Sucheta Dalal :Govt's investment dilemma: pension funds in the market
Sucheta Dalal

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Govt's investment dilemma: pension funds in the market  

Feb 19, 2007

Should pension funds invest at least 5 per cent of their corpus into the capital market in order to boost their returns? This question usually meets with a snap answer; unfortunately the yea-sayers equal those who say nay. Reformists believe that a 5 per cent investment is too tiny to cause serious damage to the overall corpus, even if it is grossly mismanaged, while it can boost overall returns of the pension fund if managed well.

On the other hand, many of us who have watched how the system operates and how easy it is for unscrupulous market intermediaries to induce fund mangers to buy dud stocks or provide exits to a price ramping operation are wary about opening the doors to capital market investment, without a completely revamped system of regulation, supervision, disclosure and accountability.

At the end of January, Trustees of the Employee Provident Fund Board, once again rejected the proposal to invest any money in the capital market. The Communist Party of India (Marxist) also declared its intention to oppose capital market investment by the New Pension Scheme or to allow private players to manage these funds.

In fact, permitting the new contributory pension funds to invest in the market will create the biggest pool of funds after the demise of the Unit Trust of India. It will also be the target of every unscrupulous market operator and businessman colluding with friendly politicians.

Are these fears justified? Those who support investment of pension funds in the stock market must pay attention to the Chinese stock market bubble. Edward Chancellor’s recent column in the Wall Street Journal says that the bubble commenced after the state social security funds started buying up stocks in 2005. According to him, “state owned enterprises, local governments and Communist Party bigwigs are widely believed to be deploying funds in the stock market”.

The Chinese government, which is a player in every aspect of the stock market, including control over stock brokers, is trying to talk down the market for fear that an all out crash could take the country into recession.

Chancellor writes, “The aftermaths of great financial bubbles also follow a common course — investor disappointment often give way to recriminations and a political backlash”. It is something that our government, already fighting the inflation demon, would want to keep in mind.

While opposed to direct equity investment, many of us believe that a index tracking fund is probably safer, has less scope for mal-investment while providing the benefit of index appreciation in a fast growing economy.

However, a non-profit governance advocacy group in Hong Kong — — has recently issued a three-part alert to investors about the high cost of index tracking funds. It warns, “that a Mandatory Provident Fund (MPF) index-tracking fund cost employees 2 per cent per year on their accumulated contributions, equivalent to a 55 per cent value-reduction over 40 years, or 33 per cent over 20 years, relative to the underlying investment performance”.

The site argues that these costs are higher than what an investor would have earned by investing directly in the market or in an index fund. Webb says that every $1,000 investment in the MPF has cost $138 in five years — “if the MPF continues over a lifetime of contributions, the performance of all funds will be crushed by the expenses”.

The advocacy group argues that the MPF is hugely expensive to administer and regulate, and as the contributions accumulate, “it won’t be many more years before the annual fees and expenses on the funds are more than HK spends on old-age social security”.

Indian policy-makers have debated several aspects of the Hong Kong MPF system, so it is important to note its drawbacks as well. Logically, competition between fund managers ought to have kept expenses low and in check. The Hong Kong MPF is managed by well-known names such as — ING Pension Trust, HSBC, Fidelity, Prudential and Sunlife.

But Webb argues that competition is killed by the fact that the employers choose the fund managers not the contributing employees. Employees can change fund managers when they switch jobs, but they would incur exit loads or redemption charges. Interestingly, civil servants in Hong Kong are not subjected to the high overhead costs of MPFs, because their pension is paid out of taxes collected by the exchequer.

David Webb, who heads the group, is now lobbying to get the government to drop its proposal to increase ‘relevant income’ for calculating employee contributions to the MPF from $ 20,000 to $ 30,000. He has also called for an abolition the MPF itself on the grounds that long-term blockage of an employees funds in unfair, especially when he/she cannot touch the money even if the loss of a job is likely to lead to a default on mortgage payment. In these circumstances, high expenses and fund management fees begin to rankle even more.

Indian employees may not necessarily be as conscious about the cost of their money if such a pension scheme were to be launched in the near future. After all, we are used to gross inefficiencies in our financial system that allows banks to enjoy large spreads of 4 to 5 per cent.

Many Indian index-tracking funds already have an expense ratio of as much as 2.5 per cent thanks to the inaction or reluctance of the market regulator to cap these charges. Furthermore, a few index funds have even managed to significantly under-perform the index when all they are supposed to do is simply buy and hold index stocks!

High expenses, costs and fees will turn into a contentious issue in India as well if the government proposes to mandate contributions. Moreover, in the absence of any social security, no democratic government can survive the damage if a contributory pension fund scheme, with compulsory employee contributions goes belly up due a flawed system of funnelling money into stock markets.

-- Sucheta Dalal