average
portfolio composition of various pension funds.
In interpreting the portfolio of the pension fund in terms of a
benchmark, one needs to state what is the composition of the benchmark or at
least the rule which is followed for the dynamic formation of the benchmark.
This is done in the rest of this paper by using the theory developed by Merton
and others for the solution of intertemporal utility maximisation problems.
Such a solution has profound implications for consumption and optimal
portfolios, which may help in identifying the sources of international
diversification of portfolios.
The plan of the paper is the following. The second section reviews
some empirical evidence about the importance of pension funds in different
countries. The third section looks at the Italian case where pension funds will
start operating presumably in 1998. The fourth section reviews the theory of
asset allocation. The fifth section derives the consequences of such a theory for
interpreting the asset allocations of pension funds. The sixth section concludes.
1.
Asset allocation by pension funds
Asset allocations chosen by financial intermediaries and by
individuals have not been the object of extensive empirical studies, mainly due
to lack of adequate data sets. However, availability of data on portfolio
composition is useful to directly characterise the strategy of a financial
institution. The analysis of such data may reveal the existence of interesting
patterns, which may confirm or disclaim the validity of various theories. For
example the international diversification puzzle, see French and Poterba (1991),
arises from the observation that most financial institutions seem to hold
portfolios which are heavily tilted towards domestic assets. The puzzle arises
when one tries to explain this portfolio behaviour in light of the financial theory
which would suggest the optimality of international diversification.
In the case of pension funds Davis (1995) reports some important
features of asset allocation at the beginning of the 1990s. The data show
enormous cross-country differences in asset allocation. UK pension funds are
300
heavily invested into stocks, while pension funds of other countries mainly
invest in bonds. A common characteristic is the propensity to hold long term
assets, but the similarities seem to end at this level as the shares of stocks and
bonds are very different.
Heterogeneity in portfolio allocations has important implications in
terms of rates of return. Davis (1995) reports that UK funds had the largest
average return and one of the largest levels of volatility, coherently with the
large share of investment into stocks. Sweden has the lowest return and an
allocation mainly concentrated in bonds.
Of course average returns and volatility are an extremely rough way to
measure performance results. Clearly it is not exactly possible to connect data
on average returns to data on average asset allocations for several reasons. For
example one may note that average return is not only the result of the average
allocation but also depends on active management as characterised by asset
selectivity and market timing. Also, the use of derivatives may change deeply
the return-risk profile of any portfolio composed of basic securities.
How can the observed international heterogeneity in portfolios be
explained? The
different importance of defined benefit and defined
contribution types in the various countries does not seem to be a good
explanation. According to Lakonishok, Shleifer and Vishny (1991) the two
categories are very similar even though the former are less risk averse than the
latter. Also Trzcinka (1997) observes that the portfolio structures are similar: in
1996 the assets of the top 1 000 US pension funds were invested in stocks for
56 per cent and fixed income for 33 per cent in the case of defined benefit and
respectively 59 per cent and 30 per cent for defined contribution. However the
constraints on beneficiaries are different, as beneficiaries of defined
contribution plans are often forced to invest some portion of their pension
assets in employee stock. According to Bodie (1990) there are no significant
differences across the two types.
Moreover, international heterogeneity of asset allocations does not
necessarily amount to heterogeneity within a single country. Lakonishok,
Shleifer, Thaler and Vishny (1991) use data from US all-equity pension funds
in order to investigate the existence of herding behaviour. They point out that
there is no herding in the stock picking of pension funds, even though there is
much window dressing, especially for smaller pension funds. On the contrary,
Blake, Lehmann and Timmermann (1997) find a large degree of homogeneity
in the UK, which they explain on the basis of the structure of incentives given
to asset managers.
301
If one accepts the view that the difference in the relative importance
of defined benefit and defined contribution plans is not a plausible explanation
for portfolio heterogeneity, then one may look at different institutional and
fiscal regimes. It is interesting to note that some of the countries with low share
of investment in stocks (Denmark, Germany and Switzerland) are also those
countries mentioned by the European Federation for Retirement Provision
(1996) as examples of heavy investment restrictions. The same document also
states that the figures for the Netherlands are heavily affected by Algemeen
Burgerlijk Pensioenfonds, the Dutch civil servants pension fund which is the
largest in Europe and which up to 1996 was severely restricted. Also, the UK,
where the share of stocks in portfolio is very large, is regarded by Blake,
Lehmann and Timmermann (1997) as the country where pension funds had the
least restrictions. The picture is however changing fast, for example in the
Netherlands (see The Economist, 1996).
Sparse evidence on the effects of different institutional and fiscal
regimes cannot be used for assessing precisely what portion of heterogeneity is
due to different financial environments. It is therefore of interest to pose the
following question: may these differences be justified by theoretical models?
One way to answer this question is to identify a benchmark for pension funds.
If it were possible to show that the benchmark does not depend on countryspecific or individual-specific or time-specific characteristics, then the observed
heterogeneity should be explained entirely in terms of institutions and taxes. If
instead one could show that the benchmark does depend on specific elements,
then a serious research effort would be needed in order to analyse economic
models which may explain the observed heterogeneity.
2.
The impact of Italian pension funds
The Italian case is rather peculiar. Before going into the theory of
benchmark formation it is worth reporting some data on the Italian situation.
Davis (1995) does not report any evidence for the Italian case. This is due to the
absence of financial intermediaries with characteristics and regulations similar
to the international definition of pension funds. However during the 1980s there
have been a few institutions (Casse Previdenziali), mainly connected with
banks and insurance companies, whose purpose was investing savings of
employees for building up pensions. Italian Casse Previdenziali can be regarded
as informal pension funds to the extent that their objective was explicitly to
invest for the long run.
302
Such institutions are not well studied. Available empirical evidence
comes from a study by Assoprevidenza (1996), reporting that only 36 per cent
of the assets are allocated to financial instruments, of which about 90 per cent
have gone to short and long-term bonds and about 10 per cent to shares or
mutual funds. Casse Previdenziali have invested mainly in real estate.
New pension fund legislation has however been passed during 1997.
The new legislation allows pension funds to start operating in 1998. The
regulation on investments takes the form of constraints on holdings of different
assets in the portfolio. The Case Previdenziali described before will have to
conform to the new rules in order to keep operating.
The new pension funds will be important actors in the transition
towards a private capitalisation system. An important issue regards the estimate
of how many financial resources will be directed towards pension funds. There
are three possible sources: a) extra savings, b) diversion of part of the resources
which are currently going to the public pension sector and c) substitution
between pension funds and other financial assets and intermediaries. The
quantitative importance of these sources is difficult to estimate, particularly
regarding a) and c).
It is unclear whether pension funds will create their “own space” by
increasing the saving propensity of Italian households. From the point of view
of the pure substitution effect, an increase in savings may take place if
professional pension fund managers are able to provide a real rate of return
exceeding that of alternative investment opportunities. Unfortunately, there are
very few studies on performance of pension funds. As Trzcinka (1997) notes,
this is due mainly to the fact that US pension funds are not required to disclose
performance data on a disaggregated basis. Available studies by Lakonishok,
Shleifer, Thaler and Vishny (1991) and by Coggin, Fabozzi and Rahman (1993)
reach opposite conclusions on performance of pension funds for the US, while
Blake, Lehmann and Timmermann (1997) analyse the UK case.
Also, the rate of return is not the only variable which affects the
saving rate and the portfolio composition. Recent studies have pointed out the
existence of a strong precautionary motive connected with income uncertainty
[see Guiso, Jappelli and Terlizzese (1996) for an analysis of Italian data]. It is
unclear whether income uncertainty will increase or decrease in the future for
Italian households. It is therefore unclear whether the future saving rate in Italy
will increase or decrease when all the factors are taken into account.
International evidence is also unclear about the effects of institutional investors
on savings, see Feldstein (1978) and Hubbard (1986).
303
Most existing works consider element b) above as the main source of
financial resources for pension funds. Castellino and Fornero (1997) (which
also present an analysis for the case of an increase in the national savings rate)
base their estimate on the flows provided by new employees. Starting from a
figure for gross wages equal to 30 per cent of GDP in 1995 and remembering
that workers contribute directly for a share equal to 2/27 of their wage, one
obtains an amount of resources equal to 2 per cent of GDP. If only new
employees pay such a sum, one has to consider only a fraction of wages which
corresponds with the share of workers entering the labour force. Assuming a
working life of 60 years, one can therefore consider a share equal to 1/40 in the
first year, 2/40 for the second year, and so on, until the transition is completed
after 40 years. With this assumption one obtains an initial sum of about 885
billion lire. Assuming a 1.5 per cent real growth rate of GDP and a rate of
return equal to 3 per cent one obtains the following estimate for the stock of
resources controlled by pension funds: 2864 billion lire for year 2, 6 025 for
year 3, 10 511 for year 4, 75 000 for year 10 and 453 583 for year 20. These
numbers can be taken as a lower bound, as the methodology ignores
contributions by older employees, employers and by self-employed.
Dell’Acqua (1994) and Goldstein and Verna (1994) include these two
factors in their estimates. These papers use a more disaggregated methodology,
starting from hypotheses about new employees both in the private and in the
public sector. Dell’Acqua obtains a stock equal to 3 600 for year 1, 9 650 for
year 2, 18 000 for year 3, 29 000 for year 4, 163 300 for year 10 and 740 301
for year 20. Goldstain and Verna obtain 410, 1 500, 3 750, 7 990, 101 015 and
505 340 for the various years.
As one can see the estimates differ considerably in the long run. In the
short run the numbers are different, but the order of magnitude is similar,
especially when compared with magnitudes such as GDP, public debt or stock
market capitalisation. In the short run the quantitative impact is therefore likely
to be small, much smaller than the impact of mutual funds on share prices in
1985. In fact, the resources directed towards mutual funds were about 60 per
cent of the 1984 stock market capitalisation, while for pension fund the ratio is
likely to be less than 1 per cent.
The estimates which have just been reported ignore possible
substitution within financial assets, for example a massive flight from insurance
companies and mutual funds into pension funds. Such substitution processes
are difficult to estimate, especially given the very few scientific studies on
saving behaviour and portfolio allocation of Italian households. Even though
304
the amount of uncertainty surrounding such estimates would be very high, this
topic remains essential for future research.
3.
The benchmark
There are two different, and complementary, perspectives on the
definition of a benchmark. The first one, which I will call the economic
perspective, is connected with the identification of a benchmark as an optimal
portfolio; the second, which I will call the financial perspective, is connected
with the financial characteristics of a benchmark for a given asset class. The
first perspective is mainly related with the point of view of the final investor,
while the second is mainly related with the point of view of a specialised fund
manager.
The second perspective has been vastly debated in the finance
literature. In general it is possible to identify multiple benchmarks for a specific
asset class from the point of view of liquidity, transaction costs, easiness of
replication and so on. Such elements may be used to choose one specific index
as a reference point.
This paper is concerned with the first perspective, i.e. the formation of
an optimal portfolio for a pension fund. If the fund manager is regarded as an
expert whose task is building an appropriate asset allocation, then one can
define a benchmark on the basis of the solution to the expected utility
maximisation problem of the final owner of the funds. The theory reviewed in
this section shows that a fixed benchmark may well represent an optimal choice
from the point of view of some investors at a specific point in time, but is
unlikely to represent an optimal choice for an extended period of time.
Financial theory has studied this point at length. Merton (1990) has
considered a problem of intertemporal utility maximisation under a dynamic
constraint for wealth accumulation. The standard representation of the problem
considers a constant relative risk aversion (CRRA) utility function, which is
often regarded as the most general (among the class of intertemporally
separable utility functions) specification compatible with a specific description
of preferences, see e.g. Ingersoll (1987).
Suppose first that there are no labour income and returns are
identically and independently distinguishable from constant mean and variance.
In this case Merton shows that:
305
a) the portfolio choice is independent of consumption,
b) if the planning horizon is infinite then the optimal portfolio is also
independent of age,
c) the solution of the intertemporal problem corresponds with the
solution of a sequence of static maximisation problems and
d) all the agents optimally invest in the riskless asset and in a
portfolio composed of all the available risky assets.
The presence of labour income does not necessarily need to make an
important difference to the solution, [see Jagannathan and Kocherlakota (1996)
for an introduction to the problem]. Labour income could make a difference if it
were correlated systematically with rates of return of financial assets. Suppose
for example that asset i is a stock index which is negatively correlated with
labour income of person A. In theory person A should then hold a large share of
asset i in his portfolio, as it would work as an insurance policy against falls in
his labour income. Take instead person B, a fund manager, whose labour
income is substantially positively correlated with the risky return of security i.
For person B it would be optimal, from the point of view of consumption
stabilisation, to hold a portfolio which shorts asset i.
The other key assumption which in the previous model led to a
constant portfolio is that returns are distributed identically and independently
over time. This assumption is not realistic. The empirical literature has
identified a number of correlations between various moments and various state
variables which suggest that returns are not independent and identically
distributed for stocks, bonds and exchange rates. The relevant problem is
therefore better described by the assumption of time-varying moments. One can
therefore assume that moments of the distribution of returns are correlated with
a set of state variables.
If there are N state variables then the solution to Merton’s problem is
still easy to interpret. The optimal portfolio is now composed of 2+N subportfolios, whose weights are time-varying and depend on the changes in the
opportunity set and on the wealth and consumptions path. The first two subportfolios are identical to those held by the static maximiser. The others are
portfolios with the highest possible correlation with the state variables. Suppose
that one state variable is negatively related to future returns on the portfolio
currently held by an investor (a subset of all the available securities) and that in
a certain time period there is a positive shock to such a state variable. Then
expected future returns on the portfolio decrease. An investor who wants to
306
smooth consumption will protect himself by holding a security (or a subportfolio) whose return is positively correlated with that state variable.
4.
Implications
The theory of optimal asset allocation yields a number of insights
which are very valuable in discussing the benchmark of pension funds.
First, in a world where the strong conditions described in the previous
section hold (so that the optimal portfolio is constant) then financial institutions
have a relatively simple task. They may simply offer the portfolio of risky
assets starting from the available supply of shares. In theory, the investor is
then able to choose the share of his wealth allocated to the riskless asset and
that allocated to the risky portfolio according to his risk aversion. The financial
benchmark consists of the portfolio of risky assets.
If the fund manager wants to advise the investor about the proportion
invested in the riskless asset and in the risky portfolio, then it is necessary to
solve the problem of the agent. The economic benchmark, that is the allocation
between the riskless asset and the risky portfolio, depends on risk aversion of
the final investors. In fact even in the static context, the optimal portfolio will
in general depend on the specific form of the utility function. Practitioners often
simplify the problem by assuming that the utility function is of the meanvariance type. This assumption leads to the efficient frontier as a set along
which one portfolio may be chosen to suit the specific preferences of the
investor.
This situation implies a limited differentiation in the supply of
financial institutions. In such a world it would be unlikely to observe many
financial actors with many different portfolio solutions like mutual funds,
banks, pension funds, insurance companies. The presence of so many types of
institutional investor suggest that the hypothesis leading to a constant
benchmark are likely to be inappropriate to understand financial markets.
The model which allows for risky labour income is a step in the right
direction (in terms of realism). It was observed before that risky labour income
could make the optimal portfolio investor-specific in case of significant
correlations between labour income and returns. The data however show that
for most occupations there is a very low correlation between labour income and
rates of return on the stock market, see Heaton and Lucas (1996). This is
consistent with a whole branch of the empirical literature which obtains results
307
of excess volatility of stock prices, see Shiller (1989). Such a literature shows
that price volatility is largely driven by shocks to future expected returns, see
Campbell (1993). It follows that risky labour income is unlikely to be so
important in practice for the design of the benchmark of pension funds.
Much less is known about the correlation between risky returns and
the state of unemployment. It can be guessed that in order to provide insurance
against the possibility of becoming unemployed a worker of a specific sector s
should hold a portfolio long in those sectors which have the lowest possible
correlation with sector s. This may introduce an element of investor-specificity
depending on the various occupations. This component seems to be a future
research subject of great empirical interest.
Given the current level of empirical knowledge, theoretical
explanations of observed heterogeneity in the benchmarks of financial
institutions seem to depend largely on the connection between the statistical
distribution of returns and the state variables. Empirical evidence on this
connection is mixed. On the one hand it is true that expected stock and bond
returns are time-varying and are connected with information variables. Also,
volatility is persistent and does depend on past volatility. On the other hand, the
share of the volatility of returns which is explained by volatility of
macroeconomic variables remains a low part of total volatility, especially at the
monthly and quarterly frequencies which are practically relevant to asset
managers [see Ferson and Harvey (1991)].
Pension funds may find two roles in the dynamic world. In a lowprofile case they may offer to investors the portfolios that are maximally
correlated with the relevant state variables and let the investors choose their
optimal portfolio composition. Here pension funds may provide statistical and
economic analyses aimed at identifying the state variables and measuring their
correlation with the returns processes. After this research process is finished,
they act substantially like index funds. The fund creates a few portfolios with a
very slowly changing composition over time, with large correlation with the
state variables. The investor may then decide the optimal mix of such portfolios
at each point in time, e.g. quarterly. The pension fund is then evaluated for its
ability to form and maintain such portfolios and for its tracking error.
In a high-profile case pension funds can also advise the participants
about the weights that each portfolio should be given, even though such
weights may depend on various investor-specific characteristics, like age and
consumption or at least may depend on characteristics which are homogeneous
across classes of investors, for example age and/or occupation. The rules for
308
forming the portfolios are similar to those used in the passive case. The rules
for switching among the various portfolios are to be studied on the basis of an
analysis of the risk aversion of the investor and of the relations between the
state variables and the distribution of future returns. In both cases it is not clear
how defined contribution pension funds may differentiate themselves from
other institutions like mutual funds. In some sense both types of institutions
should aim at maximising expected utility by taking periodic asset allocation
decisions. To the extent that they try to solve the same problem they should
obtain the same solution, except for differences in estimating the moments of
the relevant distributions. One possible element of differentiation is the horizon
of the investor, which is long for pension funds and short for mutual funds.
Such differences may have some impact on the optimal portfolios.
Going back to the question which motivated the analysis, it seems that
under realistic hypotheses there are many elements which would suggest that
the optimal portfolio may be country-specific. For example pension funds based
in different countries may hold different optimal portfolios to the extent that
there are country specific relations between asset returns and state variables. For
example Bagliano and Beltratti (1997) show that in Italy there was no
statistically detectable long run relation between the real stock index and a
measure of economic activity like industrial production in the period 19521995. The only statistically significant (and negative) relation was between
inflation and the real stock index. On the contrary in the US the negative
relation between the stock index and inflation was contemporaneous to a
positive relation between industrial production and the real stock index. This is
a striking example of different sensitivities of the same asset class to the same
state variables. Under these conditions it is very likely that the optimal portfolio
of one type of institution would depend on the country of origin. The home
country ’’bias’’ suggests the existence of various not perfectly understood factors
which would prevent the Italian institution from investing completely in US
securities.
As a second example consider the case of a pension fund which is
aimed at investing financial resources collected from workers of a specific
sector, e.g. the chemical sector. The theory suggests that the pension fund
should underweight the portion of portfolio allocated to shares of chemical
companies and overweight the shares of companies of sectors negatively
correlated with the domestic chemical sector. Such overweighting may not be
feasible by simply investing in domestic companies. The country may lack
publicly traded shares in the sector with negative correlation with the chemical
sector. The theory would suggest to overweight the shares of foreign companies
but this may introduce other problems. Country or exchange rate risks may
309
limit the extent of international diversification and the final portfolio may not
be optimally diversified.
From the last point of view, the introduction of the EURO may deeply
affect asset allocation policies. By eliminating exchange rate risks within
European countries, the EURO may make diversification easier and may
therefore induce pension funds of different European countries to become more
similar over time.
5.
Conclusions
The theory suggests that the optimal portfolio of pension funds should
be time-varying. The correlation between asset returns and state variables and
the attempt to hedge sector-specific wealth dynamics may introduce
heterogeneity in the portfolios of pension funds of different countries. This is,
to my knowledge, a largely unexplored empirical research area. Empirical work
is necessary to understand whether the relevant correlations are indeed different
across countries and whether their importance is such to explain a significant
portion of the differences in observed portfolios across countries. The concept
of a dynamic benchmark introduces a number of complex and interesting issues
in the management of pension funds. Among such issues are: how to structure a
time-varying asset allocation policy, and how to evaluate long run risk. From
the point of view of ’’realistic’’ intertemporal optimisation large numerical
capabilities are necessary for enlarging the description of the problem in terms
of the number of assets and the number of periods.
From the point of view of the structure of the optimal portfolios,
much work remains to be done in identifying state variables and in
understanding which financial assets can best represent reliable insurance
policies against these sources of risk. Existing econometric work on asset
pricing and the real economy shows that under normal economic conditions the
variance of asset returns is much larger than the variance of shocks to the state
variables. The resulting asset prices incorporate so much noise to make the
formation of stable mimicking portfolios a difficult exercise.
Finally, much more work remains to be done on identification of the
relevant state variables, particularly in view of the change in regime associated
with the introduction of a common currency. Hopefully, the European Central
Bank will be able to control inflation effectively, reducing its role as a state
variable. Further analysis might identify more specific types of state variables
connected with regional and sectoral uncertainties.
310
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and Inflation in the Italian Stock market: A Long-Run Perspective”,
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313
Chapter XIV
INSTITUTIONAL INVESTORS, CAPITAL MARKETS AND EMU
by
Karel Lannoo*
Introduction
Marked differences can be observed in the development of domestic
capital markets in the EU and in the role of institutional investors. Equity
markets are very important in some countries, but negligible in others.
Similarly, pension funds are strong players in some countries while nonexistent in others. Institutional investors have an outspoken preference for
equity in some countries, but for government paper in others.
Monetary union will strengthen the integration of European capital
markets, which started with the liberalisation of capital movements and the
single market programme, and will bring more convergence in the development
of capital markets. Some effects will be immediate, as a result of the
replacement of the domestic currency by the euro, while others will be gradual,
as a result of increased competition. The euro zone will be the second largest
bond market in the world, and equity markets should become more integrated.
Overall, EMU will lead to more liquid, mature and efficient capital markets in
Europe.
Monetary union will considerably ease asset allocation for
institutional investors in Europe. The introduction of the euro will make
currency-based investment restrictions meaningless, allowing institutional
investors to spread investments throughout the euro zone. The fixed interest
*
Centre for European Policy Studies (CEPS), Brussels. This paper draws
upon research carried out for a CEPS project on capital markets and EMU. I
also benefitted from the discussions at a conference on pension funds and
financial markets in Bocconi University, Milan on 13 June 1997.
315
portfolio will be distributed over sovereign paper from different European
countries, ranked on the basis of the quality of the issuer. Equity investments
will be primarily diversified on the basis of sectors, rather than on their
currency-denomination.
This paper mainly focuses on European markets, although
comparisons are drawn with other markets. In a first part, it examines the role
of institutional investors in Europe and discusses the main reasons for the
perceived differences in practices and preferences. A second part examines the
development of equity and bond markets. The third part speculates on the
likely effects of EMU. Some tentative conclusions are drawn at the end.
1.
Institutional investors in Europe
Institutional investors are commonly defined as financial institutions
that invest their clients’ money on a longer-term basis, such as insurance
companies, pension funds and investment funds. They are distinct from banks,
which take short-term deposits from clients. The distinction is not always easy
to make, however, since it does not take into account the differences in the
structure of the financial services industry in the EU nor the changes that have
taken place since the late 1980s. In some countries, banks increasingly provide
a whole series of financial services, ranging from traditional banking functions,
to insurance policies and investment vehicles. The insurance sector is
experiencing a similar evolution, but in the other direction. Because both
remain separately authorised legal entities, we can compare their relative
importance. It should also be noticed that banks in some countries possess
important stakes in industry and therefore fulfil the same role as institutional
investors in other countries.
The importance of institutional investors depends on two elements in
the broader regulatory framework: the taxation of capital income and the way in
which retirement plans are financed. The first explains the importance of
investment funds in Luxembourg, since that country does not apply
withholding taxes on interest income. The differences in the role of pension
funds in the EU is explained by the second. Most European countries still have
no pension funds of any significance, since pensions are financed on a pay-asyou-go basis, and the high level of replacement ratios in the official pension
discourages the formation of additional privately sponsored funded plans (2nd
pillar pensions). The absence of a well developed 2nd pillar pension could also
explain the importance of other forms of organised savings, such as investment
316
funds in some countries, which could to a large extent be explained as
individual retirement savings (3rd pillar).
In volume terms, insurance companies are the most important group
of institutional investor, with total assets in the EU as high as pension funds
and investment funds combined. In relative terms, there are remarkable crosscountry differences, with the Southern EU countries and Finland having a much
smaller insurance sector than the Northern European countries. Pension funds
are only of importance in three EU countries, the Netherlands, the UK and
Ireland, which have well-developed second pillar pension schemes. Over time,
the strongest growth was observed in the sector of the investment funds, which
grew from ECU 316 billion in 1987 to 1,171 billion in 1995. Pension funds
grew from ECU 781 billion in 1992 to 1 188 billion in 1995.
1.1
Insurance companies and pension funds
Full liberalisation of the insurance sector in the EU occurred with the
third generation life and non-life insurance directives (1994). These directives
introduced the single licence for the provision of insurance services throughout
the EU and harmonise qualitative and quantitative rules for the investment of
assets. Investments must take account of the type of business carried on by an
undertaking in such a way as to secure their safety, yield and marketability.
They must be adequately diversified and spread (“prudent man rule”).
Requirements to invest in particular categories of assets are abolished, and
replaced by minimum rules for the investment of technical reserves, the list of
admissible assets to cover these reserves, their diversification and valuation.
Maximum percentages apply for investments in securities (<20 per cent),
unsecured loans(<10 per cent) and real estate (<10 per cent), or an overall limit
of 40 per cent in high risk assets, provided that each particular investment does
not exceed 5 per cent of the assets. The directives also contain rules on
currency matching, which require insurance firms not to hold assets for more
than 20 per cent in currencies which do not match the liabilities. ECUdenominated assets thereby count for local currency; the euro, which will
replace the ECU on 1 January 1999, will thus also be considered local currency
from the start of Stage III of EMU onwards, (provided this rule was properly
implemented by the member states).
Pension funds are not included in the EU regulatory framework for
financial services.
A draft directive liberalising the management and
investment of pension funds in the EU had to be withdrawn by the European
Commission in 1994, as a result of broad disagreements between the member
317
states on its objectives.1 The draft pension funds directive contained only
qualitative rules for the spread of investments in the EU, and a lower currency
matching rule than the life insurance directives, which represented the main
stumbling block of the proposal. This directive would have favoured retirement
savings under the form of pension funds, as compared to group insurance
schemes, which are subject to the rules of the life insurance directives. Some
member states with pension funds, such as Denmark, have however made their
pension funds subject to the rules of the life insurance directives, but most other
member states with pension funds have kept them under a separate legal
regime. Restrictions on pension fund investments have thus not yet been
harmonised. An overview of the most important quantitative restrictions on
pension fund investments in Western Europe is given in Table 1.
As can be seen from Tables 2 and 3, the investment behaviour of
pension funds and life insurance companies shows more similarities across
countries than across sectors, with pension funds and insurance companies in
the English-speaking countries investing over 50 per cent of their assets in
equity and those in Continental European countries investing the biggest part in
fixed income. Data on the distribution of assets of life insurance companies
indicate an average investment of 67 per cent in domestic fixed income and
9.5 per cent in equity in Germany, Spain, France and Italy. This compares with
24 per cent for domestic fixed income and 61 per cent for equity in the UK.
Table 1. Most important quantitative restrictions
on pension fund investments in Europe
Belgium
Denmark
France
Germany
Italy
Portugal
Switzerland
>15 per cent in government bonds
rules of the EU’s 3rd life insurance directive, 80 per cent
currency matching
>50 per cent EU government bonds
<30 per cent EU equities, <25 per cent EU property, <6 per cent
non-EU equities, <6 per cent non-EU bonds, <20 per cent overall
foreign assets, >80 per cent currency matching
<20 per cent liquid assets, <50 per cent non-listed OECD
securities, <5 per cent non-OECD securities, >30 per cent
currency matching
<40 per cent in foreign equity
<50 per cent real estate, <30 per cent Swiss equities, <30 per
cent foreign loans, <25 per cent foreign equities
Sources: De Ryck (1996), European Commission (1997), own research.
318
That asset allocation is determined more by country-specific patterns
than by investment restrictions appears from the fact that German pension funds
invest much less in equity than they are allowed by law. This can also be
observed in the case of the Netherlands, which has no quantitative restrictions
on pension funds investments.
Table 2. Asset structure of life insurance companies, in per cent
(1994)
Equity
Denmark
France
Germany
Ireland
Netherlands
Spain
Sweden
United Kingdom
25
19
5
12
14
2
23
61
Fixed
income
66
69
76
75
75
55
61
27
Real
estate
3
8
5
12
6
10
7
9
Other
6
4
14
2
6
33
9
3
Foreign
assets
5
n.a.
10
6
n.a.
n.a.
15
Note: fixed income data for Germany and the Netherlands include loans.
Sources: European Commission (1997) based on CEA and OECD data.
Table 3. Asset structure of pension funds, in per cent
(1994)
Equity
Belgium
Denmark
Germany
Ireland
Japan
Netherlands
Spain
Swede,
Switzerland
United Kingdom
United States
36
22
11
55
29
30
4
32
11
80
52
Fixed
income
47
65
75
35
63
58
82
47
64
11
36
Real
estate
7
9
11
6
3
10
1
8
16
6
4
Sources: De Ryck (1996), European Commission (1997).
319
Liquidity
10
4
3
4
5
2
13
13
9
3
8
Foreign
assets
7
6
25
5
12
30
10
The differences in asset structure of pension funds may also be
determined by differences in pension schemes. Ireland, the Netherlands, the UK
and to a lesser extent the US, employ defined benefit schemes for pension
plans, whereby the employee’s pension is based on a certain percentage of his
final salary. Continental European countries rely more on defined contribution
schemes, whereby accumulated contributions constitute the final pension,
which is comparable to a life insurance annuity. Defined benefit schemes can
result in an actuarial deficit, since the present value of the pension is
independent of the fund’s assets. Such schemes, however, induce fund
managers to take higher risks to cover future liabilities, and thus to invest a
higher proportion in shares, which give better returns over the long term.
1.2
Investment funds
Under EU rules, free provision of investment funds is regulated by the
UCITS directive (undertakings for collective investment in transferable
securities) (1985). This directive defines the modalities for the single licence for
the sale of UCITS throughout the Community. Member states that apply more
stringent standards may not forbid the sale on their territory of UCITS
authorised in another member state. The directive sets out harmonised rules for
the management and investment of UCITS, their composition and the
information requirements. National marketing and advertising restrictions do
not fall within the scope of this directive. They remain under host country
control, which means that UCITS must still comply with national rules in that
respect. A 1988 amendment modified the rules with regard to investment
policy.
In relative terms, investment funds are most important in
Luxembourg, which is due to the tax regime, followed by France and Spain
(see Table 4). In these three countries, but also in the Southern EU countries,
investment funds are more important in asset terms than insurance companies.
Overall, bond funds represent the largest group of investment funds in
the EU, with 36 per cent, followed by money market funds with 31 per cent and
equity funds with 23 per cent. Some interesting observations can be made
regarding the importance of the different types of funds across EU countries.
Equity funds are the most important funds in the UK, the Scandinavian
countries and the Netherlands. Bond funds are the most important in Germany,
Luxembourg and Portugal and money market funds in Spain and France. In
general, the split reflects differences in investment behaviour of the other
institutional investors, which to a certain extent is normal, since investment
320
funds are also used by other institutional investors. To the extent, however, that
investment funds are held by individual citizens, it reflects the perceived
differences in investment behaviour: a decided preference for equity in the
English-speaking countries and for fixed income in the major continental
European countries. Although no definite figures exists, the European
Federation of Investment Funds (FEFSI) estimates that the major part of
investment funds are held by individuals.
Table 4. Investment funds asset spread in the EU (1995)
In ECU billion
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
United Kingdom
EU
Switzerland
Total
26 1
18 8
50
09
406 8
104 7
81
66
62 4
253 3
48 6
10 4
78 3
21 0
120 4
1171 5
35 0
Equity
1 321
5 314
2 665
0 487
38 528
24 72
0 36
2 435
16 709
38 215
22 603
0 34
1 195
15 515
108 421
278 8
21 441
%
51
28 3
53 1
52 1
95
23 6
45
37 1
26 8
15 1
46 5
33
15
73 8
90 1
23 8
61 3
Bonds
18 82
5 023
2 213
0 222
116 031
57 142
3 385
0 502
24 213
135 469
18 421
5 39
27 956
3 538
4 249
422 6
13 533
%
72 2
26 8
44 1
23 8
28 5
54 6
41 9
77
38 8
53 5
37 9
51 9
35 7
16 8
35
36 1
38 7
Mixed
5 257
6 143
0 145
0 172
50 904
2 046
0 184
3 469
7 062
10 001
2 679
0 092
4 249
1 966
7 287
101 7
0
%
20 2
32 7
29
18 4
12 5
20
23
52 9
11 3
39
55
09
54
94
61
87
00
Money
0
2 258
0
0 053
201 354
20 824
4 146
0 153
13 323
69 647
4 934
4 378
44 934
0
0 433
366 4
0
%
00
12 0
00
57
49 5
19 9
51 3
23
21 3
27 5
10 1
42 1
57 4
00
04
31 3
00
Source: Europe - Federation of Investment Funds (FEFSI), 1997.
2.
European capital markets: A brief overview
2.1
Stock markets
Although the combined GDP of the EU is higher than that of the US,
its total stock market capitalisation amounted to only 53.7 per cent of US stock
market capitalisation in 1995. When one excludes the UK, the figure drops to
33.7 per cent. Europe’s share of world market capitalisation amounts to 23.2 per
cent, compared to 42.5 per cent for North America and 30.3 per cent for south-east
Asia. Therefore, European stock markets still have much potential.
321
On a comparative national basis, EU stock markets show a highly
varied picture, however, and generalisations are difficult to make. Fundamental
differences exist in the importance of stock markets, the number of listed
companies, the international role of exchanges and trading techniques. They
reflect differences in the origin of the exchanges, in corporate finance and
shareholding structures, in the role of financial intermediaries and the
competitive strength of financial centres.
