Kapil Mahajan & Sumit Bhatnagar: The pros of pension funds

Much has been said about the need for pension reforms in India to provide better returns to retired people.

Allowing pension funds to invest in equity instruments is an option, thus reducing the burden on the exchequer. But here we present a different perspective: a case for pension funds in the Indian securities market.

Pension funds invest long-term contractual savings in various financial instruments. Currently, investment avenues for pension funds are restricted to central and state government securities; special deposit schemes (SDS); bonds of public sector undertakings and public sector financial institutions; and certificates of deposit with banks.

Investment in equity instruments is not permitted. This has inhibited the emergence of long-term players in the capital market.

Internationally, pension fund investment regulations take two approaches "" the qualitative (the prudential approach) and the quantitative.

The former has a behavioural orientation, implying the duty to act with prudence and with due diligence with respect to the management of pension funds and their assets.

There are no limits on investment in equity instruments. This approach is followed in the US, the UK and Australia. The quantitative restrictions provide clear-cut limits on asset allocations and investment avenues.

This approach is followed in countries such as India, France, Italy and Germany.

On the basis of the recommendations of the OASIS (Old Age Social and Income Security) Report (2000), the government is planning to allow private pension funds (with three styles of portfolios, having different allocations in equity and bond instruments).

People will be given the freedom to choose any scheme depending on their risk-bearing capacities.

Permitting pension funds to invest in equity instruments will not only benefit investors but also bring in gains to the securities market, as discussed below.

Critics may argue that allowing investment in equities results in higher risk, but this can be addressed by hedging and using derivatives instruments.

The first and the foremost is a correction of the skewed market structure. Currently, foreign institutional investors (FIIs) are the dominant players in the Indian equity market, holding approximately 21.5 per cent of the outstanding shares of the Sensex companies at the end of second quarter of 2004-05.

In terms of free float, on average FIIs' shareholdings in the Sensex companies are approximately 34 per cent. In other words, one of every three shares (of the Sensex companies) available in the market for trading belongs to FIIs.

In companies such as Zee Telefilms (70.19 per cent), Bhel (63.69 per cent), and Satyam (61.06 per cent), FII holdings in free float are way too high. It is evident that the market structure in India is largely biased towards FIIs.

If they suddenly withdraw, it would be disastrous, especially in the absence of any countervailing force (the role that the erstwhile UTI used to play).

Nowadays, the LIC cushions any major fall. If this practice continues, we may see another UTI-like episode. Any sudden withdrawal by FIIs and its effect can destabilise the economy as a whole.

There is enough evidence to suggest that investments by domestic institutional investors are more conducive to market stability and growth than those of foreign investors.

In the latter case, there is always a fear of flight of capital. For instance, the financial market meltdown in Latin America was the outcome of the indiscriminate overreaction of individual investors and fund managers of the US to the Russian crises of 1998 (Kaminsky et al, 1999).

Chile, dominated by domestic institutional investors, was an exception and its economy was reasonably insulated from the general instability across Latin American economies.

It is naïve to blame the FIIs for these situations, because the bottomline is that they are here to make profits and will exit the market at the slightest hint of bad news, or for better opportunities in other markets.

Only in the absence of any domestic institution does their money become indispensable for the domestic market. Hence, it will be prudent to put our house in order by building strong countervailing domestic institutions such as pension funds, rather than clamouring against their huge positions in the equity market.

Though pension funds are termed "passive investors" (because portfolio churning is low) because they adopt a "buy and hold" strategy, with a sizeable presence, they and other domestic institutional investors can ensure market stability.

This is not to suggest that these institutions should intervene each time the market falls, but to counter any irrational exuberance/ pessimism in the market. This will ensure that the market does not dance to the tune of FIIs.

Two, pension funds being large, shareholders with a long-term investment strategy tend to play an important role in bringing in the best practices of corporate governance in companies that get the investments.

Effectiveness, however, depends on their holdings/ voting rights in the companies. When they hold a major chunk of shares in a company, they can be active shareholders rather than just walking out by selling the shares.

In countries such as the US and the UK, where pension funds hold about 30 per cent of equities, they are instrumental in bringing in corporate governance on board. CalPERS (California Public Employee Retirement System), the largest public pension plan in the US, is one of the most powerful and active shareholder activists*.

Globally, pension funds have succeeded in bringing about high standards of accountability in corporate management.

In India, there is hardly any instance of shareholder activism among the institutional investors. Of them, only financial institutions (FIs) have played a somewhat active role in the governance of companies, and that too because of their role as lender rather than as shareholder.

Though FIIs have a high concentration of holdings in the equity shares of the top 100 companies, they are not too active. So, the desideratum is pension funds in India creating a class of effective shareholders who believe in acting like owners.

Three, the corporate debt market in India is still under-developed. It is characterised by low liquidity and lack of depth, both in terms of paper quality and participants.

A large number of diverse sophisticated/ institutional investors with different maturity needs and expectations of returns is a precondition for the development of a corporate debt market.

The introduction of pension funds can bring about this diversity. International experience shows pension funds have provided the much-needed boost to the development of corporate debt markets in terms of demand for corporate bonds, liquidity, and improved market microstructure (E Phillip Davis, Pension Funds and Financial Markets).

For instance, in emerging markets like Chile, pension funds have played an important role in the development of a debt market. Pension funds hold about 70 per cent of assets in debt securities including corporate bonds (5.1 per cent)**.

Four, pension funds' investments in capital markets (equity/ debt) will bring depth and liquidity. In 2002-03, the Employees Provident Fund Organisation alone invested Rs 12,000 crore in various permitted instruments.

If a substantial portion of it had been channelled to the equity/ debt market, it would have increased liquidity in the market.

Further, pension funds can be major stimulators of financial innovation. Internationally, they have directly/ indirectly supported product innovation, that is, the development of asset-backed securities, use of structured finance and derivatives products, launching of index-traded funds and so on.

Permitting pension funds to invest in equity/ debt instruments can play a dual role in not only providing better returns to its constituents but also, at the same time, in developing the capital market. The government has to just take the road already laid out.

A 1995 study by Steven Nesbitt, senior vice-president of the consulting firm of Wilshire Associates, which was under contract with CalPERS, examined the performance of 42 companies targeted by CalPERS.

It found the stock price of these companies trailed the S&P 500 Index by 66 per cent in the five-year period before CalPERS acted to achieve reforms. The same firms outperformed the Index by 52.5 per cent in the following five years.

A similar independent study by Michael P Smith (with Economic Analysis Corporation, Los Angeles) concludes that corporate governance activism has increased the value of CalPERS' holdings in 34 firms over the 1987-93 period by $19 million at a monitoring cost of $3.5 million. **Queisser (1998)