Executive summary of the final report of the independent review of the Government Superannuation Fund Authority (GSFA) carried out by Mercer Investment Consulting.
Mercer Investment Consulting (Mercer IC) believes that GSFA has set clear investment objectives.
Mercer IC believes that the investment objectives may be relevant but that the sponsor of the superannuation scheme, the Crown, has the ultimate responsibility for this judgement.
The Crown has not articulated its judgement on the relevance of investment objectives as adopted by GSFA. There is scope, Mercer IC believes, for the Crown, via the Minister, to provide clearer guidance to GSFA on the purpose for the assets. The wording of the legislation itself “maximising return without undue risk to the Fund as a whole” does not provide enough guidance as to what ‘undue’ risk is in this case.
The appropriate risk tolerance for the Fund’s assets is the key, the only key, to answering the question of appropriate investment objectives for the GSFA to pursue. To date this issue has been ‘resolved’ through GSFA ‘interpreting’ the appropriate risk tolerance in conference with Treasury officials.
‘Best practice’ portfolio management involves the clear discernment of the purpose of a portfolio but so far this issue has yet to be fully resolved in our view and therefore is an obstacle to any objective assessment of whether ‘best practice’ is being or has been followed. This issue is also relevant to the issue of the investment performance of the GSF in its first few years.
Mercer IC has studied the policies and procedures followed by the GSFA and has been very favourably impressed with the operation of the GSFA relative to industry best practice. The GSF is the largest superannuation scheme operating in New Zealand and, while not a standard scheme could be expected to be a market leader in its policies and procedures.
Mercer IC believes that the GSFA has laid strong foundations in its first four and a half years, and has done so in spite of extremely volatile market conditions in its first 2 years of operation.
Mercer IC does not see the modelling assumptions as a potential source of issues for the Review. The modelling assumptions used have been examined and are generally within the tolerances of views adopted by various agencies that specialise in this field.
Mercer IC has studied the processes followed by GSFA in determining and reviewing its benchmark portfolio and with the qualifications already made about what ‘best practice’ investment objectives means in this case, is satisfied that the process has been very robust. Contestable advice has been obtained and considered.
GSFA has adopted a policy of not changing the actual portfolio weightings in order to avoid or take advantage of opinions about short term market valuations and expected returns. GSFA has addressed this issue conscientiously and continues to monitor the debate and the methods which might be employed to implement new policies as and when these are considered to be appropriate.
Aside from specified aspects, on the whole we consider the GSFA operates a manager selection process which is close to “best practice”. From inception the GSFA has drawn on the research views of an investment adviser which is reputable and has knowledge of the fund manager industry on a global basis. Generally a wide range of views have been brought to the table, including that of the Board, Management and external advisers.
GSFA took contestable professional advice to guide its decision to move from 50% local currency hedging up towards 80% hedging. For New Zealand based investors with the degree of exposure to offshore growth assets similar to GSFA, Mercer IC believes that a very high degree of hedging back to the NZ$ (e.g. the 80% level) is not optimal because the expected returns to hedging may not be sufficient to offset the depreciation of the NZ$ over any period. ‘Best practice’ on this issue in the market place is evolutionary.
Mercer IC has developed a detailed view of ‘best practice’ governance of superannuation schemes. This section sets out the rationale for the Mercer global view on this issue and the development of a generic questionnaire as input to an analysis of the quality of governance of GSFA. The questions cover the RFP questions as well. Our opinion is that GSFA is operating under best practice governance taking into account the nature of the Authority.
Mercer IC believes that the capacity of the GSFA to deliver very high quality levels of service to the Crown and to GSF members has been admirable within its annual appropriations. Mercer understands that the appropriations process allows for GSFA to estimate and structure appropriate budgets for its business strategies and argue the case for suitable funding. The process involves Parliament voting an appropriation of an overall amount for the purpose, rather than line by line appropriations. Therefore, GSFA has an avenue for expanding its resources as required if it can argue successfully that the expected net benefits are attractive. Mercer expects that GSFA will be doing so to meet the challenges to be faced over the next few years.
Mercer IC has carried out a review of the documentation procedures set out in the several reports relating to reporting and flows of information within the GSFA and between the GSFA and its suppliers. Mercer IC has also carried out several site visits to GSFA and can confirm that all processes are being followed.
The Authority has established a comprehensive compliance plan, by way of an in-house questionnaire, to ensure that it complies with the legislation and regulations that govern the GSFA and the GSF.