Table 5. Comparative data on European stock markets (1995)
Country
1995
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Luxembourg
Netherlands
Portugal
Spain
Sweden
United Kingdom
EU 15
Switzerland
Norway
Czech Republic
Hungary
Poland
Slovakia
Slovenia
Japan
US-NYSE
US-NASDAQ
Domestic capitalisation
in Ecu million
% GDP
23 921
13.4.
79 115
38.5.
43 817
33.1.
34 139
35.3.
389 389
33.2.
438 639
23.8.
12 867
14.7.
19 954
42.6.
163 702
19.7.
23 138
176.6.
223 779
73.9.
14 138
17.7.
148 679
34.8.
134 221
76.7.
1 038 318
123.2.
2 787 815
43.3.
310 785
131.1.
34 753
39.0.
7 894
22.8.
2 891
9.6.
4 907
3.6.
1 082
8.1.
4.6.
2 790 428
72.8.
4 302 727
81.7.
882 594
16.7
Domestic listed Foreign listed
companies
companies
95
38
150
138
242
10
73
0
710
194
678
944
186
0
53
9
250
4
55
229
217
216
89
0
362
4
212
11
1 745
520
5 117
2317
216
233
151
14
68
0
42
0
53
0
19
0
36
0
1 714
77
1 996
246
4 717
395
Sources: EBRD, FIBV, FESE and European Commission.
322
In 1995, market capitalisation of domestic stock, expressed as a
percentage of GDP, ranged from 123 per cent in the UK and 74 per cent in the
Netherlands to 24 per cent in Germany and 20 per cent in Italy (Table 5).2 The
number of domestic listed companies ranged from 1 745 in the UK to 710 in
France, 678 in Germany and 250 in Italy. Overall, the average stock market
capitalisation in the EU falls far below the levels registered in Japan and the US. By
the end of 1995, the 15 member states of the EU had a domestic stock market
capitalisation of only 43 per cent of GDP, in contrast to 73 per cent in Japan and
98 per cent in the US (NYSE and NASDAQ). Excluding the UK, the average stock
market capitalisation in the EU amounts to 31 per cent of GDP. The number of
domestic listed companies in the EU comes closer to the figure for the US, NYSE
and NASDAQ taken jointly. The difference within the EU, however, between the
UK on the one hand and the other member states on the other is large.
Some countries are notable exceptions to the low levels of stock
market capitalisation observed in continental Europe. In the Netherlands,
Sweden and Switzerland, for example, the levels stand much higher than in
other continental European countries and reach Anglo-American standards.
Moreover, a marked increase of market capitalisation as a percentage of GDP
can be observed in the former two countries in recent years, from 62 per cent in
1993 to 96 per cent in 1996 in the Netherlands and from 57 per cent to 97 per
cent in Sweden for the same period.
2.2
Bond markets
World bond markets are dominated by the US dollar which garnered
43.1 per cent of total bonds outstanding in the major bond markets in 1995 (see
Table 6). The US dollar sector was more than 2.3 times greater than the second
largest market, the Japanese yen bond market. EU currencies’ share amounts to
33.8 per cent, with 5.4 per cent for “opt-outs” and “unable” countries (Denmark,
Greece, Sweden and UK). The dollar sector’s share has slowly declined since the
1970s, with some interruptions.
Public bonds represent the largest share of total debt outstanding in
world bond markets, with 62 per cent in 1995, compared to 38 per cent for the
private sector. The US dollar share is slightly higher in this sector, with
47.1 per cent of all public bonds. EU currencies’ share is lower, at 30.9 per
cent. The EU currencies’ share is higher in private bonds, with 36.5 per cent of
all debt outstanding, compared to 36.7 per cent for the dollar. Above all DEM
has an important share in this sector, which is caused by the German
Pfandbriefe, the securitised mortgage loans of German mortgage banks.
323
Pfandbriefe have only been issued as international bonds since early 1996. In
international placements of private bonds, EU currencies’ share is considerably
higher, with 38 per cent (DEM 12 per cent), compared to 37 per cent for the
dollar and 15 per cent for the yen.
Table 6. World bond markets (1995)
Currency
US$
Yen
Deutsch mark
Lira
French franc
Pound sterling
Canadian dollar
Other EU currencies
Other non-EU
currencies
Total
In per cent
Total 1995
8 837.3
3 807.4
2 282.9
1 084.4
1 024
540.9
424.1
2 002
480.1
2 0483.1
100
% Total public
43.1
5 982.2
18.6
2 311.7
11.1
879.7
5.3
877.5
5.0
728.1
2.6
361.5
2.1
291.4
9.8
1 088.7
2.3
187.3
12 708.1
62.0
% Total private
47.1
2 855.1
18.2
1 495.7
6.9
1 403.2
6.9
206.9
5.7
295.9
2.8
179.4
2.3
132.7
8.6
913.3
1.5
292.8
7 775
38.0
%
36.7
19.2
18.0
2.7
3.8
2.3
1.7
11.7
3.8
Source: Salomon Brothers (1996).
The high figure of international placements of private bonds in EU
currencies hides the almost non-existence of corporate bonds in Europe. In
1995, German firms issued $0.142 billion, French firms $6.4 billion, UK firms
$20.7 billion, compared to $77.2 billion issued by Japanese firms and
$154.3 billion by US firms.
European bond markets are dominated by the DEM, with a share of
32.9 per cent, followed by the lira with a 15.6 per cent share and the French
franc with 14.8 per cent share. The pound has a 7.8 per cent share, other
European currencies 28.9 per cent. The share of the DEM is much higher in
private bonds (46.8 per cent) than in public bonds, where DEM’s share equals
that of the lira (22.3 per cent).
324
3.
The dynamic effects of EMU
3.1
Who becomes the benchmark issuer?
Unlike the US market, the euro government bond market will not
have a central debtor, thus remaining fundamentally different from the US
market. Europe will not have a centre with fiscal powers in the foreseeable
future, and fiscal policies will continue to fall under the responsibility of the
member states. The ECB however will set a common money market interest
rate, which raises the question of how euro-denominated government bonds
will be rated in EMU, and which country will set the benchmark.
The convergence over the last year of yields on 10-year debt securities
of the group of the most- likely EMU countries with the current benchmark, the
German Bunds, is probably not an indication. This phenomenon has come to
represent more a sign of the political commitment of certain countries to join
EMU than of their respective fiscal performance. UK Treasury gilts for example
are priced considerably higher than Spanish bonos, although the UK fiscal
performance is no worse than the Spanish. The difference between the UK and
Italy is even more pronounced. Does the market think that the EMU members
might provide a common responsibility for sovereign debt, notwithstanding the
no bail-out clause of the Maastricht Treaty?
Data on interest rate spreads between sovereign paper denominated in
the same currency, such as DEM, might be revealing. It shows that the market
worries more about currency risk than about fiscal risk (see Table 7). This
situation is likely to change in EMU, or even as soon as the participating
countries are known. Divergence might grow again, based on the differences in
the fiscal position of the participating countries. One indication is the foreign
currency rating of government debt, as publicised by the international rating
agents. Of all EU countries, only Austria, France, Germany, the Netherlands
and the UK received the highest rating. Finland and Ireland were rated in the
second and respectively third class, although both countries are out of the
Maastricht excessive deficit procedure. This compares with triple A ratings for
all EU countries except Greece on local currency debt (IBCA, Standard &
Poor’s; Moody’s domestic currency rating has in several cases come closer to
the foreign currency rating of the two other rating agents: it believes that EU
central banks will no longer assist their governments in case of financial
trouble).
An often-cited example of the degree of divergence are the Canadian
provinces. It suggests that spreads might amount to about 50 basis points for
325
10-year bonds, a slight increase as compared to the current differences in euroDEM spreads. It again indicates that the market does not extract a very high
risk premium for differences in fiscal performance. Will differences of hundreds
of basis points, as existed in the past, be definitely over within EMU?
It has been argued that the German Bunds might lose their benchmark
status in EMU to France. French government bonds cover the maturity
spectrum more evenly than the German Bunds, and thus provide sufficient
liquidity in all segments of the market. Second, French products are more
standardised, which makes the conversion of the stock of outstanding French
debt easier. German debt is more widely dispersed over central and local
government, in different products. Third, the French markets are supported by a
transparent and liquid market for repurchase agreements, while the bulk of
DEM repo trading is located in London.
Table 7. Long-term sovereign foreign currency credit ratings in the
EU (1997) and spread on Euro-DEM bonds with German debt
(in basis points)
Country
Germany
France
Austria
Netherlands
Belgium
Ireland
Denmark
Finland
UK
Sweden
Spain
Italy
Portugal
Greece
Moody’s
S&P’s
Aaa
Aaa
Aaa
Aaa
Aa1
Aa2
Aa1
Aa1
Aaa
Aa3
Aa2
Aa3
A1
Baa1
AAA
AAA
AAA
AAA
AA+
AA
AA+
AA
AAA
AA+
AA
AA
AABBB-
EuroDEM
bond
spread
16
21
19
21
19
21
23
23
Domestic
Existence of
currency DEM excessive
spread
deficit
(May 97)
(May 97)
yes
-5
yes
8
yes
-14
no
7
yes
79
no
67
no
46
no
144
n.a.
116
yes
71
yes
150
yes
83
yes
yes
Sources: Schinasi (1997), Vereinsbank (1997), own research.
326
3.2
Portfolio shifts of institutional investors
Are big shifts to be expected in portfolio composition of institutional
investors as a result of EMU? The most important changes could happen in the
fixed interest portfolio of insurance companies. EU-licensed insurance
companies are subject to an 80 per cent currency matching rule, meaning that
the currency denomination of assets has to match those of the liabilities. As
indicated before, harmonised rules for pension funds do not exist in the EU.
Substantial changes in the pension fund investment as a direct result of EMU
are less important, however, since the Netherlands and the UK, which represent
76 per cent of pension fund assets in the EU (1995), have no meaningful
quantitative investment restrictions on pension fund investment (with the
exception of the Dutch civil servant pension fund ABP). The effect on pension
funds will be mainly indirect.
Traditionally, continental European insurance companies have
invested massively in domestic government debt. The replacement of the
domestic by a euro currency matching rule should allow them to rebalance into
debt securities of other EMU member states issued in euro. From a prudential
point of view, they should even be forced to spread their investments. But to
what extent will this happen? An important element will be the differences in
risk premia on EU government debt. Although the spread with German Bunds
of the most likely EMU candidates has disappeared, renewed divergence based
on the fiscal position of the different EMU members could be an incentive for
insurers to diversify into debt securities of other member states.
Portfolios should also become more international and less
domestically focused. Whereas the investments of the 20 per cent non-matching
currencies were previously held in other EU assets, these could become assets
of other non-EU OECD countries. In view of the Maastricht criteria and the
Stability Pact, which limit budget deficits, the question arises of whether
restrictions on investment in equity and private bonds by insurance companies
will in the long run not become too tight. Or will they result in a welcome
captive market for sovereign securities as population ageing increases
government debt? Furthermore, in some countries pension funds are regulated
as group insurance schemes and fall under the insurance directive restrictions,
whereas in other countries they are subject to a much more liberal regime.
Employees and firms might thus be better off in some countries than in others.
327
3.3
Market restructuring
The start of monetary union and disappearance of the national
currency will bring about sea changes in organised markets and financial
services. In the organised markets, the most obvious targets are derivative
exchanges, although restructuring will also affect stock markets. There were 23
futures exchanges in Europe 1996, offering 68 derivative instruments based on
national currency, interest rates and government bond rates, with an average volume
of 3.5 million contracts. The most important ones are London (Liffe), Paris (Matif)
and Frankfurt (DTB). These three exchanges have a joint share of 85 per cent in
interest rate futures (1995). It is highly unlikely that so many derivative exchanges,
all based on the euro, will be viable in EMU, because of the disappearance of
exchange rate differentials and the convergence of interest rates. Parallel euro future
contracts in French and German government bonds will become superfluous.
The disappearance of domestic currency might lead to a concentration
in European stock exchanges. Many of the initiatives to create a more
competitive European stock market have failed so far, due to intense rivalry
between the different exchanges. So far, this rivalry has only helped to
strengthen the position of the New York stock exchange, which, helped by a
liquid dollar market, possessed a 43 per cent share of world market
capitalisation in 1995, compared to 23 per cent by Europe. Firms and investors
will go for the most competitive, liquid and technologically advanced stock
exchanges.
EMU will probably lead to the emergence of a real corporate bond
market in Europe, which heretofore has generally been poorly developed. Many
reasons could be put forward, but the lack of a liquid market might be one of
the most important. Monetary union, but also the competitive process it will
trigger, will bring change. Banks will look for more profitable activities, such
as acting as lead managers for bond issues. Demand from institutional investors
for more diversified portfolios could also contribute to the growth of the
commercial paper market.
4.
Conclusions
EMU will lead to a more liquid and mature European capital market.
This should stimulate European institutional investors to become more
competitive and to spread their investments in a broader range of assets.
328
EMU will make remaining distortions at EU level more visible. The
pressure for a harmonised minimum withholding tax at EU level will grow.
Remaining investment restrictions on pension funds will look even more
outdated, and should therefore be abolished. Pension fund managers should be
allowed to offer their services throughout the EU on the basis of a single
licence. The European Commission’s initiative to relaunch the debate on the
subject through its recent “Pensions Green Paper” should therefore be
encouraged.
The key to a bigger role for institutional investors in Europe rests,
however, with the individual states, and the answer they will give to the
growing ageing and the declining activity ratios of the population. European
states that rely heavily on pay-as-you-go financing in retirement provisions
have so far been rather slow to reform their pension systems in the direction of
a partly-funded system. It is no coincidence that the states with the most
developed funded systems have the best capitalised stock markets as well.
Whether there will be more convergence in asset allocation in Europe
is an open question. Increased competition between institutional investors could
result in a higher share for equity in portfolios, since they give a better return on
the long run. Increased personal choice in pension planning could also lead to
more short-term low-risk investments, as the experience of the 401(k) plans in
the US indicates.
329
NOTES
1.
See Lannoo (1996) for a detailed overview of the objectives of the draft
directive and the reasons for its withdrawal.
2.
The reliability of data on stock market capitalisation may be impaired by
circular holdings - the cross-shareholding of listed companies. The
Federation of European Stock Exchanges (1994) estimated that the degree
of direct circular holdings between the 5 per cent largest companies on a
stock exchange was less than 10 per cent. The smallest circular holding
ratios were found in Dublin, London and Athens, where they seemed to be
almost non-existent. Paris, Brussels and Stockholm had the largest degrees,
with 15 per cent, 22 per cent and 26 per cent, respectively.
330
BIBLIOGRAPHY
BENAVIDES, R. (1996), World Bond Markets, Salomon Brothers, August.
BULCHANDANI, R. (1996), Interest rates after EMU, Morgan Stanley
Investment Research Europe, November.
DE RYCK, K. (1996), European Pension Funds, Their Impact on Capital
Markets and Competitiveness.
Deutsche Bank Research (1996), EMU and financial markets - some issues and
prospects, EMU Watch, No. 22, December.
European Commission (1997), External aspects of EMU, Commission staff
working document.
European Commission (1997), Supplementary pensions in the Single Market. A
Green Paper.
European Federation of Investment Funds (FEFSI) (1997). Annual Statistics 1995.
Federation of Stock Exchanges in the EC (1993). Share Ownership Structure in
Europe.
Federation of European Stock Exchanges (FESE)(1996), European Stock Exchange
Statistics, Annual Report 1995.
Fédération Internationale des Bourses de Valeurs (FIBV)(1996). Annual
Report 1995.
GROS, D. and LANNOO, K. (1996). The passage to the euro. CEPS working
party report No.15.
LANNOO, K. (1996), The draft pension funds directive and the financing of
pensions in the EU. The Geneva Papers for Risk and Insurance, January.
331
McCAULEY, R. (1997), The Euro and European Financial Markets, Paper
presented at the IMF seminar on EMU and the International Monetary
System.
SCHINASI, G. (1997), European Monetary Union and International Capital
Markets: Structural Implications and Risks, Paper presented at the IMF
seminar on EMU and the International Monetary System.
Vereinsbank (1997), The euro and the capital markets, from minor league to the
world series. April.
332
Chapter XV
WARNING: PAST PENSION FUND PERFORMANCE IS NO
GUARANTEE FOR FUTURE PERFORMANCE
by
Helmut Reisen*
Introduction
This contribution deals with the demographic pressures that are likely
to arise for fully-funded pension schemes as a result of population ageing in the
OECD. It first highlights differences in the prospective demographic trends
between the ageing OECD and the younger non-OECD area. Second, it
provides a capsule summary of general-equilibrium work which predicts a
decline in capital returns as an autarchy response to higher age dependency in
the OECD area. Third, some empirical evidence for a significant influence of
the prime-savers ratio (people aged between 40 and 60 years as a proportion of
people older than 60) on the Standard and Poor’s average price earning ratio is
presented. An out-of-sample simulation predicts the price-earning ratio to
decline from the year 2007 as a result of a decline in the prime savers ratio.
This leads us to warn that past pension fund performance (and capital returns)
cannot be taken for granted for the coming decades when the OECD baby
boomers start to retire. A final section explores the possibilities of attenuating
any decline in prospective capital returns through pension-fund investment in
the younger emerging markets.
1.
Demographic trends inside and outside the ageing OECD area
Despite some uncertainties in forecasting demographic trends over the
next 50 or so years, uncertainties which are mostly due to assumed changes in
fertility rates, some demographic trends can be predicted with a high degree of
*
OECD Development Centre.
333
confidence. Three salient aspects deserve to be highlighted, because of their
great importance for the future economic interdependence between the ageing
OECD1 and the non-OECD area:
− While population ageing is a global phenomenon, OECD
populations are ageing from the ‘middle’ of the age pyramid, in
contrast to non-OECD which is ageing from the ‘bottom’. In other
words, the prospective demographic changes imply divergent
trends in labour force growth across the two regions. Labour force
growth rates will strongly decline in the ageing OECD area and
turn negative after 2010. In strong contrast, ageing is increasing
the labour force in the non-OECD area; the proportion of the
working-age group in total non-OECD population will roughly
remain constant.
Chart 1. Relative change of labour force (=Age group 15-60)
OECD and Non-OECD, 1951 - 2050
3
2.5
2
1.5
1
0.5
0
-0.5
-1
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Notes:
____ OECD------ Non - OECD
− Ageing from the ‘middle’, the ageing OECD area will face a
strong drop in the support ratio of workers to retirees, in
particular after 2010. Likewise, the support ratio will start to fall
in the non-OECD, but from much higher levels than in the OECD
area.
334
Chart 2. Support ration = Age group (15-60) / Age group 60++
OECD and Non - OECD, 1950 - 2050
8.5
7.5
6.5
5.5
4.5
3.5
2.5
1.5
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Notes:
____ OECD------ Non - OECD
− A much-neglected aspect of prospective demographic changes is
that they will shift the balance between the age groups that may be
characterised as net borrowers and net savers. Changes in the age
composition of the population will have consequences for the rate
of net financial asset accumulation and on the rate of return of
financial assets. The United States shows relatively high
household savings in the high-income age cohorts (40-60),
whereas net savings in the other age cohorts is low or negative
(Attanasio, 1994). As the “baby boom” generation filters through
its peak asset accumulation years, the ratio of prime savers to the
working age population will rise until the year 2007 and then
decline. For the entire ageing OECD, the prime savers ratio will
peak somewhat later (2015), before it starts to drop. By contrast,
the rise of the prime savers ratio in the rest of the world, which
started at around 1990, will not halt before the year 2050.
335
Chart 3. Prime Savers Ratio = Age group (40-60) / Age group (15-60)
OECD and Non - OECD, 1950 - 2050
50.0
45.0
40.0
35.0
30.0
25.0
1950
Notes:
1955
1960 1965 1970 1975 1980 19851990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
____ OECD------ Non - OECD
Neo-classical growth theory and prospective asset developments
suggest that the above three demographic aspects will burden the performance
of OECD pension funds over the coming decades. To a certain degree,
however, investment in the emerging markets can attenuate the prospective fall
in capital returns.
2.
The demographic impact on capital returns in neo-classical
growth models
The arithmetic of unfunded, earnings-related pensions is largely
governed by changes in the support ratio and by real wage growth (which in
turn depends on labour productivity in the long run). These pension
arrangements are essentially locked into the ageing economy, unable to escape
the prospective demographic pressures resulting from the expected drop in
support ratios. It is little understood, however, that even fully funded pension
schemes will not escape demographic pressures. The arithmetic of funded
pensions (that are fully dynamic with respect to growth in labour productivity)
can be described by the intertemporal budget constraint.
336
(1− a )T
1)
∫
sy0e
−( r − g)t
0
where
T
dt −
∫c e
−( r −g)t
0
(1− a )T
dt = 0
(1-a)T =years of pension contribution
aT = years of pension receipt
r-g = δ =discount rate, equal to the real rate of return less
labour productivity growth
s = yearly rate of pension contribution
y0 = real per capita income in year 0
c0 = yearly pension level in 0
v = cy =pension benefit c as share of per capita income
Integration of (1) yields
2)
s = v (eδaT - 1)/(eδT - eδaT),
which links the yearly level of pension savings for a given pension
level v to the rate of return and to the length aT of pension benefits. While it is
obvious that higher life expectancy will put pressure on the arithmetic of
funded pensions, the demographic changes highlighted in section 1 may well
add to that pressure by driving down the rate of return on pension investments.
A variety of general equilibrium analyses that employ the standard optimal
growth model predict a decline in the rate of return on capital as a result of the
prospected decline in the labour force and support ratios in the ageing OECD
area (Cutler, Poterba, Sheiner and Summers, 1990; Yoo, 1994a; Börsch-Supan,
1996; MacKellar and Reisen, 1998).
The autarchy response to higher age dependency in the OECD area is
to lower output per capita and, with a lag, consumption per capita. Slower and
negative labour force growth will reduce investment requirements, because it
lowers the capital-widening investment demand per worker. With a fixed
saving rate, lower labour force growth promotes capital deepening, that is a rise
in the capital-labour ratio. That, in turn, will lower the marginal productivity of
capital, relative both to the rate of time preference and to the marginal
productivity of labour. The drop in capital productivity will be exacerbated by
diminishing returns to scale. Lower capital productivity results in lower returns
on savings, both in absolute terms and relative to real wages.
While there is little debate on the validity of the neo-classical
argument spelled out above, there is little empirical evidence on the quantitative
effects of prospective population ageing in the OECD area. Simulating the
2
autarchic response of the ageing OECD to the prospected drop in the support
337
ratio and labour force growth, Börsch-Supan (1996) and Yoo (1994a) arrive at
very similar results for the prospective rate of return to capital. While these
rates of return, proxied by the rate of return to physical capital, are around 6 per
cent in the 1990s baseline, they drop in both simulations by more than 200
basis points to the year 2020. Note that savings, which equal investment to the
closed OECD economy, fall as a result of the excess capital stock when the
labour force shrinks. If a shift from PAYG to funded pension schemes would
instead stimulate savings as is sometimes maintained (e.g. Feldstein, 1996), the
rate of return might even decline more than in these simulations. Börsch-Supan
(1996) notes, moreover, that reasonable changes in the rate of technical
progress will not change the overall results of a substantial decline in savings,
investment and the rate of return in the long run.
3.
The demographic impact on pension fund performance
The rate of return is proxied in the neo-classical growth model by the
rate of return to physical capital, but institutional pension assets tend to be held
in equities, bonds and real estate. The ageing process can be expected to affect
the return on these broad asset classes; research on this is virtually non existent.
It can be hypothesised, however, that real estate prices should be negatively
affected by a shrinking population (Mankiw and Weil, 1989); bond yields by
the decline in investment needs as analysed in the growth models, and by
higher relative bond demand as pension funds mature; and equity prices as
lower growth will translate into lower corporate profits (Bakshi and Chen,
1994; Yoo, 1994b). While financial markets are usually assumed to be efficient,
no arbitrage opportunities exist to exploit the price trends predicted above if
demographics affect the demand for assets in a similar way.
This section will focus on the life cycle and cohort effects that the
transgression of the US “baby-boom” generation is expected to exert on
financial asset accumulation and then decumulation (McKinsey Global
Institute, 1994; Attanasio, 1994). The strong baby-boomer cohort (those born
between 1950 and 1967) is now between 47 and 30 years old. These large
cohorts have now entered the period in their life cycle (40-60 years) when their
liabilities are decreasing on average, and they are saving at higher rates from an
increasing income. While it seems that the United States is the only major
OECD country that fits the hump-shaped life-cycle saving profile postulated by
standard economic theory (Börsch-Supan, 1996), the US case will be of major
importance for financial-asset developments and returns. First, in 1992, US
citizens held more than 40 per cent of the financial stock in the OECD area.
338
Second, financial market returns in OECD countries (except Japan) are highly
correlated with and governed by the US financial markets.
Chart 4 shows a strong increase in the ratio of prime-saving cohorts
relative to the working-age population for the United States, up to the year
2007. While the ratio peaked first around 1960 at 40 per cent, it fell
continuously until 1984 (to 32 per cent). Since then, the ratio has steadily risen
and will continue to rise until 2007, when it will peak at 46 per cent. From then
on, the prime savers ratio is prospected to decline gently. As the baby-boom
generation enters its peak asset accumulation years, a strong increase in the rate
of net financial asset accumulation can be expected (McKinsey Global Institute,
1994). Allowing for cohort effects should reinforce the result because the large
baby boom cohorts are saving at higher rates at every age than earlier cohorts
and they are saving from higher income levels (Attanasio, 1994). Likewise, the
combination of life cycle effects and cohort effects implies that the rapid phase
of financial asset accumulation relative to earlier levels will, ten years from
now, give way to financial asset stagnation or even decumulation. Then, not
only will the prime savers ratio decline, but the large baby boom cohort will
start to retire and to draw on the accumulated pension assets, while the
subsequent prime savers cohorts will be much smaller. The support ratio in the
United States will soon start a strong decline, as can be seen from Chart 5.
Multiplying the prime savers ratio (40-60 years old/15-60 years old)
with the support ratio (15-60 years old/60+) yields another ratio that relates the
prime-savers cohort in the United States with the age cohort of people 60 years
and older. This demographic variable, which corresponds to the peak asset
accumulation relative to the peak asset decumulation cohorts according to the
life cycle hypothesis, can be expected to drive financial asset accumulation and
stock market valuations, at least in the United States. Indeed, it does.
Table 1 presents regression analysis for the determinants of Standard
and Poor’s 500 annual average price-earning ratio for the observation period
1977-96, based on 20 annual observations. The SP 500 P/E ratio is determined
within a standard stock market valuation model, with the demographic variable
(40-60 years old/60 years+), the (inverse of the) US Federal Reserve discount
rate and the annual change in average hourly wages as explanatory variables.
All these variables enter the regression with the expected sign and are
2
significant at the 1 per cent level. The adjusted R indicates model
completeness, and the Durbin-Watson coefficient close to two indicates the
3
absence of autocorrelation .
339
Chart 4. Prime savers ratio = Age group (40-60) / Age group (15-60)
United States, 1950 - 2050
48.0
46.0
44.0
42.0
40.0
38.0
36.0
34.0
32.0
30.0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
Chart 5. Support ratio = Age group (15-60) / Age group 60++
United States, 1950 - 2050
5.2
4.7
4.2
3.7
3.2
2.7
2.2
1.7
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
340
Table 1. The S+P 500 Price/Earning ratio and demography
(st. error in parenthesis)
Dependent variable
SP 500 P/E ratio
Explanatory
variables
Prime savers
(40-60) as % of
60 years +
FRBNY Discount
rate (inverse)
Change of
hourly
wages
0.09***
(0.02)
46.1***
(7.7)
-1.5***
(0.45)
Number of observations:
20
Period: 1977-96
2
Adjusted R : 0.88
Durbin-Watson: 1.98
*** = significant at the
0.01 level
Sources: Own calculations based on data provided by Dresdner Bank (SP 500 P/E);
UN Population data file; IMF, International Financial Statistics (items 60 and 65ey).
Despite the importance of US interest rates in determining the priceearning ratio, the regression shows that US stock market valuations have been
significantly supported by the rise in the prime savers ratio (since 1983), while
the support ratio has remained fairly stable. That favourable demographic
support for valuations will not last for much longer, as around the year 2000 the
support ratio is prospected to start a 30-year long decline, to be reinforced by
the prospected decline of the prime savers ratio from the year 2007. Chart 6
provides an out-of-sample forecast, assuming interest rates staying at the 1996
level and hourly wage rises along the pace experienced over 1986-96. The outof-sample scenario, which is fully driven by the ratio of prime savers to people
older than 60, tells us that the US stock market valuations will peak at a priceearning ratio of 20 and then start a long decline, before P/E ratios will stabilise
at a level of around 14 at around 2030. The prospective drop in the SP 500 P/E
ratio would represent a decline of 30 per cent, on account of deteriorating
demographic fundamentals.
341
Chart 6. S&P 500 price/earning ratio
25
23
Fitted Value
21
S&P 500 PE
19
17
15
13
11
9
7
5
1977
1982
1987
1992
1997
2002
2007
2012
2017
2022
2027
2032
2037
2042
2047
While all this is highly speculative, it confirms earlier concerns
(Schieber and Shoven, 1994) that, as US funded pensions cease to be a source
4
of net savings, asset prices will be negatively affected . This can reinforce the
maturity-induced shift of pension portfolios from equities and long-term bonds
into short-term securities or cash, as Schiefer and Shoven suggest, but it can
also lead to a shift of equity portfolios into the younger economies where the
prime savers ratio will continue to rise well into the year 2050.
4.
The scope for emerging markets to improve pension returns
While the demographic trends (which can be anticipated well in
advance) mean in the context of a closed OECD-wide economy prospective
asset decumulation and lower financial returns, early asset diversification into
the younger economies can change this gloomy outlook for funded pensions
significantly. The effects of pension asset decumulation of the numerous baby
boom cohort during their retirement years can be spread on emerging-market
assets that still will benefit from net additions of the rising prime saver cohort
342
in these younger economies. The diversification will also attenuate the
retirement-induced run-down of OECD home assets and hence will help
stabilise financial returns on OECD assets during the first half of the next
century.
Moreover, the diversification of OECD pension assets into the nonOECD stock markets provides the prospect of higher expected return for a
given level of risk or, put alternatively, lower risk by eliminating non-systemic
volatility without sacrificing expected return. It is less the superior growth
performance of the non-OECD area than the low correlation of returns
generated by the emerging stock markets with those of the OECD stock
markets that governs this expectation (Reisen, 1994). The correlation between
returns on OECD and emerging stock markets will remain low even when
diversification gains are seriously exploited. Differences between the two areas
with respect to the exposure to country-specific shocks, the stage of economic
and demographic maturity and the (lack of) harmonisation of economic policies
suggest that the diversification gains for OECD pension assets will not
disappear quickly. The benefits of global portfolio diversification also apply to
emerging country pension assets as they could diversify away some of the risks
stemming from high exposure to shocks in their own countries by investing
some of their pension assets in OECD countries (Reisen, 1997). To the extent
that average long-term returns in emerging markets are higher than in the
mature OECD stock markets, OECD pension funds that put some of their assets
into emerging markets will enjoy a ‘diversification free lunch’, by both
reducing overall portfolio volatility and by raising mean returns simultaneously.
Only at a greater emerging-market share in the global portfolio does the
proposition that higher returns can only be obtained at the price of higher
volatility become confirmed.
Finally, the neo-classical growth model predicts that ageing countries
can partially offset the reduction in domestic saving and in the rate of return by
exporting capital (excess savings) to younger economies where the rising labour
force leads to higher demand for capital-widening investment. Age-induced
differences in the growth rates of labour and capital will cause growth
differentials to widen in favour of the younger economies. The demand for
capital from the younger economies drives up interest rates relative to the
autarchy response to OECD population ageing.
For the arithmetic of funded pensions, presented above in equations 1)
and 2), full capital mobility will thus imply higher pension benefits for retirees
in OECD Member countries as a result of higher rates of return. Moreover, in
the standard growth model, the discount rate will be raised as a result of lower
343
labour productivity as part of the capital is shifted away from OECD labour. In
turn, the extra capital which equips labour in the non-OECD area will foster
labour productivity there, while it hurts the rate of return on funded pensions in
the non-OECD world relative to autarchy. However, higher non-OECD wages
should translate into higher retirement savings in the non-OECD region.
As a matter of illustration, the benefits of full capital mobility for
funded OECD pensions can be assessed by inserting the simulation results into
equation 2) obtained by MacKellar and Reisen (1998) who consider various
scenarios with respect to capital mobility between the OECD and the nonOECD. In a base scenario with no further financial integration it is assumed
that only 2 per cent of both retirement saving and non-retirement saving are
invested in the non-OECD over the next fifty years. In the scenario
corresponding to rapid financial integration, these shares would rise from the
current two per cent level to 15 per cent by the year 2020 and remain there
through 2050. Without further financial integration between the OECD and the
non-OECD, demographic pressures would cause the rate of return to capital
from 10.4 per cent per annum (ignoring taxes) in 1995 to 7.9 per cent in 2050
in the OECD area. With rapid financial integration between the two regions, the
age-induced drop in capital returns would be attenuated in the OECD area,
falling to roughly 9.0 per cent per annum. Assuming 45 years of pension
contribution and 15 years of pension receipt, an after-tax rate of return worth
60 per cent of the above capital returns and annual growth in labour
productivity of 2 per cent, the required saving rate to finance a pension level
worth half per-capita income would require a saving rate of 5.8 per cent for the
open OECD economy compared to 7.2 per cent for the autarchic OECD.
Policy-makers will have to consider whether the risks implied by a massive
exposure of OECD pension assets to the non-OECD compensate the gain
obtained by OECD pension savers in terms of higher capital returns.
344
NOTES
1.
Some OECD member countries, notably Korea, Mexico and Turkey, are
excluded from the definition of ‘ageing OECD’ since they tend to share the
demographic features of the non-OECD world.
2.
Under the premise that it is possible to suppress trade with and capital flows
to countries outside the OECD area.
3.
Since SP 500 price-earning ratios were only available from the year 1977
onwards, a similar regression for the consumer price index adjusted SP 500
index was performed for the period 1950-1996. After correcting for
autocorrelation, the regression test statistics were very similar to the ones
2
reported here, with a high adjusted R , a Durbin-Watson coefficient close to
2, and with all three explanatory variables highly significant.
4.
While Schieber and Shoven’s (1994) pension saving model predicts that
pension benefits will first exceed contributions in 2006, they expect net
asset decumulation at around 2030, thanks to annual investment income on
accumulated pension assets.
