Professional Asset Management of Occupational Pension Funds in Greece
- Nick Vosniakos
- Dec 9, 2022
- 17 min read
How the investment of pension funds' cash and assets creates multiplier benefits for policyholders and increases the future pension benefits offered. Financial analysis and presentation of the institution of pension funds with efficient asset management.
Two months ago in the economic news, a very pleasant event happened that is very important for the investment world. It was the decision of the Occupational Insurance Fund of Pharmaceutical Employees to proceed with the establishment of a mutual fund management company. The aim of this move, according to the management, is to make better use of the fund's reserves and to cover its long-term actuarial deficit. This move is important for two reasons. Firstly, because it demonstrates the benefits of professional management of the reserves of an insurance and pension fund, giving a vote of confidence in this institution, and secondly because with its creation it will now be the third strongest professional insurance fund in Greece in terms of assets, which amount to EUR 347 million. It, therefore, creates a special interest in the fields of Finance and Investments, offering me the opportunity to present this financial institution to you, in accordance with international practices. I may still be too young to discuss about pension but it is an area of huge financial and investment interest!
Insurance system and social security pillars
People and societies need an insurance and pension system to provide social protection against expected risks in life. The insurance system is related to health risks and helps people to cover their health care and medical needs in case they need it if they experience health problems and are unable to cover the costs of health services during their lifetime. The pension system is about protecting people from poverty when they leave the labour market, due to old age and limited capabilities, and can no longer generate income to meet their living needs. At this point, they are provided, in replacement of their monthly salary, with a pension to cover their consumption and living needs for the rest of their lives until death. Both the insurance and pension systems smooth the entire life cycle, protect against natural risks and maintain social balance and cohesion. These two systems, which are often difficult to separate, are financed by contributions and deductions made by citizens themselves from the income they generate annually during their productive years in the labour market.
Modern insurance systems consist of 3 pillars. The first pillar concerns compulsory state social insurance to provide a minimum level of social benefits to the insured. The social security system in Greece is financed by the pay-as-you-go financing system. In this system, current contributions pay for current pensions and health insurance benefits, without capital formation. Of course, due to adverse demographic developments in Greece and Europe with an ageing population and declining birth rates, the redistributive system of the first pillar of social security has become ineffective as the active productive population that generates income and pays contributions shrinks. This shrinks the benefits offered and, combined with decades of operation under the guarantee and funding of the state, undermines its sustainability. This is the problem that the second pillar comes to smooth out.
The second pillar of the insurance system concerns the occupational voluntary insurance of certain groups of the population, who, in addition to the basic insurance, wanted to save and contribute more in order to have a second source of pension and insurance benefits. This led to the creation of occupational insurance funds, which replaced the redistributive nature of the state insurance system with a capitalization system in which each insured person has his or her own personal account and the future benefits he or she receives (as a pension or lump-sum payment) depend on the contributions made in previous years, rather than a fixed amount. Professional Insurance Funds in Greece are legal entities under private law of a non-profit character. Their purpose is to provide insured persons and beneficiaries of benefits with supplementary insurance protection beyond that provided by compulsory social insurance and they operate on the basis of the capitalization system (Article 7 par. 5 of Law 3029/2002). They require the existence of capital for the payment of benefits and constitute an effective solution as organized savings schemes for employees in order to ensure a better quality of life in retirement.
The third pillar concerns the individual private insurance of each citizen individually through a private insurance company. These companies provide targeted and tailored insurance plans to meet the individual needs of each policyholder and many of these can be converted into pension plans and provide not only health insurance and life insurance but also pension coverage. It is an extension of the traditional personal piggy bank that was in every home to cover emergencies and problems. The insurance company that covers the insured against various risks now holds this role. This pillar along with the first one are not the subject of this article. We will mainly focus on the 2nd one and show how it can be improved through professional management of the assets of the professional funds.
Occupational insurance pension funds
A pension fund is a fund that accumulates capital to be paid out as a pension to workers when they retire at the end of their careers. Both employers and employees contribute funds to a 'pool' of funds that are set aside for future pension payments. Pension funds are pooled monetary contributions from pension plans set up by employers, unions, trade unions, professional associations, or other organizations to provide pension benefits to their members. Of course, these funds may be multi-employer or multi-employee funds or funds of different occupational groups or companies, i.e. funds set up by groups of people who have no occupational ties, do not belong to the same professional group, do not have the same occupation and are not employed in the same enterprise.
