Effective management of public superannuation funds

K. S. Welivita

Public superannuation funds have the potential to benefit from low operating costs because they enjoy economies of scale and avoid large marketing costs. But the important advantages are dissipated by a poor record on investment performance, caused by a weak governance structure, lack of independence from government interference, and a low level of transparency and public accountability.

The superannuation funds sector consist of three state-managed funds and about 170 privately managed approved provident and pension funds. The Employees Provident Fund (EPF) is by far the largest and most important scheme covering both the public and private sectors. It is also the largest institutional investor in the country and, a vital component of the overall Financial Sector Reform Agenda.

The Employees Trust Fund (ETF) which was created in 1981 to promote stock ownership among employees and is financed by 3 percent employer contribution.

Public superannuation funds were forced to invest in government bonds and housing loans at nominal interest rates, while investing in foreign assets was prohibited. In countries that suffered from high inflation, real investment returns were negative, while even in countries where nominal interest rates exceeded inflation, the return on public superannuation fund reserves were well below equity market returns and well below the returns achieved by private superannuation funds.

Governance structure

Recognizing the poor track record of public superannuation funds and the need to build reserves to meet the growing demographic pressures on public superannuation schemes, several countries have in recent years revamped the governance structure and investment management of their public superannuation funds or have created new funds that have benefited from a strong governance structure, independence from government, and high level of transparency and public accountability.

International experience suggests that progress toward improving the management of public superannuation funds relies on the presence of good governance, meaning the systems and procedures that the government uses to manage its affairs.

The main components of good governance include transparency, systems for conflict resolution, and accountability for each function and role.

The management of the fund should be free of inappropriate interference from the government in pursuing its objectives and meeting its responsibilities. Ideally, the government should remain at arm’s length from the investment decisions of the fund management.

To make realistic recommendations to improve governance and management, it is important to understand local institutional and economic constraints.

These constraints come from four main sources;

(a) a legal framework that makes the application of best-practice models difficult,

(b) governance problems at the macro level,

(c) limited administrative and institutional capacity, and

(d) the level of development of financial markets.

The management should be required by law to establish internal governance structure and processes aimed at minimizing corruption, mismanagement, and fraud.

Governance procedures should include;

(a) the mandatory establishment of a risk management and audit committee,

(b) a code of establishment for staff and senior executives,

(c) a detailed description of the roles and responsibilities of different groups within the organization,

(d) a process of quality control and rigorous documentation, review and audit requirements for investment decisions and information technology support systems.

Organization structures that provide managers with incentive to comply with their mandate and run the superannuation fund in the best interests of members are central to achievement of good governance.

To this end, two basic elements need to be considered: transparency and reward structures. Regarding transparency, the objective is to full disclose information (for example, the financial situation of the fund, the composition of the portfolio, investment decisions, and performance).

Regarding rewards structures, the goal is to ensure that those making decisions are held accountable. Good judgment and good performance should be rewarded, while poor judgment and bad results should be penalized.

Investment strategies

To the greatest extent possible, incentives and rewards should be linked to delegated responsibilities and should be risk based. Those who make delegated decisions should be rewarded or sanctioned according to the way in which they exercise their delegations. Managers should be required to review periodically, the exercise of delegations they have made. Compliance should be rewarded, and breaches of guidelines, either for governance or for investment, should be penalized, even where the returns are higher than expected.

Public superannuation fund managers have the responsibility to select an investment strategy that balances risks and returns appropriately for members. The investment policy comprises three main components: setting long term performance targets, defining an acceptable level of risk tolerance, and setting parameters for short-term asset allocation. These need to be set out clearly in an investment policy statement.

The primary focus of investment policies for investment is to balance market risks and returns. Three type of risks need to be managed:

(a) the risk of loss due to counter-party default,

(b) the risk of loss due to movements in market prices,

(c) the risk of loss due to operational failure.

In addition to these risks it is necessary to concerned about the role in the domestic capital market and exposure to government debt.

In the private sector, the market risk dimension of investment strategies is increasingly expressed as a comprehensive measure of risk, such as value at risk. This comprehensive measure of risk automatically signals inadequate diversification.

Therefore, funds can be managed effectively in the absence of strict sectoral limitations or target ratios. However, this approach has yet to reach far in to the public sector, where investments often are handicapped by limited mandates and restrictions that militate against modern risk management practices.

Domestic market

The investment policy set by the board of directors, should be fully documented and state that the purpose of accumulating and investing superannuation reserves is solely for the benefit of the fund members. In general, rules that limit or prohibit investments, including investments in foreign securities, reduce the capacity of the fund to diversify and to serve the interest of fund members.

The two exceptions to this general rule are loans to related parties - either government or fund members - and investment in risky derivatives. The investment policy statement should identify the potential for the fund to be or to become a dominant force in the domestic market should specify how the fund would resolve such situation. The investment policy should be explicit about how the superannuation fund would exercise its voting rights as a shareholder.

Corporate governance

The investment policy should identify all relevant risks and the approach to measuring, monitoring, and managing each risk. A particular problem arises from investments in non-marketable assets. These investments reduce the liquidity of the fund and are more prone to malpractice at the time of acquisition, valuation or sale. Assets can be purchased above market prices or sold below market prices to benefit fund managers. Also, valuation problems can make it difficult to asses whether the asset is generating gains or losses.

In general, the investment policy should seek to minimize investment in illiquid assets. One way to contain the risks involved with investment in illiquid assets is to limit the amount to a benchmark maximum, according to a realistic assessment of the spectrum of investments available. Where such investments are permitted, a clear policy for their purchase, disposition and valuation should be established.

The policy could include either mandatory independent assessment of each purchase and sale of illiquid assets or supervision by the audit before the transaction occurs.

This assessment should evaluate the price set for the transaction, the independence of parties involved, and the appropriateness for the transaction for the fund, with respect to the targeted rate of return.

Investment policy should respect exposure limits, too. To diversify risk, funds should not invest more than 5 percent of their reserves and should not own more than 5 percent of the liabilities of a given company. Respecting these rules reduces the influence that funds might have on corporate governance and thus reduces the possibility of conflicts of interest.

In order for superannuation fund assets to be appropriately managed, the superannuation fund governing body and other parties involved in superannuation fund asset management must be able to readily ascertain the value of superannuation fund assets for which they are responsible, regardless of the nature of the investments held in the superannuation fund. In general, current market values should used where available. If not available, a fair valuation methodology acceptable under International Financial Reporting Standards (IFRS) should be used.

Our country faces a compelling challenge in improving governance and management outcomes for public superannuation funds. Indeed, the examination of governance structures and management of public superannuation funds in Sri Lanka reveals a serious gap when compared with best international standards and practices for good governance and sustainable management.

The writer is Deputy General Manager (Internal Audit) Employees Trust Fund Board