Retirees Expect Pension Funds to Bring Long-Term Gains
Data from Chile Show Pension Fund Managers Prefer Short-Term Investments
Herding Behavior In Pension Funds' Investment Choices
Washington, February 6, 2012 — Pension funds in stable developing countries are expected to focus on long-term gains for retirees, given that such funds enjoy stable capital, professional management and strong support from policymakers. But are the funds functioning as pensioners assume?
Not quite, according to recent World Bank research, which analyzed a rare trove of data covering trading activities from 1996 to 2008 by the entire Chilean pension industry, which is based on a defined-contribution scheme. Fund managers, according to the analysis, appeared to have adopted passive investment strategies, holding a large amount of short-term assets, such as cash, government paper and corporate debt, which can be easily liquidated.
About one-third of non-equity assets in Chilean pension funds were held for one year or less during the period, 60% of them up to three years and nearly 80% five years or less — averaging 3.16 years. By contrast, U.S. multi-sector mutual funds, which also invest in government and corporate paper, mature in 9.55 years on average.
“Despite the benefits of long-term debt, emerging economies seem to face an uphill battle to extend debt maturities,” says Sergio Schmukler, an economist in the World Bank’s Development Research Group, who conducted the research with Claudio Raddatz and Luis Opazo, both of the Central Bank of Chile. “Many people put all their retirement money into pension funds for a good return 20 or 30 years later, but the funds aren’t working as many envisioned.”
The research comes as several developing countries are trying to develop markets for long-term lending, adopting measures such as promoting institutional investors and lengthening the maturity structure of sovereign debt. Yet little is known about how financial intermediaries, such as pension funds, are investing the pensioners’ savings. Under the defined-contribution system adopted by many countries, pensioners are forced to put their savings in funds managed by financial intermediaries, assuming that professional asset managers would invest for the long term.
The new findings about Chilean pension funds are surprising. Chile offers one of the most suitable environments among emerging economies for long-term investing. The government, with a series of reforms, tried to develop markets and extend maturities. It has a stable economy and a relatively developed capital market, with many types of large institutional investors.
Over the years, Chilean pension funds have accumulated much of the country’s savings. Fund managers there have access to long-term investment instruments issued by the government or the corporate sector. In addition, they don’t seem to be hoarding short-term investments for future opportunities, such as buying bargain-priced assets, either. In fact, pension funds tend to have little turnover, which doesn’t square well with the idea that they become drivers of secondary capital market liquidity.
Why, then, do the fund managers prefer short-term investments? Those investments are less risky to Chilean pension funds. And fund managers have the incentive to not fall behind their peers. Managers are constantly evaluated by investors, regulators and their managers against benchmarks, and if they don’t do well, they could lose customers and have fewer assets to manage.
That herding behavior isn’t limited to short-term investments. The funds also tend to copy each other’s investment decisions, especially in opaque areas such as corporate bonds and financial institutions bonds, the research shows. Herding is more obvious among similar types of funds, indicating that managers tend to stay with their direct competitors, instead of deviating from industry standards.
Much is at stake. Without a long-term focus, pension funds may generate lower returns than expected for retirees. Companies and governments, meanwhile, will have limited capacity to engage in projects that are profitable in the long term but risky in the short term. Developing countries, after paying hefty fees to fund managers, may not achieve their long-term development goals in asset maturity.
Already, defined-contribution systems are attracting criticism. But optimal solutions are hard to find. Argentina recently abandoned a pension system similar to Chile’s. Its system is now nationalized. A more cautious approach: change the incentives for asset managers and encourage them to herd less and invest for the long term, Schmukler says. But that can be hard to achieve, considering the need to evaluate managers in the short run.
“Investors and regulators face a trade-off between the need to monitor asset managers on a regular basis, and giving them incentives and space to engage in long-term arbitrage and asset discovery,” the authors write.