Pension funds usually raise large sums of money through contributions. To maximize their value, these amounts are invested in the capital markets to generate profits (returns). The funds are invested on behalf of the employees instead of remaining dormant in bank accounts. The returns generated by the investments serve as earnings for the employee on retirement. The main objective of a pension fund is to ensure that there will be enough money to cover employees' pensions after they retire in the future. The funds return all their financial surpluses from investments to the individual accounts of their members. The operation of pension funds requires a high level of skills to make the best use of assets. The conversion of their assets into new value is essential to finance pension benefits. Savings are not sufficient to meet this objective. Appropriate investments are necessary.
In developed countries, the revenues from the management of social security institutions' assets contribute to the creation of reserve capital and thus to the sustainability of the system. Greece is called upon to follow the international trend of professional management of insurance fund reserves in order to address its insurance problem and the actuarial gap in the existing redistributive system, undermining its sustainability. Therefore, in order for workers not to be surprised at retirement with a lower pension than they expect, unable to earn extra money to support their standard of living, their early participation in such schemes is encouraged. A total of 30 professional occupational insurance funds have been set up in the country in recent years, with assets under management of more than EUR 1.9 billion. This number indicates a rapidly growing market, which aspires to cover most of the country's employed and self-employed with additional, supplementary benefits.
Institutional Investors
If you ever wondered who might have the most money in this world or who might be the richest with the most cash at hand, swimming in money, the answer is institutional investors. Institutional investors are continually the surplus economic units in the economic system, as all participants in the economy continually contribute money to them. Institutional investors include insurance companies (which collect premiums), pension funds (which collect contributions for pensions), investment savings trusts, and university endowments (donations from benefactors to university institutions). All of this accumulated money is invested by institutional investors in an effort to make profits for those they support, turning them into the world's largest investors. It is to them that everyone runs to ask for money when they don't have any! Pension funds are the largest investment schemes in most countries and dominate the stock markets where they invest. When managed by professional fund managers, they are the domain of institutional investors who seek to maintain stable and sustainable returns. Typically, pension funds are exempt from capital gains tax and the profits from their investment portfolios are tax-free.
Investment Process
The main investment style of a pension fund is diversification and sustainability. Pension funds seek to diversify the portfolio by allocating capital to different investment vehicles (equities, bonds, derivatives, alternative investments, etc.) in order to preserve capital and spread risk. This means that in the event that one of these investment instruments is in decline, the total assets under management are not affected. It is also common in investments that when some investment products fall, others move in the opposite direction and rise. Pension funds invest in both to achieve an immunization of capital loss. In finance, the basic rule is that an increase in return implies an increase in risk. Pension funds, because of their size and importance, focus their investment strategy primarily on minimizing investment risk and capital preservation, as they manage policyholders' money which, if lost, would have catastrophic consequences, such as loss of pension.
For many years, in achieving this objective, pension funds have been limited to conservative investments, mainly in government-backed securities, such as highly rated bonds (investment grade bonds) and blue-chip stocks of strong companies. Besides, to forestall the very sceptical and suspicious people who believe that investing money in such investment products in the stock market is like playing in the casino, and risking too much like gambling, I will point out that for pension funds and insurance companies alike there is a restriction on which stock market products they can invest in. They can only invest in those securities which, according to the credit rating agencies, belong to the investment grade. Those investments which belong to this grade are considered to be quite low-risk, with no elements of intense speculation, significantly reducing the risk assumed. Of course, at the same time, returns are sacrificed, meaning that investments in such products ensure the preservation of capital but greatly reduce the expected returns achieved. In professional insurance funds, this is not a problem, as the main objective is to minimize risk and conservative investments with low returns are encouraged.
