Ewart S Williams: Investment strategies in an uncertain world
Address by Mr Ewart S Williams, Governor of the Central Bank of Trinidad and Tobago, at the
Business Insight Caribbean Investor Conference, Port-of-Spain, 1 December 2006.
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Good afternoon, ladies and gentlemen. Let me first thank the organizers, Business Insight Limited, for
inviting me to this very interesting conference which focuses on "Investment Strategies in an Uncertain
World". The media release couple days ago observed that the Conference was prompted by the
significant declines experienced in the stock markets of Trinidad and Tobago, Jamaica and Barbados
over the last two years and noted that investors and market practitioners were looking for answers.
I saw from the programme that there was a discussion this morning on the evolution of the market in
Trinidad and Tobago and it may well be that you have already solved the problem. I hope it is not too
late to give my take on the matter and discuss some options, which in my view, could ease some of
the current pension funds restrictions while maintaining prudential standards to protect the workers'
savings.
Let me first give the background to the current issue.
Since its inception in 1981 there has been little growth in the number of companies listed on the
Trinidad and Tobago Stock Exchange. In 1981 there were thirty-five listed companies with a total
market capitalization of $2.3 billion. Twenty-five years later, there are thirty-two listed companies with
a market capitalization of approximately $110 million.
It is estimated that institutional investors (largely pension funds) account for about ninety percent of
total demand in a market in which only about twenty-two percent of shares are actively traded - the
remainder having been bought to hold.
Since it was established in 1981, the value of stock market capitalization in Trinidad and Tobago has
grown by over 50 times and much of the increase has taken place since 2002. In that year market
capitalization was $48 billion and this grew to a peak $120 billion in mid 2005 before falling to $107
billion at end of 2005. Since then market capitalization has declined by a further 18 percent.
When the IMF conducted its financial sector review in mid-2005, prior to the slide in the market, it
observed that, "the sharp increase in stock market capitalization was not reflected in earnings". From a
sample of 13 firms, representing some 60 percent of market capitalization, stock prices between 2001
and mid-2005 rose 1.5 times while earnings per share increased 0.5 times. For conglomerates, stock
prices increased almost 2.5 times, while earnings per share increased by 0.6 times.
The IMF experts suggested that such large spreads were usually due to the weaknesses in market
infrastructure and the fact that share prices have been driven up by speculative demand. In the case
of Trinidad and Tobago market, they pointed to the poor supply of stocks, a trading system that
allowed significant price increases on unmatched bids, highly illiquid stocks and a tendency for
institutional investors to buy and hold stocks rather than trade.
The Central Bank assumed regulatory control of the insurance industry and private pension funds in
June 2004: by end 2004, the Bank wrote to the pension plans reminding them of the fifty percent limit
for equity holdings. At that time some 42 out of 204 active pension plans had exceeded the fifty
percent limit and their average holdings were fifty-eight percent. It is estimated (on the basis of
incomplete information) that by end December 2005, about 11 pension plans still had equity holdings
in excess of fifty percent of total assets and that as of September 2006, two plans remain in excess.
There is no doubt that the stocks sell-off by pension funds contributed to the decline in stock prices.
From January 2005 to September 2006 net sales by pension funds amounted to about $700 million.
However, some other factors would certainly have contributed to the decline in the market. In the first
case the market was due for a correction, following the increases in stock prices which could not be
justified by the earnings performance of the various companies.
Second, the introduction of electronic trading in March 2005, by making price movements dependent
on actual trades, as opposed to "bids" would have had a dampening effect on stock prices.
Be that as it may, the fact is that the stock market index declined by about thirty percent between its
high point in mid-2005 and end-September 2006. This sharp decline in stock prices has caused
widespread concern among market participants as well as the public at large and a call for an increase
in the limit on investments in equities.
It is useful to understand the history behind the fifty percent limit that now exists for pension funds. In
order to mitigate the volatility associated with equity investments, the drafters of the Insurance Act
proposed broad investment limits to ensure that the portfolio of a pension plan will follow a certain
prescribed "risk-averse" structure. Consistent with this philosophy, it was stipulated that no pension
plan could invest more than forty percent of its assets directly in equities. This limit was increased to
fifty percent in November 2000 in order to accommodate new public offerings resulting from the
Government's divestment programme (NFM and NEL).
Statutory limitations imposed on institutional investors are in no way peculiar to the region. The
majority of OECD countries have limits for equity as an asset class in their pension fund regulation.
Recently, the EU introduced a prescribed limit of seventy percent of assets for equity investment, in
combination with the Prudent Person Approach. Notwithstanding, higher legal limits, actual equity
holdings by pension funds in most countries are seldom above 30-40 percent.
In recent times, the trend has been to reduce equity exposure in light of poor stock market
performance. It is interesting to note that this is being done even in markets that are more efficient and
liquid than ours.
While there are no legally prescribed limits, actual equity holding of pension funds in Jamaica have
averaged around twenty-six percent of total pension fund assets; the ratio for a range of Latin America
countries is between four and thirty percent. In these countries, the investments of choice for pension
funds are government securities. The rationale for the investment pattern is that pension liabilities
span many years and require reasonably predictable cash flows. This makes them less suited to the
risky volatile returns that are typical of equity markets and more suited to the assured cash flows of
government securities.
In supporting an increased limit for equities, pension fund managers point to the lack of alternative
investments. And that's largely true. With the government budget in chronic surplus, the supply of
government debt has been declining (in terms of GDP), and there continues to be a dearth of
corporate bonds. Pension funds are allowed to invest up to twenty percent of total assets in real estate
but this window has not been utilised (holdings of real estate now average one percent of total pension
fund assets). Pension funds are allowed up to twenty percent of total assets in foreign investments but
this also has not been fully utilized, with foreign investments averaging only about nine percent of total
assets.