345
BIBLIOGRAPHY
ATTANASIO, O. (1994), “Household Saving in the US”, in: J. Poterba (ed.),
International Comparisons of Household Savings, University of Chicago
Press, Chicago.
BAKSHI, G.S. and Z. CHEN (1994), “Baby Boom, Population Ageing, and
Capital Markets”, Journal of Business, Vol. 67.2.
BÖRSCH-SUPAN, A. (1996), “The Impact of Population Ageing on Savings,
Investment and Growth in the OECD Area”, in OECD (1996) (ed.),
Future Global Capital Shortages: Real Threat or Pure Fiction?, OECD,
Paris.
CUTLER, D., J. POTERBA, L. SHEINER and L. SUMMERS (1990), “An
Ageing Society: Opportunity or Challenge?”, Brookings Papers on
Economic Activity, 1990:1.
DAVANZO, L. and L. KAUTZ, (1992), “Toward a Global Pension Market”,
The Journal of Portfolio Management, Summer 1992.
FELDSTEIN, M. (1996), “The Missing Piece in Policy Analysis: Social
Security Reform”, NBER Working Paper, No. 5413.
MACKELLAR, L. and H. REISEN (1998), “A Simulation Model of Global
Pension Fund Investment”, forthcoming, World Development.
MANKIW, N.G. and D.N. WEIL (1989), “The Baby Boom, the Baby Bust, and
the Housing Market”, Regional Science and Urban Economics, Vol. 19.
McKinsey Global Institute (1994), The Global Capital Market: Supply,
Demand, Pricing and Allocation, Washington, D.C.
347
REISEN, H. (1994), “On the Wealth of Nations and Retirees”, in R. O’Brien
(ed.), Finance and the International Economy: 8, The Amex Bank
Review Prize Essays, Oxford University Press.
REISEN, H. (1997), “Liberalizing Foreign Investments by Pension Funds:
Positive and Normative Aspects”, World Development, July 1997.
SCHIEBER, S. and J. SHOVEN (1994), “The Consequences of Population
Ageing on Private Pension Fund Saving and Asset Markets”, NBER
Working Paper, No. 4665.
YOO, P; (1994a), “Boom or Bust? The Economic Effects of the Baby Boom”,
Federal Reserve Bank of St. Louis Review, Vol. 76(5), SeptemberOctober.
YOO, P. (1994b), “Age Distributions and Returns of Financial Assets”, Federal
Reserve Bank of St. Louis, Research Division Working Papers 94-002 B.
348
Chapter XVI
AGEING-INDUCED CAPITAL FLOWS TO EMERGING MARKETS
DO NOT SOLVE OECD’S BASIC PENSION PROBLEM
by
Hans Blommestein*
Introduction
Differences in demographics between OECD countries and
developing countries may stimulate the flow of capital to emerging markets.1 It
has been argued (correctly) that not only unfunded PAYG pension systems will
face financial difficulties related to prospective demographic pressures in the
OECD area, but also funded OECD pension schemes, because of the expected
2
ageing-induced drop in the rate of return on capital. For this reason, it may be
a good strategy for OECD pension funds to invest in the younger emerging
market economies as it may reduce the longer-term, ageing-induced financial
pressures, both by reducing overall portfolio volatility and by raising expected
mean returns. Clearly, it is not impossible that OECD countries may benefit
from investing part of their portfolio in emerging securities markets. The
objective of the paper is therefore not to deny that it may be beneficial for
OECD pension funds to invest in emerging markets, but to raise a few
questions regarding the arguments supporting: (i) the expected negative impact
of ageing on financial asset prices in the OECD area; and (ii) the size or
significance of the expected potential benefits of investing in emerging markets
by OECD pension funds. The paper concludes that ageing-induced capital
flows to emerging markets do not solve OECD’s basic pension problem. My
arguments are based on both methodological and financial-economic
considerations.
*
Senior Financial Economist, OECD.
349
1.
Methodological problems in predicting long-term trends
Several authors have used neo-classical growth models to analyse the
expected long-term demographic impact on capital returns. It is an excellent
example of using economic analysis for peering into the future. Unfortunately,
social scientists are almost always wrong when they try to predict future events
and trends, and economists are no exception. The epistemological reasons do
not concern us here, but they are important in explaining why the forecasting of
long-term trends (demographic trends, labour force growth, the rate of net
financial asset accumulation, and the rate of return of financial assets over the
next fifty years or so) is fraught with huge uncertainties. Uncertainty about
growth, productivity and financial assets returns in the distant future (i.e. when
the large baby boom cohort will start to retire) is high enough to be very careful
in interpreting and accepting the simulation evidence from studies based on
long-term projections. In this context, it is instructive to recall the fate of
previous long-term projections, such as the ones produced by the Club of Rome
in the 1970s: they were dead wrong. Economists (and other social scientists)
may be right about the direction of a change in trends, but they usually are
completely wrong about the timing and size of these changes.
2.
Funded systems and portfolio diversification
In spite of these methodological problems in forecasting future trends,
I believe that studies on the financial aspects of ageing populations
convincingly demonstrate that:
− Integration of non-OECD financial markets into the OECD
financial area is beneficial for both the ageing OECD countries
and the younger non-OECD economies. However, it has to be
recognised that increasing financial integration in principle
reduces the diversification benefits of cross-border institutional
investments [see the increase in correlations in Table 1 below].
− Fully funded systems can probably not fully escape the
demographic pressures of “baby boom bubbles”. What has not
been convincingly demonstrated is the seriousness of the problem.
− Asset diversification by OECD pension funds into the younger
non-OECD economies is a potentially sensible strategy [see table
1]. Moreover, it may also be sensible for non-OECD pension
funds to invest in the ageing OECD area.
350
Table 1. The benefits of diversified risk - Correlations between
US and emerging markets
All emerging markets
Correlation between S&P 500 and:
1975-95
1990-95
0.27
0.41
Latin America
0.24
0.38
East Asia
South Asia
Africa
0.16
0.24
0.07
0.27
0.23
0.03
Source: ICFA
3.
The basic pension problem
In order to comment on some of the issues raised in the literature on
the demographic impact on capital returns, I am re-stating the “basic pension
problem”, regardless of the presence of PAYG or funded systems. The key in
all retirement programmes is physical resource availability or, equivalently, the
level of standard-of-living.
The financing of any pension system (funded, non-funded, public,
private) is merely to facilitate the allocation of real resources that fund the
consumption of goods and services during retirement and to allocate risk in the
most efficient fashion. There is a pension problem when there is a (expected)
short-fall in resources needed for planned or promised retirement consumption
purposes.
4.
Demographic pressures on funded pension systems
Several studies have focused on the projected shortfall in real
resources as a result of the demographic pressure of the “baby boom bubble” on
funded pension systems in the OECD area. In this context, two main
arguments have been presented as to why it is beneficial for OECD pension
funds to invest in the younger non-OECD economies. The first argument is
based on the push factor that demographic developments put downward
pressures on the rate of return on capital. The second argument is a pull factor
based on higher expected returns and/or improved risk diversification. Both
351
arguments reinforce the differentials in the expected rates of return between
OECD and emerging market economies and the associated stimulus of capital
to emerging markets.
The first argument (the push factor) is based on the simple mechanics
of a neo-classical growth model, in which demographic pressures will drive
down the rate of return on pension investments in the OECD area. Now it is
not impossible that this will happen and it is perhaps even likely. I think,
however, that the case for this scenario is not so strong as some studies suggest.
Ergo, the power of the push factor -- and thus, the potentially beneficial effects
of investing in the non-OECD area -- is less pronounced.
First, the quantitative evidence is very weak, as it is based on -- by
definition -- crude projections (or, perhaps better, speculations) about the
distant future. For example, on methodological grounds, I would find it very
difficult to take projected drops in the rate of return on capital of more than
200 basis points in the year 2020 very seriously. The drop may be smaller,3
although it is impossible to generate reliable projections.
Second, an endogenous growth framework would allow a more
optimistic perspective about productivity growth. Endogenising productivity
changes makes it possible to explain observed long-run differences in growth
performance of countries that are impossible to explain using a neo-classical
growth framework (Jones and Manuelli, 1997). For example, human capital
externalities account for the fact that international differences in the returns to
human capital vastly exceed the differences in return to physical capital
(Lucas, 1988).
But even if one stays within the neo-classical world, there is scope for
higher capital productivity than suggested in some studies. The maturing of
emerging technologies and further substantial deregulation of industry and
finance, will, in themselves, improve the growth rate of productivity without
large capital investment and savings. Increased productivity from the
information technology (IT) revolution is an important example. Thus far, the
claims that the IT revolution has dramatically increased productivity do not
show up in aggregate productivity growth. Nonetheless there are several
reasons that give cause for optimism that, over time, investments in IT will
4
boost productivity growth. Moreover, a switch to funding is likely to reduce
distortions to labour and financial markets and to saving, and may in itself
reduce the negative economic impacts of ageing, by boosting both labour force
participation and aggregate savings.
352
In general, savings and investment decisions are increasingly guided
by market tests. It is likely that this will result in labour-saving investments
(due to demographic developments)5 with improvements in productivity. (One
could envisage a vintage growth framework whereby older vintages of the
capital stock are being scrapped and replaced by less labour-intensive, more
productive vintages.)
However, this line of argumentation weakens, but not necessarily
invalidates, the central point made in the literature: an ageing population is
likely to reinforce the tendency for economic growth to gradually slow when
the ratio of capital to labour rises and rates of return to new investment decline.
Improvements in capital productivity from current rates sufficient to eliminate
fully ageing-induced funding gaps seem implausible. A solution to the “basic
pension problem” requires not only an improvement in productivity, but also an
increase in domestic savings. In this respect, a switch from PAYG to a funded
6
system leading to higher domestic savings would be most welcome. This may,
or may not, result in a decline in the rate of return on capital. (Some authors
argue in this context that the stimulation of savings will result in a further
decline in the rate of return.) However, even if total domestic savings would
not increase, there is evidence that the growth of funded pension systems
increases the availability of long-term savings. When pension funds are not
unduly constrained in their asset allocation strategies, it is likely that both the
supply of risk capital (Blommestein, 1998) and capital productivity will
increase substantially.
5.
International portfolio diversification: Financial
implications of capital exports to emerging markets
market
The second argument (the pull factor) in favour of investing in
emerging markets by OECD pension funds is based on the consideration that
demographic developments might make it a sensible strategy to reallocate part
of domestic OECD pension funds to younger, non-OECD economies, in search
of higher returns and/or improved risk diversification. However, the arguments
in favour of this portfolio reallocation process needs to be very carefully
assessed.
First, many younger economies in the non-OECD area are not (yet)
very attractive to invest in. Fragile banking systems, illiquid and poorly
regulated stock markets, political risk, etc., may constitute a barrier for OECD
pension funds and other institutional investors. Mexico’s crisis in 1995 and the
353
1997 currency crises in several countries in South-East Asia are useful
reminders of some of the investment risks involved.
Second, also a closer look at stock market returns and equity risk in
emerging equity markets gives reason to be cautious. Although the growth
record shows that in the period 1985-1995 the OECD countries have tended to
grow more slowly (i.e. around 1.8 per cent per annum) than the developing or
emerging economies (i.e. around 3.4 per cent), this has not been uniformly
reflected in stock market returns. In fact, over the last 10 years, the G7 stock
markets have given better returns than the emerging markets. Information on
equity risk and returns in emerging markets and the United States over the last
20 years are provided in Table 2. It shows that the S&P 500 has given better
per month returns than the average of all the emerging markets. The same
conclusion is valid for data recorded over the last 5 years. Average monthly
returns in Latin America and Asia were somewhat higher than the S&P 500.
However, at the price of significantly higher risks. Naturally, the future might
bring better news in terms of higher expected returns and /or lower risks,
especially in the light of the expected ageing-induced pressures on financial
returns in the OECD area.
Table 2. Returns1) and risk in emerging equity markets
Years 1975-95
(%)
(All data in US
Dollars)
S & P 500
US T Bills
All emerging
markets
Latin America
East Asia
South Asia
Africa
Years 1990-95
(Compound
average
return)
Standard
deviation
(Compound
average
return)
Standard
deviation
1.11
0.62
0.99
4.25
0.25
5.61
0.93
0.39
0.84
3.30
0.13
5.66
1.53
1.43
1.16
-0.07
9.01
9.54
5.29
9.95
1.98
0.25
1.17
0.97
7.48
8.31
6.48
10.65
Note: 1) Returns are on a monthly basis
Source: ICFA
354
Meanwhile, it may still be beneficial for OECD pension funds to
invest in emerging markets because it could improve the risk characteristics of
the portfolio. Consider, as an example, an efficient frontier for United States
portfolio investors over the last 20 years [see Chart 1]. The frontier shows
combinations of risk and return for two asset classes -- United States equities
and emerging market equities. Although United States equity holdings over the
1975-1995 period gave investors both higher returns and lower risks than the
emerging markets as a group, there are still benefits from diversification. The
asset allocation mix is dependent on the desired risk-return profile of the
pension funds in question. Chart 1 shows that United States pension funds
could have reduced their risk by giving up some return; by investing 30 per cent
of their equity portfolio in emerging market equities they would have
minimised their risk.
Chart 1. Risk vs. Return: Emerging market and US stocks
December 1975 - June 1995
Average Monthly Return (%)
1.22
1.21
1.20
100% S&P 500
1.19
30% Em. Markets Composite,
70% S&P 500
1.18
1.17
1.16
100% Em. Markets
Composite
1.15
1.14
3.5
4.0
4.5
5.0
Standard Deviation of Returns (%)
Source: Goldman Sachs Global Research.
355
5.5
6.0
Third, it is not a priori clear that the portfolio reallocation process
between OECD and non-OECD assets will always lead to a better financial
condition of OECD pension funds, even if the return on securities in the nonOECD area is higher. The portfolio reallocation process by itself does not
induce new productive savings and investment. The reallocation may even
induce great financial market tensions in the OECD area (financial market
turbulence may also occur in the emerging financial markets, making
investments by OECD pension funds less attractive). If OECD pension funds’
assets would be shifted en masse from OECD securities (equity and debt
instruments) to non-OECD securities, then holders of debt and equity
instruments in the non-OECD area must be induced to exchange them, net, for
OECD securities.
But, if OECD pension funds achieved higher returns investing in nonOECD securities than in lower-yielding OECD securities, OECD area incomes
generated by their asset portfolios (including the return on holdings by OECD
pension funds) would fall by the same amount, potentially worsening the
financial condition of OECD institutional investors. In order to induce a switch
from OECD to non-OECD securities, the price of non-OECD securities must
rise and OECD securities prices must fall. But, this could create large financial
market turbulence. The total market value of OECD plus non-OECD securities
is, to a first approximation, likely to be unaffected by a shift in the balance of
paper claims.
One might speculate that the tension between the altered relative
supply of non-OECD and OECD equities, on the one hand, and unaltered
overall economic value of companies in both the OECD and non-OECD areas,
on the other hand, would be resolved by an increase in the issuance of nonOECD securities relative to OECD securities. This could reverse much, if not
all, of the price shift in favour of non-OECD securities.
This picture of changes in asset prices might become even more
complex when one considers also the shift from government securities to
private debt and equity instruments; for example, in the context of the
7
privatisation of social security systems.
In sum, the potential negative impact of the portfolio reallocation
process on OECD equity and bond prices reduces the potential diversification
8
benefits for OECD pension funds to invest in non-OECD financial markets.
Fourth, there is evidence that downside market movements occur
much more in parallel than upside ones. Recent studies9 shows that shocks in
356
volatility are closely linked with rising correlations, in particular in the case of
stock markets. An increase in correlation is normally associated with sharp
downside movements of securities markets. For example, there is clear
evidence of a world market factor in results of the market crash of October
1987.10 Unfortunately, the fact that most assets seem to move uniformly during
market crash situations reduces the benefits of controlling absolute (downside)
risks using investment strategies based on diversified benchmarks.
6.
Conclusion
Clearly, there is no easy (“free lunch”) solution to the basic pension
problem.
Without an increase in productive OECD savings and an
improvement in productivity, the shortfall in real resources needed for
retirement consumption purposes is unlikely to be met by investing in younger
economies. Moreover, whether retired OECD workers get most of their
consumption through (funded or unfunded) public or private pension schemes,
their consumption will be derived from the output of future workers and the
future capital stock. The negative implications of slow growth will be the same
11
whether pension incomes come from public or private sources.
357
NOTES
1.
See, e.g. World Bank Policy Research Report (1997).
2.
Barr (1992), Vittas (1992), Reisen (1997) and World Bank Policy Research
Report (1997).
3.
For example, Feldstein and Samwick (1998) project that the marginal
product of capital declines from 9.0 per cent with the existing US capital
stock to 8.3 per cent after 25 years, 7.5 per cent after 55 years and 7.2 per
cent after 75 years. A drop of only 70 basis points after 25 years!
4.
See, e.g., Allen (1997). More generally, it has been argued that the US
economy and other OECD countries are at the threshold (or beyond) of a
new economic era in which human capital has become the driving force of
economic growth. These trends and structural changes should not be
confused with statements concerning an ill-defined “new economy” with the
associated “new paradigm” asserting that “globalisation” and “technological
changes” have made inflation and business cycles obsolete [ see, e.g.,
Greenspan spells it out, Economist, October 11th, 1997.]
5.
Cutler, Poterba, Sheiner and Summers (1990) have argued that innovation
increases as labour gets scarce. This may mean that ageing-induced
technical progress could help to maintain living standards, regardless of the
effects of ageing on savings and investment (E. P. Davis (1997).
6.
Phil Davis (1997) has noted that the switch from PAYG to funding is
unambiguously likely to raise saving. His argument is based on the
reasoning -- earlier proposed in a World Bank Study (1994) -- that the
conditions under which funding will have a positive effect on saving
(namely, myopia, limited access to credit, and lack of credibility of the
existing PAYG pensions scheme) are precisely the same forces that reduced
the negative impact of PAYG on saving. Also Feldstein (1977, 1995) has
argued that a switch to funding would potentially raise aggregate savings,
359
thus increasing the stock of fixed capital and the extra output out of which
future pensions are to be paid.
7.
For example, the 1997 Economic Report of the President notes that critics
of allowing the US social security trust funds to invest in equities argue that
“such investments would primarily represent a reallocation of assets
between those held in trust funds and those held -- either directly or
indirectly -- by households. It could improve the financial position of the
trust funds, because of equities’ historically higher average returns, but for a
given level of saving it would not increase the returns for the country as a
whole. Investing a portion of the trust funds in equities would raise the
price and lower the return on equities, and lower the price and raise the
return on Treasury securities. Higher Treasury yields would raise Federal
interest costs and, all things being equal, the non-Social Security portion of
the deficit” ...... “The analysis is [further] complicated because the initial
effects on rates of return could be moderated as corporations restructured
their finances to take advantage of cheaper equity financing, and as
international buyers increased their purchases of now higher yielding
Treasury securities”.
8.
It is important to note that it is feasible to achieve the benefits of
international diversification without the cross-border transfer of capital
resources. For example, by buying securities issued by multinational
companies. Another possibility is to use stock index swaps. Robert Merton
has advanced the idea of using international equity swaps which would
separate capital flows from risk-sharing (Merton 1989).
9.
Kessler (1996) and Solnik, Boucle and Le Fur (1996).
10.
Roll (1988) showed that in all of the 23 countries under examination, the
October 1987 equity index returns were negative.
11.
Bosworth and Burtless (1997).
360
BIBLIOGRAPHY
ALLEN, D. S. (1997), “Where’s the Productivity Growth (from the Information
Technology Revolution)?”, Review, Federal Reserve Bank of St. Louis,
March/April, Vol. 79, Number 2.
BARR, N. (1992), “Economic Theory and the Welfare State: A Survey and
Interpretation,” Journal of Economic Literature, June.
BLOMMESTEIN, H. J. (1998), The Impact of Institutional Investors on
Financial Markets, in: “Institutional Investors in the New Financial
Landscape”, OECD, Paris, this volume.
BOSWORTH, B. and G. BURTLESS (1997), “Budget Population Ageing,”
The Brookings Review, Summer.
CUTLER, D., J. POTERBA, L. SHEINER and L. SUMMERS (1990), “An
Ageing Society, Opportunity or Challenge?,” Brookings Paper on
Economic Activity, 1.
DAVIS, E. P. (1997), “Can Pension Systems Cope?”, The Royal Institute of
International Affairs, London.
Economic Report of the President (1997), United States Government Printing
Office, Washington D.C.
FELDSTEIN, M. (1977), Social Security and Private Saving: International
Evidence in an Extended Life Cycle Model, in: M. Feldstein and R.
Inman, eds., The Economics of Public Services, International Economic
Association, Washington D.C.
FELDSTEIN, M. (1995), “Social Security and Saving: New Time Series
Evidence,” NBER Working Paper No. 5281, Washington D.C.
361
FELDSTEIN, M. and SAMWICK, A. (1998), “The Transition Path in
Privatising Social Security,” in: M. Feldstein, Privatising Social
Security, University of Chicago Press, Chicago, forthcoming.
JONES, L. E. and MANUELLI, R. E. (1997), “The Sources of Growth,”
Journal of Economic Dynamics and Control 21.
KESSLER, C. (1996), “Diversification -- Is It Still Alive?”, Economic and
Financial Prospects, No. 6, December, Swiss Bank Corporation.
LUCAS, R. E. (1988), “On the Mechanics of Economic Development,” Journal
of Monetary Economics 22.
MERTON, R. C. (1989), “On the Application of the Continuous-Time Theory
of Finance to Financial Intermediation and Insurance,” The Geneva
Papers on Risk and Insurance, Vol. 14, No. 52, July.
REISEN H. (1997), “Can the Ageing OECD Escape Demography through
Capital Flows to the Emerging Markets?”; Paper presented at the OECDADB International Forum on Asian Perspectives, “The Future of Asia in
the World Economy, Paris, June 23-24.
ROLL, R. (1988), “The International Crash of 1987,” Financial Analysts
Journal, September/October.
SOLNIK, B. C. BOUCLE and Y. LE FUR (1996), “International Market
Correlation and Volatility,” Financial Analysts Journal, 9/10.
VITTAS, D. (1992), “The simple(r) Algebra of Pension Plans,” Policy
Research Working Paper 1145, World Bank.
World Bank (1994), “Averting the Old Age Crisis: Policies to Protect the Old
and Promote Growth,” Oxford University Press.
World Bank (1997), “Private Capital Flows to Developing Countries”, Oxford
University Press.
362
Part IV
THE REGULATORY AND SUPERVISORY ENVIRONMENT AND
RISK MANAGEMENT
A. PENSIONS
363
Chapter XVII
REGULATION OF PENSION FUND ASSETS
by
E. Philip Davis *
Introduction
This article assesses the main issues in pension fund asset regulation.
It compares and contrasts the adopted solutions in the major OECD countries
and seeks to assess briefly some of the consequences which arise for portfolio
distributions and, consequently, for the cost of providing pensions. As an
introduction, the justifications for financial regulation are outlined in the first
section in general terms and their applicability to pension funds is considered.
The second section outlines the principal regulatory issues affecting pension
funds’ assets (covering portfolio regulations, funding regulations and ownership
of surpluses). The potential costs imposed by such regulations are indicated by
calculations of returns on pension fund portfolios highlighted in Section 3. An
attempt is made in a final section to come to a view regarding ’good regulatory
practice’ in this area. An annex looks briefly at regulatory structures. Note that
the article abstracts from some important areas of regulation of pension funds,
namely those of liabilities (social security integration, benefit insurance,
indexation, portability, defined benefit/defined contribution) and broader
*
The author is a senior economist at the Bank of England, Research
Associate of the LSE Financial Markets Group, Associate Fellow of the
Royal Institute of International Affairs and Research Fellow of the Pensions
Institute at Birkbeck College, London, who is currently seconded to the
European Monetary Institute. (E-mail ‘[email protected]’.) Views
expressed are those of the author and not necessarily those of the
institutions to which he is affiliated. The article draws on Davis (1995); see
also Turner and Watanabe (1996) and Watson Wyatt (1997). Note that
although the article reflects information available to the author at the time
of writing, regulations are not infrequently subject to amendment.
365
structural regulations (trustees, fraud protection, information, compulsion).
These are covered in detail in Davis (1995).
1.
Reasons for regulation of pension funds
Abstracting from issues of redistribution, a case for public
intervention in the operation of markets arises when there is a market failure,
i.e. when a set of market prices fails to reach a Pareto optimal outcome; when
competitive markets achieve efficient outcomes, there is no case for regulation.
There are three key types of market failure in finance, namely those relating to
information asymmetry, externality and monopoly. These apply in differing
degrees to the various types of financial institution; in particular there are quite
distinctive problems associated with banks (Davis 1993) as opposed to pension
funds. Nevertheless, a finance-based approach is not the only way to view
pension fund regulation. It can also be argued that enhancing equity, adequacy
and security of pension arrangements can be seen as objectives of pension fund
regulation independent of financial aspects. Tax privileges to pension funds
underpin this alternative approach.
We begin, however, with the arguments based on pension funds’
status as financial institutions. As regards information asymmetry, if it is
difficult or costly for purchasers of a financial service to obtain sufficient
information on the quality of the service in question, they may be vulnerable to
exploitation. This may entail fraudulent, negligent, incompetent or unfair
treatment as well as failure of the relevant institution per se. Such phenomena
are of particular importance for retail users of financial services such as those
provided by pension funds, because clients are seeking investment of a sizeable
proportion of their wealth, contracts are one-off and involve a commitment over
time. Equally, such consumers are unlikely to find it economic to make a full
assessment of the risks to which pension funds are exposed -- including the
solvency of the sponsor.
Information asymmetries are clearly less important for wholesale
users of financial markets (such as pension funds themselves in their dealings
with investment banks), which have better information, considerable
countervailing power and carry out repeated transactions with each other. A
partial protection against exploitation, even for retail consumers, is likely to
arise from desire of financial institutions such as life insurers offering personal
pensions to maintain reputation, or equally for non financial companies to
retain a good reputation in the labour market -- a capital asset that would
depreciate if customers were to be exploited.
366
Nevertheless, it can be argued that given such information
asymmetries, regulation should enforce prudent management of pension assets,
preventing their being concentrated on certain instruments in a risky manner,
and that funds accumulated should be sufficient to cover accrued obligations
and not vulnerable to expropriation by company management or take-over
raiders.
Externalities arise when the actions of certain agents have non-priced
consequences for others. The most obvious type of potential externality in
financial markets relates to the risk of contagious bank runs, when failure of
one bank leads to a heightened risk of failure by others, whether due to direct
financial linkages (e.g. interbank claims) or shifts in perceptions on the part of
depositors as to the creditworthiness of certain banks in the light of failure of
others. Types of ‘run’ may also occur for other types of institution such as
investment banks.
Given the matching of long run liabilities and long run assets,
externalities are less likely for pension funds. There remain possible
externalities from failure of pension funds, notably to the state, whether as
direct guarantor or as provider of pensions to those lacking them. These give
additional justifications for pension fund asset regulation, in particular those
which ensure minimum funding. Equally, positive externalities may give
reasons for governments to encourage pension funds, such as desire to
economise on the costs of social security or foster the development of capital
markets. The latter are an additional motivation for rules in most -- but not all -OECD countries which require funds to be invested outside the company in
order to benefit from tax exemption.
A third form of market failure may arise when there is a degree of
market power. This may clearly occur for pension funds, particularly when
membership is compulsory; attention to the interests of members is of particular
importance in such cases, whether or not there is also asymmetric information.
As argued by Altman (1992), employers in an unregulated environment
offering a pension fund effectively on a monopoly basis will structure plans to
take care of their own interests and concerns, so for example will institute
onerous vesting rules and better terms for management than workers. It is of
interest that unregulated funds in the third world do indeed institute such rules
(Davis 1995). They will also want freedom to fund or not as they wish and to
maintain pension funds for their own use, regardless of the risk of bankruptcy.
They will not take care of retirement needs of some groups in society such as
those changing job frequently, young workers and women with broken careers
367
due to childbearing. Union pressure may ameliorate some of these problems for
employees, but not for the most peripheral groups.
Some would argue that pension funds should be regulated
independently of these standard justifications, for example to ensure tax
benefits are not misused, and that the goals of equity, adequacy and security of
retirement income are achieved -- in effect correcting the market failures in
annuities markets that necessitate pension funds and social security. Regulation
may also be based on the desire for economic efficiency, for example removing
barriers to labour mobility. Indeed Altman (1992) goes further in suggesting
that the term “private pension” is itself a misnomer as the distinction between
private and public programmes is increasingly blurred. Terms and conditions
are often prescribed by the government; they are publicly supported by tax
subsidies; there is compulsory provision in several countries; and in some
countries private funds take over part of the earnings related social security
provision.
Regulations are of course not costless, and it is emphasised below that
excessive regulatory burdens may discourage provision of private pensions
when it is voluntary, and reduce competitiveness of companies when it is
compulsory.
2.
Regulation of pension fund assets
This section assesses regulation of pension funds assets in a range of
OECD countries, and covers successively regulation of portfolio distributions,
regulation of the funding of benefits and ownership of surpluses in defined
benefit funds. The regulations are summarised in Table 1.
2.1
Regulation of portfolio distributions
Quantitative regulation of portfolio distributions is imposed in a
number of OECD countries. The ostensible aim is one of protecting pension
fund beneficiaries against “imprudent” investments, although motives such as
ensuring a steady demand for government bonds, or protection of benefit
insurers may, according to some commentators, also play a part. In this context,
limits are often imposed on holdings of assets with relatively volatile returns,
such as equities and property, as well as foreign assets, even if their mean
return is relatively high. There are also often limits on self investment, to
368
Table 1. Asset regulations (1)
(2)
Portfolio regulations
Regulation of funding
Australia
Prudent man rule
Irrelevant as defined contribution;
minimum contribution rate
enforced..
Belgium
15 per cent to be invested in
government bonds, no more than
15 per cent in sponsor, 40 per cent
limit on real estate, 10 per cent
deposits
Funding obligatory of ABO based
on current salary, interest rate
7 per cent
Canada
Prudent man, tax on foreign assets
over 20 per cent, 7 per cent limit
on property; no self investment.
Maximum 20 per cent overfund of
ABO. Funding obligatory.
Denmark
Property loans, shares and
investment trust holdings limited
to 40 per cent, foreign assets to
20 per cent; 60 per cent to be in
domestic debt. No self investment.
Irrelevant as defined contribution;
benefits must be funded externally.
France
Assets of supplementary funds
(ARRCO/AGIRC) to be invested
50 per cent in EU government
bonds and less than 33 per cent in
loans to sponsors. Insured funds
max. 40 per cent property and
15 per cent Treasury deposits.
Funded company schemes
discouraged; book reserve funding
subject to tax discrimination. 4 per
cent to be credited to accounts
annually.
Germany
Guidelines; maximum 30 per cent
EU equity, 25 per cent EU
property, 6 per cent non-EU
shares, 6 per cent non-EU bonds,
20 per cent foreign assets, 10 per
cent self investment limit
Funding obligatory up to ABO.
Option of book-reserve funding.
Ireland
Schemes must diversify prudently,
self investment limited to 5 per
cent.
Funding of ABO required; deferred
rights indexed
Italy
Most schemes are insured,
investments may be in state bonds
(maximum 90 per cent), bank
deposits, property, mortgages,
securities, investment funds.
Payments equal to 7 per cent of
salary. Insured plans must be fully
funded on a 15-year projection.
369
Table 1. Asset regulations (1) (continued)
Portfolio regulations
Regulation of funding
(2)
Japan
Guidelines; (currently being
Tax exempt up to ABO only.
phased out) maximum 30 per cent Option of book-reserve funding.
equity, 20 per cent property, 30 per
cent foreign, 10 per cent in one
country; min 50 per cent bonds.
Netherlands
Prudent man concept, 5 per cent
self investment limit; unofficial
30 per cent equity limits..
Portugal
Maxima of 50 per cent real estate, Funding obligatory of ABO.
25 per cent equity, 20 per cent unit
trusts, 20 per cent foreign equities
and bonds.
Spain
90 per cent in stocks, bonds,
mortgages, property, deposits; no
more than 10 per cent in one
company
Funding obligatory of ABO plus
4 per cent margin; maximum
interest rate 6 per cent
Sweden
Majority to be in listed bonds,
debentures and retroverse loans to
contributors.
For ATP, IBO is funded.
Contribution rate adjusted 5-yearly
to balance fund.
Switzerland
30 per cent limit on domestic
Funding only obligatory for ABO;
shares, 55 per cent on property,
PBO usually funded. 4 per cent to
30 per cent foreign currency assets. be credited to accounts annually.
United
States
Prudent man concept; 10 per cent
self investment limit for defined
benefit funds
United
Kingdom
Prudent man concept; 5 per cent
Maximum 5 per cent overfund of
self investment limit, concentration IBO. An inflation-indexed ABO
limit for defined contribution plans must be funded.
(1)
(2)
Funds are expected to cover PBO;
maximum 15 per cent overfund of
ABO, minimum is ABO itself.
ABO must be funded. Maximum
50 per cent overfund of the ABO.
Higher insurance premia if
underfunded.
Note that although the table reflects information available to the author at the
time of writing, regulations are not infrequently subject to amendment.
ABO refers to the accrued benefit obligation; PBO the projected benefit
obligation; IBO the indexed benefit obligation. Source: Davis (1995, 1996),
EFRP (1996) (Watson Wyatt, 1997).
370
protect against the associated concentration of risk regarding insolvency of the
sponsor. These limits do not, of course, apply to reserve funding systems such
as those common in Japan, Germany, Luxembourg and Sweden, where 100 per
cent of assets are invested in the sponsor.
Apart from the control of self investment, which is clearly necessary
to ensure funds are not vulnerable to bankruptcy of the sponsor, the degree to
which such regulations actually contribute to benefit security is open to doubt,
since pension funds, unlike insurance companies, may face the risk of
increasing liabilities as well as the risk of holding assets, and hence need to
1
trade volatility with return . Moreover, appropriate diversification of assets can
eliminate any idiosyncratic risk from holding an individual security or type of
asset, thus minimising the increase in risk. Again, if national cycles and
markets are imperfectly correlated, international investment will reduce
otherwise undiversifiable or "systematic" risk (see Davis 1995).
Even for defined contribution funds, it is hard to argue a sound case
for such rules, given the superior alternative of prudent man rules (see below).
