Rules of engagement for funds

Provincial social security funds in China are invested very conservatively and have earned just 2 percent a year over the last 10 years or so. There is a need to boost the returns on these funds in order to finance the defined benefits without increasing contributions. At the end of March, the Guangdong provincial social security bureau decided to let the National Council for Social Security Fund manage around one-third of its funds, 100 billion yuan ($15.86 billion), as the NCSSF has made returns of around 9 percent a year.

The detailed rules of engagement for this experiment have not been publicized, but a number of questions remain unanswered.

Will the assets be ring-fenced and managed as a segregated account, or will they be merged with all the other funds managed by the NCSSF and the overall return credited to the amount allocated by the Guangdong social security bureau?

The NCSSF manages around 800 billion yuan, so the funds from the Guandong bureau are not insignificant. The size of the funds is certainly large enough to merit a separate investment account. It would not be necessary to merge the assets to enjoy the economies of scale that come with a large account. A separate account would be transparent and would not be complicated or confused by the returns being earned on the funds that the NCSSF was managing before the transfer.

What costs will the Guandong social security bureau incur?

The investment strategy adopted by the NCSSF will need to generate a return on assets that exceeds the return the Guangdong bureau could have achieved before fees.

Moreover, the costs that the bureau incurs will continue to a large extent, but they will now be spread across a fund that is two-thirds its previous size. The Guangdong bureau will need to assess what cost savings can be made now that the NCSSF is taking over some of its role in order to avoid a duplication of costs.

Also what fees will the NCSSF charge the Guangdong bureau? As discussed earlier, these fees will be in addition to costs that the bureau is already incurring. Moreover, if the NCSSF outsources any of the tasks to external managers, there will be additional fees again. It will be important that the target returns are greater than previously achievable plus these additional expenses.

It appears that there will be a guarantee that the return will not be less than two years' deposit rates, who is going underwrite this guarantee and will there be a charge on the assets for the guarantee?

The extent to which the fund manager invests the funds in anything other than two-year deposit bonds represents a risk that the return will be lower. Any premium paid to offset that risk is an additional expense to the fund.

This needs to be managed carefully so that the net return is higher than would be achieved without taking the risk. Furthermore, due diligence should be carried out on the guarantor to ensure that they are financially capable of supporting the guarantee.

The returns achieved by the NCSSF have only recently been achieved at a significant premium to bond returns. This has largely been as a result of participation in equities and being granted preferential access to equities arising from the privatization of State-owned enterprises. It has been suggested that for the Guangdong funds, the NCSSF's guidelines might restrict them to investing in fixed income, will the NCSSF have any latitude to invest away from any guidelines?

The asset allocation rules will be crucial to a successful investment outcome. However, the rules that govern how the managers can seek higher returns as new opportunities present themselves must be transparent.

The coming 24 months of this experiment will reveal if this bold move can raise the returns on the social security funds for China's workforce.

The author is an actuary with Milliman, an actuarial consulting firm, founded in Seattle in the United States in 1947, and is responsible for employee benefits

consulting in South Asia.

(China Daily 04/10/2012 page9)