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PROFITABILITY GUARANTEES International Seminar “Pensions for the Future: Developing Individually Funded Programs” - FIAP Melvin Escudero Superintendent Supervising Managed Portfolios May 2008 CONTENTS 1. 2. 3. 4. Historical perspective Critique of profitability guarantees Evolution of profitability guarantees The practices of the global investment management industry 5. The new Peruvian model 6. Conclusions 1. HISTORICAL PERSPECTIVE Profitability Guarantees Since the creation of private pension systems, most of these models have incorporated some explicit profitability guarantees, with the aim of generating confidence in the new systems and provide security for participants and interest groups, as well as reduce the AgentPrincipal interest conflicts. Currently, several countries continue to have profitability guarantees, as shown in the table below: Maximum or Minimum Profitability Profitability Guarantees Países The only guarantee that exists is the Guaranteed Minimum Pension paid by the Federal Government (chargeable to global taxes) to those who do not have sufficient balances in their accounts after 24 years of contributions to finance a pension of at least the minimum wage Mexico Chile Profitability Fluctuation Reserve by Fund Type. Type A and B Funds (maximum or minimum as the case may be, between): a) The real annualized profitability of the last 36 months average of all the Funds of the same type, as the case may be, ± 4% b) The real annualized profitability of the last 36 months average of all the Funds of the same type, as the case may be, ± the absolute value of 50% Cash reserve invested in the Cash Reserve Fund corresponding to 1% of the of such profitability. value of the funds. This capital requirement is invested in the managed Funds Type C, D and E (maximum or minimum, as the case may be, between): .funds a) The real annualized profitability of the last 36 months average of all the Funds of the same type, as the case may be, ± 2%, and b) The real annualized profitability of the last 36 months average of all the Funds of the same type, as the case may be, ± the absolute value of 50% of such profitability. 2/ Colombia Argentina 2/ 3/ Minimum profitability . Determined by the lesser of : a) The simple average -25% of the weighted average of the profitability of the funds and a reference portfolio b) The simple average of the weighted average of the profitability of the funds and a reference portfolio -2.2% Minimum Profitability . In a specific month, the profitability of a retirement and pensions fund, corresponding to the last 12 months, cannot be less than the minimum profitability of the system equal to the minimum of seventy per cent (70%) of the average profitability of the system, or the average profitability of the system - 1/ Decreto Ley 3500 2/ Decreto Número 2664 de 2007 3/ Instrucción SAFJP N° 19/2007 y Ley 24.241 Yield Stabilization Reserve, corresponding to 1% of the value of the funds. This capital requirement is invested in the managed funds. . The Fund Managers must at all times maintain a cash reserve of about 1% of the pension Fund, with such not being able to be less than one million five hundred thousand pesos. The cash reserve amount is invested in a bank account in the name of the fund manager, in instruments with the same .limitations applicable to the fund. 1. HISTORICAL PERSPECTIVE A. Profitability Bands and Lower Volatility Maximum profitability (Profitability Fluctuation Reserve) Minimum Profitability (With respect to the system average) Stems from the defined benefit plan accounting perspective The purpose is to limit short-term volatility in order to achieve more uniform longterm profitability. B. Mitigate Moral Hazard Fund managers’ capital is small compared to the funds they manage, so that managers are tempted to assume large risks. Fund interests must be aligned with those of the fund managers so that fund managers that have consistently bad profitability also participate in the losses. 1. HISTORICAL PERSPECTIVE C. Endow the new Private Pension Systems with safety and trustworthiness The pension fund managers are private agencies. In order for members to feel protected and believe in the system, there must be similar guarantees to those required of banks and insurance companies (capital requirement, provisions, technical reserves). In order to be accepted by politicians and interest groups. It was important for the system to function without members suffering large losses (reputation of the system). D. Restrictions of the start-up context The system was just beginning. Capital markets were not very developed. Instruments had little liquidity. There was no adequate price formation. 1. HISTORICAL PERSPECTIVE E. Financing of Minimum Profitability Guarantees With resources from within the pension fund: Profitability fluctuation reserve With the pension fund manager’s capital: Monetary: Cash reserve Non-monetary: Hypothecation certificate, other guarantees If the cash reserve is invested in the fund, moral hazard diminishes. Hypothecation certificates, on the other hand, do not have the same effect. Fund manager growth must be parallel to fund growth. From the government: In case the fund managers go bankrupt and the guarantees do not cover the minimum profitability. 