There seems little evidence that defined contribution investors need "protecting
from themselves" i.e. prevented from taking high risks. Indeed, in practice,
experience suggests that investors in individual defined contribution funds tend
to be too cautious to develop adequate funds at retirement, see Rappaport
(1992), while companies running defined contribution funds may invest
excessively cautiously to avoid lawsuits.
Portfolio limits would, however, appear to be particularly
inappropriate for defined benefit pensions, given the additional "buffer" of the
company guarantee for the beneficiaries and risk sharing between older and
younger workers, and if benefits must be indexed. Clearly, in such cases,
portfolio regulations may affect the attractiveness to companies of providing
pension funds, if it constrains managers in their choice of risk and return,
forcing them to hold low yielding assets and possibly increasing their risks and
2
costs by limiting their possibilities of diversification . It will also restrict the
benefits to the capital markets from the development of pension funds. And, in
3
the case of restrictions which explicitly or implicitly oblige pension funds to
invest in government bonds, which must themselves be repaid from taxation,
there may be no benefit to capital formation and the "funded" plans may at a
macroeconomic level be virtually equivalent to pay-as-you-go.
We commence by outlining the situation in the countries which
impose such asset restrictions. German externally financed pension funds
(Pensionskassen), besides a 10 per cent self investment limit, remain subject to
371
the same regulation as life insurers (20 per cent limit on foreign asset holdings,
36 per cent limit on equities, 25 per cent on property), see Ahrend (1996).
Although these regulations have been eased in recent years, it is arguable that
they remain particularly inappropriate for German pension funds given they are
obliged to offer a form of inflation indexation. Japanese funds face ceilings on
holdings of certain assets (such as 30 per cent for foreign assets and for
equities), which Tamura (1992) suggests "(inappropriately) imitate regulations
devised for trust banking and life insurers". There are plans, however, to
abolish these restrictions (Pensions and Investments 1997). As discussed below,
by offering tax privileges to ’booking’, Germany and Japan effectively impose
4
no limits on self investment of book reserves (although the Germans do insist
on insurance of such reserves -- and tax privileges have been reduced in Japan).
Swiss limits are similarly structured, but somewhat less restrictive
than the Germans’; a 30 per cent limit on domestic shares, 55 per cent for real
estate and 30 per cent on foreign assets (Meier (1993)). Scandinavian portfolio
restrictions for externally funded schemes are in many ways even tighter than
the Germans’, in that minima are also specified. The Swedish ATP (funded
social security), as well as externally financed private pension funds, have
historically been obliged to hold the majority of their assets in domestic listed
bonds, debentures and retroverse loans to contributors (although recent
deregulations have permitted limited investment in property, equities and
foreign assets, which some private plans have reportedly taken advantage of).
Historically, restrictions on equity investments were justified on the additional
ground that for ATP they would involve backdoor nationalisation and worker
control. Danish funds effectively have to hold 60 per cent in domestic debt
instruments and domestic real estate (since other assets, defined as “high-risk”,
are limited to 40 per cent). However, since 1990 they have been allowed to hold
20 per cent in foreign assets. Investment in the sponsor is forbidden and a
maximum of 2 per cent of assets may be invested in one company. Belgian
5
funds must invest at least 15 per cent of their assets in government bonds ,
although international investment is liberalised, with a few funds holding
50 per cent of their portfolios in foreign assets.
Restrictions are also severe in a number of countries where pension
fund development to date has been relatively minor (Table 1). Mutual societies
providing pensions in France (via group-insurance policies) must follow
insurance regulations which insist that they invest at least 34 per cent in public
bonds, and a maximum of 40 per cent in property and 5 per cent in shares of
foreign insurers. The assets of the supplementary funds ARRCO and AGIRC
must be invested 50 per cent in EU public bonds. The new pensions legislation
in France promises to be more flexible, however. Portuguese funds may invest
372
in a variety of domestic assets, while foreign equity and bond investment is
restricted to 20 per cent. Spanish rules are rather flexible, with investment
permitted in bonds, equities, real estate and bank deposits; other assets may not
exceed 10 per cent of the portfolio. International investment has reportedly been
liberalised since the abolition of exchange controls.
Portfolio restrictions are not, however, imposed in all the countries
studied. For example, pension funds in the US are subject to a ’prudent man
6
rule’ which requires the managers to carry out sensible portfolio diversification
in the context of the fund as a whole; there are no limits to portfolio
distributions other than a 10 per cent limit on self investment for defined
benefit funds. United Kingdom pension funds are subject to trust law and
7
implicitly follow the ’prudent man’ concept; as long as trust deeds are
appropriately structured they are not constrained by regulation in their portfolio
distribution except for limits on self-investment (5 per cent) and concentration.
Australian funds’ investment has been unrestricted since exchange controls were
abolished in 1983 and public sector funds were deregulated in 1985, except for
a 10 per cent limit on exposure to the sponsor. Dutch private funds face no legal
restrictions, except for a 5 per cent limit on self investment, see Van Loo (1988)
although regulators reportedly impose informal 30 per cent limits on equity
8
holdings (Wyatt 1993). In contrast, until recently the Dutch public service fund
(ABP) faced strict limits, being able to invest only 10 per cent abroad, and
20 per cent in shares or real estate. Irish funds are obliged to invest prudently
and diversify, and are obliged to announce any investment in excess of 5 per
cent of the scheme’s assets in any firm (including the sponsor).
Some countries have switched to prudent man rules; Canadian funds
were strictly regulated till 1987 (when the prudent man concept was introduced)
and have till recently faced limits on the share of external assets, as tax
regulations effectively limited foreign investment to 10 per cent of the
portfolio. A tax of 1 per cent of excess foreign holdings was imposed for every
month the limit was exceeded. The limit is now 20 per cent. Coward (1993)
reports that the authorities will "trade" relaxation of the foreign asset limit with
investment in small Canadian firms There is also a 7 per cent limit on real
estate (5 per cent on one parcel), a limit of 10 per cent on assets of one
company, and 30 per cent of its voting assets.
2.2
Regulation of funding
9
Regulation of the funding of benefits and associated accounting rules
is a key aspect of the regulatory framework for defined benefit pension funds,
373
which may strongly influence portfolio distributions, notably by influencing the
degree of volatility in asset prices that can be accepted. Note that by definition,
a defined contribution plan is always fully funded, as assets equal liabilities,
whereas with defined benefit plans there is a distinction between the pension
plan (setting out contractual rights to the parties) and the fund (a pool of assets
to provide collateral for the promised benefits). When the fund is worth less
than the present value of promised benefits there is underfunding; when the
opposite is the case, there is overfunding. Calculation of appropriate funding
levels requires a number of actuarial assumptions, in particular the assumed
return on assets, projected future wage growth (for final salary plans) and future
inflation (if there is indexing of pensions), as well as estimates of death rates
and the expected evolution of the relative number of contributors and
beneficiaries over time.
Minimum funding requirements set by regulation seek to protect
security of benefits against default risk by the company, given unfunded
benefits are liabilities on the books of the firm, and therefore risk is
concentrated and pensioners (or pension insurers) may have no better claim in
10
case of bankruptcy than any other creditor. Funding offers a diversified and
hence less risky alternative backup for the benefit promise, as well as offering
the possibility of unplanned benefit increases if the plan is in surplus. Extra
protection against creditors of a bankrupt firm is afforded when the pension
fund is independent of the firm and when self investment is banned or severely
restricted. There are usually also upper limits on funding, to prevent abuse of
tax privileges (overfunding). Bodie (1990) suggests that the three main reasons
why firms fund, besides regulations per se, are the tax incentives, provision of
financial slack (when there is a surplus) that can be used in case of financial
difficulty, and because (in countries such as the US) pension benefit insurance
may not cover the highest-paid employees.
A few definitions are of assistance in discussing funding rules. The
’wind-up’ definition of liabilities, the ’solvency’ level at which the firm can meet
all its current obligations, is known as the accumulated benefit obligation
(ABO). Advance provision for salary increases up to retirement, as is normal in
a final salary scheme, gives the projected benefit obligation (PBO) which is not
guaranteed except in the United Kingdom and latterly the Netherlands. The
indexed benefit obligation (IBO) assumes indexation after retirement, which is
often not provided in Japan, the US or Canada but is the rule in Switzerland and
11
the Netherlands. It is a legal obligation in Germany , Sweden and the UK. (See
Bodie (1991) for a further discussion of these concepts.) Taking account of
future obligations instead of purely focusing on current liabilities is likely to
permit smoother levels of contributions as the fund matures, which may be
374
better for the financial stability of the sponsor. An important argument in
favour of the PBO/IBO over the ABO is that it ensures advance provision for
the burden of maturity of the plan, when there are many pensioners and fewer
workers, by spreading costs over the life of the plan12 [Frijns and
Petersen (1992)].
In the United States an important influence on funding was the
Employee Retirement Income Security Act (ERISA) of 1974, itself partly a
response to several major failures of firms with underfunded pensions, which
had left pensioners destitute (see Andrews 1993). This act provided for
minimum standards of vesting and increased funding requirements, both of
which increased the burden to firms of running a defined benefit pension
scheme. Unfunded schemes were henceforth forbidden. It also introduced the
Pension Benefit Guarantee Corporation (PBGC) to guarantee (up to a limit)
benefits of defined benefit funds in default, funded by contributions from all
defined benefit plans; the funding requirement can be seen partly as a protection
for PBGC. This has not prevented heavy financial claims on the PBGC,
following several cases of default of underfunded schemes. Following ERISA,
the growth in pension funds slowed. Some firms terminated their schemes, and
the number of new defined benefit plans initiated dropped. Some firms
switched to defined contribution plans; and overall coverage ceased to grow.
More recent changes in United States regulations have clarified
funding rules by defining pension fund liabilities as the ABO. i.e. the present
value of pension benefit owed to employees under the benefit formula absent
any projections of salary, discounted at a nominal rate of interest. Implicitly,
these are the obligations of the fund if it were to be wound up immediately.
Recent estimates suggest that 76 per cent of pension funds are overfunded on
this basis, with an average overfund of 74 per cent. In this definition of funding,
indexing up to retirement is not compulsory but only an implicit promise,
despite the fact most US schemes are actually final salary. This has an
important influence on portfolio distributions, since underfunding on this basis
("shortfall risk") can be avoided, and tax benefits to the firm maximised, by
holding bonds; equities are only suitable for overfunded schemes. Meanwhile,
under an Act of 1987, existing unfunded liabilities must be amortised over 10
years and not 30 years, as was previously the case.
The United States illustrates the interaction of funding rules with
accounting standards and tax law in influencing funding. Under the United
States accounting standard FASB 87, if pension assets fall below the ABO, the
unfunded liability must be reported in the firm’s balance sheet, and since they
375
are senior debt, they act as a major problem for the firm in raising funds.
However, a surplus cannot be included on the balance sheet, although it can be
implicitly recouped via a reduction in contributions, as discussed below. The
accounting standard requires presentation of the PBO, as well as the ABO, thus
ensuring at least partial focus on future liabilities. However, overfunding in the
United States has since 1987 been limited by tax law to 150 per cent of the
ABO. This implies a rise in interest rates could prevent further funding, leaving
the plan underfunded when interest rates fall. This would not have been the case
for a PBO definition of the tax free limit, taking projected rises in benefits into
account, as long as the Fisher effect holds, i.e. interest rates rise with expected
inflation. Note that in principle a fund may be adequately funded on a
continuance basis, but not on a wind up basis, if, for example, asset prices are
temporarily low. It can also be argued that funding and taxation provisions in
the US (and Japan) encourage firms to delay funding; the risk to future
pensioners is that firms will in due course find the burden too great, leading to
curtailment of benefit promises (Schieber and Shoven 1994).
In Canada schemes must be funded as going concerns, including
projections of salary rises (i.e. the PBO); unfunded schemes are forbidden and
any unfunded liabilities must be paid off in 15 years.
In Japan, the traditional means of provision of retirement benefits was
via pay-as-you-go, with a special reserve account on the balance sheet as
benefits accrue (Clark 1991). Pension funds (Tax Qualified Pension Funds and
Employee Pension Funds), must be funded only up to the ABO, and there is
reportedly very little overfunding, partly because contributions which would
raise funding levels above the ABO are taxed. In Japan (Clark 1994) book13
value accounting is held to obscure poor performance of pension funds and
prevent a clear assessment of funding -- indeed it is often suggested there is at
present massive underfunding. Book value accounting may also prevent funds
from selling poorly performing shares and prevent switching of asset managers
(as both would entail realisation of losses).
In Germany, various laws or court decisions have enforced minimum
standards of funding for pension funds and what amounts to inflation indexing
of pensions. Tax relief is not provided for assets held to cover inflation risks.
These provisions are felt to be particularly burdensome, and have helped blunt
the growth rate of externally funded private pension plans as opposed to "book
reserved" benefits (Deutsche Bundesbank 1984, Ahrend 1996), thus also
limiting pension funds’ potential contribution to development of capital markets
in that country. In Germany and Switzerland, accounting conventions also have
an impact on funding decisions, as shortfalls of pension funds assets relative to
376
liabilities (with assets valued defined at the lower of cost and market value) are
included in the company accounts (Hepp 1992). It is suggested that this helps to
account for conservative investment strategies based on bond holdings,
independently of portfolio regulations discussed above, despite the fact that
funding of projected "real" obligations should make equities attractive. Rules
forcing employers in Germany and Switzerland to credit at least 4 per cent to
pension accounts annually may have a similar effect.
A particular feature of German private pensions which should also be
highlighted in this context is the large volume of reserve financing, where
pension liabilities are held directly on the balance sheet of the sponsoring firm
and not externally funded. This system accounts for well over 50 per cent of
private pension liabilities (see Nürk and Schrader 1996). By offering tax
privileges to such book reserves, Germany effectively imposes no limits on self
investment of book reserves (although the German authorities require
insolvency insurance of such reserves). Moreover, it can be argued that such
book reserve plans are highly inimical to the growth of equity markets, since
they provide firms with greater internal cashflow, but do not provide any
stimulus to equity markets. Cash flow is retained in the firm and not spread to
new firms that could otherwise float on the equity market. Such reserves also
are by nature highly undiversified, and hence require a compulsory mutual
insurance system (PSV) to be viable. Reserve funding is also common in Japan,
Luxembourg, Austria and Sweden. It used to be the rule in Spain and Portugal,
until reforms in each country in 1987 led to a switch to funding. In Belgium,
reserve funding was forbidden under a reform of 1985, owing to fears for the
security of pensions in the case of insolvency.
In the United Kingdom, plans which contract out of earnings-related
social security have historically only been obliged to fund sufficiently to
provide an equivalent 'guaranteed minimum pension' (GMP), but this is far
below actual benefit promises. Funding above this level is not legally
required -- although trustees are bound by their duty of care to ensure funding is
in place -- nor is there a requirement to include deficits in company balance
sheets. In practice a continuance basis namely the IBO tends to be used on
which overfunding is limited to 5 per cent. A crucial difference from other
countries is that adequacy of funding is judged (by actuaries) by current and
projected cash flows from assets and not current market values; this allows
volatile assets such as equities and foreign assets to be heavily used. This is
reflected in accounting standard SSAP24, which also bases fund valuation on
such actuarial valuations and long run smoothing. Historically, this has not
conflicted with the need to cover obligations if the fund were wound up, since
the PBO has tended to exceed the ABO. But compulsory indexation, currently
377
being introduced14 will increase the ABO and could put the system under threat
(Riley 1992). Meanwhile, although the government guarantees to pay the GMP
if a plan fails, there has historically been no system to guarantee non-GMP
pension benefits in the United Kingdom -- partly for this reason regulations
have historically been less strict than elsewhere, and managers could adopt a
high return/ high risk portfolio strategy.
However, the Goode Committee on UK pension law -- set up to report
on regulatory shortcomings in the wake of the Maxwell scandal, and which
reported in 1993 -- recommended a minimum funding rule based on the ABO
and market value based accounting, with only a three-month grace period to
top-up the fund, albeit with a 10 per cent shortfall being permitted without the
immediate need to top-up. Insurance against fraud was also recommended, as
well as indexation and abolition of the Guaranteed Minimum Pension. As
discussed in detail in Davis (1997), the government accepted the
recommendation of a market value based minimum funding rule. Accordingly,
a ’minimum funding standard’ for defined benefit funds was introduced in the
1995 Pensions Act (Kelly, 1995). Not all aspects of the Goode proposal were
accepted. In particular, the term ’funding’ was chosen deliberately instead of
15
’solvency’ to show that the calculations were to be made on the assumptions of
an ongoing scheme, which could rely on future returns on its assets to pay its
obligations, rather than on a winding up basis, which would need to take into
account the much higher cost of buying annuities to cover obligations. There is
a variation in the tightness of the funding standard depending on the maturity of
the fund. A 90 per cent level of funding will need to be returned to 100 per cent
in five years, and a shortfall below 90 per cent to be remedied in 12 months,
although the latter will not lead to immediate windup. The Act also affects
16
funding by withdrawal of the GMP , and its replacement with a obligation to
index up to 5 per cent, which will again raise the ABO (in effect, maximum
funding is based on an “indexed ABO” allowing for future inflation quite
distinct from that used in the US). Besides inducing a switch to defined
contribution, this might alter quite significantly the asset mix of UK defined
benefit funds, towards less volatile but also less profitable assets.
Under the Act, there is a counterpart regulation for defined
contribution funds which seeks to ensure contribution obligations are fulfilled.
A payments schedule has to be agreed, setting out employers' and employees'
contributions and the due dates. If arrears build up, the Occupational Pensions
Regulatory Authority will take measures to enforce payment (see the Annex for
a discussion of regulatory structures).
378
Funding rules in other countries, such as the Netherlands, usually
have the ABO as a floor, but the authorities assume (and tax authorities allow)
that the PBO will actually be funded, usually with an allowance for (noncompulsory) indexation. In Spain there is a formal margin of 4 per cent over the
ABO which is set as a minimum. Ireland, like the UK, obliges funds to index
deferred pensions, which thus raises the ABO.
As noted, the interest rate assumed to be earned on assets is a key
aspect of the funding arithmetic. If it is too high, funding may be inadequate; if
too low, there may be overfunding and corresponding abuse of tax privileges.
James (1993) notes that US municipalities, as well as some private funds,
reduced their funding in the mid-1980s in response to what proved to be a
temporary rise in asset returns, which was reflected in the interest rate
17
assumption. When rates fell, many were left underfunded . Feldstein and
Morck (1983) report that many underfunded plans in the US tended to use a
high rate to discount fund liabilities. The importance of the choice of discount
rate is shown by the fact that a 1993 US Department of Labour estimate that a
1 per cent fall in the bond rate raises pension liabilities by 10 per cent. This
shows the importance of a long run view of asset returns, or at least a fixed
benchmark rate.
The latter is the case in the Netherlands, where funding is
compulsory, and the government sets a maximum real interest rate assumption
of 4 per cent, as well as an assumption for wage growth. (This regulation may
encourage funds to hold bonds, since their real returns have typically been in
this range, although equities yield more.) Since in practice Dutch funds have
been able to earn over this level, surpluses estimated at 30 per cent were present
by 1990. A special levy of 40 per cent is enacted on such surpluses in excess of
15 per cent of liabilities, to offset the implied tax evasion. In the US, in the
light of the tendencies noted above, the SEC have insisted that interest rate
assumptions follow actual bond yields closely. In Japan contributions are set
assuming a 5.5 per cent nominal rate of return on fund assets; the fund
managers’ target return was historically 8 per cent, but has diminished recently.
Since the risk free rate is well below 5.5 per cent, there is growing
underfunding. In Canada a nominal return of 8.5 per cent and 5.75 per cent
wage growth are standard assumptions. In Belgium, the discount rate is set at a
nominal 7 per cent, while in Spain there is a maximum rate of 6 per cent (the
lower the rate, the more assets are required). In the UK the government accepts
the (varying) judgement of the actuaries, and generally also allows for an
assumption of wage growth.
379
Finally, since most Danish and Australian funds (as well as a
proportion of funds in Switzerland and the Anglo-American countries) are
defined contribution, the issue of minimum funding is not considered a
regulatory matter (although like the UK, minimum contributions may be
enforced). The issue of limiting tax privilege also arises, and is dealt with via
contribution limits or taxation of returns.
2.3
Ownership of surpluses
Ownership of surpluses in defined benefit pension funds is a key issue
in a number of countries, particularly because predator firms may seek to strip
surpluses after taking over another firm, although also the firm may seek to
recoup the funds for its own use. On the one hand, this may be seen both as an
abuse of tax privileges and (more contestably) as seizing assets held for the
benefit of members. On the other, it can be argued that if the fund is only a
backup for the firms’ promise of pensions, and if the firm is equally responsible
for making good any deficit, then the surplus should belong to the firm. It is
important to note that the funding rules outlined above define the surplus. In
addition, such issues only arise for defined benefit funds; in defined
contribution funds there is no surplus to strip, as assets equal liabilities by
definition.
In the US, a law enacted in 1987 states that the employer owns all
surplus assets so long as certain standards are complied with (see Mitchell and
Mulherin 1989). This, following the second line of argument above, is seen as
economically reasonable since funds are purely a means to collateralise a
(separate) benefit promise. In other words, the employee has rights to a pension,
but not to the means of financing those rights. However, there are limits to such
ownership, as under ERISA, firms cannot use pension assets as collateral for
loans. In the 1980s, many funds with surpluses were terminated and the surplus
taken by the sponsor (asset reversion). It can be argued that such behaviour
implied breach of implicit contracts between employer and employee. Later,
18
substantial tax penalties were introduced to discourage this , although there is
nothing to stop firms absorbing surpluses more gradually, by taking
contribution holidays.
In the UK, this issue again came to the fore in the 1980s as high
returns in capital markets increased assets while widespread redundancies
19
tended to restrain liabilities . The surplus is generally held to belong to the
sponsoring company, which can recover it at the discretion of the tax authorities
by direct withdrawal (subject to a 40 per cent tax) or by a contribution holiday.
380
However, court judgements have severely restricted ability of predators to
extract surpluses from take-over targets’ funds via so-called winding-up20 or
21
spin-off termination of schemes -- although such strategies have been
extremely common in the United States. The two key judgements, the Browne
Wilkinson judgement and the Millet judgement were both against Hanson PLC.
They set out two important principles, respectively that no management
committee had the power to state in advance that it would veto all proposed
future pension rises, and that pension schemes can change their trust deeds to
prevent predatory take-overs designed to extract pension fund surpluses.
Moreover, the 1990 Social Security Act states that when a plan is
terminated, it shall be assumed to provide for indexation of pensions for up to
5 per cent inflation, thus reducing the potential surplus to be extracted. And
there is increasing support for arguments on the employee’s side, namely that
pension rights are not gratuities but part of a remuneration package earned by
service. This point of view has been supported by recent rulings of the
European Court that suggest that for the purposes of equal treatment pensions
are to be considered as deferred pay (Goode (1992)). The logical conclusion -not adopted in the UK -- would be to outlaw even contribution holidays and
make employers much more restrained in funding. Finally, the 1995 Pensions
Act has restricted the amendment power of trust deeds so that members must
consent before their accrued rights are adversely affected.
In the Netherlands, where the pension fund is an executive body
independent of the sponsoring firm, usually in the legal form of a foundation or
financial institution, or in Switzerland, where it is a foundation with joint
representation of employer and employee representatives on the board,
ownership lies with that body itself. This means the company cannot lay claim
to the assets, although surpluses can be returned by reduced contributions.
In Japan the surplus may neither be stripped nor used to increase
benefits, but used to operate "welfare facilities". This puts the fund under
pressure to smooth its income to ensure such payments continue -- which may
entail inefficient investment.
3.
Costs of asset restrictions
An important policy issue is the influence of portfolio and funding
regulations on asset holdings of pension funds, and their impact on
performance. These are widely held to diminish the efficiency with which
funding may provide pensions, as a corollary reducing the overall attractiveness
381
of funded schemes to sponsoring companies and to individuals (see
EFRP (1996) and Davis (1995).
Table 2 shows the patterns of portfolio distributions of pension funds
for 1994 in a range of OECD countries. There are marked differences,
e.g. equity holdings varied from 4 per cent in Spain to 80 per cent in the U.K.,
and foreign assets from 5 per cent in France to 37 per cent in Ireland.
Table 2. Portfolios of pension funds, 1994
Per cent of assets
Australia
Austria
Belgium
Canada (1992)
Denmark
Finland
France
Germany
Ireland
Italy
Japan (March 1994)
Luxembourg
Netherlands
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States
Prudent man
Asset restrictions
Equities Bonds and Property
loans
48
11
36
38
22
5
14
11
55
9
27
20
23
10
4
32
13
80
48
49
16
27
75
47
49
65
73
39
75
35
62
61
70
67
72
82
47
52
11
38
38
63
8
2
7
3
9
12
7
11
6
23
2
0
9
3
1
8
20
6
0
5
8
(1)
Foreign assets are included in the categories to the left.
Source: EFRP (1996).
382
Liquidity
and
deposits
17
12
10
7
4
10
40
3
4
6
3
10
2
15
13
13
15
3
7
7
12
Foreign
assets(1)
16
20
35
9
7
n/a
5
6
37
5
7
n/a
17
n/a
5
12
9
30
10
20
11
Detailed analysis suggests that, as might be anticipated, liabilities,
asset returns, taxation and risk reduction can be traced as important influences
on pension funds’ portfolios [Davis (1995, 1996)]. But portfolio restrictions as
outlined above also play an important role. Such portfolio limits apply in
countries such as Japan, Switzerland, Germany, Sweden, Denmark, France,
Portugal and Belgium. Less severe limits apply in Italy and Spain. Such limits
are not, however, imposed in all the countries. Pension funds in the US,
Canada, Australia, the UK, Ireland and the Netherlands are subject to explicit or
implicit ’prudent man rules’ which require managers to carry out sensible
portfolio diversification; there are no limits to portfolio distributions other than
a limit on self-investment. In general, the latter countries are characterised by
higher equity (including risk/venture capital) and foreign asset holdings and
lower bond holdings; the summary rows at the bottom of the tables show that
the average portfolios of the two groups are 49 per cent equity, 38 per cent
bonds and 20 per cent foreign for the "prudent man" countries, and 16 per cent
equity, 63 per cent bonds and 11 per cent foreign for the countries with asset
restrictions.
Table 3 compares the actual holdings (Table 2) with the limits in
Table 1. The tables suggests that the effect of portfolio distributions cannot be
viewed in isolation. Pension fund sectors often fall short of the limits which are
imposed (or, correspondingly exceed the maxima). The main exception is
Japan, where holdings of equities in 1994 were close to the limit. The common
shortfall may be partly explicable in terms of desire for a margin of safety, to
avoid overstepping the limits in times of asset price volatility. Furthermore,
whereas the sectoral data show average holdings, they may obscure the fact that
a significant portion of funds face binding limits on holdings. However, as
suggested in Davis (1996) and in Section 2(b), funding rules, tax limits and
accounting standards may also play a role, limiting asset holdings to an extent
which goes well beyond the portfolio restrictions, largely because of the
heightened “shortfall risk” that they entail. Compulsory asset return (such as
4 per cent in Germany and Switzerland) may be particularly constraining,
forcing firms to adopt a one-year horizon despite 30-year liabilities. In addition,
and beyond the scope of this paper, the structure of fund management “peer
group” pressure on asset management, chosen benchmarks and risk aversion of
trustees may also play a role in inducing funds to hold large proportions of
domestic debt instruments.
383
Table 3. Portfolios of pension funds relative to limits,
selected countries, 1994
Percent of assets
Equities
Bonds and
loans
Property
Denmark
-18
+5
Germany
-25
-14
Japan (March 1994)
-3
+11
-18
Switzerland
-17
-35
(1) Foreign assets are included in the categories to the left.
Source: EFRP (1996)
Foreign
assets (1)
-13
-14
-23
-21
A useful means of judging the cost of these regulations and market
imperfections -- and hence the potential benefit to funds of liberalisation -- is to
assess pension funds’ performance both relative to that in other countries
without portfolio restrictions and to that of artificial portfolios. Patterns of
portfolio distributions and risks and returns on assets can be used to derive
22
estimates of the returns and risks on portfolios (Table 4 ) on average over
1967-90, and hence the cost to the firm of providing a given level of pension
benefits (for a defined-benefit fund), or the return to the member (for a definedcontribution fund). These may then be compared with real average earnings
growth; this is a relevant comparison because liabilities of defined-benefit plans
are basically indexed to average earnings, while the replacement ratio a definedcontribution fund can offer will depend on asset returns relative to earnings
23
growth. As a further experiment, portfolio returns may be compared to the
returns on artificial diversified portfolios holding 50 per cent equity and 50 per
cent bonds between 1967 and 1990, implicitly assuming quantitative portfolio
restrictions are replaced by prudent man rules. As noted, equity holdings for
pension funds in OECD countries are generally below 50 per cent (Table 2); in
fact, these portfolios approximate those of pension funds in the United States,
where a prudent man rule is in operation.
Table 4 indicates that there is a sizeable margin of portfolio returns
over average earnings in most countries with prudent man rules (bearing in
mind that rules in Canada and Australia were only eased in the 1980s). In
contrast, countries with portfolio restrictions tend to have a much smaller
margin, or even a negative one. German funds are shown to perform reasonably
despite portfolio regulations -- this may link to positive real returns on bonds in
the 1970s in that country. Calculation for sub periods shows a weaker relative
performance since 1980 (Davis 1995 and Table 5 below).
384
As regards the comparison with artificial diversified portfolios, the
results confirm that returns may be boosted by raising the share of equity, at
some cost in terms of risk, although the estimates suggest that risk is mitigated
by international diversification.24 Only for the United Kingdom and Ireland are
returns on these portfolios consistently below those actually obtained. Several
of the countries which fell below a satisfactory return on assets relative to
average earnings (such as Denmark and Sweden) would have found provision
of funded pensions less costly -- of itself and relative to pay-as-you-go -- if they
had followed such a rule. German funds would also have boosted their
headroom considerably.
Table 4. Returns on pension fund portfolios 1967-90
mean (standard deviation) of real total return in local currency
Percent domestic
currency
Australia
Belgium
Canada
Denmark
France
Germany
Ireland
Italy
Japan
Netherlands
Sweden
Switzerland
United
Kingdom
United States
Prudent man
Asset
restrictions
Portfolio
return (1)
Domestic
(2)
1.6 (14.7)
2.7(16.1)
4.2 (18.4)
2.2 (11.2)
5.3 (18.9)
5.2 (18.0)
6.1 (15.2)
3.8 (13.3)
1.9 (22.1)
5.5 (15.5)
4.5 (17.0)
3.8 (13.5)
2.0 (15.4)
3.8 (14.8)
1.6 (9.8)
3.6 (12.7)
5.1 (4.4)
5.0 (11.9)
4.0 (9.4)
4.0 (6.0)
0.2 (7.6)
1.5 (6.4)
5.8 (12.5)
2.2 (11.9) 2.1 (12.9)
3.4 (11.1) 3.2 (14.2)
2.9 (8.1) 4.5 (15.7)
Domestic &
international
(3)
2.8 (15.1)
3.8 (16.7)
2.2 (10.8)
4.6 (13.4)
4.9 (15.9)
6.2 (13.4)
3.8 (12.4)
2.0 (18.7)
5.3 (14.3)
4.2 (15.2)
3.7 (15.2)
2.0 (12.3)
3.7 (14.1)
Average
earnings
growth
0.7 (3.4)
1.7 (2.8)
2.8 (3.6)
4.0 4.0 (3.1)
2.0 3.1 (4.3)
4.2 (4.2)
2.4 (3.2)
1.5 (3.5)
1.9 (2.1)
2.6 (2.5)
Portfolio less
average
earnings
0.9
-0.1
0.8
1.1
3.0
-0.2
1.6
-1.3
-0.4
3.2
2.8 (12.5)
3.3 (13.4)
4.4 (13.7)
0.2 (2.1)
1.6
2.9
2.0
1.8
0.0
Notes:
(1) Estimated return on actual pension fund sector portfolios
(2) 50% domestic equity, 50% domestic bonds.
(3) 40% domestic equity, 40% domestic bonds, 10% foreign equity, 10% foreign
bonds.
Source: Davis (1995, 1996).
385
Again, we averaged out the results for the countries with prudent man
rules and asset restrictions to find a summary indicator of the differences. It is
shown that the countries with prudent man rules, on average, obtain a higher
real return than those with asset restrictions (3.4 per cent compared to 2.9 per
cent), with slightly higher volatility (11.1 per cent standard deviation compared
to 8.1 per cent). However, the difference in asset returns must also be judged
against the background of returns on 50 per cent-50 per cent equity-bond
portfolios. These show that the potential real return for the countries with asset
restrictions is rather higher (4.5 per cent compared with 3.2 per cent for the
prudent man countries), presumably linked to higher economic growth also in
the context of segmented capital markets for part of the period. Corresponding
to this, real average earnings growth is also much higher in the countries with
asset restrictions, thus implying that the excess of pension funds’ returns
relative to target is much lower. In fact, whereas in the prudent man countries
there is a satisfactory 1.8 per cent excess of pension fund returns over average
earnings, in the countries with asset restrictions the return is actually identical
to average earnings growth.
Table 5 shows alternative estimates provided by the European
Federation for Retirement Provisions (1996), which cover the period 1984-93.
It hence omits the inflationary period of the 1970s, and covers a period when
world capital markets have been integrated and growth performance in the
countries shown rather comparable. In this case, the advantage of prudent man
rules is decisive, with an average real return of 9.5 per cent compared with
6.9 per cent for the countries with portfolio restrictions.
Table 5. Returns on pension fund portfolios 1984-93
(mean of real total return in local currency)
Percent - domestic Portfolio
currency
return
Belgium
8.8
Denmark
6.3
Germany
7.2
Ireland
10.3
Japan
6.5
Netherlands
7.7
Spain
7.0
Percent - domestic
currency
Sweden
Switzerland
United Kingdom
United States
Prudent man
Asset restrictions
Source: EFRP (1996)
386
Portfolio
return
8.1
4.4
10.2
9.7
9.5
6.9
Note that all these calculations are of returns net of administrative
costs. It can also be argued that portfolio and other asset or return restrictions
lead to a climate of weak competition (as asset managers cannot readily
compete on performance). In such a climate, administrative costs are also likely
to be higher. For balance, a qualitative criticism sometimes made of prudent
man rules can be mentioned namely that they may lead asset managers to
follow a “consensus” asset allocation, fearing that others will be seen as
imprudent. This in turn could lead to “herding”. On the other hand, such a
situation may imply the prudent man rule is wrongly applied, since a prudent
asset allocation should depend on liabilities and hence may well vary sharply
between funds.
