Cerulli Asia-Pacific Edge: Asian pensions gather pace

Asia Pacific Edge, October 2010

Asia’s largest state pension funds are swiftly evolving into sophisticated institutions willing to allocate to new markets and asset classes. It’s a transition that is creating opportunities for external fund managers in the region and worldwide.

A look at four of the largest state pension funds in Asia illustrates the changing nature of this sector of asset management. Korea’s National Pension Service, China’s National Social Security Fund, Malaysia’s Employee Provident Fund and Taiwan’s Public Service Pension Fund all to varying degrees show increasing innovation in investment approach, diversification, and willingness to use international external managers.

The biggest of the four is Korea’s National Pension Service, previously known as the National Pension Corporation. As of March 2010, when last disclosed, it had W289.5 trillion (US$245.8 billion) under management and its management has spoken of hoping to reach US$400 billion. These figures dwarf the Korea Investment Corporation sovereign wealth fund, which has tended to attract more headlines; in fact, it’s the state pension fund that has by far the most money and hence probably the greatest opportunities for international fund managers. Since all Korean workers, including foreign employees, are covered by the NPS, it is only going to keep growing: it already covers 18 million people.

One reason the NPS has not attracted quite the same attention as sovereign funds is that most of its assets are deployed domestically and conservatively. By the end of 2008, for example, 77.7% of the fund was in domestic fixed income and 12.1% in domestic equity – only 2.4% went into overseas shares, 4% overseas fixed income and 3.8$ alternative investments.

But the NPS also discloses a long-term target for asset allocation, and this speaks of dramatic shifts in assets. By 2014, it hopes to have more than 10% in overseas equity, up to 10% in overseas fixed income, and more than 10% in alternative investments, with the domestic fixed income contribution dropping to a maximum of 60% and domestic equities potentially topping 20%. (These figures add up to more than 100% as some of them are maximum allocations.)

When a $250 billion fund changes its allocations in this way, that means almost US$19 billion of money shifting into overseas shares, for example – a clear opportunity for foreign managers. It’s not yet clear what form the alternative allocations will take, but it’s already evident this part of the portfolio is going to involve a major chunk of direct property: purchases have included 12% of Gatwick Airport, the HSBC headquarters in London’s Canary Wharf, and the Aurora Place office tower in Sydney.

We know that the NPS is a willing outsourcer, as it has previously published a list of international managers it works with, including 20 active and passive international equity managers, six fixed income managers and 23 alternatives, mainly private equity groups. Domestically, NPS outsources about as much of its equities coverage as it handles internally; overseas, though, it’s unlikely to believe it has the expertise to invest successfully through internal staff, suggesting that most of this shift to overseas assets will be done through external mandates.

While what’s happening at the NPS is exciting, the pace of development is arguably greater in China. The National Council for Social Security Fund was only founded in 2001, following a State Council decision the previous August; by the end of 2009 it had RMB116.5 billion, or US$113.7 billion, under management.

As with Korea’s NPS, the story is not really about allocation today, but where it’s going. As of December 31 2009, it had only 6.54% allocated to global stocks; additionally some of the 40.67% allocated to fixed income is likely to be international. However these proportions are considered likely to increase. The law allows NCSSF to invest in quite a range of international securities and assets: bank deposits, foreign treasury bonds, bonds of international financial organizations, bonds of foreign entities, foreign corporate bonds, overseas bonds issued by the Chinese government or Chinese enterprises, money market products such as banking drafts and large CDs, stocks, funds, derivative instruments such as swaps and futures, and “such other investment products or instruments jointly approved by the Ministry of Treasury and the Ministry of Labour and Social Security.” Particularly on the debt side, that really doesn’t exclude much.

Additionally, NCSSF has built a strong roster of international managers for mandates. The first round was announced in 2006, with a further 13 active equity mandates announced in 2009 (see table). The range of top managers suggests to many observers that overseas allocations will increase, particularly to emerging markets (notably, there was no separate mandate for US equities last year).

Nobody is expecting NCSSF to go wild with mandates to hedge funds and exotic asset classes any time soon. As a social security fund, its policy is based around what it can afford to lose as much as what it should gain: in the medium to long-term it is expected to return no less than 3.5% annually, while never losing more than 10% in a year.

But it’s the fund’s potential that really suggests opportunity. NCSSF’s own literature describes its role, with magnificent simplicity, as “to be a solution to the problem of aging.” It gets contributions from the central government, from the lottery public welfare fund, from the transfers or sales of state-owned shares, from other capital raisings approved by the State Council, and even from other funds such as the Industrial Pooling Fund, another pension fund whose assets the NCSSF has also run since April 2004. It is headed by Dai Xianglong, and that’s considered relevant too: he’s one of the most powerful politicians and bankers and China with a CV that includes being mayor of Tianjin and head of the People’s Bank of China, the central bank. Nobody doubts that a great deal more assets are going to be entrusted to this powerful institution.

At more established pension funds, the pace of change is naturally less intense. Taiwan’s Public Service Pension Fund dates from 1943, for example, and is unlikely to reinvent itself dramatically now: its 2009 asset allocation ratios (40/60 fixed income to capital gains assets, 54.9%/45.1% domestic to overseas, 55%/45% external to outsource) has been refined over many years and will not swiftly be changed. One could argue it has already reached some of the destinations that newer funds will later arrive it, in terms of international investment and use of external managers. Outsourcing practices here tend to resemble sophisticated sovereign funds: Cerulli understands PSPF prefers not to give passive mandates, instead preferring value-add active strategies; that no further overseas mandates are expected this year; that ETFs are used; and that multimanager structures are eschewed because of the additional layering of outsourcing involved and the consequent loss of control.

Fundamentally, the challenge for Taiwanese institutions is very different to that in a newer pension market like China: it’s the daunting prospect of not having enough funds to meet the liabilities of those who will soon seek to draw down their pensions. In China, those sorts of issues are decades away.

Between the two extremes falls Malaysia’s Employee Provident Fund – younger, dating from 1991, but clearly well established and serving a society in transition from developing to developed world. The EPF has more than 12 million members and had RM406.55 billion (US$130 billion) under management by June 30 this year; its future is bolstered by mandatory contributions of 20% of employee wages (8% from the wage, 12% from the employer).

The EPF is a conservative institution and its asset allocations are chiefly domestic. As of June 30 23.32% of its funds were in Malaysian government securities, a further 37.28% in loans and bonds and 6.79% in money market instruments; beyond those debt-related securities 32.21% was in equities and just 0.4% in property. Of all that, just US$5.92 billion was invested overseas by the end of 2009, US$2.38 billion of it outsourced to external fund managers.

The EPF has a strategic asset allocation document which calls for a greater expansion into international equities, to 9% of the total portfolio, and this is beginning to happen; $1.28 billion of these investments were made in 2009 alone.

For all these funds, and other Asian state pension funds, the shift towards international diversification and use of new asset classes is just part of the story. Underpinning it all is a population which, while largely youthful today, will one day need to be provided for in old age. Some countries, like Japan, are pretty much at that point already; others, like Taiwan and Korea, are much closer to it than those like China or India. Each of them needs to deal with the prospect of deficit for this segment of population, and their conclusions about the challenge ahead will dictate how they build their pension funds, how they allocate, and what spoils fall to external managers.

For managers chasing mandates, it is helpful to be able to demonstrate long-term track records, to be able to deliver reliable performance without necessarily shooting the lights out, and to become a trusted partner. Unlike in sovereign wealth funds, where the focus is often on innovative new alpha-generating ideas and alternative assets, pension funds for the moment are more likely to reward proven steadiness.