2. CRITIQUE OF PROFITABILITY GUARANTEES A. Herd effect The minimum profitability guarantee conditions similar portfolios because the managers do not take the differentiation risk in order to avert capital loss. The consequences are poor competition and inadequate portfolios. Current portfolio theory: Portfolios gauge their performance against a benchmark. If the benchmark is the system average (PPS), fund managers seek a profitability above, but not too far above, the benchmark. (There is a herd effect in the entire global asset management industry) 2. CRITIQUE OF PROFITABILITY GUARANTEES A. Herd Effect ― Passive Portfolio Management (Beta – Strategic Asset Allocation, Passive Management) A large percentage of the portfolio is kept at a long-term horizon with no transactions (70% core position, remaining 30% used for active management) ― Active portfolio management seeks to anticipate direction changes for high yield obtainment. (Tactical Asset Allocation – Security Selection - Alpha Searching) 2. CRITIQUE OF PROFITABILITY GUARANTEES A. Herd Effect Restrictive regulation accentuates herd behavior.. ― This could result in the portfolio’s core position (passive management) being very high (Core position 90% and active management 10% or less) ― Herd behavior also depends on market size. The herd effect is greater Large fund size. Small fund size. Without restrictive regulation Core Position Market Fund Fund Less propensity Greater propensity to the to the herd effect herd effect Market With restrictive regulation Active Managment 2. CRITIQUE OF PROFITABILITY GUARANTEES B. The Initial Model conception issue Defined benefit plan rules cannot be applied to a defined contribution plan. The member (stockholder) buys shares monthly. He must buy at market price and sell at market price (mark to market) and not at standardized accounting values for avoiding volatility. C. System cost increase Part of the commissions fund that managers charge members must be used for financing profitability guarantees. This cost is transferred to members, who pay higher commissions. Less financial flexibility of fund managers due to distortion in their net worth and financing of the minimum profitability cash reserve. 2. CRITIQUE OF PROFITABILITY GUARANTEES D. The fund belongs to members with different risk profiles There are members who wish to assume more risk and consider their interests impaired by maximum profitability. They reject the existence of a fluctuation reserve. Young members can assume more risk because their investment horizon is longer so losses can be compensated. E. Current autonomy with respect to the calculation formula and the average portfolio All the funds follow the largest fund (or funds). The largest fund may not be the best. Small funds cannot differentiate much from them. 3. EVOLUTION OF PROFITABILITY GUARANTEES The move of profitability guarantees towards more flexibility as a result of criticism, has brought about several gradual changes: A. Elimination of the fluctuation reserves The maximum profitability reserve has gradually been eliminated. Why can members not enjoy high yields? B. Modification of the minimum profitability calculation formula The aim was to minimize the negative impact of portfolio management for the purpose of improving profitability. Increase the calculation period for the purpose of smoothing out the short term high volatility effect and apply the guarantee only when the managers have yields below the system average. 3. EVOLUTION OF PROFITABILITY GUARANTEES C. Broaden investment alternatives For greater differentiation in the make-up of the different fund managers’ funds (avoid the herd effect). D. Change the reference index (PPS benchmark) The Colombian case: The benchmark is no longer just the system average. Minimum profitability is obtained by combining the weighted average profitability of the system with the average profitability of the stock exchanges and the profitability of a reference portfolio. Avoids fund managers following bad managers of large funds and approaching market evolution instead. 4. THE PRACTICES OF THE GLOBAL INVESTMENT MANAGEMENT INDUSTRY The global asset management industry does not use the minimum profitability guarantee. The global asset management industry applies the following practices: • Calculation and evaluation of performance with respect to a benchmark (performance measurement, performance attribution, performance appraisal) for each asset type in the portfolios. • Disciplined compliance with the investment mandate or policy (avoid style drift). • Definition of the strategic asset allocation (on the basis of longterm projections) and tactical asset allocation (deviations from the strategic asset allocation pursuant to short-term directional expectations). 4. THE PRACTICES OF THE GLOBAL INVESTMENT MANAGEMENT INDUSTRY • Better practices in the investment management and risk processes. • Professional fiduciary duties minimize the conflicts of interests and moral hazards so that there are effective compensation mechanisms in case of loss and damages due to prohibited practices. Contractual structure, self-regulation and the effect of reputation are mechanisms and incentives that align interests in favor of the clients, minimizing the need for explicit or monetary guarantees. 