For many years Cyprus was a rather inaccessible economy. Artificially high interest rates and restrictions on the movement of capital did not inspire much thought or creativity, to put it mildly. And as the island’s abundant sunshine contrasted starkly with its reputation for shady dealings, money laundering being the primary form, it was clear that the investment scene needed its own version of the famously refreshing Cypriot fresh orange juice. Now EU accession has brought relief to the barren landscape and a number of investors are keenly eyeing more credible sources of return.
The institutional market in Cyprus consists of the following main institutional categories: insurance funds which are mainly unit-linked products; the pension provident funds; the closed-end company funds and mutual funds.
Christos Akkelides, director of asset management services at Egnatia Financial Services in Nicosia estimates that the total size of the provident funds market is CyP1.8-1.9bn (€3.2bn). “The majority is defined benefit, concentrated in five or six large employers,” he notes.
Defined benefit (DB) plans exist for the so-called semi-government schemes like the utilities and the funds like the banks and oil companies or for sector funds like the hotel workers and construction workers’ fund. “There will be no switch to defined contribution in the next five years,” Akkelides notes. “The reason is that the unions are very powerful and are strongly resisting such a move. But eventually we will follow the rest of Europe.”
Most of the occupational pension funds are run by boards of trustees similar to the UK model.
Management of the system has been surprisingly lax. “Defined benefit plans are governed by individual trustee boards but there was no supervisory authority,” Mannaris notes. “But in practice the DB plans have always invested prudently”
Until Cyprus joined the EU investments in overseas assets were not permitted. This and the fact that there are limited opportunities in the local market meant that most pension funds did not consider their investments in the most appropriate manner relative to their liabilites.
Until 2001 Cyprus operated an enforced system of fixed interest rates of 6.5% on lending and deposits. Akkelides notes. “The high fixed rates ensured that government bonds and deposits were the best investment in terms of risk return profile. Cyprus was a very closed economy.”
“It didn’t make much difference whether you invested in bonds or cash,” notes Marios Demetriades, manager of Nicosia-based Laiki Asset Management. “So it took a while for people to understand the difference. Even when interest rates were falling and it was very obvious that people should buy long-term bonds to hedge themselves against the convergence with the euro interest rate. Then the banks started offering high short-term interest rates because they lacked liquidity. People couldn’t understand that even though they were getting high interest rates for one year they were foregoing the high interest rates for subsequent years.”
“Investing in cash and government bonds (which offered attractive rates of return up to now) was considered good enough,” says Philippos Mannaris, head of Hewitt’s Retirement and Financial Services practice for Cyprus clients, based in Athens. “Now, with falling interest rates (in anticipation of joining the Euro-zone) and large deficits emerging in some DB schemes it became apparent that their current investment strategies were not in line with their funding objectives.”
The electricity workers’ fund of around CyP240m and the telecom workers fund of around CyP300m are the largest semi-government funds in Cyprus and represent more than 80% of DB fund assets. “They are currently heavily mismatched being 90% invested in cash and bonds,” says Mannaris. “This is mainly due to the limited local opportunities, the restriction on overseas investments and the lack of sufficient knowledge and awareness about the need to seek proper investment advice to obtain an asset allocation which suits their liabilities.” He adds: “Most DB funds of the semi-public sector (including these two) invested heavily in government bonds via the primary market, partly influenced by the government and mainly because this was the best available alternative to cash. We are glad to see that at least the larger funds are being proactive and are starting to give greater focus on enhancing investment strategy returns on a risk-adjusted basis and a move to further prudent diversification such as increases to overseas investment and consideration of broader range of investment opportunities.”
Most pension funds belong to semi-government organisations which have boards of directors appointed by the government. “In most of the cases these funds have investment sub-committees which consist of members who in most cases don’t have the necessary expertise,” says Demetriades. “So they have no incentive to take any risk at all. They also feel that if they take risk and something goes wrong they will be criticised.”
