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Attention turns to low returns

Kazakhstan was the first country of the former USSR to implement a pension reform. A funded pension pillar has been working there since 1998. It operates in parallel with the pay-as-you-go system inherited from Soviet times. Along with mandatory pension contributions there are also voluntary and voluntary/occupational contributions.

Kazakhstan's population exceeds 15.3m; the number of individual pension accounts for mandatory contributions is 8.2m. According to Kazakhstan's Agency on Regulation and Supervision of the Financial Market and Financial Organisations (AFN) the total net pension assets as of 1 September 2006 constituted KZt810.9bn (€4.95bn). Growth of these assets from 1 January is 25%.

Total pension savings in the voluntary and voluntary/occupational components of the pension system are less than $5m (€3.9m). There are only 33,000 voluntary pension accounts, amounting to KZt553.1m. The number of voluntary/occupational accounts is even smaller -
3,700, amounting to KZt25.8m.

Kazakhstan has 14 savings pension funds (NPFs). Eleven companies are engaged in asset management, of which seven are specialised in managing the investment of pension savings and four are NPFs that are licensed to manage pension their own assets.

The largest NPFs by net assets under management are NPF of the People's Bank of Kazakhstan (NBK), UlarUmit and the State Fund (GNPF). These funds together manage about 53% of total assets in the system. The NPF of the NBK alone manages about 27% (it is larger than its closest competitor by $600m).

The top two leaders belong to the largest banks - NBK and Kazcommerzbank. To acquire customers the NPF of NBK used the bank's distribution network, which is the largest in the country and represents assets inherited from Sberbank of the USSR. UlarUmit was formed through the merger of two funds, which immediately allowed it to increase market share in terms of assets under management and the number of accounts.

The third fund, GNPF, has had a competitive advantage from the first days of the funded pension pillar. This state fund benefited heavily from the so-called ‘by default' principle where pension savings of employees who did not chose an NPF were automatically deposited into GNPF. This advantage allowed it to quickly move ahead of the competition on assets and the number of accounts. The word ‘State' in the name in itself made it more attractive to customers who, at that time, did not trust private institutions. Recently, GNPF was transformed into a joint stock company.

Today Kazakhstan has only one corporate NPF - Kazakhmys. Two other funds - CaspyMunaiGaz and Philip Morris Kazakhstan joined ABN AMRO (called Grantum NPF). The acquisition of high-income oil clients and sophisticated management techniques based on western standards allowed ABN AMRO NPF to rise to fourth place. It is the leader in terms of the average savings per customer.

The fastest growing fund by assets is DA Kunayev.

It is clear that the record breaking return achieved by NPFs in 1999 - 1,080% - is unrepeatable. Today Kazakhstan's real returns could be close to those in the developed countries, if it were not for high inflation.

As of 1 August 2006, the weighted average coefficient of nominal
returns on pension assets of NPFs between July 2003 and July 2006 reached 24.12%, while the total inflation during the period was 25.96%.

Total net investment income (on pension assets) distributed to individual pension accounts during the
entire period constituted KZt219bn. Of the total pension savings 27%
came from net investment income. During the first eight months of 2006, the net investment income from pension assets grew by KZt45.9bn or 35.4%.

As of July 2006 the total investment portfolio was broken down into the following instruments and percentage of total assets:

Government securities

q long-term domestic securities of the ministry of finance - 20.22%

q Eurobonds on the sovereign debt of Kazakhstan - 0.28%

q short-term domestic securities of the ministry of finance and of Kazakh National Bank - 7.10%

q municipal bonds - 0%

Foreign

q stock of foreign issuers (foreign currencies) - 0.36%

q non-government bonds of foreign issuers (foreign currencies) - 7.89%

q foreign government securities - 1.09%

q securities of international financial organisations - 0.30%

q foreign mutual funds - 0.02%

Corporate

q Kazakh companies' stock- 12.06%

q Kazakh companies' bonds - 31.11%

Deposits

q deposits and certificates of deposit in the Kazakh National Bank and second tier banks - 17.62%

q deposits and certificates of deposit (foreign currencies) - 0%

Other

q gold - 1.08%

q Kazakh mutual funds - 0%

q Investment accounts and other assets - 0.87%.

Although the list of allowed financial instruments has recently been expanded, the pension funds prefer to follow conservative investment policies. The main trend is to gradually move out of stocks of Kazakh companies into corporate bonds (including from foreign issuers) and deposits.

Prime minister Danial Akhmetov advocates a change in the development strategy of the country's funded pension system. There is a serious problem with low returns of the funds. They generate negative returns after inflation is taken into account.

One proposed solution focuses on raising the returns on government securities at least to the level of inflation. Another proposal is to broaden the possibilities of investing pension assets into current investment
projects that are guaranteed by the state. To attract funds to these projects the government is planning to issue "infrastructure bonds". One of the specific projects mentioned in this context, for example, is building a railway in eastern Kazakhstan.

Also, starting in 2007 for the first time ever in the pension system of Kazakhstan the government will
hold pension asset managers and NPFs responsible for reaching a certain target level of returns.
New amendments to the pension legislation established asset managers' and NPFs' liability if they do not meet the target. In case nominal returns on pension assets, as calculated for the end of the calendar year, are below the minimum required return, the pension funds/asset managers will have to compensate their clients for the difference from their own capital. The date from which the minimum required return is calculated based on the results of 2004-2006 is 31 December 2006.

If the weighted average coefficient
of nominal returns (24.87% as of 1 September 2006) does not change, then the level of minimum return required for this period will be slightly above 17%. Clients of pension funds that fail to generate this basic return will be compensated up to 17%.

Alexander Kupriyanov is with the Kellogg School of Management, Northwestern University in Chicago and Vadim Loginov is with FundsHub.RU

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