5. NEW PERUVIAN MODEL 1 Investment Flexibility • Public and Private offer • New projects • Infrastructure • Concessions • Housing • Exploitation of natural resources • Forest plantations • Currencies, Commodities • International Funds • Degree of investment and speculation • Emerging Markets • International Funds • Private equity • Risk capital • Derived instruments • Securities lending 2 3 4 Professional Risk Management High Standards of Professional Diligence (Prudent Investor Rule) Structure of the Investment Process • Integral Investment Risk System • Separation of Functions of the Risk Unit (Middle Office) • Professional and Ethical Capability • Audits of risk units • Better transaction practices • Risk limits and parameters • Periodic risks report • Risk indicators • Risk estimation models • Multifunds (1 Conservative, 2 balanced, 3 growth) • Disciplined investment policies • Efficient investment costs • Performance analysis (Risk adjusted profitability) • Regulation of conflicts of interest • Benchmark per asset class • Trustee governance • Appointment of Directors • Information Reserve • Profitability guarantees ( minimum profitability and cash reserve) • CPMP investment regime 5 Management Supervision • Daily investment reports • Daily control of limits and guarantees • Multifunds inspections and audits • Evaluation, revision and recording of new financial products • Evaluation of financial instruments risk • Market Watch • Generation of pension fund statistics The Multifunds System Start up date: December 9, 2005 Expected Profitability Fund 1 (Conservative) Fund 2 (Balanced) Fund 3 (Growth) low medium Expected Risk low MANAGED PORTFOLIO PER FUND TYPE (In millions of US$) 25,000 5,044 Fund 3 20,000 4,706 Fund 2 Fund 1 moderate 724 15,000 high high 65 10,000 14,640 NOMINAL AVERAGE PROFITABILITY PER FUND TYPE (%) Dec-06/Dec-05* Jun-07/Jun-06 16.9 23.8 28.3 53.7 84.6 107.5 Fund 1 Fund 2 Fund 3 Dec-07/Dec-06 April-08/April-07 10.6 4.46 25.0 5.16 43.5 6.6 *For Funds 1 and 3, corresponds to profitability Jan 05/Jan 06. Variable Income Debt Titles Short Term and Cash Derivatives Fund1 10% 100% 40% 10% Fund 2 45% 75% 30% 10% 5,000 9,058 0 691 843 1,024 1,250 Dec-05 Dec-06 Dec-07 Apr-08 EVOLUTION OF THE PERUVIAN MULTIFUNDS SYSTEM ( In Millions of US$) MAXIMUM LIMITS PER INSTRUMENT CATEGORY Category 15,820 12,851 Fund 3 80% 70% 30% 20% Fund 1 Fund 2 Fund 3 Total Dec-05 % Dec - 06 % Dec- 07 % 690,567 7.0% 843,318 5.8% 1,024,075 5.0% 9,057,624 92.3% 12,850,610 89.1% 14,640,242 71.9% 65,046 0.7% 723,786 5.0% 4,706,373 23.1% 9,813,237 100.0% 14,417,714 100.00% 20,370,689 100% April - 08 % 1,250,224 5.7% 15,820,305 71.5% 5,043,729 22.8% 22,114,257 100% WHAT THE NEW PERUVIAN MODEL ENTAILS A. Evaluation of Managers – Benchmark per Asset Class The “PPS average” benchmark model is changed to a model of relative benchmarks per asset class (broad market indexes) B. Investment Flexibility The increase in investment alternatives (traditional and alternative) makes differentiation possible and improves the risk-yield profile of the portfolios C. Alignment of Interests and Member Protection C.1. Trustee liability C.2. Minimum Profitability built into the model – Relative Var C.3. Cash reserve C.4. Effect on reputation A. RELATIVE BENCHMARKS The profitability reference indicators enable the measurement and comparison of the fund managers’ performance taking into account risk adjusted yield. The benchmarks are determined for each asset class. Each AFP chooses its own benchmarks, establishes the degree of confidence of the Var and the applicable methodology. The Superintendency will supervise that the benchmarks corresponds to the investment policies of the funds. The benchmarks can be different for each fund, even for the same asset class. The benchmarks will enable analysis of the yields: Asset class Share titles Debt titles Cash assets Profitability Indicators Nominal Profitability (Rnom) Real Profitability (Rreal) Domestic market International Market Domestic Market Fund Type I Internat. Market Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Benchmark Rnom / Stand Dev Rnom Sharpe Ratio Tracking Error Information Ratio NEW BENCHMARK ADVANTAGES a. They meet validity characteristics not found in the PPS average benchmark. They are specified in advance and known by the interested parties; they are unambiguous since the identify and weight of the securities are clearly defined; they are investable since a passive strategy can be followed with them, and they are measurable over time b. They enable more efficient portfolio management The restriction of optimizing the portfolio subject to the PPS market benchmark does not exist, enabling the achievement of more efficient horizons NEW BENCHMARK ADVANTAGES c. They enable greater portfolio differentiation Given the fact that each AFP chooses its own benchmarks, it promotes greater differentiation for the same fund type (1, 2 or 3) between different AFPs. They enable greater freedom for tactical asset allocation and the possibility of generating active returns. d. They enable better evaluation of the fund managers Since the fund managers are evaluated in relation to the strategy established and the benchmarks befitting such strategies (the benchmark is not imposed) in a way similar to that applied in the global asset management investment industry. B. INVESTMENT FLEXIBILIZATION Traditional assets (liquid): Shares, bonds and mutual funds in different markets. Non-traditional Assets (not liquid): Assets and bonds of new projects (project finance), alternative investment funds (Private equity funds, hedge funds, commodities funds, real estate funds etc.) securitization of real estate assets (mortgage and asset-backed securities) and other assets, structured instruments (protected capital notes + derivatives on different underlying assets) etc. The use of both private and public offer markets, both primary and secondary, to access all available