Different views of sustainablilty

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The government is claiming that recent changes increasing contributions to the state pension system are a major reform. But George Coats finds there are those calling for a more fundamental overhaul

The government raised employee and employer contributions to the state old age pension, the earnings-related general social insurance scheme (GSIS), in April this year. The move was part of what labour and social insurance minister Sotiroula Charalambous called “major reforms to the GSIS [that] include both measures to increase income and to reduce expenditure”.

The reforms also included the creation of a €1bn reserve fund to support the GSIS. Charalambous told a Pensions in Crisis conference organised by Cypriot/Lebanese consultancy Muhanna in early March that public expenditure on pensions was projected to rise from 6.9% of GDP in 2004 to 15.5% by 2050. “The fact that the bulk of pensions are basically financed on a PAYG basis will have serious implications for the future sustainability of pensions and for the economy and public finances in view of the ageing population,” she added.

Within days, the Cypriot parliament had approved a government bill that in the following month raised contributions from 16.6% of a salary to 17.9%. The law programmes in increases of 1.3% - 0.5% from employees, 0.5% from employers and 0.3% from the state - every five years until 2039 when the contribution level reaches 25.7%.
In addition, the government pledged to contribute €200m a year over the next five years to create a  €1bn reserve fund.

A year earlier, the Council of the EU had noted that the long-term budgetary impact of ageing in Cyprus was among the highest in the EU and it urged the adoption of pension reform measures to reduce risks to the sustainability of public finances. Charalambous’ reform law, which was drawn up by the leftist administration of Demetris Christofias, who won the February 2008 presidential election, was presented as having sustainability at its core. “The objective of the government’s social policy is to ensure the financial sustainability of the public and private pensions schemes in the context of a three-pronged strategy for tackling the budgetary implications of ageing, notably by supporting longer working lives, by balancing contributions and benefits in an appropriate and socially fair manner, and by promoting the affordability and security of funded and private schemes,” Charalambous, who is a member of Christofias’ communist Progressive Party of Working People (AKEL), told the Muhanna conference.

So in addition to increasing GSIS contributions the reform raised the contribution period required for receipt of a minimum old age pension from three to 10 years and the total period (of contributions plus credits for education) from 12 to 15 years.
Well, so far, so more or less rosy. But there are those who disagree.

“The reform was mainly concentrated on increasing revenues by increasing contributions,” says social insurance consultant Panayiotis Yiallouros. “But this will not solve the problem of sustainability in the long run. For the past 45 years or so successive governments have been in the habit of borrowing the surpluses of the social security fund, which amount to 35-40% of GDP, and using the money for general budgetary purposes. Currently 98% of the GSIS assets are invested in government treasury bills. If this policy continues it will shift the financing burden onto future generations. But it would be impossible for a government to repay the sums already borrowed and because of this policy being followed for such a long time it would be very difficult to change without upsetting the whole public finance balance.”

Instead, notes Yiallouros, the government is proposing to create a reserve fund. “The minister says the plan is that within five years such a fund would have the equivalent to €1bn, which is about 15-17% of the total debt the state owes to the social security fund.”

Yiallouros accepts that the reform will improve the financial position of the GSIS. “The reserve will be maintained at the current level relative to annual expenditure until about 2015, although it will then start to decline but will not be depleted until 2055, he says. “The impact on public finances is also projected to be positive, as net cash flow from the budget to the GSIS will halve by 2020. However, and this is a big issue, if the practice of investing in government securities continues then the whole reform package will mean nothing. We will end up with a PAYG system which, because of the element of solidarity, will be unfair for future generations, and the health of the system will depend mainly on the public finances.”

The Cypriot government likes to emphasise the positive. Finance minister Charilaos Stavrakis recently dismissed IMF projections that Cyprus’ 2009 growth rate would be 0.3% and claimed rather that it would have the highest and only positive growth rate in Europe for the year 2009 at around 2%. Although he conceded that ‘’2010 will be a difficult year”, the message is that even in these trying times Cypriot public finances are robust.