The need for professional asset management emerged internationally from the 1970s onwards. As markets evolve and given the continued need for a relatively high rate of return and protection against risk, pension funds have the possibility to invest in the majority of asset classes. The investments they make must be both prudent and diversified in such a way as to prevent significant losses. The traditional investment strategy for a pension fund is to allocate its assets between different investment products such as bonds, equities and leasehold properties. Today, many pension funds have switched from actively managing a portfolio of stocks and bonds to passive investment vehicles by investing in mutual funds, exchange-traded funds (ETFs) and index funds. These are ready-made investment packages that offer sufficient diversification, as they consist of a wide variety of stock market products and a combination of these.
An emerging trend is to put some money into alternative investments in search of higher returns and greater diversity. An emerging trend is the allocation of funds to alternative investments, specifically commodities, high-yield bonds, mutual funds, hedge funds, real estate, derivatives and high-yield bonds. Asset-backed securities portfolios, e.g. student loans, mortgages or credit card debt, are new investment tools used by pension funds to increase the total rate of return. Investments in private equity are becoming increasingly popular among pension funds. These are long-term investments in private companies, with the aim of receiving dividends, on the one hand, and selling the company and making significant capital gains when it matures, on the other. Real Estate Investment Trusts (REITs) are also quite popular among pension funds, as they are passive investments in real estate markets, offering investors exposure to the real estate market.
Strategic and Tactical Asset Allocation
Strategic asset allocation is the decision to be made about the percentages of money to be invested in each investment asset class. What percentage of the money will the fund invest in bonds, what percentage in stocks, what percentage in alternative investments, and what percentage will be held in cash? The answer to these questions is to be provided by the board of each professional insurance fund and its investment committee, which should be composed of financial and investment experts. After thorough analysis and serious targeting, they should determine these allocations of money. For example, if the fund wants to pursue a conservative policy, it should invest more in bonds, which are considered more stable assets. If they want to boost returns a little bit they will choose to push a higher proportion of funds towards equities. In the event that several pensions have to be paid or a difficult economic situation is expected, the investment committee will decide to keep more of the reserves in liquid assets. The asset allocation strategy is a portfolio strategy. The investor sets target allocations for different asset classes and periodically rebalances the portfolio, which is rebalanced to the original allocations when they deviate significantly from them due to different returns from different assets.
According to a recent OECD report "PENSION MARKETS IN FOCUS 2021", the following chart shows the distribution in investment categories of occupational insurance funds compared to various countries around the world.
As it turns out, Greece, in my opinion, shows an excellent distribution pattern across all asset classes, without being overinvested somewhere and underinvested elsewhere, achieving remarkable portfolio diversification of pension fund assets. The proportion invested in equities, bonds and bills and bonds by Greek investment funds is, in my view, at a fairly good level, as is the exposure to various concentrated investment schemes (CIS), such as mutual funds, ETFs and index funds. The only point I could make is that it could hold a smaller percentage in cash and invest that percentage in alternative investments, which it seems Greek pension funds not to be investing at all. These given their higher risk should not take up a large portion of the portfolio. That doesn't mean they would be non-existent. They often help to hedge risk and boost returns in times of recession or when other categories are not performing well enough. My point is borne out by the figure below from the same report showing the average allocation to each asset class over time globally. The trend globally seems to be for occupational pension funds to reduce their exposure to both cash and bonds and channel the difference into equities and alternative investments. I believe this is being done to stimulate returns but also to provide exposure to more investment products for more effective diversification.
The above asset allocation strategy will then have to be executed to decide in which securities of each category the pension funds' money will be invested. This process is called tactical asset allocation and allows portfolio managers to create additional value by taking advantage of certain market situations. Tactical asset allocation is an active management portfolio strategy that reallocates the proportion of assets held in various asset classes to take advantage of market pricing anomalies or strong market sectors by making purchases and sales of securities continuously throughout the year. It answers the questions of which company stocks to buy, which countries' bonds to invest in.
Because most occupational insurance funds lack infrastructure, departments, specialized staff and expertise, they outsource this process to external fund managers and professional advisors, who take over the execution of the strategy. In case a fund does not wish to hire an external manager, it will engage in passive asset management which means it will not make frequent operations of buying or selling securities, depending on market trends, but will invest its capital in a stable long-term basis in some mutual funds, exchange-traded funds or stock market indices, which are already ready-made investment packages, sufficiently diversified for the fund's needs, since there is no possibility of active management. It is left to the board of directors to choose the investment management style, which can be either active management of the reserves by adjusting the investment position, or passive management of the assets through a traded fund.