investment opportunities. This flexibilization makes it possible to access new efficient investment frontiers (greater risk adjusted profitability) and promotes greater differentiation between portfolios. C. 1. FIDUCIARY GOVERNANCE A set of the highest professional standards in investment and risk management applicable to third party fund managers (directors, managers and operating personnel), such as the AFPs. The application of these standards minimizes the moral hazard, aligning the interests of the fund manager and members, as well as promoting the selfregulation of the fund managers. Functions like a social contract that guarantees a professional and diligent handling of the funds, endowing the pension funds system with confidence and trustworthiness. The best practices applied in the PPS include the use of ethical codes, professional capability, adequate handling of conflicts of interest, transaction monitoring (market watch), the prevention of prohibited transaction practices, efficiency in investment costs, among others. C. 2. MINIMUM BUILT-IN PROFITABILITY – RELATIVE VAR The risk of the portfolio performing below the benchmark must be measured. The Var is calculated between the deviations of the portfolio with respect to the benchmark (Relative Var). For a degree of confidence, that is chosen by the fund manager itself (for example 95%), the maximum difference between portfolio yield and the benchmark is measured. Both the benchmark and the methodology of the relative Var are chosen by the fund manager so that this profitability guarantee is built-in and should enable the adequate optimization of the portfolio (it is a risk management tool and no longer an external restriction which limits management efficiency) Relative Var RELATIVE VAR ADVANTAGES a. It does not harm the optimization process It is a product of each AFP’s investment process (built-in variable), and does not mandatorily restrict the optimization process, allowing for more efficient portfolios. b. It enables better evaluation of the Fund Managers Each Fund Manager is evaluated with respect to the established strategies and investment style set out in its investment policies. c. It avoids the herd effect It minimizes incentives for the portfolios of different AFPs to look alike since each fund manager follows differentiated strategies pursuant to the chosen benchmark. d. Provides confidence and trustworthiness to the system If the fund managers perform very badly in relation to their benchmark, the profitability guarantee must be put into effect (cash reserve, guarantees chargeable to capital). C. 3. Cash Reserve requirements as Profitability Guarantee The monetary input demanded of the Fund Manager which pursues the following objectives: a. Minimize the Moral Hazard of the Fund Manager Given the fact that the Fund Manager is required to invest its capital in a percentage relative to the size of the fund (approx. 1%), it has incentives for efficient performance. b. Capital lien required for covering operational risk Designed to cover losses due to inadequate procedures, personnel and IT technology failure or external events. Recommended for the insurance and banking industries pursuant to Solvency II and Basle II standards, respectively. c. Capital lien required to cover minimum profitability deficit In case a Fund Manager does not achieve the required minimum profitability in a specific fund, the cash reserve can be used to cover such deficit. C. 4. Effect on Reputation Having a reputation for being a bad fund manager is extremely costly. Member migration costs (migration to other fund managers) and political cost ( very socially-sensitive issue). It is difficult to build up a good reputation and very easy to lose it. Intense competition and aggressive advertising magnify the deficiencies of other fund managers. 6. CONCLUSIONS At the outset of the Private Pension System (PPS) there were certain structural characteristics (poorly developed capital market, little liquidity, lack of expertise, a system unknown to the public) that made the existence of profitability guarantees relevant as mechanisms that generated confidence in the new and unknown activity of pension fund management. It was important to imbue the new system with security and create confidence among the members, politicians and other interest groups, above all due to the fact that the fund managers were private companies managing the public’s money (the banks and insurance companies have capital requirements as a best practice) As the PPS progresses, it develops and improves. Also members have more experience and interest groups are better acquainted with the functioning of the system. Therefore we seek a more flexible system that favors portfolio optimization and generates greater value for members. 6. CONCLUSIONS The global asset management industry does not use the minimum profitability guarantee. It is replaced by contractual credibility and the effect on reputation based in the performance attribution analysis. In the case of PPS, it is important that the established methodology of minimum profitability guarantee does not hurt the process of portfolios optimization (the benchmark is no longer an average of the PPS returns) and there will be an adequate coverage for operational risk. The fund managers have incentives for proper portfolio management since the bad reputation cost derived from not doing so is very high, constituting a complement to explicit incentives such as benchmarking and trustee liabilities.