Wednesday, September 21, 2016

Personal Wealth, The Edge Malaysia Weekly Cover Story: Lower for longer I

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on September 12 - 18, 2016.

Pension funds are beginning to see lower returns from their investments and have warned that this could continue for some time. Hence, contributors will be forced to rethink their retirement planning strategies.

A prolonged period of low growth and low returns from investments is beginning to affect pension funds around the world. Soon, their contributors will be faced with a stark new reality and will have to re-evaluate their retirement plans as they dig deeper into their savings to fund their golden years.

Pension funds are acknowledging the tough investing landscape and are beginning to manage the expectations of their contributors. Numerous experts have pointed out that double-digit returns from assets are a thing of the past and single-digit returns are what we can expect going forward.
The Employees Provident Fund (EPF), which has provided an annual dividend of 6% and above since 2011, has warned that it will not be able to maintain the rate this year as its investment income for the first quarter ended March had declined 36.21% year on year to RM6.78 billion.
At the results announcement, EPF CEO Datuk Shahril Ridza Ridzuan said the fund was bracing for a difficult year, given the uncertainties in the global economy following prolonged slow growth in the major economies and high volatility in the equity and commodity markets. EPF had 14.55 million members as at December last year.

Kumpulan Wang Persaraan Diperbadankan (KWAP), a pension fund for civil servants, has also been going through trying times. CEO Datuk Wan Kamaruzaman Wan Ahmad says the biggest challenge for pension funds is obtaining the desired returns.

“For that reason, we need to lower expectations. The trouble is we are used to the 6% or more returns of the last decade and since the fund’s inception. But the reality is that getting anything beyond 5% is very difficult at this point in time. Based on where the interest rates, dividend yields and corporate performances are currently, we think 4.5% is a more achievable figure,” he tells Personal Wealth in a recent interview.

Wan Kamaruzaman says the pension fund had seen an average return of 6% a year. The downtrend began last year.

“We did not do that well last year, especially on the equities side. We had negative returns from local equities. So [our portfolio] only returned about 5.4%.

“The bond market has done reasonably well, but the reality is that the market is a double-edged sword. You do well after the overnight policy rate (OPR) cut, but your reinvestments are all at lower levels after that, [and this drives your] portfolio returns downwards.” Last year’s gross investment return of 5.4% was below the 6.15% to 7.07% range for the previous five years.

Pension funds rely on formulas that depend on interest rate movements to determine their assets and liabilities. When rates fall, investment returns are impacted negatively. As a result, their obligations to future retirees balloon.

While lower bond rates enhance the value of existing holdings, pension funds record losses when the bonds with bigger payouts purchased many years ago reach maturity and are replaced with lower-yielding investments.

Wan Kamaruzaman says there are very few signs that the “lower for longer” environment will turn around soon. Instead, we can expect this scenario for the next three to five years.
“In the US, they cut rates to almost zero in 2008/09, and it has remained about the same until today. They recently raised it by 25 basis points, and that was after almost eight years. Europe just started lowering rates, and has gone into negative territory. In Japan, it has been there for much longer,” he points out.

Wan Kamaruzaman says the downtrend is just beginning and will soon translate into lower dividend payouts for investors and contributors. “The 3% OPR level is not too bad, compared with the rates in the developed world. In addition, you cannot get the kind of returns you get from Malaysia’s bond market in the more mature bond markets like South Korea, Hong Kong or Singapore. So, we are quite happy we are getting over 3% from the government bonds and about 4% to 5% from corporate bonds. If they go lower, it will be a challenge.

“[When referring to returns in the next few years], we are looking things trending down and staying low. It is actually a ‘U’ rather than a ‘V’-shaped graph, or more accurately, a prolonged ‘U’.
“In terms of dividend payments to investors and contributors, the downtrend is just beginning, so people have not really felt it. Returns can only go further down before they go up in the ‘lower for longer’ scenario. So, contributors will have to get used to this trend.”

EPF and KWAP are not the only retirement funds grappling with the problem. On Aug 26, Japan’s Government Investment Pension Fund reported a loss of 3.9% or ¥5.2 trillion (RM211.9 billion) for the April to June quarter. The world’s largest pension fund partly attributed it to the rise of the yen after the Brexit vote and poor US unemployment data in May.

The returns of the government pension fund are a huge concern since more than a quarter of Japan’s population are age 65 and above. The loss is similar to the US$50 billion investment losses attributed to the strengthening of the yen and fall in Tokyo stocks owing to the global market turmoil.
The US’ second largest pension fund announced at end-July that it made a return of just 0.61% for its fiscal year ended June 30, its worst performance since 2009. Investment managers at the California Public Employees’ Retirement System attributed it to the challenging low-return environment. Until last year, the fund had had an average annual return of 7.8% over the last 20 years.