Whichever way each fund manages its reserves and investments, the result is reflected in the returns achievable, given the risk assumed. According to statistics from the Hellenic Association of Professional Insurance Funds, the average annual return over the last decade for all Greek professional insurance funds is 4,6 % per annum. This is an excellent return that significantly minimizes risk and generates significant benefits that will be analyzed below for the members of the funds. The same point is confirmed by the recent OECD report "PENSION MARKETS IN FOCUS 2021" with Greece ranking above the simple average alongside developed countries. The picture of Greek occupational pension funds looks very good investment-wise and quite sustainable, demonstrating significant investment achievements and gains for fund members.
Asset Management Effectiveness and Efficiency
The evaluation of the effectiveness of either the active or passive management of the fund manager is a key responsibility of the investment committee of each professional insurance fund, which is controlled by the BoD and members of the fund. The assessment of its performance must be made by measuring both the returns achieved by the money manager and by taking into account the risk assumed. The risk should be aligned with the acceptable level of risk set by the committee, which should be in constant collaboration with the policyholder in formulating the investment strategy, taking into account the risk aversion of each policyholder. In addition, both the manager's ability to select appropriate assets for investment and its ability to anticipate future asset prices and market turns should be assessed. The above evaluation, in line with the investment committee's strategy, is aided by many portfolio and investment position evaluation tools developed by financial science and widely used both in the literature and by professional asset managers and brokers. These are various indicators that judge the success of the portfolio manager and can reveal dark spots where the manager has deviated from the strategy and wanted to hide.
In the calculation of the above indicators and in the overall assessment, the existence of economic data is a prerequisite. The publication of the results in an annual report, as well as the detailed positions and operations of the fund manager in buying and selling securities should be reflected in detail, to reflect the entire course of investments during the year. This is a problem that is encountered in Greece, where not enough data is published in a detailed manner and the limited statistical and other historical data published in Greece makes analysis difficult, something that I demonstrate and point out in every article and analysis I conduct that concerns Greece and I come up against this obstacle. With sufficient information both the investment committee and the members are able to evaluate both the external fund manager they have hired or the internal asset management, in an active or passive way, and decide whether to follow the same strategy or to make improvements if they are not satisfied. With rich investment information, it is possible to compare investments and monitor the progress of the Pension Fund over time to make rational decisions.
Benefits of professional asset management
The institution of professional insurance and professional management of reserves has quantitative and qualitative benefits. The institution of occupational insurance is a consequence of the global trend in the operation of second-pillar pension schemes and is related to the need to complement public pension insurance schemes, which are under pressure from an ageing population and the deterioration of the employee-retiree relationship. The professional management and investment of the assets create a number of benefits for the members of each fund.
1. Creating value and profits
The basic idea is that money that sits and is not invested does not create value. Investments require savings. But mere saving is not enough. Savings are the basis for investment. However, it is the investment of contributions that will succeed in creating additional economic benefit for the insured person, as they promise some returns. The benefits that an insured person will receive when he or she retires are a function of the contributions paid and the returns achieved on them. The return is defined as the percentage change in the price of the investment portfolio over a given period of time. The return achieved will therefore depend on the assets in which the manager invests and the type of strategy.
2. Protection against inflation
Private pension plans offered by companies or other employers rarely have an escalating cost-of-living factor to adjust for inflation, so the benefits they pay may lose purchasing power over the years. In addition, pension funds that rely only on contributions rather than investments are greatly affected by inflation, the tendency for prices to rise over time, reducing their purchasing power. This is what investments come to resolve and, with the returns realised, they can cover inflation, protecting the long-term value of money and maintaining its purchasing power. After all, it is one of the return targets set by the management of such funds for returns to exceed the level of inflation. Using the above average of 4.6% annual returns achieved by Greek pension funds, we can see that they are at a very satisfactory level, always exceeding inflation and generating additional profits.
It seems that they can't cover this year's inflation but it is a temporary situation that the economy has entered and in the coming years it will have been dealt with. It is a goal of most countries and Central Banks to keep inflation low, around 2%, through various policies. With an average annual return on the funds at 4.6%, the informal cost of inflation is more than twice covered which means that money is not only protected and not losing value but increasing in value, a very positive development for their members. Even if inflation is maintained for the next few years, there are enough profitable previous years to absorb this negative development.
