The Social Security Reserve Fund (FEFSS) is the buffer fund for the Portuguese social security department's pay-as-you-go system. Until 1998, the fund's investments were limited to vehicles issued by Portuguese entities. But that was to change with the introduction of the euro, as Portugal's ‘domestic' market in terms if its currency was greatly expanded to include the Euro-zone. All euro-denominated investment vehicles are now potential investments for FEFSS.
But some felt there was scope to broaden the fund's investment reach yet further. In 2003, the directors of the Instituto de Gestão de Fundos (Fund Management Institute) questioned the best long-term asset weighting the scheme should go for and whether or not investing in assets denominated in OECD member currencies would improve its level of diversification. The board reached two conclusions.
Firstly, the state-sponsored scheme would add value to Portugal's national budget if long-term profits on returns remained positive relative to the cost of public debt. Otherwise, divesting the scheme's assets would be a better option to cover new public debt being issued in line with the needs of the social security system.
Secondly, a strategic asset allocation study was undertaken to determine the best possible composition for a portfolio of just euro-denominated assets versus an alternative portfolio that included OECD currency-denominated assets and the added value this diversification would bring.
In line with the historical 4% volatility rate of Portugal's national debt over the past 10 years, the board allowed for 4% volatility in the asset allocation study, with each proposed portfolio containing a 25% allocation to bonds.
The main result? The diversification into OECD assets increases the expected real return from 3.46% to 3.88% for the same anticipated 4% risk allowance. It also found that positive real returns can be expected sooner, in just under 2.9 years instead of 3.6. The equity weightings also increased from 12% to 21% and the real estate investments from just 2% to a healthy 10%.
With the optimum strategy decided, FEFSS entered the final stage of its review which consisted of setting benchmarks and selecting the right reference index for each asset class and monitoring the reliability of its long-term expectations through risk, return and correlations. A full market benchmark was determined to measure the scheme's performance.
When investing directly in the markets, FEFSS says institutional investors pay for trading and settlement services and then for custody and other administrative and fiscal areas such as tax recovery. Since most of these expenses are scalable, FEFSS believes it may be beneficial to outsource these services to major players in the investment management industry In addition, institutional investors have a long-term investment horizon and a considerable part of their portfolio is structurally invested.
With this in mind, FEFSS's board took the decision to implement a management model with a low tracking error. Thus, structural elements of the portfolio have been progressively outsourced to large institutions on an ‘all-in' cost basis, including the cost of trading, settlement, custody, income collection, tax recovery, and securities lending.
FEFSS says this approach has allowed its in-house teams to devote themselves to monitoring the way the investment markets evolve, enabling them to follow a tactical asset allocation programme. They have essentially focused on reviewing allocations relative to benchmark for US equities, European equities and Pacific equities and their respective weightings. They also determine currency hedging positions for the euro-dollar, euro-yen and euro- sterling exposures. They can undertake duration management for the euro, US dollar, sterling and yen bond yield curves and determine the allocation of real estate assets to different property sectors, such as the retail, office and logistics markets. Taken as a whole, the tactical allocation policy is designed to outperform FEFSS's benchmark.
To prevent excess negative returns, FEFSS has devised a strategy that the anticipated 12-month rolling returns does not fall below 80 basis points with a 95% confidence level.
FEFSS claims this process of enhanced management allows it to take decisions involving many variables. The board then submits these decisions to a benchmarking process that checks both market indices and peers' performance.
Highlights and achievements
Pay-as-you-go systems across Europe are facing crisis. And if they are to carry on providing pensions to growing armies of pensioners, then the need to review the way they make money is as pertinent as for funded schemes in the private sector.
The decision of Portugal's FEFSS not to confine itself to euro-denominated assets has paid off. Return forecasts are good and the diversification will give it a certain level of protection and flexibility.
Outsourcing many of the administrative functions has allowed it to streamline its internal teams so they can focus on investments and implement a comprehensive and well-structured tactical asset allocation policy.
The new structure should give the scheme confidence and allow it to keep Portugal's state pensioners covered in a cost-effective and efficient manner.