Charalambous is similarly optimistic. The global financial crisis has not had any immediate and direct impact on the GSIS, she says, because it is “in effect a PAYG scheme”. She is similarly upbeat about the funded second pillar system, the DB occupational pension schemes for employees in the public and semi-public sector and the DC voluntary provident funds for private sector employees. Some 43% of the around 300,000-strong workforce have some form of second pillar coverage, including 100,000 or so in provident funds. “Pension plans are primarily invested in secure assets like bank deposits and bonds, and the level of investment in real assets such as equities is relatively low at around 15% of total assets,” she says.

Philippos Mannaris, head of the Hewitt office in Nicosia, agrees. “They have been fortunate,” he says. “Their conservatism paid off relatively well over 2008. Most of the funds in Cyprus are heavily invested in cash - the average allocation to cash in 2008 was around 65%, with 30% of the funds having 100% in cash - so they protected their capital relatively well compared with other jurisdictions in Europe.”

But this relative security was not a considered approach but is rather a reflection of the schemes’ slow response to the previous pension reform, which implemented the EU pensions directive and which in theory came into force in November 2006.

“There is a time lag,” notes Mannaris. “A lot of the funds haven’t fully implemented the provisions of the new legislation. We estimate that around 60% of occupational pension plans and provident funds, which under the new legislation are all institutions of retirement provision, have still not drawn up a statement of investment principles, which is required by law. And more than 50% of funds don’t use a custodian, don’t use professional asset managers and don’t use an independent investment consultant - so there is a lot of room for improvement in their governance structures.”

However, Mannaris sees some progress. “A trend that started appearing a couple of years ago to move closer to a more best-practice governance structure as far as the investment management function is concerned seems to be still in place,” he says.

This was a move by the more developed pensions vehicles to move ahead to implement the requirements of the November 2006 legislation. These included the pension schemes for the electricity and telecoms utilities and the provident fund for hotel employees.

But their forays into riskier assets at the end of a bull market, proved ill timed. Mannaris, whose firm is the primary source of pension fund advice, is unrepentant. “Those that improved their governance and investment structures by setting long-term objectives, aligning their long-term asset allocations, diversifying and employing professional asset managers have fared relatively better compared with funds that remained invested passively in the local stockmarket,” he says. “And in terms of trends going forward, there is a combination of reactions. Some of the bigger and more sophisticated funds are looking into the opportunities that may be presented to take advantage of the situation, revising their asset allocation strategies to position themselves for the recovery and looking increasingly at diversifying overseas, particularly within the euro-zone. However, we also see funds that are retrenching and reducing their equity exposure and moving back into ‘safer’ asset classes. Whereas in the last few years we saw capital-guarantee products being fashionable, now we see them backing off from those and retrenching back to investing in corporate bonds, cash and government bonds.”

The different approaches are not just a function of how advanced a fund may be but also its status. Although the November 2006 law views both occupational pension funds and provident funds as institutions of retirement provision, the provident funds are at a disadvantage when it comes to investments. They traditionally have more cash than pension funds because their members are allowed to take their money on changing job or being dismissed, and they can only take it as a lump sum rather than an annuity.
“We see a huge increase in payouts by some of the industry-wide funds for people being laid off and taking their pot of money,” says Mannaris. “The economic crisis and rising unemployment is having an impact on some of the big provident funds.”

And this is something that the largest provident fund, that for the hotel employees, wants the government to address. “If somebody leaves from my fund, if he changes job or leaves the industry, we give him the money and he takes it and can do what he wants,” says Marinos Gialeli, general manager of the €250m Cypriot Hotel Employees’ Provident Fund. “But we want the government to change the law so that when somebody leaves we can transfer their pension assets to the new employer or if the new employer doesn’t have a pension fund, to freeze the money here until they retire. This is one measure that I think we have to change as soon as possible. But there are people who argue that the provident funds are not for retirement, that it is an obligation of the government to find the money for retirement and that the provident funds are just to give some extra money. But where is the government going to find the money?”

Timing diversification
The Cypriot Hotel Employees’ Provident Fund is the island’s largest private sector pensions vehicle and its most forward looking.

To this end, it was the first to take advantage of legislation to implement the EU pensions directive that came into force in November 2006 and required local pensions institutions to seek professional advice and to formulate an investment strategy to diversify their portfolios overseas and to allocate more money to non-interest-related products, non-cash and fixed income products.