3. Wealth Concentration Multiplier Benefits
Some may wonder why they do not invest their own money and savings for their own insurance and retirement and start divesting their investments when it is time to retire and get old, funding their own retirement. The answer lies in the investment power of money compounded in large amounts. For a €10,000 investment, a 4.6% annual return generates €460 in profits. But what happens for a 10,000,000€ investment? This in turn will generate 460,000€ annual profit for the same return. If there are no large pension return liabilities in that year many of these gains will be capitalised and reinvested further increasing the invested capital and even further increasing the next year's returns. This phenomenon in finance is known as the benefit of compounding, i.e. reinvestment of earnings. This could not happen easily and would take a long time for single low-capital individual investments.
4. Access to more stable investments
There are some investments that are only for institutional investors and big investment houses. Small investors are either not allowed or cannot participate in some investments because of the large capital requirement, such as the issuance of certain bonds or the shares of very large companies. However, many times these investments promise better returns, with lower risk and are more stable. Imagine a private club where only accredited members are allowed to join. This access is gained by joining a professional insurance fund with an individual account and contributions. The money can be invested in investment products that someone alone would never have access to, reaping the associated benefits.
5. Risk Dispersion
The benefit of risk diversification is twofold. On the one hand, it refers to the qualitative characteristic of having received a pension from elsewhere. In the event that the basic state pension is affected, an insured person can have a second source of income from another institution, so that he or she can maintain his or her standard of living. On the other hand, risk diversification refers to investments. In a professional insurance fund with many members and funds, there will be specialized professional managers who, because of their specialization, will be able to manage an investment portfolio more effectively and deal more efficiently with the risk associated with fluctuations in the prices of securities and the loss of capital from them.
6. Tax benefits and incentives
Today, the tax framework for the operation of occupational – professional social security funds in Greece, as defined by Law 4172/2013, provides that the contributions of members and employers are 100% deductible and lump-sum benefits are not taxed. This means that there is a tax benefit that cannot be found elsewhere, which anyone can take advantage of by participating in such insurance schemes.
Conclusions
It is a very positive element of everyone's profession to have an occupational insurance fund so that can also be insured with a second provider, as the benefits are many, especially for funds that actively invest their assets to achieve returns. Unfortunately, important professions and sectors are missing from these schemes. It is very important to insure in 2nd pillar insurance schemes for the sustainability of the system, due to the lack of reserve funds to cover the actuarial deficit in the 1st pillar insurance redistribution scheme's inputs in Greece, due to the demographic aging of the population. An occupational insurance fund is a self-financing, capitalized fund that makes investments to benefit its members, who maintain individual insurance accounts and each of them knows their insurance picture based on their contributions and the profits from their investments. Although saving is a sacrifice today in terms of reduced current consumption, saving today ensures higher consumption in the future, when people will need it most, while providing the basis for investment.
It is foreseen that in the future people who participated in both 2nd pillar occupational insurance funds and 3rd pillar with individual insurance will have a significantly better standard of living and retirement compared to others who rely exclusively on compulsory state social security. The differences will be very pronounced and obvious! There are already 30 Professional Insurance Funds operating in Greece, with the latest to join the dance being the Occupational Insurance Fund of Pharmaceutical Employees, which we wish every success. The Professional Insurance Funds are an institution that started in 2004 and continues to grow in the country very strongly so that Greece can catch up with international developments, which are very much ahead in this sector. However, already as I have shown you in the above analysis the picture is very good beyond expectations and with the same sustainable course maintained, the benefits will be many for the members. As long as the management is always done professionally, in accordance with good practices, by financial professionals skilled in financial analysis and investment management.
It would be interesting enough to show you the returns achieved annually by each professional fund and the cumulative returns for the members since its inception, and to carry out a comparative analysis to see which of them is the best and most efficient for its members in terms of investments. However, this would require a thorough financial analysis by extracting historical data and studying all historical financial statements, a process that requires a lot of time, which I do not currently have. Perhaps it would be carried out in-depth in a future article... Until then, be well and thanks to those who managed to get here, read and understand the whole article.