In emerging markets like Chile - which has one of the most advanced pension fund regulatory structures in the emerging market space - private sector pension funds were first allowed to invest in equities as early as 1985 (up to a maximum of 30 per cent). And subsequently in more sophisticated instruments - such as private debt and derivative instruments - as well as mutual funds.
Since then, these funds have been major providers of liquidity to sovereign and corporate debt, as well as the domestic equity markets. Noticeably, up to 50 per cent of private pension fund assets are invested in domestic equities, providing individual investors with a choice to participate in a more risk-on format.
Promise of higher returns
This is higher than the average of most emerging markets, and approaches levels seen in OECD countries. The development of capital markets has run in tandem with such regulations, with returns being significantly higher (between 2-3 per cent per annum) for investors in such schemes.
Unsurprisingly, this has led to a significant rise in assets under management. There has been a virtuous cycle of capital market (and economic development), with the growth of pension fund assets in domestic markets, which has allowed for greater shareholder activism, and, more critically, greater ability of savings and wealth to be created.
The recent change in UAE laws for pension funds promises to unleash a similar wave of assets to be deployed in the capital markets, triggering the next stage of growth. While details of the laws will clarify issues over time, the impulse behind these regulatory reforms are the same: enabling individual investors to have greater choice in deployment of end-of-service schemes. And have the ability to choose various types of risk parameters they are comfortable with.
It is important to note that there have already been a few announcements of such alternative ‘Golden Pension’ schemes (from National Bonds), and more likely to follow. But the impact this will have over time towards the development of domestic corporate fixed income as well as equity markets is clear as a bell.
Shock absorbers to fund outflows
A few of the advantages are apparent: pension funds act as ‘shock absorbers’ to non-resident capital outflows. Given the immigrant demographics of the country, pension fund schemes over time will weaken the incentive to send money back home, as domestic opportunities for capital gains and retention start to proliferate.
Secondly, companies that have pension funds investment in them outperform those that don’t. According to studies, the degree of outperformance is between 3-5 per cent per annum, creating an incentive for management to engage with such schemes to boost their attractiveness to other institutional investors, domestic and foreign.
With pension funds participating in newly subscribed offerings, the incentive on the part of individuals to borrow to increase their subscriptions in the latest IPO recedes, as investors would have greater ability for access through such structures.
Most critically, pay-as-you-go schemes increase the sustainability of savings and, therefore, investment ideas that are being generated, and foster an environment for increased productivity and therefore greater percentage of residents staying in the country. The UAE has already attracted hundreds of thousands of people via its Golden Visa scheme.
A basket of investment options
The next natural stage of evolution is to provide the salaried populace with sustainable investment alternatives that serve to increase their return on savings. The IPO wave allowed for individuals and institutions to ‘stock pick’ what they thought was best. With the pension fund regulation, individuals will have the ability to invest in a basket of securities that seek to balance their objectives of capital preservation along with capturing growth opportunities.
As the ecosystem evolves, it would be unsurprising to see the creation of specialized pension fund structures even catered around professions (such as the California Retirement system for teachers), by emirate, and/ or other alternatives, especially among the private sector. Whilst it is easy to speculate on the path of market evolution, what remains clear is that this change is another watershed moment in the history of not only capital markets in the UAE, but also a further magnet in attracting and retaining talent of individuals by removing uncertainty (and lack of growth) around their gratuity schemes. And allows greater participation in the growth of the domestic economy, without the need for taking big swings and risk losing it all.
The times, they are a changing.