It undertook an ALM study based on the demographics of its members in 2006 and implemented it in 2007. “We saw that we had to deliver 5.64% per year to our members, with a volatility of 3.24%,” recalls general manager Marinos Gialeli. “Previously, the allocation was 60% in cash, 5-6% in real estate, 2% equities, 15% in members’ loans and the rest was in government and corporate bonds. Based on the ALM results we decided on a portfolio breakdown of 55% in bonds and cash, 15% in equities, 15% in real estate and 15% in loans to our members. It was a very conservative approach. The trustee committee wanted to start slowly and increase the risk when they were more familiar with the investment process.”

The allocation represented the fund’s first investments outside Cyprus. “Of the 55% in bonds and cash, 10% was invested in global bonds and of the 15% in equities 10% was in global equities,” says Gialeli.

The fund drew up its investment strategy with the assistance of the local Hewitt office and hired managers - Schroders and Edinburgh Partners for global equities, accounting for 10% of its portfolio, It has appointed, BlackRock, Merrill Lynch and Goldman Sachs for global bonds, and three local managers, Eurobank Asset Management and National Bank of Greece Asset Management and Hellenic Bank Investments, for local equities.

The timing looked perfect. On 1 January 2008 Cyprus adopted the euro and at the time Gialeli noted that this made the investment process easier, with the euro-zone being regarded as a domestic not a foreign market, easing his trustees’ concerns. In addition, 2008 marked the fund’s 40th anniversary.

But in the event, the timing left the fund with little to celebrate. Initially, it felt unaffected by the market downturn and saw the situation as a buying opportunity. However, by year-end it posted a return of -1.85%, after 6.67% in 2007.

The fund’s members are not amused, says Gialeli. “We have had a lot of arguments with our members over the negative return. Many people do not really understand it. We do communicate. We have everyone’s address, we sent them our results for 2008 and we send a magazine. We have a website where members log-in and they can see their accounts, and we have a call centre, and I personally go to every big hotel in Cyprus to talk to people. But a lot of them feel that if we hadn’t done anything, if we’d left the allocation as it was, then there would not have been a crash and the performance would be much better.”

This is not true, according to Philippos Mannaris, head of the Hewitt office in Cyprus that assisted the fund with the implementation of its asset strategy. “The hotel employees’ fund’s decision to diversify paid off,” he says. “We ran a simulation to see the result of its pre-existing allocation. The new strategy pretty much protected its capital whereas, had it not diversified overseas, the loss would have been significantly higher. That’s because the local stockmarket fell by almost double global equity markets in 2008.”

Following the crash, the allocation has again changed. “Now it’s 30% cash, 35% bonds, 10% in equities (down from 15% because their value has fallen), 9% real estate and the rest was loans to members,” says Gialeli.

The fund is not rebalancing. “On the income side we are getting money in from investments like cash deposits that expire, from the coupons of the bonds and from rents, but most contributions now go to cash,” says Gialeli.

And this year the return looks more promising. “Our return for the first four months of 2009 was around 5% and we may have more than 5% for the year,” he adds. “It all depends on the way that the equities go.”

But the fund faces other problems. Its members rely on the tourist industry, and at 10-15% down on last year the outlook for the 2009 season is not very promising. “So far there have been no substantial layoffs,” says Gialeli. “And the foreigners from eastern Europe and the Balkans attracted to work in the hotels sector in recent years and who may not be re-employed provide a buffer for the local employees.”

Provident funds provide their members with lump sums, not annuities, and these can be taken whenever a member losses or changes a job, which creates an additional volatility. “I have suggested to the board that if somebody changing job wanted to leave the money with us and take an annuity, but the board did not like the idea because it is not something that is required by law,” Gialeli says.

Was the diversification the right thing to do? “Yes,” Gialeli adds emphatically. “Professionally it was the best way to go. The timing was bad but we will stay as we are and in the future I have no doubt it will work well.”

And indeed the fund’s approach has been successful overall in the past. Its annual return since 1996, including 2008, was 5.9% per year.

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