Jun 9, 2017
Poor retirement: why it is necessary to change the remuneration system of pension funds

Author: Marina Rudneva

The current model of fund remuneration is hopelessly outdated, which limits NPFs in investment choices, deprives customers of increased income, and the economy – of "long term" pension money

The current model of fund remuneration is hopelessly outdated, which limits NPFs in investment choices, deprives customers of increased income, and the economy — of "long term" pension money.
In March 2016, the State Duma received a bill "On Amendments to Certain Legislative Acts of the Russian Federation Regarding Regulation of Activities of Non-State Pension Funds" that provides for the introduction of fiduciary responsibility and related changes in the payment system for services of non-state pension funds (NPFs) for managing pension savings. Fiduciary responsibility means the funds' and their management’s financial responsibility for fair fulfillment of their obligations to invest the funds of insured people. Representatives of the Bank of Russia spoke about the introduction of such a mechanism long ago — before the large-scale reform of the pension sector, it involves the conversion of pension funds working with pension savings into joint-stock companies and their inclusion in the guarantee system.

As for the new remuneration system, according to the logic of the bill, it should consist of two components: a variable part (success fee) and a fixed part (management fee). For the NPFs, this innovation would be as important and significant as tightening of liability since the current system of remuneration, which assumes the existence of a success fee only — remuneration for success of no more than 15% of the total investment income, was introduced at the stage of the industry’s inception and is hopelessly outdated.

If in the fat years of economic growth (2005–2007) this system worked and NPFs sometimes showed a return of 16% or even 19%, the percentage of shares in the portfolios reached 10%-25%, then the 2008 crisis and subsequent recurrent crises reduced the average profitability of NPFs to 6%, and the percentage of shares in the portfolio dropped down to 6.1% (in 2013). Trying to cope with the shocks, NPFs moved to the break-even strategy of each current year, enhancing short-term investment tools in their portfolios, redistributing shares into conservative tools, like deposits in banks or in fixed-interest securities with a limited range of issuers. As a rule, such investments are low-yielding.

The new reality of the "sanctional" economy in 2015–2016, when foreign capital markets were closed to Russia and the inflow of investments had significantly reduced, reheated the problem of having "long term" investment money. And pension money has always been considered to be just that. That is why projects with the time horizon of 15–20 years are the most attractive for investment by NPFs. These investments would significantly increase the income for clients in the period of active payments (2025–2030). Though, such investment strategies are characterized by uneven profitability since long-term securities do not imply an accrual of profit during their circulation, but have lump-sum payments at the end of the term. This is one of the reasons why NPF portfolios have very few assets like that.

At the same time, economic development requires investments in shares of innovative domestic industrial companies and significant state infrastructure projects. The mechanism providing a reasonable harmonization of the interests of the state and insured people is the division of NPF remuneration into fixed and variable parts. Then NPFs can allocate the fixed portion (management fee, 1% of net assets value) to compulsory expenses (maintenance of accounts, remuneration of management companies and special depository). At the same time, the variable portion retains and creates new incentives for NPFs to increase their profitability of investing pension savings and increase the share of investments in the real sector of the economy with longer payback periods.
Only simultaneous introduction of fiduciary responsibility mechanisms and change in the NPF remuneration model, stipulated in the law described above, will lead to the investment strategy of funds that the state and economy need. The Prime Minister Dmitry Medvedev positively responded to the bill. It was approved at the government meeting, but after its submission to the State Duma, the consideration was postponed for an indefinite period.

Moreover, a heated discussion ensued. Thus, representatives of the Pension Fund of the Russian Federation (PFR) believe that 1% as a management fee is too much. Some experts are concerned that NPFs will start to stagnate and cease to develop. For some reason, the basic argument of the bill’s initiators is not taken into account at all — the implementation of its provisions will reduce the cost of remuneration to participants of the pension market by 20–30% and, consequently, increase the investment income of citizens and their future pensions by RUB 5–7 billion. Now NPFs pay management companies, brokers and special depository from their assets, in fact, not with their money. And according to the new remuneration scheme, the entire fee will be allocated to NPFs that will distribute it among the fund, management companies and special depository. By doing so NPF will count pennies and will evaluate the efficiency of every invested ruble. For participants of the pension market, that is a real incentive to reduce costs for services and promote competition on NPF market.

Thus, this bill combined with the management fee mechanism solves the following problems:

—    increase in the share of investments in the real sector of the economy and infrastructure projects;
—    increase in the revenue of insured people;
—    increase in transparency and stimulating the development of the economy and the stock market;

While the introduction of fiduciary responsibility alone will provoke funds to refuse of long-term planning of their activities and further development of the industry. NPFs will focus their efforts on maintenance of their activities exclusively within a financial year and will limit investments with low-risk instruments. As a result, the financial market will stay unbalanced, investments in infrastructure projects that are vital for the country and the economy will stop, citizens will receive less investment income than due, and the level of pensions will remain low.