A related point that is sometimes put forward is that under a prudent
man rule funds may seek to invest only in larger and well-known companies,
avoiding high-risk or venture capital style investments. But this would be to
ignore the fact that investment in such assets may well be seen as prudent in the
context of a well-diversified portfolio. It is certainly the case that venture
capital, startups, LBOs etc. are a rather small proportion of the portfolio even in
the Anglo American countries. But especially in the US and Canada, it is not
clear that there is a deficiency or lack of supply of risk capital as a consequence.
And holdings are lower in countries such as Germany having asset restrictions.
Before concluding, one may mention an argument that suggests asset
restrictions’ effects may be diminishing. This is reportedly the case for US life
insurers, which hold far more equity than their formal 15 per cent restriction.
But the risk could be that supervisors are unable to monitor asset holdings
while lacking a prudent man rule, asset managers are not under pressure to
ensure holdings are appropriate.
Conclusion
To conclude, it will be apparent that there is no overall international
consensus on good regulatory practice for pension fund assets, even if the
objective of overcoming various market failures in financial markets and
ensuring equity, adequacy and security of old age income are similar. On the
one hand, there appears to be reasonable agreement on ownership of surpluses.
It is generally accepted that surplus assets belong to companies, although their
access to them is generally restricted, given the potential tax abuse to recovery
via contribution holidays. On the other hand, there are strong divisions on
portfolio regulations (prudent man vs. portfolio restrictions) and on funding
387
(book reserve vs. ABO vs. PBO vs. IBO). Historical development clearly plays
a major role.
When a choice is feasible, the ’correct’ approach often depends on a
trade-off. On the one hand, a desirable objective is allowing flexibility and
minimising costs to the company, On the other, the interests of the recipients in
a secure retirement income must also be taken into account. The former cannot
be disregarded so long as provision is voluntary, as firms retain the option to
wind up their funds or switch to defined contribution. Even if provision is
compulsory, burdensome regulation may have undesirable effects on
competitiveness.
Some a priori suggestions regarding "right answers" can nonetheless
be made (amplifying comments made above). For example, it is notable that
most countries with strong portfolio regulations offer lower returns than those
with prudent man, see Tables 4 and 5, albeit also with somewhat lower
volatility. Only in the case of self investment and concerning the need for
adequate diversification -- as in a prudent man rule -- would modern portfolio
theory agree with the need for quantitative portfolio regulation. Prudent man
rules also have the benefit of flexibility -- their interpretation can evolve over
time. There may be external benefits to the economy via greater supplies of risk
capital relative to asset restrictions. Portfolio regulations would seem in many
cases to be set neither to help the company nor to protect the beneficiary, but
rather to help governments sell bonds to a captive market, and protect them
from the danger of having to “bail out” a bankrupt pension fund. In the process,
they effectively limit the supply of equity capital, hindering small and growing
companies.
Funding rules tailored to the nature of the benefits (as in the
Netherlands), such as the PBO or IBO in the case of final salary schemes would
seem to offer greater security to members than the alternatives of no funding
rules, only covering state pensions, only the accrued obligation or relying on
the fallible independence of trustees. The PBO ensures smoother funding
patterns for the sponsor as the fund matures; it also seems to be consistent with
flexibility in asset holdings (although accounting standards and tax regulations
also play a role in determining the effect of funding rules on portfolios).
It is also worth noting that some of the issues covered (funding,
ownership of surpluses) are absent or less important if there are defined
contribution and not defined benefit funds, and the need for them in a sense
show some of the advantages of defined contribution over defined benefit funds
(i.e. that the latter are more vulnerable to manipulation and market failure). But
388
the issue of choice between the two types of fund raises of course wider issues,
owing to a need to balance the superior employee retirement insurance (at least
for workers who remain with a single employer) and various benefits to
employers (such as lower labour turnover and ability to take contribution
holidays) offered by defined benefit plans as against the benefits of labour
mobility to mobile workers and to the wider economy offered by defined
contribution plans, and to set regulation appropriately.
389
Annex
REGULATORY STRUCTURES
Effectiveness of pension fund regulation -- both on the asset and
liability sides -- is influenced by regulatory structures and procedures and their
link to organisational structure which in several countries are somewhat
unwieldy. For example, in the US the Department of Labour oversees minimum
funding and investment standards as well as dealing with cases of fraud, while
the Internal Revenue Service sets maximum funding rules to prevent abuse of
tax advantages. Then the Pension Benefit Guarantee Corporation collects
insurance premia and pays benefits but has few enforcement powers. So, for
example, the tax authorities would prefer minimal funding to prevent loss of tax
revenue, while the insurers would seek maximum funding to prevent large
insurance claims. Moreover, the tax authorities can grant contribution waivers
to firms in financial distress, which leads to underfunding of pension plans,
against the interests of the PBGC. Meanwhile fund trustees are responsible for
ensuring funding is in place for beneficiaries. and have to demonstrate in an
audited annual report of income and assets filed with the IRS that they had
managed the fund prudently (in particular, that the fund is adequately
diversified). Also a master custodian has to be appointed to oversee fulfilment
of ERISA requirements, keep appropriate records, and provide security against
prohibited transfers.
In the UK statutory pension fund regulation has until recently been
administered by different bodies, namely the Occupational Pensions Board on
behalf of the Department of Social Security and the Pension Schemes Office for
the Inland Revenue. In addition, under the 1986 Financial Services Act, the
investment management regulatory bodies regulate insurance companies and
other financial institutions offering pensions, asset managers and those offering
advice to individuals regarding pensions. The tax authorities are concerned to
avoid overfunding, while the Pension Board checks on a three yearly basis
whether assets are sufficient to pay the minimal state-guaranteed pension
(GMP). It also assesses whether funds meet the standards to contract out of the
391
state earnings related pension, checks revaluation and preservation of rights for
early leavers, etc.
The 1995 Pension Act which followed the Goode Report partly
centralises regulation. A seven member Occupational Pensions Regulation
Authority was set up. Members are appointed by the government but at least
one is suggested by life insurers, one by employers’ groups, one by trades
unions, one by pensions professionals. A further two are experts in the pension
field. The authority is able to appoint and remove trustees, set civil penalties,
wind up schemes, impose fines on employers and trustees, and order restitution.
It has the power to require documents from advisors, trustees and sponsors and
to inspect premises. It is to have a staff of 200, financed by a levy on the
pension fund sector. But note that tax treatment is still dealt with separately.
Also, the regulator relies on "whistle blowing" by professional advisors and
scheme members to discover misdemeanours. This weakens (on grounds of
cost) the suggestion of the Goode Committee that the regulator should routinely
examine scheme financial statements. Also, an ombudsman provides redress for
individual complaints against funds. Although a pension ombudsman already
existed prior to the above mentioned Act, powers to investigate complaints of
unfair treatment and adjudicate on disputes is being increased.
In Canada, apart from federal taxation provisions, regulation is carried
out at the provincial rather than the national level, and hence pension law can
differ between provinces (in practice, Ontario tends to be the leader). This can
create particular problems for employees moving between jobs in different
provinces -- which in turn foreshadows possible future difficulties in the EC. In
Switzerland, too, regulation is generally carried out at cantonal level, except for
’large’ companies, but the federal authorities are tending to oversee and
harmonise cantonal supervision.
In most Continental European countries such as the Netherlands,
regulation of pension funds is carried out by a single statutory authority, the
Insurance Supervisory Board. In the Netherlands, pension funds are legally
obliged to provide the Board with detailed information annually on the benefit
payments and investments of the fund. It ensures that the commitments of the
pension funds are sufficiently covered by their assets. It also involves itself in
more general structural issues. If the Board finds procedures or regulations
unsatisfactory, it can apply social pressure by making a public complaint. In
practice, this is rarely necessary. In some countries such as Germany, the
392
supervisors also check that portfolio regulations are complied with and require
a five-year business plan1. In Denmark, there are three yearly actuarial reports.
It will be noted from this description that the mechanics of
supervision generally entail reliance on annual reports and accounts prepared by
auditors and full actuarial reports at longer intervals. However, the Netherlands
is unusual in that the authorities conduct on-the-spot inspections of all funds
every 10 years. In the US, the Department of Labour runs computer checks to
identify plans needing further investigation (or investigations may be triggered
by complaints by members). 250 investigators are employed.
On balance, one may conclude that regulatory structures and
procedures appear to have developed piecemeal in a number of countries. It
could be suggested that the Dutch have a reasonable model (one supervisor,
annual checks on the adequacy of funding, overview of plan rules, on-site
inspections, etc.) for others to follow; the new UK structure also warrants
scrutiny.
1.
Note, however, that there is no special supervisory body for book reserves
or support funds. Accountants and tax authorities are implicitly relied upon.
393
NOTES
1.
Indeed, in several countries, a false parallel seems to be drawn by regulators
between life insurers and pension funds.
2.
Technically, portfolio restrictions are likely to prevent managers reaching
the frontier of efficient portfolios, which indicates where return is
maximised for a given risk.
3.
For example, by closing down all alternative investment strategies such as
international diversification.
4.
Book reserve pension funds may cover some of their liabilities by investing
via special security funds (Spezialfonds), whose investments are subject to
less stringent restrictions.
5.
This provision will be dropped shortly.
6.
The precise wording is that fund money must be invested "for the sole
benefit of the beneficiaries" and investments must be made with "the care,
skill, prudence and diligence under the circumstances then prevailing that a
prudent man acting in a like capacity and familiar with such matters would
use in the conduct of an enterprise of a like character and with like aims"
7.
There is no explicit prudent man rule, but the duty of prudence to trustees
can be interpreted as requiring diversification.
8.
From the beginning of 1996 the ABP was subject to the same regulations as
private funds.
9.
Regulation of funding is typically carried out by periodic submission of
accounts and actuarial reports to the authorities.
10.
Adequate provision of unfunded pensions is likely to be particularly
difficult for declining industries, as the worker/pensioner ratio falls.
394
11.
As discussed below, German schemes are forced to index but unable to fund
the difference between the PBO and IBO tax free.
12.
The facility with which funds of declining industries in the UK funded on a
PBO/IBO basis (such as coal mining and railways) coped with maturity are
a case in point.
13.
A reform is currently shifting funds to market value accounting (Pensions
and Investments (1997)).
14.
Given the cost of this measure, a decline of defined benefit provision by
companies and a switch to defined contribution has taken place in the UK,
although its extent should not be exaggerated.
15.
Following representations by the actuarial prof ession.
16.
There will still be a form of minimum pension, which will be based on that
of a "reference scheme" accruing 1/80th per year of service applied to an
earnings definition based on 90% of the member’s earnings which would
qualify for SERPS averaged over the last three years of service.
17.
Note that only long maturity bonds will increase in price so as precisely to
offset the increase in liabilities.
18.
The tax on reversion of surpluses is 20% if 25% of the surplus is used for a
replacement plan or to increase benefits. If not, it is 50%.
19.
A redundant worker’s pension is frozen in real terms rather than rising in
line with average earnings, as would be the case for a worker continuing in
service.
20.
By winding up a scheme, accrued liabilities are frozen in real terms while
assets continue to grow at the rate of return in the capital market, increasing
the surplus further.
21.
The attempt is made to capture the surplus in the pension fund of a
subsidiary when it is sold to another company.
22.
Annual holding period returns on marketable fixed-rate instruments are used
instead of redemption yields. In our view, the holding period returns are the
more relevant measure for an ongoing portfolio, since they take full account
of losses or gains due to interest-rate changes (although other assumptions
regarding holding periods could also be made).
395
23.
It also indicates whether in practice the return to funding (the asset return)
exceeds that on pay-as-you-go in a steady state (the growth rate of average
earnings).
24.
The table only shows international diversification up to 20% of the
portfolio, holding bonds and equities for the ‘rest of the world’ in proportion
to global portfolio weights in the 1980s. A full ‘global portfolio’, where
domestic holdings are reduced to their weight in the global index, would
imply over 95% international investment for the small countries, and over
80% even for the UK and Germany. Similar calculations for such a strategy
(not shown in detail), with again 50% bonds and 50% equities, again shows
lower risk in domestic currency, although the change in return may be in
either direction.
396
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ALTMAN, N. (1992), "Government regulation; enhancing the equity,
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399
Chapter XVIII
INVESTMENT RULES AND STATE GUARANTEES FOR
MANDATORY PRIVATE PENSION FUNDS
by
Dimitri Vittas*
Introduction
Faced with growing financial deficits, many countries around the
world are reforming their social security and pension systems. In several
countries, reform measures are focused on removing serious design faults in
their existing systems and changing the various pension parameters in a way
that would avoid the financial collapse of their systems. A major factor in
some countries, especially in Western Europe and East Asia, is the growing
burden of rapidly ageing populations. However, there is a growing number of
countries, especially in the developing world, that undertake more fundamental
and systemic reforms. These entail not only the restructuring and downsizing
of public pension systems, but also a more decisive move in the direction of
creating multi-pillar systems that comprise as an important element the
establishment of a mandatory, privately-managed, pension pillar.1
At the time of writing this paper, eight countries in Latin America and
the Caribbean (LAC) (namely Chile in 1981, Peru and Colombia in 1993,
Argentina in 1994, Uruguay in 1995, and Bolivia, El Salvador and Mexico in
1997) have implemented systemic pension reform, while three countries in
Eastern Europe and Central Asia (ECA) (namely, Kazakstan, Hungary and
Poland) have enacted legislation in the course of 1997 mandating the creation
of private pension funds. As observed in Vittas and Queisser (1997), no two
pension reform programs have been identical. They have many and important
differences in the design of the modernised public pillar as well as in the
structure of the new mandatory private pillar.2 However, all countries share in
*
Development Research Group, The World Bank.
401
common a desire to downsize the public pillar and expand the role of private
pension funds.3
The introduction of mandatory private pension funds imposes a clear
obligation on governments to ensure not only the safety of pension fund assets
but also the achievement of results that would be at least as good, if not
superior, to what might have been obtained under a voluntary scheme or under
a purely public system. This raises many regulatory issues (Davis 1997,
de Ryck 1997, Queisser 1997, and Vittas 1996a).
Some of these have prudential and protective objectives and seem
wholly acceptable in the current approach that favours prudential over
substantive regulation of financial institutions. These regulations are therefore
less controversial and cover such prudential and protective issues as
authorisation criteria, minimum capital requirements, external custody
arrangements, asset segregation and professional asset management, external
audits and actuarial reviews, and information disclosure.
The more controversial regulations include structural and substantive
regulations that affect the structure and contestability of the market for pension
funds or impose constraints on the investment policies and performance of the
pension funds. This paper focuses on the rationale for, and potential impact of,
investment rules and state guarantees. It draws extensively on Vittas (1996a),
which also discusses the regulatory controversies of structural controls.
Investment limits, valuation rules, minimum profitability rules, and
state guarantees raise many controversial issues in pension fund regulation. On
the one hand, there is a need to protect workers from imprudent behaviour by
asset managers. But on the other hand, such rules tend to give rise to moral
hazard, to stifle financial innovation and competition, and to constrain
investment efficiency.
1.
Investment limits
One of the most controversial aspects of pension fund regulation is
the use of strict investment rules, not only in the newly created compulsory
personal pension plans in Chile and other Latin American countries, but also in
many OECD countries, especially in continental Europe and Japan. The main
criticism is directed at the prohibition of, or low limits on, investments in
overseas assets. But low limits on equity investments and the tendency to use
pension funds as captive sources for financing government budgets or social
402
investments, such as low cost housing and low interest mortgages, have also
caused concern.
1.1
Minimum and maximum limits
Investment rules, if applied, should emphasise profitability and safety.
This means allowing pension funds to seek the highest returns in the market,
but requiring them to diversify their asset holdings. Thus, in discussing the
impact of investment rules, a clear distinction should be drawn between rules
that impose minimum requirements for investments in particular types of assets
from those that impose maximum limits. The former amount to a direction of
investable funds, while the latter aim at avoiding an excessive concentration of
risks.
Strict investment rules and even prescribed investments have long
characterised the investment policies of public pension funds. For instance, in
Singapore and Malaysia, the national provident funds, which mobilise large
long-term financial resources equivalent to between 40 per cent and 70 per cent
of GDP, have until recently been required to invest most of their funds in nonmarketable government bonds. In Sweden, the ATP public pension fund has
been required to invest in government bonds as well as the bonds of mortgage
credit institutions at interest rates that were usually below market levels by a
couple of percentage points. In most countries with partially funded social
security systems, there has been a clear tendency to require investments in
government bonds, in constructing low cost housing units, and in providing
low-interest housing and other loans to participating workers. Investment
returns in many of these cases have been well below market levels. As the
various instruments carried fixed rates of interest, the funds suffered from
highly negative real rates of return when inflation rates got out of control.
The social security institution of Egypt suffered heavily from negative
real rates of return during the 1980s as did the national provident funds of most
African countries and the partially funded social security institutions of Latin
American countries (World Bank 1994). In fact, the negative returns earned on
their reserves and subsequent erosion of their value has been one of the main
reasons for the historical transformations of social security systems from a
partially funded to an unfunded "pay-as-you-go" basis. But strict investment
rules and prescribed investments have also been imposed on private pension
funds. A good example is provided by South Africa, where both pension funds
and insurance companies were subject to such requirements before the late
1980s with adverse effects on their total returns.
403
Maximum limits on investment allocations have traditionally been
imposed in Continental Europe and East Asia and have also been extensively
used by the reforming countries of Latin America, Eastern Europe and Central
Asia.4 The quantitative limits on investments have rarely been binding as
pension fund trustees have tended to adopt more conservative investment
policies than those permitted by the rules. This has long been true of pension
funds in continental European countries (e.g. Switzerland, the Netherlands and
Germany) but it has also been observed in Chile and Argentina. This
conservative approach may be explained by a low level of risk tolerance by
pension fund trustees and a major pre-occupation with the so-called "shortfall"
risk, by the incentive structure facing pension fund managers, and by lack of
familiarity with equity and overseas markets (International Monetary
Fund 1995).
This implies that calls for more liberal investment rules could be
toned down, although the presence of tight investment limits may delay the
progressive adaptation of investment policies by pension fund trustees.
Moreover, even if the rules are not binding, there is mounting evidence that the
investment performance of pension funds operating under quantitative limits
has been inferior to that of funds operating in more liberal environments
(Davis 1997).
Another problem with investment limits is that they may fail to
achieve the desired amount of investment diversification. While they avoid
excessive concentration of risks, they cannot ensure appropriate diversification.
For instance, a pension fund may invest in bonds and bank deposits within the
prescribed limits but fail to invest in equities. Imposing the principle of
adequate diversification without specified upper limits may in fact be more
effective in achieving the objective of prudent diversification.
1.2
The "Prudent Person" rule
In some OECD countries, mainly Anglo-American ones, the "prudent
man" (or more politically correct, the "prudent person") rule has traditionally
been used. This approach is now also spreading in other developed countries.
This rule requires managers to follow high fiduciary standards in investing the
funds. It allows fund managers to set their own investment guidelines and
avoids the pitfalls of government direction of funds and government
interference with market processes and especially with financial innovation.
404
Despite its superior investment performance and its greater flexibility,
the "prudent person" approach has come under criticism in recent years, both
because of its vagueness and because of its tendency to cause uniform
investment policies among pension funds and thus contribute to the herding
behaviour that characterises most institutional investors.5 However, the
vagueness of the "prudent person" concept is also one of its strengths and lies
behind its flexibility.
In recent years, the meaning of the concept has been modified to
require pension fund trustees and asset managers to be more concerned with
corporate governance in the companies in which they invest. In earlier periods,
the concept implied that pension funds should exert pressure on corporate
management by selling the shares of poorly performing companies. But it has
increasingly been recognised that, with the growing dominance of institutional
investors, the "exit" option was no longer as liquid and easily used as before
and pension funds needed to exercise some "voice" in corporate affairs. The
new concept effectively requires pension funds to cast their votes and also to
support the creation of more efficient and responsive corporate governance
structures.
Another sense in which the "prudent person" concept has evolved is
with regard to investments in unlisted instruments. Whereas in the past,
investments in listed securities were encouraged, now pension fund trustees
seek investments in private equity that are more profitable. Although
investments in private equity have been subject to a relatively low limit, the
level has been rising in recent years and pension fund trustees haven been able
to do so by following average practice among most trustees.
The "prudent person" approach seems appropriate when employers
operate defined benefit (DB) schemes and assume the investment risk of the
funds. As long as the pension plans are adequately funded, with top-up
contributions from sponsoring employers if necessary, allowing investment
policy freedom to company-based pension funds would seem to cause few
safety concerns.
In defined contribution (DC) plans, however, relying on the "prudent
person" rule may be less effective, as workers assume the investment risk and
may not have the information and expertise to monitor the investment
performance of different funds. In developed countries with growing DC plans,
a strong emphasis is being placed on clarifying the duties of trustees and on
educating them in asset and liability management techniques and in selecting
asset allocation policies that take into account the risk/reward characteristics of
405
different financial instruments and the risk tolerance of pension plan members.
But in developing countries with a mandatory pillar investment rules may need
to be much stricter in order to protect the large numbers of unsophisticated and
inexperienced investors who are forced to participate.
1.3
Types of investment rules
Investment rules are set at three different levels, the first two of which
are not as controversial as the third. The first level refers to the type of
instruments that are eligible. Ideally, investments should be effected through
organised exchanges and in listed, highly rated, and actively traded securities.
Any exceptions should be subject to clearly stipulated limits. Loans to
members should be avoided, even if they are subject to low limits compared to
accumulated balances. This is because pension funds may have difficulty in
charging market rates of interest on such loans and in ensuring their timely
repayment.
Similarly, direct investments in nonlisted and/or low rated assets
should be discouraged, although indirect investments in such assets through the
use of securitised instruments, such as mortgage-backed securities for housing
loans and venture capital funds for investments in new firms and infrastructure
projects, could be encouraged. The rules regarding highly rated and actively
traded securities should prohibit placing funds with insolvent banks and should
require any transactions with related parties within financial conglomerate
groups to be effected at market terms and conditions.
The second level relates to imposing clear limits on exposure to
individual issuers of securities. For example, holding of equities or bonds of
any one issuer are usually limited to 5 per cent or 10 per cent of the total assets
of the fund or 5 per cent or 10 per cent of the total value of securities of a given
issuer.
This limit avoids excessive concentration of risks and close
involvement with any one company. A higher limit might require a pension
fund to become involved in board representation and managerial control. In
general, it is better for pension funds to exert voice and control in corporate
affairs through collective bodies. The 5 per cent or at most 10 per cent limit is
usually applied with particular force to securities issued by the sponsoring
employer of a fund.
There is also usually a limit on borrowing and pension fund leverage.
Borrowing is permitted for short-term liquidity purposes and for enabling the
execution of transactions and may be subject to a low limit of not more than
406
10 per cent of the value of assets. Long-term borrowing and leveraging through
the use of derivatives is prohibited. Use of derivatives is only permitted for
hedging purposes or for increasing revenues but without exposing pension
funds to large potential losses.
These two types of investment rules are found in most countries and
as already indicated are not particularly controversial. Even if not imposed by
regulations, they are likely to be set by the internal guidelines set by pension
fund trustees.
The limit on investments in the securities of sponsoring
employers and on borrowing are also found in the Australian mandatory
pension system, which otherwise follows a relaxed regulatory approach,
emphasising protection from fraud, theft and negligence but no other state
guarantees.
The third level of investment rules has to do with limits on risk
classes of assets. One fundamental problem of these rules is that assets
belonging to a particular class may exhibit different risk characteristics. For
instance, a five-year government bond is a very different risk instrument from a
zero-coupon thirty-year government bond. Similarly, an equity stake in a
newly-created high technology company has different risk/reward
characteristics than the equity of a mature utility company. These differences
in risk characteristics imply a more refined application of rules. After all,
investment guidelines issued voluntarily by pension fund trustees to asset
managers would need to draw a distinction between large cap and small cap
equities as well as between high and low grade debt instruments.
Objections to the use of limits on risk classes of assets should be
softened if account is taken of the need of pension funds to invest in balanced
portfolios and of the growing trend toward passive indexation among pension
funds in Anglo-American countries. Critics of limits should not confuse the
investment policies pursued by diversified and balanced pension funds with
those that are more appropriate for specialised mutual funds.
Investment rules setting maximum limits on different classes of assets
appear to have worked quite well in countries like Chile. To be effective, such
rules must be flexible and revised in line with the growing maturity of pension
funds. Thus, any limit on equity investments should be revised upwards as the
pension funds grow in size and become more mature and the capital markets are
modernised and become more efficient.6
407
1.4
Limits on overseas investments
A perennial question facing regulators of pension funds is whether to
allow investments in overseas securities. The argument in favour of overseas
investments is to permit a diversification of country risk and also to seek
suitable investments for the placement of available funds. The argument
against is that allowing investments overseas would deprive the domestic
markets from valuable long-term financial resources and would thus weaken the
modernising influence that pension funds may have on the domestic markets.
The issue of limits on overseas investments has attracted exaggerated
attention, at least insofar as the mandatory private pension funds of developing
countries are concerned. Pension funds in developed countries have shown a
clear "home bias" in their investment allocations and have usually stayed well
within officially imposed limits. Even pension funds operating in countries that
have adopted the "prudent person" approach have also exhibited a strong "home
bias" (International Monetary Fund 1995, Reisen 1997).
A workable compromise would be to allow overseas investments once
accumulated pension fund assets reach a given percentage, say 10 per cent or
20 per cent of GDP. This limit is clearly arbitrary but it allows a certain
maturing of pension funds and provides an outlet if potential issuers of
domestic securities do not respond to the greater availability of institutional
funds.
Investment in overseas assets is often handicapped by the lack of
familiarity of foreign securities by local managers. This, plus the high
transaction costs in establishing managerial relationships with foreign asset
managers, probably explain why most pension funds stay well within their
permitted limits. Authorising domestic mutual funds that specialise in foreign
securities may facilitate overseas investments by pension funds as it would
economise the use of specialist managers and would overcome the lack of
locally available information on the prospects of foreign securities. Allowing
the use of hedging instruments to guard against currency risk would also be
essential.
Overseas investments are clearly more important for smaller
countries, especially those that depend on a few industries that may in turn be
dominated by a few family firms. The lack of suitable domestic instruments is
usually a very strong argument for permitting investments in overseas
securities. It should, however, be emphasised that the potential contribution of
408
pension reform might not be realised if pension funds are allowed to invest
freely in overseas securities.
Faced with the need to develop acceptable domestic instruments, the
authorities may undertake other economic reforms. A "holistic" approach on
economic reform is often emphasised. This should cover not only capital
market and fiscal reforms but also a break-up of existing family cartels and an
opening to foreign direct investment and strategic foreign entry. If foreign
multinationals are encouraged to list their local subsidiaries and joint ventures,
they could engender a substantial increase in the domestic supply of suitable
securities.
The need for safety and for ensuring the financial success of pension
reform suggests that a cautious approach should be followed, not only with
regard to overseas investment limits but also with investment rules in general.
Investment rules would need to be relaxed and become more liberal as private
pension funds mature and both pension fund managers and their affiliated
workers become more sophisticated.
2.
Valuation and accounting rules
Valuation and accounting rules vary considerably from country to
country, depending on whether pension funds are voluntary or compulsory and
whether they are based on worker or employer mandates. Valuation and
accounting rules have a significant impact on the investment policies and asset
allocations of pension funds (Griffin 1997).
In countries with worker mandates where pension funds operate on
mutual fund principles, valuation rules require assets to be "marked-to-market"
on a daily basis. Using listed securities through organised exchanges facilitates
market valuation. For assets that do not trade on organised exchanges (such as
real estate), pension funds could be required to use a valuation model developed
by the supervision agency. Such models could be based on the traditional
"moving average" valuations used by accountants for nontraded assets.
Although market values are subject to continuous, and sometimes
large, fluctuations, using them is better than book values which may result in
large deviations from the true value of various assets and the creation of hidden
reserves. If reserves are to be used for smoothing out large fluctuations in
market values, they should be set up in an open and transparent manner, as in
409
the case of the profitability fluctuation reserves that are used in the pension
fund systems of Chile and other Latin American countries.
To minimise the valuation problems caused by assets that are not
actively traded on organised exchanges, investment rules could prohibit direct
holdings of such assets or could subject them to very low limits. Investment
rules could instead encourage use of traded specialised investment funds (such
as real estate investment trusts, venture capital funds, or infrastructure funds) to
facilitate indirect investments in such assets. Use of specialised mutual funds
could also be advocated as a means of offsetting the natural bias of pension
funds to invest in the securities of the state or large corporations. The financing
of small firms, new ventures and large infrastructure projects could be greatly
encouraged through such vehicles.
Valuation rules are less clear-cut in countries with company-based DB
plans. Pension funds in the US and the UK are allowed to use values derived
from actuarial models that discount future income streams instead of market
values. Perhaps no major harm is caused by this approach since these
valuations are used for calculating the adequacy of funding levels, an exercise
that also takes into account the actuarially calculated present value of future
liabilities. When workers transfer to other companies and join other pension
funds, the value of their vested benefits is also actuarially calculated. However,
the situation is different in DC plans where there is a greater tendency to use
market values.
In Hungary and other Eastern European countries, what might be
referred to as the "savings account" principle is used (Vittas 1996b). This
requires the use of book values and the crediting to individual accounts of
income received and realised capital gains. Income accrued but not received
and unrealised capital gains are not allowed to be taken into account. This
approach would tend to generate hidden reserves and to complicate account
transfers.
Market practitioners as well as regulators are concerned that use of
market values in undeveloped capital markets that suffer from low trading
volumes and lack of depth and liquidity may cause excessive volatility in
reported returns. A temporary solution to this problem would be to use written
up or written down values, especially for government bonds which may be held
to maturity. This approach, plus recognition of accrued but not yet received
income, would go a long way toward correcting reported returns. However, the
longer-term objective should be to use market-value accounting.
410
3.
Minimum profitability rules and state guarantees
A mandatory "second" pillar implies a stronger obligation on the
authorities to ensure that the system is simple, fair and safe. Minimum
profitability rules and state guarantees aim to protect small and unsophisticated
investors, not only from fraud and manipulative exploitation by pension fund
managers, but also from large disparities and fluctuations in returns.
3.1
Types of minimum profitability rules
Minimum profitability rules can take many different forms. They can
be set in absolute terms and be expressed in nominal or real terms. Or they can
be set in relative, nominal or real, terms by reference to the average for all
pension funds. And they can be set on an annual, calendar or rolling, basis, or
they can cover a longer period. The less onerous for the pension funds, and by
implication less beneficial for workers, are minimum levels set in nominal
terms for the whole active life of a worker. The most onerous is the offer of a
guaranteed minimum real rate of return on an annual basis.
Minimum profitability rules vary considerably among countries. In
most OECD countries, where funded pension schemes are still voluntary, there
are no rules on minimum rates of return, even when the pension funds operate
as DC plans and workers assume the investment risk. However, insurance
companies and commercial banks offer what are known as "guaranteed
investment contracts" and "guaranteed deposit contracts" that promise a
minimum nominal rate of return, usually set at half or less the prevailing
nominal rate on safe one-year government securities.
In Switzerland, which has a mandatory "second" pillar, a minimum
annual nominal rate of return of 4 per cent is imposed on the funds. Expressing
a minimum return in nominal terms is not very satisfactory. It can be very
costly if inflation is very low, and especially when prices are falling, and it is
meaningless when inflation is out of control. Singapore also has a guaranteed
nominal rate of return of 2.5 per cent. There is also a risk that the minimum
rate of return may become a "norm" and induce fund trustees to adopt
conservative investment policies.
Expressing the minimum rate of return in real terms would provide
more meaningful protection to individual workers, but it would not be
advisable as it could expose a guarantee fund to large payments in years when
411
stockmarkets register negative real returns. The fiscal cost of a guaranteed real
rate of return could be prohibitive.
3.2
The Chilean approach
Chile and several other Latin American countries (though not Mexico)
have opted for guaranteeing relative rates of return. Pension fund management
companies are required to make up any shortfall in returns if these fall below
the average return for the sector by a specified percentage. In Chile, the
minimum rate of return, which is expressed in real terms, is equal to 50 per cent
of the average return, while in Argentina, where it is expressed in nominal
terms, it is equal to 70 per cent of the average. (For symmetric purposes, any
returns in excess of 150 per cent of the real average in Chile or 130 per cent of
the nominal average in Argentina are placed in a profitability fluctuation
reserve.) In both countries, the rule is applied on a 12-month rolling basis.
Pension fund management companies are expected to make up any
shortfalls in returns by using first the profitability fluctuation reserve, if one has
been created, and then their investment reserves (encaje). If these are
exhausted, the companies are required to provide new equity to make up any
remaining shortfall and reconstitute their investment reserves. If any company
fails to make up the shortfall and refuses to provide additional equity from
external funds, it is liquidated, the government makes up any remaining
shortfall, and the workers transfer their accounts to another company of their
choice.
Minimum relative profitability rules tend to cause pension funds to
follow uniform investment policies, as small funds cannot afford to deviate too
much from the investment profiles adopted by the large companies. To respond
to this criticism and allow more flexibility in investment policies, the Chilean
authorities are considering changing the application of the rule to a 36-month
rolling basis. Given that pension contracts are long-term contracts that can span
up to sixty years, moving from an annual to a three-year, or even a five-year,
guarantee would still provide adequate effective protection to affiliates.
The criticism that investment policies become uniform under a
minimum relative profitability rule is sometimes exaggerated. Even without
such a rule, pension funds tend to bunch their investments in similar
instruments. The rationale for such herding behaviour by pension funds seems
to be twofold: on the one hand, pension fund trustees, following the "prudent
person" rule, tend to adopt similar asset allocation policies; and, on the other
412
hand, asset managers are reluctant to underperform the market since the price
for underperformance may well be the loss of business. A minimum relative
profitability rule would protect investors from aberrant fund managers, without
necessarily causing inefficiencies in investment policies.