Akkelides also highlights the importance of trustee education. “Provident funds primarily seen as savings products and part of an overall savings portfolio, and this is my main concern,” he notes. “This will be a major stumbling block to asserting proper well defined asset allocations to meet the long term objective. So we have been trying to explain that over 20 years an incremental annual return of 1% will make a big difference to their retirement income.”
Mannaris already sees concrete evidence of an improvement in investor attitudes: “There was not much need for investment consulting services but now we are seeing an increase in demand. It appears that pension institutions will start to take more appropriate measures in setting the long-term investment strategies than has been the case so far. With the accession to EU we see people willing to modernise their investment programmes by initially gaining more understanding and knowledge on the key pension investment issues, which is the first crucial step.”
Things are moving in the right direction: “This is changing because interest rates have come down considerably and are expected to come down further with convergence with euro,” says Akkelides. “Currently the difference is 125bps. This represents a major structural change in investment landscape and it is sounding alarm bells for trustees.”
In addition to the interest rate issue, movement of capital was severely limited in the past. However, this was abolished two years ago when Cyprus joined the EU. “This and the fall in interest rates has created an appetite for other asset classes,” Akkelides continues.
“With the adoption of Euro we are likely to see more competition from foreign managers,” says Demetriades.
He adds: “The products of foreign managers are already distributed via a whole network of local fund managers. But managers like Credit Suisse AM and Morgan Stanley are already going direct to the larger funds of around CyP10m or more. We will also see in future local managers playing a part in organising discretionary mandates from foreign players. Furthermore we have found foreign partner who registered part of sicav in Luxembourg which invests in Cypriot and Greek equities. And we are managing it. Local fund managers should form alliances to manage products where they have the expertise.”
Implementation of the directive is not proving very straightforward. “A mere transposition does not create an efficient regulation framework,” says Mannaris. “There needs to be a lot of elaboration, particularly regarding the requirement for trustee knowledge. Furthermore the initial draft excludes schemes with less than 100 members. This would leave outside regulatory framework the vast majority of defined contribution plans. The government could consider relaxing this 100 member rule to, say, 50. But bearing in mind the cost constraints for small funds perhaps they should not require implementation of all requirements but implementation of some crucial elements like trustee knowledge, governance structures and investment rules.”
Demetriades is not optimistic: “I don’t think they will change; the law will initially be applied to pension provident funds of over 100 members and then gradually to smaller funds,” he says. “This excludes a significant proportion of provident funds – possibly two-thirds of assets under management – because many small companies have a provident fund.”
An area of frustration is that legislation governing mutual funds has been delayed. “The government can’t get its act together on tax incentives,” says he says. “This is a huge responsibility.”
He adds: “None of the governments that we have had in Cyprus has shown sufficient commitment in making the necessary changes. I believe the government has to become more sophisticated and proactive in these kind of things. But it is not just a problem of government. One of largest debates concerned the choice of supervisory body for the new legislation. The unions didn’t want the Securities and Exchange Commission (SEC) because they were afraid that it would be too strict.”
The SEC duly became the new supervisory body in March.
But while progress has been delayed on some fronts, developments in other areas has been much more encouraging. For example, some investors have already begun an early adoption of directive.
We have been commissioned by some of the larger provident funds to design a long-term investment strategic allocation,” Akkelides notes. “In most cases the process will be slow and we expect a time frame of three to four years in which gradual deployment into non-Cypriot assets will be effected. Our own estimate shows that currently, of CyP3.2bn of investments, around CyP3bn is placed in local investments. So there is great scope for that to change: by 2012 we expect that the proportion of local assets will have fallen to around 70%, although this is a very conservative assumption. We recommend that funds should be able to consider investing up to 50% in equities.”
He adds: “But we have to contend with the fear which clients have of trying something new. There is a great appetite for capital guaranteed products because pressure that trustees feel this has been playing a lot in the market. Not only is this fear obviously in evidence but it also becomes bigger with asset classes with higher risk return profiles.”