Taiwan’s pension funds are adopting increasingly sophisticated allocation strategies as they try to find their footing in the volatile global economy, while negotiating the limitations of a small onshore market. Progress has been slower on the policy front however, and a final date has yet to be announced for the completion of the merger of the Labor Pension Fund (LPF) and the Labor Insurance Fund (LIF).

 This long-awaited reform remains at the top of the administrative agenda and represents an important step towards streamlining the array of social security funds that comprise the region’s retirement system. While the LPF, LIF, Public Service Pension Fund (PSPF) and National Pension Insurance Fund (NPIF) continue to diversify their assets and increase outsourcing, any major changes at “the big four” seem only likely to come with the completion of the merger.

 Some industry insiders believe this could happen later this year, though that remains far from certain, says Daniel Yang, chief investment officer at local fund manager Polaris. Meanwhile, the prospect of change has played a positive role in nurturing debate over the future development of the industry and the merits of a mandatory public pension scheme as opposed to a system that gives more choice to the individual. “But there is still a long way to go, and it remains unclear which direction the industry will take.”

 Developments are moving faster on the asset allocation front, driven by low yields on Taiwanese government bonds and the stability of domestic equities in a volatile global market. Added to these factors are the long-term pressures of a rapidly aging population and a wider slowdown in the Taiwanese economy.

 Against this backdrop, asset allocation strategies are becoming increasingly aggressive, says James Liu, BNY Mellon’s Taiwan executive: “Taiwan pension funds tend to be conservative and short term. Since Ma’s re-election and the appointment of the new Premier, the asset allocation strategy for the domestic market has been more aggressive. Based on research and recommendations, it is expected the pension funds’ investment strategies will likewise become more aggressive.”

 Liu also expects a rise in overseas mandate invitations, including equities along with alternative and emerging markets strategies, as funds seek further diversification and higher returns. The island’s pension funds are furthermore hoping to benefit from China’s QFII scheme, which recently added overseas pension managers to its quota for the first time. The limits on foreign pension investments have been lowered in the past few years due to unstable world economy, however, and such restrictions are expected to remain relatively low in 2012, notes Michael Chan, managing director of asset servicing at BNY Mellon.

 Taiwan’s pension funds have in the past tended towards developed market sovereign debt, mostly for reasons of security and diversity, but are now giving increasing consideration to more daring strategies, says Pauline Lee, vice president of institutional business at J.P. Morgan Asset Management. “They have indeed been more aggressive by adding investment-grade corporate bonds, real estate investment trusts, and emerging markets equity mandates since last year. This year we may also see some RFPs for emerging market debt mandates.”

 The relative stability of Taiwan’s stock market means domestic equities form an important part of a more pro-active management strategy. “Taiwan equities pay decent yields that may reduce overall volatility in [pension] portfolios,” says Lee. The TAIEX Total Return Index has climbed by almost 15% so far this year, helped by healthy inflows from foreign investors. These amounted to NT$1.73bn ($58.72m) during the week of 20-24 February, bringing net stock purchases by overseas investors in 2012 to NT$96.07bn.

 Moreover, asset managers must up the ante if they are to meet the demanding absolute return targets set by recent mandates. The LPF’s most recent four-year RPF mandate issued in February seeks six local managers to handle a total of NT$30bn under the old pension fund system, and asks for an absolute annual return of 9%. Most of last year’s mandates set similarly high requirements.

 But the Old Labour Retirement Fund has recorded returns above 9% only three times since 1987, and last year’s returns were 3.5% in the red. Other recent LPF mandates have taken the alternative approach of using the Taiwan Employment Index 99 as a benchmark, and seeking a 1% alpha target.

 In the face of such pressures along with widespread economic uncertainties, relative return mandates are also gaining traction. While passive mandates have become an established feature of the offshore market, the LPF only issued its first passive onshore mandate last year. “We are seeing increasing interest in alternative products and also rising allocation in passive strategy on both onshore and offshore mandates,” Lee says.

 By giving asset managers more room for error, relative return mandates allow them to vie for higher yields by increasing their exposure to riskier assets like equities. As the size of Taiwan’s pension funds has swollen, passive management has also become an important solution to the growing shortage of highly-talented asset managers who are capable of satisfying the requirements of absolute return mandates, says Polaris’ Yang.

 The LPF set a relatively high tracking error (TE) of less than 6% for its first onshore passive mandate - a move partly intended to give domestic fund managers some time to learn the ropes, according to Yang. But this figure will fall in subsequent RPFs as the fund seeks more consistent returns, with the next mandate in March set to carry a TE of less than 3%.

 Offshore mandates can be less forgiving. Lee says: “In offshore mandates, RFPs typically seek an alpha target of 2% to3% and an ex-ante TE of 4% to 6%. Last year some global equity mandates required a TE of just 0.5%.  We will also see this kind of low TE mandate coming up this year.”

 Meanwhile, outsourcing continues to gain in popularity. The practice has become increasingly necessary since it first emerged 10 years ago, during which time state-managed pension and insurance assets have ballooned. Total AUM under the LPF reached NT$1.3trn as of December 2011, including NT$742.80bn under the new pension system and NT$562.13bn under the old pension system, along with NT$451.99bn under the LIF and NT$482.14bn under the PSPF. The demand for higher returns has further encouraged funds to better leverage the expertise of asset managers.

 BNY Mellon’s Chan says: “Taiwanese pension funds and asset managers are much more open to discussing the outsourcing of back and middle-office services in order to improve operational efficiency, manage cost, support international expansion and support overseas investments.”

 Middle-office outsourcing in particular is increasingly coming under consideration, he adds. “We have noticed growing interest from market participants and regulators alike to better understand the mechanics and benefits of implementing outsourcing solutions, and are having regular conversations to help improve understanding of the options available.”

While the policy outlook may be dominated by the LPF-LIF merger, also on the cards this year is a pilot housing endowment scheme, Ministry of the Interior of Social Affairs announced last month. This programme, set to kick off in 1 July in Taipei, New Taipei and Kaohsiung City, will allow eligible homeowners over the age of 65 to take out a reverse mortgage on residential properties worth less than NT$10m which will be used to fund a monthly annuity.

 The scheme is intended to improve pension provision for the large number of ex-private sector workers who have little or no coverage from their former employees and lack a commercial insurance policy. Researchers believe such a programme could attract 200,000 to 350,000 participants, with 40% coming from the Taipei metropolitan area.

 Another issue long on the policy agenda is the farmers’ pension system. “Raising elderly farmers’ monthly payments from the welfare pension has always been a political issue during presidential elections in past years,” says Hung-Hao Chang, associate professor of the Department of Agricultural Economics at National Taiwan University and author of a report recently presented to the National State Council.

 According to Chang’s research, the current system discourages farmers from passing farmland on to the next generation by basing eligibility requirements on land ownership and farm working hours. This has created a serious aging problem in Taiwan’s agricultural labour force, thereby damaging overall productivity. Official data show there were 703,278 farming households in 2005, while the average age of a farmer was 62 - much higher than in developed economies.

 One solution proposed by the professor would be to pass land management rights to the government, while allowing farmers to retain ownership.

 Such micro policy issues aside, the industry has a resoundingly positive outlook on the principle issue of the LPI-LPF merger and the centralisation of the pension system, despite its slow progress. Meanwhile, the ongoing difficulties global economy and the limitations of the domestic market are likely to continue accelerating the move towards a more sophisticated asset allocation strategy among pension funds and asset managers.