3.3
SIPOs and Benchmark portfolios
This issue remains unresolved. One alternative to minimum relative
profitability rules, which could have more appeal in advanced countries, would
be to require management companies to spell out clearly their investment policy
at the beginning of each year and to be liable for making up any shortfalls that
might result from deviating from this policy. The use of benchmark portfolios
and detailed investment guidelines may be a better approach to the current
situation in developed countries where the only constraint facing fund
management companies is the loss of business and the potentially adverse
impact on their reputation. However, these penalties would occur after the
event and would offer no consolation to retiring workers who may have
suffered large losses from the failure of fund managers to comply with their
own investment guidelines.
Statements of Investment Policy Objectives (or SIPOs) will be
required from pension fund trustees under the mandatory pension system that is
being introduced in Hong Kong, while a clearer indication of investment
strategy is required under new UK pension legislation. Presumably, fund
trustees and asset managers who deviate from these objectives would be subject
to sanctions. But no country has yet imposed a liability on pension fund
trustees or asset managers to make up any shortfall in returns that may result
from their failure to comply with their declared objectives. This may be
explained by the practical difficulty of defining benchmark portfolios,
ascertaining their implied rates of return and determining the deviation from the
stated policy objectives and the shortfall in returns. However, fund trustees and
asset managers could be held liable for gross violations of their stated
objectives, while standardised forms for SIPOs could be developed by
regulatory authorities if the use of benchmark portfolios was considered
beneficial.
3.4
State guarantees
As already noted, in the case of Chile and other LAC countries, the
government is responsible for making up any remaining shortfall in guaranteed
413
returns after the liquidation of a failed pension fund management company.
Offering this guarantee implies the creation of a strong and effective
supervision agency to ensure that pension fund management companies comply
with the rules, do not take excessive risks, and maintain the equity reserves
needed to support their operations.
But apart from guaranteeing the minimum relative profitability of
pension funds, the authorities may also need to guarantee annuity payments for
old age pensions as well as for term life (survivors) and disability pensions of
failed insurance companies (if these insurances are offered by private
companies). Upper limits may be imposed on the amounts of these guarantees,
but especially in mandatory systems where benefits are required to take the
form of monthly pensions (rather than lump sum payments), such guarantees
are essential. Annuity payments subject to specified limits are guaranteed in
both Chile and Argentina. The government stands behind these guarantees but
insurance companies are tightly regulated and supervised to ensure that they
have adequate reserves and to minimise the likelihood of insolvency.
4.
Concluding remarks
The creation of mandatory private pension funds creates an obligation
for governments to ensure that these funds are safe, transparent and fair.
Developing countries that have implemented systemic pension reforms
involving the creation of mandatory private pension funds have tended to
impose "draconian" regulations on these funds in order to protect the interests
of participating workers. These controls cover many areas, but have a
particular bearing on the investment function of pension funds.
Investment limits, valuation rules, minimum profitability
requirements and state guarantees have been extensively used in Chile and other
Latin American countries. These have been far more pervasive than
quantitative investment controls in some Continental European countries and
have differed substantially from the more relaxed approach of the "prudent
person" rule that has long been adopted in many Anglo-American countries.
The more draconian approach followed in reforming developing
countries may be justified by the compulsory nature of private pension funds,
the absence of well developed and transparent capital markets, the lack of
familiarity and financial sophistication of large numbers of participating
workers, and the paramount need to reassure sceptical workers and to avoid
414
failure of the reform program. However, the draconian controls have a cost in
terms of loss of efficiency, delayed innovation and increased moral hazard.
The "prudent person" rule has worked relatively well in countries with
DB pension plans. It is not clear how well it will work under DC plans.
Moreover, some of the costs of "draconian’ regulations tend to be exaggerated
since even with the "prudent person" approach, there is a tendency for pension
funds to have similar investment portfolios. However, the "prudent person"
rule is more flexible and leads to the achievement of higher returns. Thus, in
the longer run, developing countries should relax their investment limits and
state guarantees. To protect individual workers from aberrant fund trustees and
asset managers, use of benchmark portfolios and clear statements of investment
policy objectives (SIPOs) could be encouraged, with appropriate sanctions for
gross departures from these stated norms. However, it remains to be seen
whether such an approach could be developed in a practical fashion that would
not give rise to large investment inefficiencies.
415
NOTES
1.
In developing countries, systemic reform is predicated on the need to move
away from effectively mono-pillar systems where unfunded public systems
promised unsustainably high benefits. This was in particular the case in
Latin America and the Caribbean (LAC) and Eastern Europe and Central
Asia (ECA) countries.
2.
An interesting difference between the LAC and ECA regions is that
reforming countries in the latter are willing to authorize corporate pension
plans that meet the regulatory requirements, whereas LAC countries only
allow the participation of specialized pension fund management companies.
3.
For overviews of pension reform initiatives, see Demirguc-Kunt and
Schwarz (1996) and Valdes-Prieto (1996).
4.
However, Bolivia and Uruguay among Latin American countries require the
private pension funds to invest in government bonds in order to finance the
fiscal cost of the transition.
5.
As reported in Davis (1995), US legislation on pension funds stipulates that
under the prudent person rule, investments must be made for the sole
benefit of the beneficiaries and "with the care, skill, prudence and diligence
under the circumstances then prevailing that a prudent person acting in a
like capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims". This wording clearly
discourages deviations from industry (average) practice but allows for the
evolution of best practice.
6.
A detailed examination of the relaxation of investment rules in Chile up to
1990 is provided in Vittas and Iglesias (1992). Bustamante (1996) offers a
discussion of the continuing evolution of regulatory practice in Chile. See
also, Shah (1997) for criticism of the Chilean approach.
416
BIBLIOGRAPHY
BUSTAMANTE, J. (1996), “15 Years of Regulating and Supervising Chile's
Pension System,” Paper presented at the conference on 'Pension
Systems: From Crisis to Reform" organized by the Economic
Development Institute on November 21 and 22, 1996, mimeo.
DAVIS, E. P. (1995), Pension Funds: Retirement Income Security and Capital
Markets-An International Perspective, Oxford: Clarendon Press.
DAVIS, E. P. (1997), “Regulation of Pension Funds.” This volume.
DE RYCK, K. (1997), “Asset Allocation, Financial Market Behavior, and
Impact of EU Pension Funds on European Capital Markets”. This
volume.
DEMIRGUC-K., and A. and A.M. SCHWARZ. (1996), “Taking Stock of
Pension Reforms Around the World.” Paper presented at the conference
on 'Pension Systems: From Crisis to Reform" organized by the Economic
Development Institute on 21-22 November 1996, mimeo.
GRIFFIN, M. (1997), The Global Pension Time Bomb and Its Capital Market
Impact. Goldman Sachs Global Research. New York.
International Monetary Fund. (1995), International Capital Markets:
Developments, Prospects and Key Policy Issues. Washington D.C.: IMF.
QUEISSER, M. (1997), “Regulation and Supervision of Pension Funds:
Principles and Practices” OECD Development Center, mimeo.
REISEN, H. (1997), “Liberalizing Foreign Investments by Pension Funds:
Positive and Normative Aspect”, Technical Paper 120.
OECD
Development Center.
417
SHAH, H. (1997), “Towards Better Regulation of Private Pension Fund”,
Policy Research Working Paper 1791. World Bank, Washington D.C.
VALDES-PRIETO, S. (1996), “Pension Reform in Latin America: Transition
and Implementation Problems”, World Bank, Development Research
Group, mimeo.
VITTAS, D. (1996a), “Regulatory Controversies of Private Pension Funds”,
Paper presented at the conference on 'Pension Systems: From Crisis to
Reform" organized by the Economic Development Institute on 2122 November 1996, mimeo.
VITTAS, D. (1996b), “Private Pension Funds in Hungary: Early Performance
and Regulatory Issues”, Policy Research Working Paper 1638. World
Bank, Washington D.C.
VITTAS, D. and A. Iglesias. (1992), “The Rationale and Performance of
Personal Pension Plans in Chile”, Policy Research Working Paper 867.
World Bank, Washington D.C.
VITTAS, D. and M. QUEISSER. (1997), “Pension Reform Around the World:
A Progress Report”, World Bank, Development Research Group,
mimeo.
World Bank. (1994), Averting the Old Age Crisis: Policies to Promote Growth
and Protect the Old. New York: Oxford University Press.
418
Part IV (continued)
THE REGULATORY AND SUPERVISORY ENVIRONMENT AND
RISK MANAGEMENT
B. INSURANCE COMPANIES
419
Chapter XIX
ISSUES IN THE EFFECTIVE REGULATION OF THE ASSET
ALLOCATION OF LIFE INSURANCE COMPANIES
by
G. M. Dickinson*
Introduction
To generalise on the impact of investment regulation of life insurance
companies internationally is not an easy exercise. In order to do this with any
degree of accuracy, it would be necessary to undertake detailed discussions at
the level of individual insurance companies in particular countries. This is
because investment policies of insurance companies within a given country
vary due to differences in the types and mix of life insurance contracts sold (and
hence life insurance liabilities) and differences in the investment philosophies
of management. Nevertheless, some broad conclusions can be drawn from joint
analysis of the aggregate investment policies of life insurance companies and
the prevailing regulations. The paper draws on a survey devised by the author
and compiled by the OECD during 1994 and 1995 on the investment regulation
across 23 member countries (see Appendix). The survey covered both life
insurance and non-life insurance. The paper here only focuses on the
investment of life insurance companies, because of their importance as
institutional investors.
During the last decade, there have been significant changes in the
investment regulations of insurance companies in many OECD countries. This
has particularly been evident within the European Economic Area, where there
has been a fundamental rethinking of investment regulation, as part of the wider
reshaping of insurance legislation within the European Union. These changes
in investment regulations have come about in part because insurance regulators
*
Gerry Dickinson is Professor and Director, Centre for Insurance and
Investment Studies, City University Business School, London.
421
have been more responsive to changing local market conditions. The life
insurance industry has been a fast changing part of the financial system, with
new types of life insurance and pension-related products being introduced.
Insurance companies have been under competitive pressure to earn higher rates
of return on investments to develop new savings products and this has required
wider and more flexible financial asset choice. In particular, the growth of
linked-life contracts has required a greater need to invest in company shares
than for more traditional life insurance products. Similarly, the growth of
pensions and other long-term saving products have demanded more investment
flexibility. The fact that in particular countries insurance associations have had
discussions with the supervisory authorities to amend regulations is indirect
evidence that the restrictions on investment policies have had in the past some
constraining effect. An overview is given below of some of the major types of
regulations and an assessment, if necessarily somewhat subjective, of their
impact on investment policies.
1.
The aims of investment regulation
Historically, there have been three distinct purposes behind the
regulation of the investment policies of insurance companies: a) to protect
policyholders (consumers); b) to direct the flow of investable funds towards
what governments perceive as economically desirable ends; and c) to prevent
insurance companies from exercising undue influence within the financial
sector as a whole.
1.1
Protection of policyholders
Restrictions on the investment policies of insurance companies are
part of the wider aim of seeking to minimise the probability that insurance
companies go bankrupt and to ensure that the costs to policyholders are kept to
a minimum, if bankruptcy does occur. Because consumers pay premiums to
insurance companies in advance, how these funds are invested before they
receive their contingent payments is naturally a relevant supervisory concern.
This concern tends to be greater for life insurance compared for non-life
insurance, because of the longer term nature of the life insurance contracts,
because the size of invested funds are larger and because the funds represent to
a significant degree the long-term saving of the public.
422
1.2
Directing the flow of investable funds
Since life insurance companies, control a sizeable proportion of the
stock and flow of long-term personal savings in many developed economies,
governments have sometimes felt that they would like to influence the direction
of investments as part of their wider economic policy. This direction of
investment can have a variety of particular purposes:
i) to ensure that an adequate flow of funds is available to finance
public and private capital expenditure programmes
ii) to keep funds invested in the domestic economy
iii) to finance the budgetary deficits of governments.
1.3
Reducing potential concentration of power in the financial sector
In some countries, governments have tried to prevent very large
insurance companies from using their considerable investable resources to
exercise too much economic influence. There has been by control placed on the
diversification strategies to own or control of other financial institutions and
industrial enterprises.
But in recent years the purpose of investment regulation has had a
narrower focus within OECD countries. It has been concerned more and more
with the protection of policyholders, with less emphasis on the other two
purposes noted above. Governments have been under national and international
pressure not to interfere with the functioning of the capital market and as capital
markets have themselves developed the need for state involvement has
decreased. On the issue of minimising the potential financial power of large
life insurance companies, other means, such as competition and licensing
policies, have been considered more effective.
2.
Assessing the impact of regulation
2.1
Authorised or permitted investments
In all OECD countries, a wide range of investments can be held by
life insurance companies. There are some restrictions in a few countries which
prevent the holding of unquoted shares or unsecured loans against technical
provisions, but in all countries the investment of the capital base of life
insurance companies is free of regulatory constraint (Table 1).
423
Table 1. Major classes of unauthorised/non-permitted
investments for life insurance companies
Not permitted to be held
Not permitted against
against technical provision required capital (minimum
solvency margin)
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
Notes:
C
B
C
C
C
B, C
A, B, C
D
-
-
A) Company shares (quoted)
B) Company shares (unquoted)
C) Loans (non-mortgage or unsecured)
D) Real estate
The widening of the range of permitted classes of investments,
especially during the last five years, has removed constraints which was evident
previously in some countries. In a few countries, there are still restrictions on
the investment of technical provisions in unquoted company shares and there is
a case for these restrictions to be reviewed.
424
2.2
Limits on classes of investment
In most OECD countries there are limits on particular classes of
investment in which life insurance companies can invest and these vary
considerably (Tables 2 and 3). Although it is difficult to generalise, it is the
view of the author that these quantitative restrictions do not currently impair
investment policy to any major degree. This is because the prevailing maxima
for the various classes of investment are relatively high and in practice are
flexibly applied. These maxima on financial asset classes generally only apply
to those assets which cover technical provisions and do not apply to the total
assets of life insurance companies. This builds flexibility into the investment
restrictions, although it must be recognised that methods required to value
assets and liabilities in many countries overvalue technical provisions and
therefore undervalue the size of the capital base of insurance companies.
Hence, the apparent flexibility that exists in respect of the investment of capital
funds is inhibited in practice to some degree by these conservative valuation
bases.
If one were to identify areas where the investment constraints appear
to have had some effect, one would concentrate on the maxima which exist in
relation to investment in unquoted domestic shares, investment in foreign
securities, especially foreign shares, and investment in non-mortgage loans.
These restrictions apply because they have higher default and liquidity risks
compared to other classes of investment. Investment regulations are still based
largely on ‘prudent man’ rules which focus unduly on default risk and liquidity
risk. These issues which will be discussed in more detail later in the paper.
Although for the most part the maxima permitted in these classes of
investment have been set relatively high, one can identify a number of
countries where it is possible to argue that the maxima may have been on the
low side and thus they may have inhibited investment choice. In respect of
unquoted domestic shares, one might look in more detail at the cases of Austria,
Germany, Portugal and Turkey. One might consider restrictions on foreign
investment in Belgium, Germany and Luxembourg as being too onerous. There
are a number of countries where one might view that the limits on nonmortgage loans have a potentially constraining effect, e.g. Belgium, Denmark,
Greece, Iceland and Spain. In defining appropriate limits on financial assets,
supervisory authorities should allow for the fact that default risk can be reduced
by portfolio diversification and that liquidity risk also depends on the overall
liquidity position of the investor.
425
Table 2. Maximum percentage that can be invested in a given class of investment for life insurance
Domestic shares
Domestic shares
Foreign shares
Foreign bonds and
Real estate
Loans (mortgage)
(quoted)
(unquoted)
other securities
Australia
Austria
30*
5
30*
30*
Belgium
10
10*
10*
10**
Canada
5-25*
5-25*
5-25*
5-25*
Denmark
40*
40*
40*
10**
Finland
20
0
0
0
France
65*
65*
65*
40
10**
Germany
30
10
6
5
25
50*
Greece
30*
30*
30*
50
10**
Iceland
40*
10**
40*
10**
Ireland
55*
2.5
55*
30
15-30**
Italy
20*
20*
20**
50**
50
50
Japan
30*
30*
30**
30**
20
50***
Luxembourg
10
5
5
10
40
10*
Netherlands
10*
10*
Norway
20*
20*
20*
30**
30**
30**
Portugal
25*
15
25*
60
45**
45**
Spain
10*
10*
Sweden
0
0
Switzerland
30*
30*
25**
20**
Turkey
30
UK
10*
10*
USA(New Jersey)
15*
15*
5
5
10
60
USA (Delaware)
@
@
5
5
25
50
Notes:
* max. for these classes of investment combined ** max. for these classes of investment combined
*** max. for these classes of investment combined @ 250% (at market value) of the capital & surplus
In Germany, there is also a maximum of 30% in government bonds and asset-backed securities
maxima in respect of foreign investments are separate from the currency matching requirements for foreign liabilities.
426
Loans (Nonmortgage)
0
10**
5
10**
10**
50*
10**
10**
15-30**
0
30***
0
8
30**
10
10*
0
10*
-
Table 3. Basis to which the maxima % in investment class applies
for life insurance companies
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Notes:
n/a
B
B
A
B
B
C
B
B
C
A
B
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
A
B
B
A
C
B
B
C
n/a
n/a
A
A*
* for co. shares also applies to max. of capital base
A) All assets
B) Technical provisions only
C) Technical provisions and equalisation reserves only
Table 4. Maximum percentage that can be invested
in a single Investment
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Securities of One piece of
one
real estate
company
5-10
5
10
25
3
10
5
5-10
10
5*
10
10
2
5
7.5
5
3
10
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
Securities
of one
company
10
5-10
5-10
15
5
10
5
10
5
2
10
One piece
of real
estate
5
20
10
10
10
5
2
10
Notes: * Max. of 2% of technical provisions and 25% of capital base, but with overall
max. of 5% of technical provisions.
427
Table 5. Basis to which the maxima per cent
in a single investment applies
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Notes:
B
B
A
B
B
C
B
B
C
A
B
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
A
B
B
A
C
B
A
C
D
D
A
A
A) All assets
B) Technical provisions only
C) Technical provisions and equalisation reserves only
D) Technical provisions, equalisation reserves and minimum capital required
(minimum solvency margin) only
The valuation bases which are required to be used to determine how
these maxima apply is also important. For example, in countries where the
basis is on the lower of book or market value, a given maxima is more
potentially restrictive than if the basis is market values. More conservative
valuation bases, by their nature, are more binding.
In most cases there are no regulations requiring minima holdings in
particular classes of ‘low risk’ investments.
2.3
Limits on a single investment
A common feature of investment regulations, as can be seen in
Table 4 in the Appendix, is that there are percentage limits on how much of the
company’s assets can be invested in the securities of a single company (apart
from a subsidiary or an associate company) or in a single piece of real estate. It
is common for maxima to be set at around 5 per cent for investment in the
securities of a single company (see Tables 4 and 5); it is often higher than 5 per
cent, for real estate investment, often 10 per cent. The higher limit for real
estate investments arises in part because real estate investment often includes
428
the company’s own offices. With respect to the securities in one company,
Denmark, Iceland and Italy have maxima less than 5 per cent. If there were no
such limits, insurance companies would rarely have holdings in a single
investment above 5 per cent, except where the insurance company is taking a
stake in a company for strategic reasons. It should be noted that the basis on
which these percentage rules apply varies significantly between countries and
this makes comparisons difficult (see Tables 5 and 6 in the Appendix). But it
can be said that these maximum percentages in individual investments have not
overall imposed a significant constraint on the investment policies of life
insurance companies. The policy of diversifying investment portfolios would
result in practice in holdings well below the 5 per cent level. However, these
maxima might well have inhibited the investment policies of small life
insurance companies.
2.4
Maturity matching requirements
The actuarial assessment to assess the duration or maturity matching
of assets and liabilities, allowing for interest rate risks implicit to these
asset/liability positions, is rarely specified in any detail in national insurance
legislation (Table 7). This maturity matching assessment is carried out between
the regulatory authorities and the insurance companies as part of the wider
process of solvency assessment. There is some evidence to suggest that
actuarial asset/liability valuations to determine solvency have inhibited the
investment policies of life insurance companies in some countries. Actuarial
valuations can be carried out on too rigid a basis and this can impair investment
choice. This is particularly so since the solvency assessment of an insurance
company is usually carried out on an annual basis. Annual solvency
assessments can place a greater concern on the short-term investment positions
when the real investment risks facing life insurance companies are essentially
long term. In particular, solvency assessments can result in an undue emphasis
on the short- term volatility in investment values. This emphasis on price
volatility over and above what would be considered commercially necessary
can inhibit investment in securities whose prices are inherently volatile, such as
company shares. To the extent that life insurance companies offer, or are
required to offer, high guaranteed surrender values to policyholders, this
concern with the short term price volatility of assets is a legitimate supervisory
concern, since the cancellation of life contracts, or the ability to borrow against
these surrender values, can impose a liquidity risk on insurance companies.
429
Table 6. Valuation bases used in applying quantitative investment restrictions for life insurance companies
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
Shares (quoted)
Shares (unquoted)
d
b
d
e
a
e
a
b
b
d
d
a
a
d
a, d
a
d
d
a
e
b
d
d
d
d
b
a
a
a
e
a
b
b
a
d
a
a
d
a
a
d
a
a
e
a
e
d
d
Government and high
quality fixed rate bonds
d
a
a, d *
c
c
c
c
b
a
d
d
a
a
g
a, c, d
a
d
d
a
c
b
d
c
c
Lower quality fixed
rate bonds
d
a
a, d *
c
c
e
c
b
a
a
d
a
a
d
a, c, d
a
d
d
a
c
b
d
a
a
Loans (mortgage)
d
a
a
c
a
c
a
a
b
a
d
a
a
d
a, c
a
d
a
a
d
a
d
a
a
Loans
Real estate
(non-mortgage)
d
d
n/a
a
a
d
c
e
a
a
e
e
a
c
a
a
b
b
a
a
d
d
a
a
a
a
d
d
a, c
d
a
a
d
d
a
d
a
a
d
a
a
d
d
a
a
a
a
Notes: * Unquoted investment/Quoted investment
(a) Lower of purchase price or market value for quoted investments; or purchase price (or written down book value) for
unquoted investments.(b) Lowest value ever(c) Amortised value(d) Market value (e) Adjusted market value
430
Table 7. Maturity (duration) matching of investments and
policyholders liabilities for life insurance companies
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Statutory
requirement
for maturity
matching
Defined
method for
maturity
matching
No
No
No
No
No
No
No
No
Yes
No
Yes
No
No
No
No
No
No
No
No
No
No
No
No
No
Statutory
Defined
requirement method for
for maturity maturity
matching
matching
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
No
No
No
Yes
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
No
Table 8. Currency matching requirements
for life insurance companies
Required % of
currency matching of
technical provision
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
80
80
100
80
95
80
80
80
80
80
80
Required % of
currency matching of
technical provision
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
431
100
80
80
80
80
80
80
80
100
80
100
100
However, in countries where there are no high guaranteed surrender
values on life policies, then there is less need for concern with liquidity risk in
investment portfolios. In conclusion, there is some evidence to suggest that
annual solvency assessments have inhibited the investments in company shares
in some insurance markets, and this has had a greater effect than the more
obvious direct restrictions on financial asset choice.
2.5
Currency matching requirements
Currency matching rules are also found in nearly all OECD countries.
These currency matching rules are part of the wider solvency assessment
system. Where currency matching requirements impose a 100 per cent
matching of policyholder liabilities, with investments in the same currency, this
will tend to impose some restrictions on investment policy. The main impact is
to inhibit the investment of policyholder funds generated from contracts issued
in the domestic currency in foreign securities. Life insurance contracts in the
main are purchased by consumers with the aim of earning long-term rates of
return on their savings. Hence, currency matching rules which inhibit life
insurance companies from holding foreign investments not only inhibit this
ability to earn higher rates of return, but also prevent adequate international risk
diversification. There is some case for arguing that currency matching rules
have inhibited foreign investment in a number of countries, especially where
the valuation of technical provisions is carried out on conservative bases.
Again, this is because a conservative valuation of liability understates the
capital base of a life insurance company which is not usually subject to these
restrictions. Since the introduction of the 3rd Insurance Directives across the
European Economic Area, there is now more flexibility in currency matching
rules (there is only a 80 per cent currency matching requirement) and this has
eased this restriction on foreign investment. In addition, the timing of currency
matching requirements can reinforce this constraint. Currency matching
requirements need to be fulfilled every year, when the real currency risks facing
a life insurance company only arise when payments to policyholders are likely
to be made, i.e. well into the future. Again these currency matching
requirements impose a short-term constraint, which is at variance with the
intrinsic long-term nature of the liabilities of life insurance companies.
432
Table 9. Use of financial derivatives in life insurance companies
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
Turkey
UK
USA(New Jersey)
USA (Delaware)
Can they be used in
respect of the
investment technical
provisions
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
No
No
Yes
No
Yes
Yes
Yes
Yes
Can they be used in
Purpose for
respect of the
which they can be
investment of capital
used
funds
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging
Yes
Hedging*
Yes
Hedging
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Yes
Hedging
Yes
Hedging
Yes
Hedging*
Yes
Hedging*
Yes
Hedging
Yes
Hedging*
Yes
Hedging*
Yes
Hedging*
Note: *Also allowed to write covered call options
2.6
Use of derivatives
In recent years, insurance regulations have been amended to allow life
insurance companies to use financial derivatives. Table 9 shows that all OECD
countries now allow life insurance companies to use derivatives, but subject to
constraints. The use of financial derivatives have been limited to hedging, in
particular to protect against a rising bond or share markets for new investable
funds and to protect against a potential fall in asset values on investments
already held. Regulation restricts the more aggressive use of financial
433
derivatives, especially the writing of options. Call options can only be sold if
covered, e.g. when the insurance company already owns the underlying
security. With the growth of over-the-counter market for derivatives, there has
been a growing concern with the credit worthiness of the suppliers of these
derivatives and regulations have to be tightened to ensure that adequate
standards exist.
If insurance companies wish to go into the financial derivative
business, they can set up separate subsidiary companies to do so under their
holding company structures. This is technically possible in most OECD
countries, but there would be some concern by the regulatory authority if such a
subsidiary company were to collapse from large losses, since it could impair the
public confidence in the parent life insurance company.
3.
Features of a good investment regulatory system
Below is outlined the features that should be in a sound yet flexible
framework for the regulation of the investment policies of life insurance
companies.
3.1
Differential treatment for investment of capital funds and technical
provisions
It is recommended that the regulation of investments should continue
to be confined to the investments of those funds covering the technical
provisions (policyholder liabilities) and that there should be no restrictions on
the investment of the capital funds of life insurance companies. The capital
base of an insurance company serves to cushion against a higher than expected
level of payments of policyholders, to absorb the other commercial risks of the
business and to finance future growth. It is important that a life insurance
company should not be restricted in earning a high return on the investment of
its capital base so that it can grow over time. Restrictions on the investment of
capital funds can undermine the long-term financial strength of an insurance
company. It should be recognised that the capital base of a stock life insurance
company is owned both by the shareholders and by the participating
policyholders; for mutual life insurance company all the capital base is owned
by the participating policyholders.
There is some case for arguing that the minimum required capital, i.e.
the capital representing the minimum required under the regulation, should be
434
subject to some investment restrictions, while the capital over and above this
minimum should be free. While there is some force to this argument, this is not
recommended. One reason for that is that the actuarial valuation methods used
to determine the capital base of life insurance companies in most OECD
countries often understates the value of the capital base. Hence, there is already
an implicit restriction arising from this conservative valuation.
3.2
A broad view of admissible investments
In the face of changing capital market conditions, it is important that
life insurance companies are given a wide range of investments from which
they can choose. Existing regulation already afford significant degree of
liberality in the admissibility of financial assets across the OECD. This liberal
philosophy should be retained. Life insurance companies are long-term
investors and hold well-diversified portfolios and hence they can tolerate a
good degree of default risk and liquidity risk. A flexible attitude towards what
assets are admissible to be held also has implications for the capital market. If
insurance companies are prevented from investing in unquoted investments or
start-ups, this will hinder the development of the local capital market. There
are wider economic implications from this, since in many developed and
developing economies, small and medium-sized firms are generating, and are
predicted to generate, a high proportion of new employment opportunities.
Hence, wider economic factors should be considered when drafting investment
regulations: what is good for the economy in the long term is also good for life
insurance policyholders, both in maintaining the purchasing power of their
savings and in ensuring the long term solvency of their life insurance
companies.
3.3
Flexible quantitative restrictions on investment choice
There is a case for applying some maxima on the investment in
particular classes of financial asset. This is to ensure there is adequate portfolio
diversification. But these restrictions should be set at levels which do not duly
impair the investment choice of prudently-run insurance companies. These
limits should be subject to regular review to reflect changes in capital market
conditions and changes in new product trends in life insurance markets. One
could argue that since these quantitative rules have not in practice been very
restrictive, they could be removed altogether. But there is a good case for
keeping them at least as a safeguard against potentially imprudent companies,
and as a signal to the market and to consumers. These quantitative restrictions
435
could be removed and replaced by a close monitoring of investment holdings in
the statutory returns which are required to be submitted annually as part of the
solvency assessment. This might be considered as a possibility, but it is my
view that such a checking mechanism is used to underpin liberal quantitative
investment restrictions.
Similar arguments apply to the restrictions on the maxima that can be
invested in a single investment, whether in a single company or a single piece
of real estate. These regulations are again in place to ensure adequate portfolio
diversification and, as noted earlier, are set for the most part at levels in excess
of what most insurance companies would normally wish to hold. However,
small life insurance companies can be affected by these restrictions if they were
set too low and hence flexibility in their application is recommended. A
maximum of 5 per cent in the securities of one company, which is found in
many countries, is an acceptable level, although the maximum might be
allowed to vary, depending on the size of the capital base of an insurance
company.
3.4
The need to rethink currency matching requirements
There is evidence to suggest that currency matching rules do impose
some ‘home-country’ bias on the investments of life insurance companies.
There should be more flexibility in the currency matching rules in order to
permit more international investment. In national insurance markets most of
the investments of life insurance companies derive from life insurance contracts
which are denominated in the domestic currency; this is reinforced by the
commercial practice that most of the supply by life insurance companies in
overseas markets is carried through local subsidiary companies. The 80 per
cent currency matching requirement, and the associated rules in relation to
smaller currencies, now in operation in the EEA is a level that is not too
restrictive. But a 70 per cent requirement might be considered a better long
term objective. Currency matching rules also require that matching is
maintained at all times. Greater flexibility should be allowed for life insurance
investment, because of the long-term nature of the liabilities. It is only at the
time that the life insurance and pensions contracts are payable that the currency
risk arises, which for a typical life insurance company is many years into the
future, and hence the company has the time to re-establish any mismatched
currency position.
Moreover, this requirement of currency matching is concerned solely
with the solvency risk to the life insurance company. What about the currency
436
risk to policyholders? By holding investments in domestic currency, the
policyholders are being forced to hold their investments in one currency, even if
it is their domestic currency. Since policyholders will spend a significant
proportion of the financial proceeds from their life insurance and pension
contracts in the future, mainly during retirement, in foreign-produced goods and
services, too much investment in a domestic currency imposes a potential
currency risk on policyholders. This is because a domestic currency might have
depreciated against the portfolio of foreign currencies that will be needed to
1
purchase these foreign-produced goods and services in the future. With an
increasingly international economy, individuals will most probably consume
more foreign-produced goods and services in the future than they currently do.
In addition, it should be recognised that investment in the shares of
multinational firms, even if purchased on a local capital market with domestic
currency, provide international investment and currency diversification
indirectly, because these multinationals will generate future foreign income
from their overseas activities. This later point raises the more general issue of
what is an international investment. For international bond investments it is
quite clear. But it is less clear for the investment in shares. This is because the
multinational provides an indirect mechanism for investment overseas. If a
multinational firm, with its shares quoted on a local stock market, generates all
of its current and expected future profits from overseas operations, then an
investor buying its shares on its local capital market has in essence an
international investment. This is because it is the underlying profit or income
streams of a company that is relevant, not the currency in which the shares are
denominated or traded. Hence when one looks at the extent of the international
diversification of the equity investment holdings of life insurance companies or
pension funds, the real position will be underestimated if these indirect overseas
investments through multinational firms are ignored. For example, the relative
size of overseas equity investment by Japanese life insurance companies may
appear small, but it is in effect much larger when one also considers their
holdings of shares in major Japanese multinational firms.
3.5
Reconsideration of the emphasis on capital certainty in investment
regulation
In many countries, the investment regulations of life insurance
companies are to large degree still based on ‘prudent man’ rules, which have
the historical roots in the principle of ‘the capital certainty’, i.e. the preservation
of the value of the capital invested. This is manifest in the regulatory emphasis
2
on default risk and liquidity risk . It is important to recognise an essential
437
difference in nature between default risk and liquidity risk. Default risk is
essentially a characteristic of the financial asset itself, whereas the liquidity risk
cannot be assessed independently of the overall liquidity position of the
investor. For a life insurance company, where the liabilities are long term in
nature and the cash outflows are reasonably predictable, there is no undue
concern with liquidity risk since the probability of being forced to sell assets at
short notice to make payments to policyholders is low. Only if there are high
guaranteed surrender values does a significant precautionary liquidity
preference exist. Hence, investment regulations should recognise this low
precautionary liquidity preference. There should be a greater tolerance of the
liquidity risk in the investment portfolios of life insurance companies compared
to other investors whose liabilities are shorter term and their cash outflows are
more uncertain. Of course, the characteristics of life contracts can also affect
this, apart from guaranteed surrender value issues. If life insurance contracts
and pensions contracts are payable on an annual basis, there will be more
stability in future cash inflows compared to life insurance contracts which are
paid by single premiums. Hence, the particular market characteristics in a
given country need to be considered in drafting appropriate investment
regulations, and once drafted should be up-dated with changing circumstances.
A central weakness of current investment regulations is that they do
not adequately capture the two key investment risks which face life insurance
companies. These are the interest rate risk in conventional life insurance and
annuity contracts and the inflation risk in the long term saving component of
life insurance contracts, in particular those contracts concerned with retirement
provision. Both interest rate risk and inflation risk again can only be
determined by a joint consideration of the risk characteristics of the investment
and the financial characteristics of the life insurance company, i.e. in an
asset/liability framework. The relevant risk for a life insurance company in
respect of conventional life insurance and annuity contracts is the interest rate
risk, as there is an implicit interest rate guarantee in the contract pricing. This
risk cannot be captured easily through quantitative investment restrictions, but
can only be determined through an actuarial assessment of the assets and
liabilities positions of a particular company, using some form of duration or
immunisation technique. In respect of long term saving contracts, the risk here
is essentially one of maintaining purchasing power. There is a strong consumer
expectation, even when there is no contractual requirement, that the
investments purchased by the life insurance company from the savings of
policyholders will at least yield a positive real rate of return over the lifetime of
the contract. To hold index-linked bonds or a diversified portfolio of company
shares (whose returns can be expected to be correlated with the prices or
earnings) will therefore represent a low investment risk. But under ‘prudent438
man’ rules, investment in company shares are risky. Hence, there needs to be a
reconsideration of investment regulations to move away from the focus on
default risk and liquidity risk, since they can inhibit greater investment in
shares, even though they possess low inflation risk .