The Government's plan for the reform of the financial sector includes the preparation of new pension
legislation. The Bank has already begun preliminary work on a new Pension Act which is expected to
be completed, after consultation with all relevant stakeholders, in the next eighteen months to two
years.
In the meanwhile, the Bank has been discussing with stakeholders the challenges now being faced by
pension funds and which are contributing to stagnation in the stock market.
The proposals that have emerged from our discussions fit into three categories:
(i) Noting that pension plans have exceeded that fifty percent limit because of the sharp use in
equity prices, some stakeholders advocate valuing equities at original cost with a premium
adjustment of, say 25 percent.
This approach has several practical difficulties in that the valuation basis for the same equity
will differ according to the time of purchase. There are also practical difficulties involved in
retrieving data on historical costs. Perhaps more importantly, however, this proposed
valuation procedure goes against the current dominant trend (best practice) of market
valuation.
(ii) There is also a proposal for increasing the limit from the current 50 percent to 60 percent.
While this has the merit of simplicity, it has serious drawbacks in failing to recognize that a
fifty percent equity limit is already too high for pension plans that are underfunded and that
lack even rudimentary investment policies and guidelines.
(iii) The third option which has much support, uses the principles of the investment regime now
applicable to insurance companies.
The main elements of this option are:
(a) Define a funding threshold of one hundred and fifty (150) percent of pension
liabilities to which the fifty percent equity limit is applicable. Put differently, all plans
with a surplus of less than fifty percent of pension liabilities will remain subject to
the equity limit of fifty percent.
(b) Plans with a funding ratio in excess of one hundred and fifty percent will be allowed
to invest in equities beyond the fifty percent limit. Put another way, trustees will be
able to make additional equity investments with any surplus in excess of fifty
percent of pension liabilities (up to a maximum level, to be determined).
The merit of this option is that it provides the additional room to wellfunded pension plans. The
additional equity is really financed out of pension fund's surplus after providing a buffer, equivalent to
fifty percent of pension liabilities.
As you may know, the investment regime for insurance companies allows for fifty percent of the
statutory fund to be held in equities. However, the statutory fund must only be sufficient to cover policy
holder's liabilities and thus any excess or surplus assets are not subject any limits, but need to be
An examination of thirty-seven pension plans which account for eightyfive percent of total equity
investments of pension funds indicate that there are about 10 plans which are way below the 50
percent equity limit, and which could potentially invest about $1.1 billion in equities, if they so chose.
They have not done so because of their own investment preferences. This proposed scheme would
free up another $1.5 billion for equity investments. This amount compares with $700 million which was
taken out of the equity market by pension funds since the end of 2005.
In our discussions with the stakeholders it was felt that pension funds desirous of making use of this
option should (i) prepare an investment policy, in accordance with the Central Bank's guidelines on
Prudent Person Approach to Investment and Lending which was issued in May 2005; and (ii) submit
quarterly reports to the Central Bank.
The proposed approach - which is a liability-based approach - is not without its implementation
problems.
A major implementation challenge will be to ensure the accuracy of the liability data and consequently
the calculation of the pension fund's surplus, on an ongoing basis. Liability information will always be
out of date given that investment management operates on a continuous basis but actuarial valuations
are done at fixed dates, typically once every three years.
It will be very costly (and a major challenge) to require annual actuarial valuations. However, a
possible fall-back will be to operate on the basis of estimated annual liability figures (following the
three-year actuarial exercise), based on the assumptions utilized to produce IAS 19 figures (that's the
calculation of the pension surplus that feeds into the sponsoring company's annual balance sheet).
One would need to examine the feasibility and implications of using this estimation procedure more
carefully.
Another issue is that as of now, there is no standardized actuarial regime in Trinidad and Tobago, for
pension funds. Actuarial liabilities depend on the actuarial methods and assumptions used to
determine them and as you know, there is a range of acceptable methods and assumptions. This has
important consequences if liability values are used as a basis for equity limits.
Let me end with some thoughts on considerations to be taken into account in the preparation of the
permanent investment regime for pension funds (the new legislation that we expect to have in place in
a period of eighteen months to two years).
The current orthodoxy is that pension plans should be free to invest as much or as little as they want in
equities provided that it is done on a "prudent person" basis and is done within the framework of a
proper investment policy. This investment policy should take into account the plan's liability profile,
funding level and the risk tolerance of the plan's sponsor - in terms of the sponsor's willingness and
ability to increase contributions if the investment policy does not deliver. Such a policy would then be
based on input from the trustee, sponsor, management committee and actuary.
While this is attractive in principle, there are practical issues. For example, if there are no limits on
local equity purchases in a small stock market like Trinidad and Tobago, the imbalance between
demand and supply of equities could push prices beyond levels justified by the fundamentals (as has
happened hare over the last few years).
A second practical issue is whether there should be limits on foreign investments. The current thinking
in industrialized countries is that the absence of limits on international investments allows for superior
performance in terms of risk and return. In a small developing country like Trinidad and Tobago, there
are practical considerations of the effect that unfettered overseas investment would have on exchange
markets and the exchange rates.
Whatever investment regime is finally decided upon for the long term, its efficiency and sustainability
will ultimately depend on (i) a significant increase in the range of available domestic investments
(including government securities and private bonds); increasing liquidity in the stock market by
encouraging more listings providing inducements for trading as opposed to the current system of "buy
and hold" and reducing the dependence of the stock market on institutional investors.
These are tough but winnable challenges.
The Bank will continue to discuss these issues with stakeholders with a view to agreeing on a
temporary investment regime early in the New Year.