Sovereign Wealth Funds
Reserve Fund Report Cards
You won't want to hang this one on your fridge...
July 26, 2011
Pension reserve funds (PRFs) are designed to bolster governments’ commitments to first pillar pension obligations (e.g., social security). So, unlike traditional defined benefit pensions with explicit liabilities to specific individuals, PRFs have contingent liabilities to their sponsoring governments. Should pension costs explode — which they soon will — the assets in the PRF can be tapped to fill budget gaps (but they need not be).
PRFs are a useful policy tool for smoothing the costs of an aging population. And, moreover, it is hoped that the investment returns PRFs can generate through aggressive investment strategies will minimize the ultimate cost of a given government’s pension obligations; this notion is obviously quite popular among politicians faced with the unpopular choice of increasing taxes or cutting benefits. For my part, I tend to appreciate the commitment mechanism that PRFs create for short-sighted politicians.
Nonetheless, there are many PRF critics out there. Some are dubious about the actual impact that investing in risky assets will have on the funding position of retirement systems, since, on a risk-adjusted basis, the required contributions needed to fund pensions are the same however the assets are invested. Others worry about the political nature of retirement systems and whether investing in equities opens these systems up to political interference (for a detailed treatment of this issue, read this). And these concerns are underpinned by a broader question about PRFs’ ability to generate the long-term returns required to fulfill their mandates. In other words, can public sector investors compete with the private sector?
With respect to this last point, I was recently sent a copy of the OECD’s latest “Pension Markets in Focus” and told to look at Table 5 (see below). The individual who sent this to me called it a sort of ‘investment-return report card’ for the global community of PRFs since the financial crisis. And, I’ll cut to the chase, it’s not pretty; let’s just say that this report card wouldn’t be hanging on my fridge. But (!) before we get too worked up about the poor returns highlighted in the Table, I’d like to offer a friendly critique.
In my view, using a three year time horizon to assess whether these funds have “recovered” from the crisis is a mistake. Why would the OECD discount the positive returns before the crisis? For example, the OECD report shows the NZSF as having a negative 7% return for the past three years. That seems awful. However, if we look at the NZSF since inception (2003), its returns are over 8%. That’s a 15% swing! I understand what the OECD is trying to do, but I think this presentation gives a distorted picture of the funds’ long-term performance.
In addition, I have to question the decision to use three years to assess PRFs at all. Again, that’s not what I would call “long-term performance”. If the OECD really does want to “promote longer term investment by institutional investors” (and it says it does), then it should assess PRF performance over a time horizon befitting an inter-generational investor; let’s say 6-10 years minimum. By focusing on single year and three-year returns, the OECD may inadvertently be playing into the “gotcha” games that politicians play with PRF managers (which, in turn, tends to shrink the investment time-horizon of these funds). I think that’s a bad thing. In the future, I’d like to see returns reported over 1, 3, 5, 10, and even 20 years. Why? People will inevitably manage in relation to what we measure; for PRFs, let’s keep those measurements long. (click on image below to enlarge)
This post originally appeared on the Oxford SWF Project