To define rules to capture the interest rate and inflation risk in
investment portfolios is a difficult exercise. In setting investment regulations,
it is important to allow sufficient flexibility so there is no implicit constraint on
the appropriate investment of life insurance funds, especially in the investment
in company shares. This is an analogous issue to the one discussed above on
currency matching and its impact on foreign investment.
3.6
Acceptance of financial derivatives
It is important that insurance regulatory authorities accept that
financial derivatives are now an integral part of investment policy. Financial
derivatives are essentially a particular type of financial asset. There is,
however, a legitimate regulatory concern with the use of derivatives, because
they are highly-geared investments and hence carry a higher risk/return
possibilities than conventional financial assets. The use of derivatives as a
means of hedging is now well recognised by supervisory authorities. The more
difficult problem facing regulators is the extent to which life insurance
companies can be allowed to be more active users of derivatives. It is difficult
for regulatory authorities to set external limits on the risk exposures for
derivatives within a regulatory framework. Since risk guidelines need to be set,
and since these guidelines cannot easily be quantified, the regulations must
perforce be somewhat conservative in nature.
4.
Conclusion
The investment regulations of life insurance companies are currently
going through a process of change, with a growing awareness of the need to
have general asset/liability frameworks to determine solvency standards. And
a particular issue that is prompting this change is the increased focus on capital
adequacy. Regulatory authorities across the OECD are currently looking into
the possibility of adopting risk-based capital systems, drawing on the
experience and lessons of the United States and Canada. The adoption of a
more coherent framework for assessing solvency and capital adequacy will
necessarily require a reappraisal of investment regulations. Some of the issues
raised in this paper might be considered in such a reappraisal.
439
Because of the complexity of setting up solvency systems based on
asset-liability models, including risk-based capital standards, the regulation of
life insurance is likely to move more towards a combined system of external
and internal controls. National governments will define the regulatory
framework within which life insurance companies must operate and will
delegate to the insurance companies some of the monitoring responsibility to
professionals within the companies, in particular to actuaries and accountants.
If regulatory frameworks can be set up which allow some internal auditing as a
part of the overall monitoring process, then it is more likely that the system can
be tailor-made and cost effective. Investment regulations will necessarily be
embodied within these more general solvency frameworks.
Moreover, there will also be pressure from international organisations,
including the World Trade Organisation, for greater international co-ordination
between supervisory authorities to create more level regulatory playing fields to
minimise competitive distortions and to ensure that there are adequate
regulatory standards, both regionally and globally. Hence one can envisage
agreed solvency frameworks gradually emerging, with a concomitant
convergence of investment regulations.
440
APPENDIX
In this Appendix a summary of the findings of a survey carried out in
1994 and 1995 which was designed by the author and administered by the
OECD. For more detail and discussion of the survey see Dickinson and
Dinenis ‘Investment Regulations of Insurance companies across the OECD’ in
“Policy Issues in Insurance: Investment, Taxation and Insolvency”, OECD,
Paris, 1996.
Before presenting these findings, it might help the reader in the
interpretation of the findings if a stylised balance sheet for a life insurance
company. This is given in Figure 1.
The balance sheet in Figure 1 does not follow a conventional balance
sheet structure. It has been designed for the purpose of assisting a clearer
understanding of the application of these investment regulation. The main
categories of the assets and liabilities are discussed below. The liabilities of an
insurance company are grouped under four main headings: technical provisions,
equalisation reserves, current liabilities and capital base. It is assumed that the
insurance company has no debt capital or bank borrowings The technical
provisions are the obligations which an insurance company has towards its
policyholders. Broadly speaking, they represent the present value of future
cash outflows flows to policyholders, weighted by a set of probabilities, in
particular probabilities associated with mortality and policy cancellation. These
contingent cash outflows are in respect of business that has already been
accepted by an insurance company and thus excludes possible future business;
offset against these cash outflows to policyholders are the contingent cash
inflows from the premiums to be received on this existing business.
Technical provisions (or mathematical reserves, a term sometimes
used in some European countries) can be calculated on a gross or a net basis. A
gross basis means that these liabilities to policyholders are valued without any
recognition of reinsurance that might have been purchased by the insurance
company. Net technical provisions are the gross technical provision less those
441
Fig 1
Stylised balance sheet of a
life insurance company
Total
investments
technical
provisions
represent the
present value of
future payments
to policyholders
for business on
the books less
the present
value of future
premiums
receivable on
this existing
business
Assets
Liabilities
Investments
held against
net technical
provisions
Net
technical
provisions
(policyholder
liabilities)
Gross
technical
provisions
Equalisation
reserves
Recoverables
from reinsurers
investments
held for
reinsurers or
Investments
held by
reinsurers
Current
liabilities
Investments
held against
capital base
Minimum
required capital
Current assets
Capital base
Free capital
Offices & other
fixed assets
amounts that are deemed to be recoverable from reinsurers. In other words, net
provisions are the obligations that an insurance company has towards its
policyholders, on the assumption that the reinsurers will fulfil their separate
contract with the insurance company to pay the losses that they have agreed to
share. In certain OECD countries, there has been a long-standing tradition for
regulation to require technical provisions to be valued on a gross basis.
442
Clearly, this is a conservative valuation basis, since it pre-supposes the worst
scenario, i.e. an insurance company will not be able to recover from its
reinsurers. This conservative valuation is predicated on a legal fact; if a
reinsurance company becomes insolvent, an insurance company is legally
required to fully indemnify its policyholders. The second major category is
equalisation reserves. In their financial character, equalisation reserves lies
between the technical provisions and the capital base. They exist because
future claims, particularly on classes of insurance business exposed to
catastrophes, can exceed those amounts set aside for technical provisions. The
third category is current liabilities; these represent a variety of short term
payables, such as taxes due and shareholder dividend declared but not paid.
The fourth and final item on the liabilities side of the balance sheet is
the capital base. The capital base is segmented here into two categories: the
minimum required capital (required margin of solvency) and the ‘free’ capital.
The minimum required capital is that stipulated to be maintained under national
insurance legislation. The ‘free’ capital is the capital base which is held in
excess of this minimum statutory level.
Assets show how the funds set aside to pay these liabilities have been
deployed and they are here divided into three main categories: fixed assets,
current assets and investments. Fixed assets represent the offices, computer
systems and other equipment required to operate an insurance enterprise.
Current assets represent a variety of receivables, a major part of which are
premium balances owed by agents, brokers and other intermediaries. The main
item on the asset side of the balance sheet are investment holdings, which
consist of a wide variety of securities. Investment holdings are presented here
not as they are conventionally in balance sheets, in terms of types of securities
held, viz. shares, bonds, loans, real estate etc. They are segmented in terms of
the liabilities against which they are earmarked. It should be stated that
insurance companies do not in practice allocate their investments in such a
segmented way. One item that requires particular explanation is ‘investments
held for reinsurers or investments held by reinsurers’. If the valuation of
technical provisions is on a net basis, i.e. the claim recoverables have been
excluded, then the premiums to pay for the reinsurance would invariably have
been paid out by an insurance company to its reinsurers for them to invest
themselves. For insurance companies that are required to value technical
provisions on a gross basis, there are two types of situation. One is where the
premiums that are owed to reinsurers do not leave the insurance company, but
are held and invested by the insurance company on behalf of the reinsurance
company, and drawn down to pay claims when necessary. The second is where
premiums for reinsurance are paid to the reinsurers, but the valuation of the
443
technical provisions is still carried at a gross basis. In this latter case, no
investments are held by the insurance company on behalf of the reinsurer; there
is simply an offsetting accounting item.
In Figure 1, the investments held against the capital base are
disaggregated into those held against the minimum required capital (required
margin of solvency) and those held against the ‘free’ capital. In practice,
insurance companies would not usually differentiate in the investment of their
capital funds in this way, unless there are regulations requiring them to do so.
But this split is made here to make the balance sheet representation as general
as possible, in order to cover those few cases where there are such regulations.
The absolute and relative size of these various balance sheet
categories will clearly depend on the how they are valued. Because of the long
duration of these policyholder liabilities, the valuation will be sensitive to the
rate of interest used in the present value calculations: the lower the rate, the
higher will be the value placed on these liabilities. If the interest rate is low
compared with a realistic expectation of the long term rate of return to be
earned, the more conservative will be the valuation. Similarly, investment
holdings which are measured at the lower of book or market value will produce
a more conservative valuation than if measured in terms of the end of year
market value. Moreover, it will be clear that since the capital base, especially
the ‘free’ capital, of an insurance company is the residual between the value of
total assets and value of the three other categories of liabilities in the balance
sheet, its value will be particularly sensitive to the valuation basis used. These
differences in valuation can have a significant impact on how particular
investment regulations are applied in practice.
NOTES
1.
This analysis presupposes that international purchasing power parity does
not negate these currency risks
2.
The liquidity risk of a financial asset arises from: (a) its price is potentially
volatile over time, and/or (b) there is no adequate secondary market in
which it can be bought and sold.
444
SELECTED BIBLIOGRAPHY
BISHOP, M., J. KAY and C. MAYER (1995), The Regulatory Challenge,
Clarendon Press , Oxford.
DAVIS, E. P. ( 1995), Pension Funds, Retirement Income Security and Capital
Markets: an International Perspective. Clarendon Press , Oxford.
DICKINSON , G.M. (1993), “The regulation of investment policies of
insurance companies in the OECD: an overview” in Policy Issues in
Insurance. OECD, Paris
DICKINSON, G.M. and DINENIS, E. (1996), “Investment Regulations of
Insurance companies across the OECD” in Policy Issues in Insurance:
Investment, Taxation and Insolvency. OECD, Paris.
DICKINSON, G.M. (1997), “Some Issues in Risk-Based Capital”, The Geneva
Papers on Risk and Insurance. no. 82, Jan
European Bank for Reconstruction and Development (1996), “Mobilising
household savings: life insurance and pension funds” in Transitional
Report 1996: Infrastructure and Savings. London.
SKIPPER, H.D. (1993), “Insurer solvency regulation in the United States” in
Policy Issues in Insurance. OECD, Paris
SMINK, M. and VAN DER MEER, R.A.H. (1997), “Life Insurance AssetLiability Management: an International Survey”, The Geneva Papers on
Risk and Insurance. no. 82, Jan
445
Part IV (continued)
THE REGULATORY AND SUPERVISORY ENVIRONMENT AND
RISK MANAGEMENT
C. INVESTMENT COMPANIES
447
Chapter XX
REGULATION AND SUPERVISION OF INVESTMENT FUNDS IN
THE NEW FINANCIAL LANDSCAPE - A CANADIAN PERSPECTIVE
by
Glorianne Stromberg*1
Introduction
The purpose of the paper is i) to provide some information about the
review of the Canadian investment fund industry that has been underway since
1994, ii) to focus on some of the key factors that are impacting the regulation
and supervision of investment funds, and iii) to suggest some approaches to
regulatory and supervisory strategies that might be considered to deal with
investment funds in the new financial landscape.
1.
The Stromberg Report - A review of the investment fund industry
in Canada
In 1994 the Ontario Securities Commission commissioned a review of
the investment fund industry in Canada for the benefit of all of the securities
regulators in Canada. This review was prompted by the rapid growth of the
mutual fund industry2 and the fact that it had been at least 25 years since the last
3
major review of this industry had been undertaken.
The main reason for the review was to be sure that regulation was
keeping pace with changes in the marketplace, to identify any changes that were
needed to align industry interests with those of investors, and to respond to
industry vulnerabilities. In particular, recommendations were requested on the
role of self-regulatory organisations and on how the systems and procedures of
*
Glorianne Stromberg is a Commissioner of the Ontario Securities Commission.
449
the Canadian Securities Administrators4 could be structured for more effective
and efficient regulation of investment funds.
In view of the importance of the investment fund industry to Canada
and the investing public, industry leaders, as well as regulators, recognised that
it was appropriate to review practices and refocus on objectives. Early in the
process, the industry recognised that the results of the review would be largely
dependent upon the quality of the industry’s input into it. As a result, people
made a real commitment in time and resources to participate in the review. The
review served as a catalyst for industry participants to focus on what was
happening in the industry, what the concerns were and how they could be
meaningfully addressed.
Industry participants were and are proud of the fact that the industry
has grown to the size it has without there being any major problems. They
recognised and continue to recognise the importance of ensuring that the
public’s expectations are and continue to be met. Industry participants stressed
and continue to stress the importance of there being the right regulatory
environment designed to support the integrity and trust upon which the industry
is founded but freed of impediments such as inter-provincial or national barriers
that make it difficult and costly for the industry to develop and function on a
national basis or globally. They were mindful of the potential benefits that
could flow to Canada by encouraging the development of a Canadian-based
investment fund service industry that has access to and is supported by the
technological infrastructure necessary to provide services not only to Canadianbased operations but also to global ones. To encourage and sustain this
development in Canada, they advised that there is a need for Canada to provide
highly-trained people and a competitive tax and regulatory environment.
The review that was undertaken culminated in a report (commonly
referred to as the “Stromberg Report”) issued 31 January 1995 entitled
Regulatory Strategies for the Mid-90s - Recommendations for Regulating
5
Investment Funds in Canada. The Briefing Notes which were issued with the
Stromberg Report highlight i) the major strategic forces affecting the
investment funds industry in Canada, ii) what is happening in the industry as a
result of pressures brought to bear on investment fund managers, changing
consumer attitudes, and the competition for consumer savings, iii) the major
factors contributing to the widely-held view that changes in the securities
regulatory system are needed to serve the needs of the marketplace better,
iv) the major areas that present regulatory challenges, and v) the proposals that
were made for a new regulatory framework.
450
The Stromberg Report generated a lot of discussion and a lot of
activity. Innumerable committees were established by various firms and
organisations to consider the recommendations. A key group was the
Investment Funds Steering Group, a joint industry-regulatory group appointed
under the auspices of the Canadian Securities Administrators, that in turn
established several working committees to consider the recommendations. In
6
November, 1996, the Investment Funds Steering Group issued its report which
in effect validated the findings contained in the Stromberg Report, endorsed the
core strategic recommendations that were made for dealing with the identified
challenges and made recommendations for actions to implement the strategic
recommendations. In many cases the recommendations coincided with those
contained in the Stromberg Report; in other cases they did not.
The Stromberg Report has been broadly distributed throughout the
world and it is receiving considerable attention in various countries where
comparable regulatory challenges exist.
Most importantly, the Stromberg Report has caught the attention of
individual Canadians and has made them aware of issues that impact their wellbeing and what they should expect from the investment fund industry and its
regulators. The impact of this increasing knowledge and awareness of
individual consumer/investors is being felt by fund managers and by fund
distributors alike and can be expected ultimately to have an impact on how the
industry is regulated.
1.1
Areas of concern
The major areas of concern identified in the Stromberg Report relate
to: i) how investment funds are structured, ii) how they are sold, iii) the
inherent conflicts of interest with respect to both the structuring of investment
funds and the distribution of their securities that often result in the interests of
the consumer/investor not being placed first, iv) the adequacy of the proficiency
and training of some of the people who sell investment funds and of some of
the people who manage funds, v) the adequacy of the resources (human,
technical and financial) of some industry participants to carry on the activities
that they carry on, vi) conflicts of interest with respect to the management of the
investment portfolio, vii) the fact that many investors seem to have an imperfect
understanding of investment issues, viii) the fact that the disclosure system in
place in Canada is ineffective in actually informing investors of material
information they need in order to make a reasoned investment decision and is
perceived by many in the industry (as well as by investors) as being irrelevant
451
to them, ix) the fact that there is a lack of comparability about investment
products both of the same type and with their functional equivalents,7 and x) the
fact that the securities regulatory regime in Canada is cumbersome and costly to
comply with and lacks the resources to monitor compliance with its
requirements or to respond in a timely manner to the changing marketplace.
1.2
The perspective underlying the Stromberg Report recommendations
In view of the key strategic forces driving the growth of the
8
investment fund industry, the growing awareness of individual Canadians that
they must take charge of providing for their own retirement, and the resulting
competition that there is for the right to provide for the needs of these
individuals, the recommendations made in the Stromberg Report reflect the
underlying perspective that:
− what is good for the investor is good for the industry and will
foster efficient and effective capital markets;
− the industry includes all aspects of money management;
− the foundations of the industry are integrity and trust;
− because there is frequently a lack of knowledge and a lack of
bargaining power on the part of many investors, the concept of
“buyer beware” cannot by itself be permitted to govern the
activities that result in individuals investing their money in
investment funds; there is a need, in this situation, to have regard
for the interests of investors by ensuring that the system operates
fairly and openly;
− there is a need to increase the knowledge and awareness of
investors and to ensure that investors have timely, meaningful and
relevant information to assist them in making their investment
decisions and in monitoring the same;
− the line between selling and advising has substantially
disappeared and there is a need to increase the proficiency and
training of the persons dealing with the public to enable them
better to serve the needs of investors;
− there is a need for better regulation rather than for more
regulation;
452
− within this environment, the regulatory strategy should be to
allow competitive forces to operate with minimal intervention.
It is this perspective that has generated the attention of investors in
Canada and has struck responsive chords globally.
1.3
Strategic recommendations
Given the nature of the concerns identified in the Stromberg Report in
connection with the current state of the Canadian investment fund industry, it is
not surprising that the recommendations made in the Stromberg Report to
address the problems centre around two core concepts - “fairness and
integrity” and “information and knowledge”. The recommendations
contemplate a strong self-regulatory role for the industry that is supported by a
strong regulatory structure that is founded on these core concepts. The
recommendations were intended to encourage and assist the industry and its
regulators in addressing the areas of concern proactively and, in doing so, to
continue to meet the public’s expectations and to merit the public’s confidence.
The framework for the recommendations is based upon proposals for:
− centralised, co-ordinated, streamlined, functional regulation; this
would include provisions for:
a) simplifying the regulatory structure by combining provincial
resources to create a single centralised unit to regulate
investment funds;
b) establishing a Joint Regulatory Co-ordination Group
consisting of representatives of the Canadian banking, trust,
loan, insurance, pension and securities regulators (including
the self-regulatory organisations and the customer protection
organisations) to provide a co-ordinating mechanism among
the member regulators to ensure that there are no regulatory
gaps arising from i) deregulation of the financial services
industry, ii) the entry of new industry participants into the
marketplace, and iii) the multiplicity of regulators having
jurisdiction over various aspects of the business of the various
participants in the industry; another function of this Group
would be to provide a similar co-ordinating mechanism with
their international counterparts;
453
c) treating all types of arrangements whereby money is managed
on a collective basis, directly or indirectly, for individuals as
“investment funds” and bringing all such arrangements under a
common regulatory structure; what is contemplated by this
recommendation is a regime that would build specific
requirements for specific types of investment funds on a
uniform base of core principles (e.g. good faith requirements)
that would be applicable to all investment funds regardless of
what kind they were or who was offering or sponsoring them;9
− strong, effective self-regulation by the industry in respect of the
management and distribution of investment funds based on:
i) high ethical standards, ii) fair practice and business conduct
rules, iii) effective and efficient internal and external systems,
controls and procedures, and iv) pro-active and timely monitoring;
a) in this respect, the framework contemplates that a single,
strong, effective self-regulatory organisation would be
established that would operate on a national basis and in
which membership would be mandatory for everyone who
sells securities (including mutual fund securities);10
b) the framework also contemplates that managers of investment
funds would continue to be regulated by the securities
regulator directly through registration with the securities
regulator, with conditions of registration being attached
designed to provide for the above-mentioned high ethical
standards, rules, systems, controls and procedures and for
monitoring compliance therewith through a system of selfassessment review procedures comparable to those presently
required of financial institutions in respect of deposits covered
by deposit insurance;11
− improved corporate governance provisions
investment funds including:
in
respect
of
a) the enactment of an investment funds statute to provide a
common statutory framework for the constitution and
governance of investment funds, the need for which under
Canadian law is discussed in Section 18 of the Stromberg
Report;
454
b) provision for independent boards at the management level and
at the fund level;
c)
improved oversight provisions through enhancing human,
technical and financial resources to ensure the adequacy
thereof for the functions carried out;
d) codes of ethics and business conduct;
e)
proposals for dealing with conflicts of interest including those
arising from the desire i) to engage in principal trading with a
related party, ii) to deal in securities of or guaranteed by a
related party including securitisations and mortgages sourced
by a related party, iii) to participate in related party
underwritings, iv) to execute portfolio transactions through an
affiliate of the investment fund manager or portfolio adviser,
v) to execute portfolio transactions through persons (or their
related parties) who distribute securities of the investment
fund (i.e. reciprocal trading); vi) to engage in inter-fund
trading, vii) to create certain fund of fund structures, and viii)
to engage in certain soft dollar transactions;12
− increased emphasis on educational and proficiency requirements
for industry participants aimed at providing industry participants
with:
a) better training and proficiency skills;
b) better awareness of ethical standards, fair practice and
business conduct rules;
c)
better ability to meet client needs and expectations;
− increased emphasis on the importance of investor education aimed
at improving the ability of investors to:
a) identify, request, review and understand the information
needed to assess investment recommendations made to them;
b) apply the information to their own situation in making
investment decisions;
c)
identify, request and review in a meaningful manner the
information needed to monitor their investments on a
continuing basis and assess whether adjustments are needed;
455
− realignment of the elements of the disclosure system aimed at:
a) integrating primary and secondary disclosure requirements;
b) improving disclosure requirements to ensure that the
information is timely, meaningful and relevant;
c)
ensuring that disclosure is integrated and continuing;
− establishment of a basis for achieving comparability of
performance information about different investment products and
between investment products of the same type; this proposal
contemplates:
a) the development of uniform rules respecting the calculation
and use of performance information that would be required to
be universally used by all industry participants with respect to
performance information that such industry participants may
choose to give to or in respect of all types of managed
accounts;
b) that it would be desirable (and probably essential) that
international standards be developed in this respect;13
this need for comparability is an important component of the
disclosure proposals contained in the Stromberg Report.
The last four recommendations are integral to each other and to the
efficacy of the continued reliance by governments and regulators on the
adequacy of disclosure as an appropriate strategy on which to base the future
well-being of consumer/investors. To continue to rely on this strategy
necessitates finding a better way to make sure that information that is timely,
meaningful, and relevant to investors is communicated “in plain English” to
them in a way that a reasonable person acting reasonably should be able to
understand. It is submitted that information that has neither been communicated
to nor understood by an investor cannot be considered to have been disclosed to
the investor.
This strategy of disclosure is based upon the assumption that the
investor has the knowledge and awareness to understand the significance of the
information provided (or not provided) to the investor and to apply it to the
investor’s own circumstances. It also presupposes that industry participants and
regulators have a comparable level of knowledge and awareness to understand
the significance of the information that is provided (or not provided) in order
456
for them respectively to carry out their responsibilities to investors adequately.
Accordingly, increasing the knowledge and awareness on the part of industry
participants, investors and regulators alike is an integral part of the process of
achieving effective disclosure.
The need to increase knowledge and awareness goes beyond the fact
of asymmetrical information flows in the marketplace. It goes to the
fundamental ability of the consumer/investor to assume responsibility for his or
her own well-being, whether acting directly or through an intermediary.
Effective access to information and the ability to use it levels the playing field
and enables the adoption of a regulatory and supervisory structure that allows
competitive market forces to operate with minimal intervention.
The balance of the recommended strategies are structural in nature
and/or go to the fundamental integrity of the investment fund product. All of
the strategies are based on investing in solutions rather than paying for
problems. They are based on “getting it right” in the first place. This is a wellproven strategy in the marketplace that leads to the enhancement of one’s
competitive position.
2.
The changing face of the institutional investor
From the regulatory and supervisory perspective, it is essential that
the changing face of the institutional investor be recognised.
Traditionally, the institutional investor has been exempt from the
application, and the benefit, of various provisions of securities legislation on
the theory that the institutional investor is able to look out for its own interests.
This approach was reflective of an era when the institutional investor
generally was a financial institution (such as a bank, trust company, loan
company, insurance company) or a defined benefit pension fund or endowment
fund investing money for its own account. Regulation and supervision of such
institutional investors was primarily focused on solvency issues and prudential
regulation aimed at ensuring that such institutions would be able to meet their
respective obligations to depositors, policyholders, plan participants and
beneficiaries as the case may be. Investor protection was not part of the
regulatory or supervisory focus for such institutions.
In the current Canadian financial landscape, the face of the
institutional investor has changed. This is partly as a result of the deregulation
457
of the financial services industry that began in 1987 when restrictions on the
nature of the activities in which regulated financial institutions could engage
were substantially eliminated thereby, enabling them to expand their money
management and other business activities substantially.
While there are still major institutional investors who are managing
money for their own account, an increasing number of institutional investors
are managing money in a representational capacity rather than for their own
account. The fact that such institutional investors in doing so have discretionary
authority (whether limited or unlimited) does not change the fact that these
institutional investors are managers of other people’s money and that their
authorisation to continue to manage such money may be terminated on
relatively short notice or, in some cases, no notice.
The increasing representational role of the institutional investor is
seen not only in the case of the traditional “financial institutions” but also in the
case of pension plans which are increasingly being structured as defined
contribution plans instead of defined benefit plans. In the case of pension
plans, one of the implications that flows from the shift from the use of defined
benefit plans to the use of defined contribution plans to provide retirement
benefits is that the money held in defined contribution plans is being managed
in a representational capacity for the direct benefit of the plan participants
whose rights to the accumulated assets held for their respective accounts are
fully vested in them. This is in contrast to the ownership interest that the plan
sponsor of a defined benefits plan has in the assets held in the defined benefit
plan where the investment performance of such assets directly impacts on the
plan sponsor’s funding obligations and its liability for any benefits’ shortfall.
Although mutual funds (which are separate legal entities formed at the
instance of a mutual fund management organisation as a vehicle to enable
individual investors to pool their money for investment purposes) are
sometimes described as being “financial institutions” it should be kept in mind
that in Canada there is no statutory basis for their constitution and governance
as a “financial institution” and that the assets of a mutual fund are invested in a
representational capacity for investors who are entitled, usually on a daily basis,
to demand repayment of their interest in the mutual fund at the net asset value
thereof.
The purpose of focusing on the distinction between the management
of money by an institutional investor for its own account and the management
of other people’s money is to highlight the need to recognise the increasing
“retailisation” of the institutional investor and to recognise the resulting
458
increasing “retailisation” of the marketplace when considering what regulatory
and supervisory policies are appropriate for institutional investors.
This “retailisation” is occurring not just as a result of the expanded
powers of financial institutions but as a result of the convergence of several
factors including: i) the increased awareness of individual investors of the need
to move beyond savings accounts and life insurance to provide for their wellbeing, ii) the ease with which individual investors are able to invest not only in
Canada but throughout the world as a result of new and improved technology
and communication facilities, and iii) the increasingly global and free market
perspectives underlying governmental policies.
The characterisation of the marketplace as a “retailised” marketplace
contrasts with the usual characterisation of the marketplace as being
“increasingly institutionalised”. What is becoming evident is that the lines
between the “retail investor” and the “institutional investor” are increasingly
blurring and the basis for distinguishing regulatory strategies on whether the
investor is a “retail investor” or is an “institutional investor” is eroding.
From the regulatory and supervisory perspective, the fact of whether
an individual holds his, her or its investment interest in underlying securities
directly or through some sort of collective investment vehicle, should make
little difference. This is particularly important when viewed in conjunction
with the secular shift of household assets from savings and life insurance
products to investments that has occurred and is continuing. The individual
consumer/investor now has a direct ownership interest in his or her investments
that fluctuates according to the market value thereof as opposed to simply
having a contractual right to receive an agreed-upon payment or payments at a
stipulated time or times. The individual consumer/investor who holds his or
her investments either directly or through some sort of collective investment
vehicle is in direct competition with the institutional investor who invests for
its own account. In this environment the need for equality of regulatory
treatment takes on a greater dimension. It is important that the regulatory and
supervisory structure not favour the institutional investor over the individual
consumer/investor who is traditionally referred to as the “retail investor”.
3.
The needs of the consumer/investor and the implications flowing
therefrom
Before turning to a discussion of possible regulatory strategies, it
would be useful to consider the needs in the new financial landscape of the
459
consumer/investor, (a term whose bottom-line meaning ultimately describes us
all), and the implications that flow from such needs.
Apart from the relatively few people in the world for whom wealth
accumulation is not an issue, most people have realised that they have to do
something more - both individually and collectively - to assure their future
well-being. The reality is that most people are poorly equipped to do so. Lured
by the double digit returns offered by mutual funds and stock market indices,
people have turned away from deposit instruments to mutual funds and have
become “investors” rather than “savers”. However, many people have done so
without comprehending the difference between being an “investor” and being a
“creditor” of a regulated financial institution that is backed by governmental
safety nets. Many people do not have any comprehension of risk and do not
have any idea of how to manage risk. Many people do not appreciate that there
is risk inherent in being too conservative in managing their affairs.
Something needs to be done about this. The efforts that are made to
remedy this situation need to be supported by the educational system, by
employment and labour laws, by tax laws and by securities laws. This support
needs to be co-ordinated and to be complementary across the legal and
regulatory system. People’s rights and opportunities should not be permitted to
depend on where they live. Their rights and opportunities should not be
permitted to be lost in regulatory gaps or to be tied up with needless and costly
bureaucracies or institutional power struggles for the right to provide for their
needs.
Too many people have emerged from the school system inadequately
equipped with basic life skills to enable them to identify their needs, to identify
the means to achieve them and to evaluate whether the choices they have made
are meeting their needs. Many people are unable to read beyond an elementary
level and their numerical skills lag their literacy skills. People are vulnerable to
being sold a “get rich quick” scheme without truly understanding what they
have bought, its suitability for their needs, or the “fine print” that negatively
impacts on them. People tend to ignore what they do not understand particularly if it is intangible. People often spend more time comparison
shopping for a TV set or planning their vacations than they do planning and
managing their affairs to meet their current and future financial needs or
choosing a consultant to help them do so.
While the foregoing comments are based on the Canadian
environment, some aspects to some extent may reflect a comparable situation in
other countries.
460
The need to do something about this rather bleak situation is
beginning to be recognised by people in their individual capacities as
consumer/investors as well as by others who are responsible for the strategic
development of business plans, governmental policy and educational and
training programs.
The identification of the need of the consumer/investor to adopt sound
personal financial management practices and the recognition that most
consumer/investors because of their lack of personal financial expertise will
need to turn to someone for advice, has created vast business opportunities for
those in the financial services sector to convert personal financial management
know-how into an economic good that adds value to the customer and for
which there is a market. This conversion has highlighted the importance of the
need for increasing the knowledge and awareness of industry participants who
seek to provide this personal financial management know-how. In fact, the
survival of these industry participants as intermediaries is directly dependent on
their ability to do so.
Here, the competition is not just from other intermediaries. The
competition also comes from the incredibly powerful tools that technology and
communications facilities have made readily available to the consumer/investor
at nominal cost. In fact, surveys indicate that many people in their home
environment have access to better state-of-the-art services than are generally
available in the workplace.
The impact of technology on personal financial planning cannot be
overestimated. For the first time in the history of the investment funds
industry, the consumer/investor has access to information and knowledge that
was once the preserve of only the most expert investment professionals. These
tools and facilities empower the consumer/investor not only to identify his or
her own needs but to compare alternatives and, in the case of investments, to
customise his or her own portfolio, to monitor its performance, and to bring it
into line when necessary. The usefulness and versatility of, and the access to,
these tools increases almost daily.
The four-pillar structure of the financial services industry that existed
before the 1987 deregulation of the financial services industry fragmented client
finances among the four categories of players (namely, banks, trust companies,
insurance companies and dealers in securities) with there being a separate
regulatory structure for each category of player and with each category of player
vying for a larger portion of the client’s business.
461
This fragmented structure resulted in both a product-category bias and
a firm-product bias in favour of the firm and created the product-driven
business paradigm that continues to this day notwithstanding the 1987
deregulation of financial services. Apart from any other inadequacy of a
product-driven business paradigm, what such a paradigm ignores is the reality
that clients have integrated financial needs.
When one focuses on the integrated financial needs of the
consumer/investor, it becomes clear that a business or regulatory paradigm that
is not driven by the integrated financial needs of the consumer/investor will fall
short of both public and private expectations and needs.
It also becomes clear that the current regulatory and supervisory
framework may not be serving the consumer/investor as effectively as it should
be for two reasons:
a) the continued differentiation between retail investors and
institutional investors that sometimes operates at cross-purposes
given the increased retailisation of the institutional investor; and
b) the fact that notwithstanding the deregulation of the financial
services industry that began in 1987, the current regulatory
framework has continued to segment the financial services sector
along the product lines that were conventionally provided by each
of the so-called “four pillars” with there being a separate
regulatory structure for each regardless of the fact that each pillar
is now able to deal, directly or indirectly, in all products and
14
provide all services.
4.
Implications for the regulatory and supervisory framework
Globalisation, deregulation, information technology, communications
facilities, and the strengthening of the free market economic system - all of
which are enabling forces - have converged to empower not only institutions
but individuals. This has significant implications for the regulatory and
supervisory framework not the least of which is how to provide for investor
protection and market integrity in a marketplace that for all practical purposes
has become global.
Investors are becoming increasingly intolerant of what they perceive
to be regulatory barriers, maintenance of monopolies, unequal treatment and
regulatory inefficiency. At the same time, investors want a regulatory structure
462
that assures fairness, equality of opportunity, integrity of the people and firms
who are registered to provide advice and investment services to others, integrity
of the product and service provided, effective oversight and monitoring of
activities, and speedy action to deal with problems and to keep them from reoccurring.
