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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.