On Sept 1, The Telegraph reported that British firms’ defined benefit pension scheme deficits spiralled by another £100 billion in the previous month alone as record low interest rates sent liabilities through the roof.

UK plc’s total deficit now stands at £710 billion, its highest ever, according to PwC’s Skyval Index.
The Canada Pension Plan Investment Board fared better, recording a net investment return of 1.45% for the three months ended June 30. While this was positive in the light of the Brexit vote, it was still well below the returns seen over the past 10 years.

“The fund’s 10-year rate of return in the first quarter was 5.5% after accounting for inflation, down from 5.8% in last year’s corresponding quarter. The 10-year real rate of return remains above the Chief Actuary of Canada’s benchmark of 4% annualised real rate of return,” it was quoted as saying.
Earlier this year, it was reported that the average pension fund in Australia, Canada, Japan, the Netherlands, the UK and the US all produced lower investment returns than in 2014.

In late May, The Wall Street Journal reported that pension funds and other large endowment funds were heading deeper into riskier investments to get the desired returns. Many have begun investing in global stocks, real estate and private equity investments, instead of the usual high-grade bonds.
According to a study by investment consultancy firm Callan Associates, which advises large investors, this is a stark contrast to two decades ago when returns were easier to come by. The study found that a portfolio made up of only bonds in 1995 would return 7.5% a year, with a likelihood that returns could vary by about 6%. To achieve that same return in 2015, it said investors would need to spread their investments across risky assets and shrink their bond holdings to just 12% of their portfolio.

The study noted that private equity investments and stocks needed to make up three-quarters of the entire portfolio. But with the added risk, returns could vary by more than 17%.
Wan Kamaruzaman says contributors would have to lower their expectations in terms of the returns they will get as pension funds are unable to increase their risk exposure exponentially. “There are many ways to invest and get higher returns. But for a pension fund, it is about its risk appetite, and ours is a conservative one. We do not want to compromise on our risk appetite. That is why we cannot take on too much risk by investing in asset classes with a high-risk, high-return profile.”
Nevertheless, KWAP has diversified a portion of its assets into alternative investments over the years. “At the moment, almost 90% of our asset allocation is in equities (30%) and fixed income (about 54%). The rest are in private equity (2%), real estate (4%) and cash. We keep cash even though we do not have any liabilities as it allows us to be a bit more opportunistic. We can use cash when there is volatility in the market,” says Wan Kamaruzaman.

An EPF spokesman says in an email statement that while the provident fund does not usually comment on market movements, the current economic condition presents some opportunities for it to rebalance portfolios and increase exposure to asset classes such as real estate and infrastructure that potentially could provide a stable stream of income.

“As for managing expectations, our investments have always emphasised sustainability of returns over a long-term horizon as opposed to short-term gains. More importantly is that we are able to meet our two strategic investment targets — at least 2.5% nominal dividend on a yearly basis, as required by the EPF Act 1991, and at least 2% real dividend on a rolling three-year basis,” says the spokesman.

Over the years, EPF has increased its exposure to overseas assets, which has helped offset some of its losses from local investments. It has also invested about 5% of its portfolio in alternative investments such as private equity.

Unit trust fund managers have also been managing investors’ expectations. Ismitz Matthew De Alwis, executive director and CEO of Kenanga Investors Bhd, says investors should expect returns of 8% and above for equity funds, 5% to 6% for balanced funds and 4% to 5% for bond funds. These are net of fees (except for the upfront sales charge).

“The net returns on balanced funds are so close to bond funds because the latter charge a lower fee. Generally, these returns are what we are targeting. In any investment, you should target at least 2% above your risk-free rate,” he adds.

Ho Seng Yee, CEO of RHB Asset Management Sdn Bhd, says investors should expect between 4% and 12% on all types of funds when averaged over a longer period. “If you are looking at 3 to 5 years, you should have 8% to 12% for equity funds, 4% to 6% for fixed income and 6% to 8% for balanced funds. These are returns from asset classes over the longer term, so investors would have this range of returns if they stay invested longer.

“A good fund manager should be able to beat the market. We need to educate investors not to expect 12% or 15% returns at least for the next two to three years. You have to live with a lower return environment.”

Kenanga Investors and RHB Asset Management are among the EPF-approved fund managers and providers of the Private Retirement Scheme (PRS), a voluntary long-term investment scheme aimed at helping people save for retirement.

Aggressive PRS funds saw returns of -1.25% to 4.3% for the 12 months ended July 31 while moderate funds delivered returns of -3.24% to 5%. For conservative funds, returns ranged between 2.45% and 4.57%.

Some non-core funds outperformed the core funds. In particular, AmPRS – Asia Pacific REITs D and I returned 22.19% over a one-year period while AmPRS – Tactical Bond D and I returned 10.17%


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