Two factors that present major challenges to the structure of the
marketplace and to the regulatory response thereto relate to conflicts of interest
15
and to what is described as “market fragmentation”. These factors converge
into the fundamental issue of whether an intermediary can be on both the buy
side and the sell side of the same matter. An example where this occurs is the
situation where an institution underwrites, either directly or through affiliates,
the issue of securities and then exercises discretionary authority to place such
16
securities in its managed accounts. Another example where this question
occurs relates to situations where an institution, either directly or through
affiliates, engages in principal trading with its managed accounts either directly
or through the order flow.
Although these are major issues for institutional investors (and indeed
for all investors) in the new financial landscape, they are not discussed in this
paper due to time constraints. Presumably these issues will be discussed both
in other papers and at the Meeting.
Another challenge to the structure of the marketplace and to the
regulatory response thereto relates to the need to decipher when the voice of the
institutional investor is the voice of hundreds and thousands of individual
investors calling for needed market and regulatory reform and when it is the
voice of institutional self-interest that is not aligned with the interests of
individual consumer/investors, some of whom may be their clients.
5.
Suggested approaches to regulatory and supervisory strategies
It is submitted that the regulatory strategies and the recommendations
to implement such strategies outlined in the Stromberg Report (and highlighted
in Section 1.3 of this paper) provide directional guidance as to approaches that
should serve the needs of investment funds (as well as other institutional
investors) and the investors they represent in the new financial landscape on
both a national and, with some modifications, on an international basis.
Some additional observations and suggestions are made to take into
account the clearer trends that have emerged in the last two to three years as a
463
result of the increased globalisation of the marketplace, the information and
other technological advances that have been made, the expansion of
communications facilities and the increasing knowledge and awareness of
participants in the marketplace. As well, some questions are posed with a view
to stimulating consideration of alternative structures and strategies.
5.1
Regulatory structure
Given the expanded business activities and the diversified
geographical operations of today’s participants in the financial services sector,
there seems to be an even greater need to find a way to bring about centralised,
co-ordinated, streamlined and functional regulation. The continued maintenance
of a segmented regulatory structure based either on i) the fragmented “four
pillar” structure of the financial services industry that existed prior to the 1987
deregulation or ii) on the fragmented provincial (and national) boundaries, is
becoming increasingly unrealistic. Detailed regulation needs to give way to
systemic changes that can and will operate on a universal basis in each
jurisdiction. In identifying these systemic changes, perhaps a threshold
question that needs to be addressed is how can regulation be made relevant to
today’s marketplace? Have regulators become largely irrelevant to the process?
Is their relevancy more appropriately confined to enforcement actions taken in
their respective jurisdictions for “fraud on the market” type activities?
Consistent with the need to de-fragment the regulatory structure, is
the need to give high priority to bringing all aspects of money management for
others under a common regulatory structure. This arguably goes beyond the
recommendation in the Stromberg Report which referred only to arrangements
whereby money is managed on a collective basis, directly or indirectly, for
individuals. However, technological advances have now made it economically
feasible to permit customised investment portfolios to be maintained on an
individual basis for relatively small amounts that until a short time ago would
not have been economically feasible to manage except in some sort of
collective investment vehicle. This makes it desirable to provide a uniform
regime for all aspects of money management as the consumer/investor is
seldom able to appreciate the legal and regulatory differences that flow from the
different types of investment participation.
It is probably time to take a fresh look at the efficacy of the selfregulatory component of the securities regulatory regime. Is there too much
“self” in “self-regulation”? Would the regulatory system work more effectively
if the focus changed from “self-regulation” to “self-management” of regulatory
464
requirements? Are some self-regulatory organisations such as stock exchanges
with their electronic trading systems now in direct competition with the market
participants that they regulate? Should there be a separation of member
regulation activities, market regulation activities and industry trade association
or advocacy activities? Is the public interest served by having a multitude of
self-regulatory organisations for each “pillar” of the industry and/or for each
product sold by members of that pillar?
International regulatory co-operation
The technology that exists today that has effectively eliminated time
and distance to create a borderless world in terms of virtual reality has made it
even more important to co-ordinate the cross-border regulatory activities in
what people still think of being the “real world”. Common, practical approaches
to the use of facilities such as the Internet need to be developed. These
approaches need to reflect the reality of the marketplace.
Efforts to improve and simplify international regulatory co-operation
need to be encouraged at every level. The work of the International
Organisation of Securities Commissions (“IOSCO”) has been an important
catalyst in this respect.
IOSCO’s work in the investment fund area which resulted in the
adoption of principles of regulation for collective investment vehicles as a
preliminary step to creating an “IOSCO passport” is of particular interest in the
present context. Perhaps it is time to renew the efforts to create an effective
IOSCO passport and to define the parameters of its use. For instance, should
nationals of one country be able to invest in investment funds domiciled in
another country if the investment fund meets the IOSCO criteria? Free trade
agreements, tax treaties, on-line interactive communications facilities and other
kinds of technology make ideas such as these more feasible to pursue. If this
type of investment were to be permitted, it would be necessary to consider what
changes (in addition to changes in securities laws) would be necessary in other
applicable laws to provide adequate remedies in the event of the need to pursue
such remedies.
While the idea of a supra-national securities regulatory regime has
appeal, it is probably premature to concentrate resources on trying to establish
such a regulator. Instead, it might be more productive and effective to
concentrate efforts on extending international regulatory co-operation efforts
beyond compliance and enforcement activities to include developing protocols
465
for mutual reliance by regulators in one country on work done by regulators in
another country. The development of international mutual reliance, compliance
and enforcement protocols, combined with establishing joint regulatory coordination groups as advocated by the Tri-Partite Group of securities, banking
and insurance regulators (of which IOSCO is a member), and supporting the
work of IOSCO should go a long way to creating international standards and to
meeting the needs of the marketplace. Complementary activities would include
entering into reciprocity agreements to take regulatory action or enforce
judgements in the “home office” jurisdiction for breaches of applicable laws in
other jurisdictions. This is an extremely complex area that various IOSCO
Working Groups have been working on for some time.
It is noted that it is often easier to agree on the adoption of uniform
standards than it is to agree on ceding jurisdiction. Common standards of
universal application should go a long way towards facilitating cross-border
activities and minimising the need for regulatory constraints. The importance of
creating international standards cannot be over-estimated.
5.2
Regulatory system
As noted in the first paragraph of section 6, globalisation,
deregulation, information technology, communications facilities, and the
strengthening of the free market economic system - all of which are enabling
forces - have converged to empower not only institutions but individuals. This
has significant implications for the regulatory and supervisory framework.
Consideration of an issuer-based disclosure model
The most fundamental implication is the need to consider whether
there is a more effective system for securities regulation than the current
“closed system” that is in place in various countries including Canada and the
17
United States.
When one combines the above-mentioned forces with the increasing
knowledge and awareness of individuals and the resulting trend towards
disintermediation, the time seems to have arrived to consider whether the
“closed system” of securities regulation should be replaced with an issuer-based
18
disclosure model. This model would focus on ensuring that at the time of
entry into the marketplace, full, true and plain disclosure of the material facts
466
respecting an issuer and its securities is made and that this information is kept
current through continuous disclosure requirements designed for this purpose.
With the technology and communications facilities that now exist,
there is no longer any need to rely on intermediaries such as investment dealers
and advisers to disseminate this information to the marketplace or to structure
the regulatory system so that they have first access to it. This information can
and should be directly and publicly available through the Internet (or other
universally accessible communications facility) from issuers and regulators at
no cost as well as obtainable through intermediaries.
A key component to moving towards an issuer-based disclosure
model is to ensure that there are appropriate civil statutory remedies for
misrepresentations. A companion requirement is to provide for international
reciprocity in respect of the enforcement of judgements.
The suggestions for an issuer-based disclosure model are based on the
belief that information is a major equalising force. Access to it in an open and
timely manner is a crucial ingredient to levelling the playing field. It is a
valuable commodity. Systems that are designed or are permitted to operate in a
way that withhold the timely dissemination of material information result in
fundamental unfairness to the marketplace as a whole. With today’s technology
and communications systems that provide ready access to all, there is no reason
why individual investors should be put at an informational disadvantage to
institutional investors in terms of access to the information.
Interesting developments in the marketplace are occurring that make it
practical for the first time in history for the regulatory system to provide for
equality of access to information and there is increasing pressure from vocal
individual investors to be allowed such access.
Examples of what is happening in this area include the opening of
“analyst calls” to individual investors who are able to listen in on issuers’ calls
with research analysts and key institutional investors on both a real-time and
deferred time basis. Another example is the ability to attend shareholder
meetings via Internet access on both a real-time and deferred time basis. An
example of this is the Annual Shareholders Meeting of BCE Inc. held earlier
this year which enabled shareholders who were unable to be physically present
at the meeting to “be present” through the use of Internet facilities that enabled
them both to hear and see what was transpiring at the annual meeting as it
occurred. Shareholders who were not able to “attend” in real time were able to
access the proceedings on a deferred-time basis. It is not unreasonable to
467
expect this facility to be extended to allow “distant” shareholders to ask
questions at the meeting in the same manner as those who are physically
present at the meeting are able to. Yet another example is the growing practice
of issuers to give advance notice of when earnings or other announcements are
to be made and to provide telephone or Internet access information to enable
the public to hear first-hand and on a real-time basis the information that is
being released.
The application of improvements in technology and communications
facilities brings a whole different dimension to the ability to make timely,
meaningful and relevant disclosure to investors of the material facts (and of the
changes in the material facts) that they need in order to make reasoned
investment decisions both initially and on a continuing basis. Yet all of our
regulatory efforts at reform in this area are still focused on the “paper world”
with arguments over whether one should have to use “plain English” and what
information should be permitted to be kept hidden in regulatory or issuer files
rather than provided to investors. It is submitted that we need to use the tools
that are now readily available to bring about, or at least to increase the
likelihood of bringing about, effective disclosure which is defined as timely,
meaningful and relevant information that has been communicated to investors
and is understood by them or at least is capable of being understood by
investors who are reasonable persons acting reasonably.
It is acknowledged that there will always be situations of unequal
knowledge and of information asymmetry but at least the facts would be
available for all to have access to equally. Whether people choose to use the
information and what their individual capabilities are to evaluate the
information they have will depend on the respective abilities of the individuals
involved. The important thing is that the choice of whether to use the
information or to get help from an intermediary if need be to understand it is
theirs to make.
Competency standards - Education, training and proficiency
Competency is the catalyst needed to make effective use of
information. This is why the Stromberg Report places such emphasis on the
need to enhance the knowledge and awareness of investors, industry
participants and regulators alike.
Competency can be defined as the skills required to put knowledge to
work to achieve a result. Educators have a crucial role to play in this
468
environment. They bear the first line of responsibility in ensuring that
educational programs (starting in kindergarten) equip individuals with the basic
life skills that are needed to participate meaningfully in their own personal
financial planning including the ability to understand information that is
communicated to them.
It is submitted that a key role for regulators is to be more pro-active in
identifying and setting competency standards for participants in the
intermediation process. This is an area that regulators in Canada (and perhaps
elsewhere) seem to be uncomfortable with and too ready to give away.
If we want a free market system, freed of as many regulatory
constraints as possible, it is submitted that there is a need to stand back from
the detail of the regulation and concentrate on more systemic changes such as
those noted above in relation to structuring the regulatory system in a manner
designed to provide timely, continuous disclosure of information with equality
of access thereto, and to require participants in the intermediation process to
meet appropriate competency standards.
In setting competency standards, there is a need to focus on the fact
that people have integrated financial needs. Accordingly, education and
training that focuses only on firm and/or product-oriented training will fall
short of the competencies needed to meet such needs.
In structuring educational programs designed to train people in the
competency skills they need, a lot of thought needs to be given to incorporating
values-based learning aimed at building commonly-shared high ethical
standards that justify and sustain the consumer/investor’s trust in and reliance
on the integrity of the participants in the intermediation process.
5.3
Expanding public access to the Internet
There is a need to explore ways of increasing the public’s access to
the disclosure information that is filed with securities authorities. As the use of
technology increases, it is desirable to consider ways to ensure that every
segment of the community is able to access the information in the marketplace.
While the number of people with direct access to the Internet is increasing there
are still a fair number of people who would benefit from facilities being
provided in government offices, at various business sites and in public places
such as libraries, community centres and schools.
469
5.4
Fundamental laws
There is a need to review basic laws to ensure that they work
effectively for the electronic world as well as for the paper world. Issues
relating to settlement, clearing and netting procedures need to be resolved.
Universal valuation standards for securities and interests therein need to be set.
Global standards for operating central depository systems need to be
established. This is an illustrative list of areas that need to be looked at rather
than an exhaustive list.
5.5
Performance information and indexing
Universal common standards need to be developed relating to the
calculation and use of performance information. There is a need to create and
maintain in the public domain universally accessible data bases containing the
basic factual information about the respective investments funds and their
underlying investments. This is crucial to the growing use of indexing both as
a benchmark against which to measure investment performance and as a basis
for structuring, selling and valuing derivative contracts based on an index.
With respect to indexing, there is a need to address the inherent
conflicts of interest that exist when the same entity that has created the index is
responsible for valuing the underlying securities and for structuring, selling and
valuing the derivative contracts based thereon.
5.6
Specific investment fund issues
The Stromberg Report identifies numerous investment fund issues
that need to be addressed. The OECD background papers also identify many
such issues. It is impractical to attempt to deal with all of these issues in this
paper. However, reference is made to some areas where a more systemic
perspective merits consideration.
Fund governance
Fund governance issues need to be addressed. There are concerns that
trustees, directors and officers of investment funds often lack the necessary
competencies to enable them to carry out their role effectively. There is a need
to address this problem in the context of fund governance and to identify the
470
competencies needed by the people at every level of the investment fund’s
operations in order for them to do their job. Knowledge is a critical tool to the
achievement of optimal results.
The adequacy of internal controls, systems, procedures and resources
(human, technical and financial) are key factors in the governance review. The
tendency to rely on outsourcing as a substitute for in-house expertise is an area
that requires special attention. It is submitted that there needs to be sufficient
in-house capability to monitor and oversee the adequacy of the services being
provided and, in particular, to evaluate whether investment portfolios are being
managed in accordance with their stated investment objectives and risk profiles.
It is also submitted that outsourced activities should be required to be
performed to at least the same standards as would be required if the services
were not being outsourced. An example of such a standard would be the
requirement to adhere to a code of conduct with respect to personal investing
activities.
Conflicts of interest
Conflicts of interest issues need to be addressed. There is a need to
develop a better understanding of the basic laws that apply to fiduciaries and to
those who are considered to have fiduciary obligations.
With the increasing activism of institutional investors (both for their
own account and for their managed accounts), it is submitted that there is a
need to re-examine the existence of statutory and other exemptions from the
“early warning” requirements or insider reporting requirements. In an age
where information translates into knowledge and power, these exemptions seem
to be incompatible with ensuring that there is full, true and plain disclosure on a
continuing basis in the marketplace about who owns or exercises control and
direction over the securities of an issuer once a certain threshold is crossed.
Technology makes it feasible to keep track of this information and to disclose it
in a timely manner.
A related issue is the disclosure of how portfolio securities owned by
an investment fund are voted. In Canada, there is currently no requirement to
disclose this information. Whether there should be such a requirement given
the increasing concentration of ownership, control and direction over securities
by investment funds and other institutional investors is an issue that is
beginning to have some currency in the Canadian environment.
471
There are increasing requests from investors that the statements of the
investment portfolio of an investment fund and of the changes therein, (which
in Canada are required to be filed with regulatory authorities on a semi-annual
basis and to be made available only to investors who request the same) should
be required to be filed more frequently and should be more readily available for
review. Once again, technology has made it feasible to do this. Perhaps it is
time to make changes in this area to provide equality of access to, and timely
disclosure of, this information to all investors and to make it available through
the Internet.
The marketplace (which is the collectivity of investors) seems to want
the information referred to in the above three paragraphs. At least one
commercial service is gathering the information referred to in second and fourth
paragraphs of this section to the extent that it is available (or can be interpolated
from information that is available) and is packaging it for sale. Would it not be
in the public interest to have current and factual information that is publicly
available to all in the marketplace on which to base investment and business
decisions? Again, these improvements in disclosure could be part of the
issuer-based disclosure model referred to above.
Technology has made it possible to gather and use more information
about investors than ever before. This has resulted in concerns about privacy.
Determining the acceptable use of such information has become a regulatory
issue particularly for financial institutions. It is suggested that it would be
unrealistic not to allow financial institutions to use the information they have
about their customers/clients/investors for the benefit of such persons.
However, there should be strict prohibitions on trading this information to third
parties or, in other words, using the information for a purpose other than the
purpose for which it was provided to the financial institution. The privilege of
ownership of the information belongs to and should remain with the
customer/client/investor in question.
An area of possible vulnerability for investment funds is the extent to
which its investors’ investments in the fund have been acquired with borrowed
money. It is suggested that there should be some requirement to monitor this
both from the perspective of determining the impact on the financial institutions
making the loans in the event of market corrections and from the perspective of
the investment funds in the event that the loans to investors are called by the
financial institutions thereby triggering redemptions and the possible need to
sell securities to raise cash to pay the redemption proceeds.
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6.
Conclusion
The foregoing ideas are presented in the hope that they will stimulate
discussion and generate solutions to meet the needs of investors in the new
financial landscape. The present environment seems to be prepared to accept
some fundamental re-thinking of the regulatory and supervisory regime for
investment funds and institutional investors. However, it takes people to make
things happen. Let’s hope there is a community of people with a will to make
things happen. The future and well-being of the consumer/investor and
ultimately of the institutional investor depends upon it.
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NOTES
1.
Glorianne Stromberg was appointed by the Ontario Securities Commission
to review the regulation of investment funds in Canada and to provide
advice as to the issues to which regulators should respond and the changes
that should be made in the current regulatory framework. Her Report
entitled Regulatory Strategies for the Mid-’90s - Recommendations for
Regulating Investment Funds in Canada was issued on 31 January 1995 and
has had substantial influence on shaping industry and regulatory changes
currently in progress. The views expressed in this paper are the personal
views of Glorianne Stromberg. They do not necessarily reflect the views of
the Ontario Securities Commission, any of the other Canadian Securities
Administrators, staff of any of the Canadian Securities Administrators or of
other Commissioners of any of the Canadian Securities Administrators.
2.
In 1993 assets invested in mutual funds grew from C$67.3 billion to
C$114.6 billion. This growth has continued. Investors now have about
C$252 billion invested in Canadian mutual funds which are held in
approximately 29.5 million unitholder accounts. About 40 per cent of
Canadian households own mutual funds with the average household
investment being about C$55 000.
3.
See the Report of the Canadian Committee on Mutual Funds and Investment
Contracts - A Provincial and Federal Study published in 1969 by the
Queen’s Printer for Canada.
4.
In Canada, jurisdiction over securities matters is exercised by its ten
Provinces and two Territories.
The term “Canadian Securities
Administrators” refers collectively to the securities regulatory authority in
each of the Provinces and Territories of Canada.
5.
A copy of this Report and of the Briefing Notes that were issued in connection
with the Report may be obtained from the Ontario Securities Commission, 8th
Floor, P. O. Box 55, 20 Queen Street West, Toronto ON M5H 3S8 - Telephone:
416-593-8120; Fax: 416-593-8122.
475
6.
A copy of the Investment Funds Steering Group Report, The Stromberg
Report: An Industry Perspective, may be obtained from the Ontario
Securities Commission as noted above.
7.
Examples of investment funds that are the functional equivalent of mutual
funds but which are not subject to comparable regulation even though they
are made available to the retail investor include pension and other
retirement plans, variable investment contracts and annuities offered by
insurance companies and certain types of wrap accounts offered by various
dealers in securities, investment advisers and financial institutions. These
investment fund “look-alikes” present a problem both from the perspective
of the investor and from the perspective of the mutual fund manager. The
problem for the investor lies in the lack of prospectus-level disclosure about
the investment fund, the lack of comparability of performance and other
information about the investment fund and the lack of required adherence
by these investment fund “look-alikes” to prescribed merit regulation
standards. The problem from the perspective of the mutual fund manager
lies in the lack of a level playing field while competing for the same
business.
8.
These forces are discussed in Sections 2 and 3 of the Stromberg Report.
They mainly center around the economic and demographic factors relating
to an ageing population, there being fewer people supporting such
population, the lack of the likelihood of lifetime employment, the likelihood
of substantial underemployment, and the recognition of the inadequacy of
public and private pension plans to provide for retirement needs.
9.
The perspective underlying this recommendation is that regulatory
requirements in respect of investment funds should apply equally to all
industry participants and investors should be assured of certain common
standards regardless of whether they are dealing with an independent
investment fund organization, a bank, a trust company, a life insurance
company or other financial institution, an investment counsel or an
investment dealer, a mutual fund dealer or some other category of dealer or
a financial planner.
10.
This self-regulatory organization (“SRO”) would be required to adopt rules
of fair practice and business conduct that would, among other things,
address the questionable sales practices that have grown up in the industry.
It would also set standards for education, proficiency and training,
advertising of performance and other investment information, capital
requirements, internal systems, controls and procedures for SRO members,
insurance and bonding requirements and contingency fund participation. In
476
addition, the SRO would be responsible for monitoring compliance with its
rules and conducting supervisory audits.
The importance of this recommendation cannot be underestimated.
Securities regulation in Canada is founded on the principles of disclosure of
information and the registration of persons who deal with the public or
provide investment advice. The problems with the current regime on the
registration side relate to the fact that not all persons who sell investment
fund securities to the public are required to be a member of a recognized
self-regulatory organization and to adhere to the higher standards of the
SRO with respect to rules of fair practice and business conduct, education
and training, capital, bonding and insurance requirements and contingency
fund participation. Most importantly, those persons who are not members
of a recognized self-regulatory organization are not subject to the
compliance monitoring procedures of the self-regulatory organization.
Investors are often not aware of the different standards or of the impact that
the differences in these standards can have. These differences result in
potential problems for investors. These differences also present an
economic problem for dealers who are members of an SRO who are
concerned about the lack of a level playing field when they are required to
adhere to higher standards than their non-member counterparts while
competing with them for the same business.
11.
The Stromberg Report recommends that the Securities Regulator retain
direct responsibility for the registration of investment fund managers by
reason of the fact that the functions of a manager of an investment fund are
so closely linked with the functions of its sponsored investment funds. As a
result, it would be very difficult and inefficient to attempt to separate the
regulation of the two. It was therefore recommended that the establishment
of investment funds and the disclosure documents relating thereto should
remain the direct responsibility of the Securities Regulator and should not
be delegated to a self-regulatory organization and that the registration
function with respect to managers of investment funds should also remain
the direct responsibility of the Securities Regulator. See Section 14 of the
Stromberg Report for recommendations as to the standards required to be
met in order to act as an investment fund manager.
12.
See Sections 19, 20, 21 and 22 of the Stromberg Report.
13.
See Section 24 of the Stromberg Report.
14.
In the context of the integration of financial services provided by
institutions, it is interesting to note that mutual fund organizations, (which
are sometimes referred to as the “fifth pillar”), through their acquisition of
477
trust companies, have expanded the products and services that they are able
to provide and have directly accessed the ability to participate in the
Canadian Payments System.
15.
The term “market fragmentation” is used to describe order routing from the
floor of a recognized stock exchange such as The Toronto Stock Exchange
or the New York Stock Exchange to a private upstairs trading system (often
referred to as a “PUP”) operated by a dealer or to a proprietary (private)
electronic trading system (often referred to as a “PET”) such as Instinet.
Another draw of orders from the floor of a recognized stock exchange
comes from the “pay-for-order” firms such as Bernard L. Madoff
Investment Services.
16.
Some financial institutions argue that because the power conferred on them
under the legislation deregulating the financial services industry to
participate in both the business of underwriting and in the business of
providing investment management and advisory services to others allows
them to do this, the normal fiduciary obligations (some of which are
currently expressed as statutory prohibitions on certain conduct) should not
apply.
17.
This system focuses on the primary issue of specifically identified securities
and it distinguishes its requirements on the basis of who the purchaser of the
securities is and, in some cases, who the issuer is by creating classes of
exempt purchasers and of exempt securities. It is a very legalistic, technical
structure that is fraught with compliance pitfalls and does not sufficiently
recognize the fact that securities of the same class or series of a class are
fungible and that most trading activity takes place in the secondary market.
18.
Securities regulation is based on two fundamental requirements - namely,
requirements to disclose information about the securities and the issuers
thereof and requirements for the persons who deal in securities or offer
advice about securities be registered. The discussion in this paper does not
address whether changes in the registration requirements of the securities
regulatory system would be needed if an issuer-based disclosure model were
to be adopted.
478
Part IV (continued)
THE REGULATORY AND SUPERVISORY ENVIRONMENT AND
RISK MANAGEMENT
D. RISK MANAGEMENT
479
Chapter XXI
RISK STANDARDS FOR INSTITUTIONAL INVESTORS AND
INSTITUTIONAL INVESTMENT MANAGERS
by
*
Tanya Styblo Beder
Introduction
Over the past year, the institutional investor community and
institutional money management communities have taken great strides forward
in their approach and commitment to risk measurement. In particular, they
have strengthened their oversight of the investment process on both a
quantitative and qualitative basis. This has been fuelled not only by increasing
complexity of instruments but also by the dramatic expansion of asset classes
and markets in which to invest. This note looks at the motivations for and
direction of risk measurement, as these changes are vital to the health of the
global capital markets.
Institutional investors include pension funds, mutual funds, public
funds, foundations, endowments, the general accounts of insurance companies
and other large pools of money in the public and private sector. The nature of
these investment dollars has changed substantially over the past two decades.
First, institutional investors from developed countries-- rather than banks and
other depository institutions from developed countries -- now dominate the
world capital markets. This dominance is forecast to grow even greater.
Second, emerging markets have become a vital and strategic component of the
institutional investment sector, another trend that is expected to continue. These
trends are fuelled by trends in developed markets such as ageing demographics,
a need to find higher returns at a time that low interest rates prevail, and
growing fears of over-valued stock markets in the United States. Funds faced
difficult new risks and challenges as they increased cross-border investment,
*
Principal of Capital Market Risk Advisors, Inc
481
particularly into emerging markets for which little history was available. In
addition, many funds began to participate in new and complex sectors of the
capital markets such as private equity, derivatives and financially-engineered
securities, which led to the need to manage a longer list of risks.
1.
Risk Standards Working Group
Against this backdrop, a group of institutional investors formed the
Risk Standards Working Group in April of 1996 to address the need for a set of
risk standards for institutional investors and institutional investment managers.
Prior to this effort, published risk standards were primarily for broker-dealers,
banks and some types of insurance companies. The full text of the Risk
Standards was published in November of 1996 (Risk Standards Working Group
(1996) “Risk Standards for Institutional Investment Managers and Institutional
Investors”).
2.
Overview of potential risks
Whereas default risk - or credit risk - had been the primary way for
institutional investors to lose money since most financial institutions were
formed in the 1700s, this changed dramatically with the advent of technology
and the globalisation of the capital markets which began in the 1970s. Table 1
depicts just a few of the ways that financial institutions have lost money over
the past two decades. While it's a lengthy list, I am compelled to point out one
item, the footnote that reads "Partial Listing."
Several funds and other financial institutions were too slow in
acknowledging the sea change in the need to manage the risks in their
businesses and markets. Spectacular downfalls ensued by Kidder Peabody,
Barings, The Granite Funds, Daiwa’s U.S. Bank, Toyo Shinkin Bank, Nissan
Mutual Life Insurance, Confederation Life, the Maxwell Companies’ Pension
Funds, Drexel Burnham Lambert, Continental Illinois, BCCI, plus many
regional Savings & Loans and Credit Unions in Japan, Britain, Switzerland and
the United States. Against this backdrop, the Working Group reviewed how
others had lost money as one step in creating the first set of risk standards for
the institutional investment community. Chart 1 illustrates one type of losses
-- derivatives losses -- over the past decade:
482
Table 1. "Galaxy of Risks"
♦Accounting risk
♦Bankruptcy risk
♦Basis risk
♦Call risk
♦Capital risk
♦ Collateral risk
♦Commodity risk
♦ Concentration risk
♦Contract risk
♦ Credit risk
♦ Currency risk
♦Curve construction risk
♦Daylight risk
♦Equity risk
♦ Extrapolation risk
♦ Hedging risk
♦Horizon risk
♦Iceberg risk
♦Interest rate risk
♦Interpolation risk
♦Knowledge risk
♦Legal risk
♦Limit risk
♦Liquidity risk
♦Market risk
♦Modeling risk
♦Netting risk
♦Optional risk
♦Personnel risk
♦Phantom risk
♦Political risk
♦Prepayment risk
♦Publicity risk
♦Raw data risk
♦Regulatory risk
♦Reinvestment risk
♦Rollover risk
♦Suitability risk
♦Systemic risk
♦Systems risk
♦Tax risk
♦Technology risk
♦Time lag risk
♦Volatility risk
♦Yield curve risk
Partial Listing
Chart 1. Publicly disclosed derivatives losses
As of 30 June 1997
$ Billions
25
20.95
20
21.34
16.7
13.82
15
10
3.96
5
1.15
1.61
1.64
1.85
2.02
1989
1990
1991
2.24
0
1987
1988
1992
1993
1994
Cumulative losses; pre-tax equivalents
483
1995
1996
1997
A review of these losses as they pertained to funds revealed several
valuable lessons. As illustrated in the Chart 2, the vast majority of derivatives
losses for funds had been caused by over-the-counter instruments. Also, the
losses largely involved some of the more complex sectors of the derivatives
market place such as stripped mortgage-backed securities, structured notes and
collateralised mortgage obligations. A second observation from the chart is that
funds accounted for the vast majority of these types of losses in the derivatives
market place.
Chart 2. Lessons from derivatives losses
in public and private funds
Total Losses
ET Derivatives
Funds
Total
SMBS & Exotic CMOs
Structured Derivatives
OTC Swaps, FRAs
Other
OTC Options
0
3.
5
10
15
20
25
Risk controls and risk standards
A discussion of these losses revealed the need for institutional
investors to look at the documents which define the relationship with their
money manager. In particular, several types of widely-used risk controls
embedded in manager guidelines had grown out of date. Table 2 offers a few
examples of “older” risk controls that failed in the new environment of more
complex instruments and cross-border investment:
484
T able 2. S am p les o f “O L D ” risk C on trols th at failed
♦
♦
♦
♦
♦
♦
♦
“A A A and less than 2-year m aturity”
“L ow interest rate risk”
“L ow currency risk”
“H igh liquidity”
“N o com m odities”
“H edging is allow ed”
“Speculation is not allow ed”
S o u rce: A ctu a l In ve stm en t G uide line s
The Risk Standards Working Group consisted of 11 members from a
well-known group of institutional investors. It included pension funds, public
funds, endowments, foundations and insurance companies. The group met four
times, beginning in April of 1996.
Chart 3. Opinions on risk standards
Investment Managers
Plan Sponsors
Owners of
Assets
Legal Advisors
Investment Industry
Risk Management
Industry
Groups
and
Associations
National and
International
Regulators
Auditors and
Accountants
Rating Agencies
485
The mission of the Risk Standards Working Group was “to create a
set of risk standards for institutional investment managers and institutional
investors.” This task included a review of all of the constituents in the
institutional investment community that needed to be considered when creating
the risk standards, from plan sponsors to regulators to the beneficiaries of the
plans as summarised on the chart above.
The task also included a thorough review of all of the other risk
standards that had been published in the market place. These are summarised
in Table 3. As illustrated, prior to these risk standards, there has not been any
which focused on the specific issues that face the institutional investment
community. For example, the Group of Thirty Recommendations published in
1993 focus largely on derivatives and the shorter holding horizons of brokerdealers. Institutional investors often have long holding periods and invest in
asset classes that are difficult if not impossible to mark to market on a daily
basis (for example real estate).
Table 3. Risk management frameworks
Comparison
Framework
G30
1993
DPG
1995
Principals &
Practices
1995
Fut. &
Options
Assoc. 1995
GARP
1996
RSWG
1996
Primarily
Derivatives
æ
æ
æ
æ
æ
Primarily
Dealers &
Banks
æ
æ
æ
æ
æ
Some EndUser Focus
æ
æ
æ
æ
æ
Institutional Institutional
Investment
Investors
Managers
æ
æ
A review of the different frameworks revealed that while there were
vast differences between the recommendations, six elements were common to
all (Table 4).
486
Table 4. Risk management and risk measurement
Common framework recommendations
Six elements are common features of risk measurement and risk
management frameworks
1.Use of risk
2.An independent risk oversight (IRO) function
3.Requisite knowledge and systems
4.Specific written policies, controls and procedures
5.Daily or frequent mark-to-market
6.Stress testing and simulation
Of particular interest to The Working Group were risk considerations
that impact the daily lives of institutional investors such as:
− Longer time horizons
− Holding period
− Evaluation
− Multiple asset classes
− Multiple portfolio managers/firms
− Distinct fiduciary responsibilities
− Heavy reliance on outside data
− Historical focus on performance versus risk-adjusted performance
− Increasing dependence on theoretical models
After drafting the Risk Standards, the Working Group obtained
comments and suggestions for changes from a large group of institutional
investors, money managers and those who provide services to the industry.
During the nine months that have passed since publication of the
standards, international interest has encouraged a review and discussion by the
institutional investment community in Canada, Asia, Australia, New Zealand
and Europe. However, the task of implementation is large, as no investors
487
reviewed to date comply with all of the standards – as the introduction by the
Working Group states, the standards are a goal for the community to attain
rather than a statement of current practice. One process underway is to require
a minimum set of risk management standards and risk measurement reports
from each manager that institutional investors have hired. This is often
accompanied by a request for representations such as: i) the manager has
adopted the minimum risk management standards of the institutional investor,
ii) all violations of the standards/limits have been promptly reported and
corrected; iii) manager guidelines are in place and no known violations exist;
and iv) random audits are allowable.
In closing I would like to point out that only one-third of the
standards are quantitative in nature – the other two-thirds of the standards are
qualitative. This drives home the point that while quantitative techniques are
necessary to the risk oversight process, they are not sufficient. Risk, in and of
itself, is not bad. Investment managers have to take some risk to obtain returns
in excess of a benchmark. What is bad is risk that is mispriced, mismanaged,
or misunderstood. Particularly frightening is the unknown risk--the risk that
something might happen that has never happened before--and the potential loss
associated with that uncertainty. It is with this in mind that the Risk Standards
were created.
488
OECD PUBLICATIONS, 2, rue André-Pascal, 75775 PARIS CEDEX 16
PRINTED iN FRANCE
(21 98 02 1 P) ISBN 92-64-15980-0 – No. 50245 1998
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