Mercer IC believes that the fees paid by the GSFA are reasonable by comparative standards. In saying this we note that, at the margin, there is often the opportunity for clients of significant size (or status) to attempt to drive fees to minimal levels. However, this is not always of mutual benefit given client expectations for servicing and the need for the manager to adequately resource the delivery of their mandate objectives.
Mercer has formed a positive overall assessment of the custodian monitoring currently being undertaken by the Authority of its current custodian. To further enhance the governance structure around the custody arrangements we believe that the Authority ought to undertake a benchmarking review of their current custodian, at a minimum, once every three years.
Both of the transitions undertaken by the Authority in April 2004 appear to have been executed with low transition costs as measured by the implementation shortfall technique. Mercer strongly recommends that each time the Authority intends to undertake a transition a detailed and documented decision making process be undertaken.
Mercer IC has studied the processes for monitoring and reviewing fund managers and believes that these conform broadly to the notion of current best practice in the industry. The rebalancing processes have been studied by Mercer IC and found to be best industry practice in defining and achieving an appropriate trade-off between the high costs of rebalancing within very narrow ranges and the loss of portfolio efficiency relative to benchmark, of straying too far away from benchmark portfolio weightings.
There are within the GSFA business structure, clear, separate responsibilities and accountabilities for the key functions of investment management, custody and oversight. These responsibilities and accountabilities are monitored and reviewed appropriately.
The risk management process is a very thorough one and has been subject to public scrutiny since 2001 through GSFA’s annual reports to Parliament or tabled in Parliament by the Minister in the form of Statements of Intent. GSFA has also adopted a formal Risk Management Policy Statement.
GSFA argues well that the process of implementing a new investment structure was constrained by market exit strategies needed to sell off large holdings in NZ Government Stock without disrupting the market. Mercer IC also is familiar with the investment climate prior to, during and following the transition phase of the GSF, from its former defensive investment structure to its new diversified portfolio.
From the viewpoint of the general taxpayer it is reasonable to ask whose responsibility it was to make a decision about when to proceed with the restructuring of GSF assets and the related decision about how to proceed. The former question remains relevant to the Review because the review period covers the period when the transition was achieved. Can an objective judgment be sustained that GSFA ought to have delayed putting into effect an investment strategy which was more risky than its historical strategy, at a time when global financial markets were extremely volatile? Mercer IC believes that the general taxpayer should look to this Review for answers to this question and this is the spirit in which Mercer has approached this task.
What appears to be the case is that GSFA assumed the responsibilities referred to in the previous paragraph, appropriately under the legislation, and also appropriately, referred their decisions to the Minister who acknowledged their decisions without fresh direction.
In short, GSFA decided, having taking counsel from a variety of professional sources, that it was desirable to start the transition to a new investment structure as early as possible. GSFA had expressed its own misgivings, especially after the events of September 11, 2001 and actively sought advice.
Mercer IC has sought to make a clear distinction between market entry and the transition process. The market entry discussion ought to include a view on whether to proceed with a transition at all and, if not, what will be the determinants of the speed of the transition. GSFA worked very hard in 2001 through 2003 on the latter issue and Mercer IC accepts the difficulties which GSFA faced in doing so. A separate and formal discussion about whether to proceed at all is an area where we feel that GSFA, and perhaps the Crown, share some responsibility for proceeding to transition a traditionally defensive Fund strategy to a more aggressive strategy during a period of highly volatile financial markets.
The advice given to GSFA was that in spite of financial market volatility there were no compelling reasons to defer the immediate implementation of the transition plan. Neither did the legislation nor Crown directives suggest a timetable nor a process for determining a timetable. But, given the history, nature and size of the Fund assets was the GSFA correct to judge that the time was right to proceed with the transition to a new structure?
With hindsight it is easier to zoom out and suggest that in 2001 GSFA ought not to have approved implementing the transition at all. Mercer’s understanding is that GSFA had the authority to do so. Neither did the Minister react negatively to the plans put before him in September, 2001. But did GSFA in the end feel that it was desirable to proceed with a transition immediately? Yes, because professional advice was received that although short term volatility would be high - indeed, global share markets recovered very strongly in the quarter (December 2001) in which GSFA commenced the transition – this volatility ought not to deter GSFA from proceeding with a transition.
Therefore, the answer for the general taxpayer is that GSFA, on balance and after seeking counsel, felt that overall market conditions did not warrant delaying the start of the transition but did warrant close scrutiny and a cautious transition process. While this was a tough judgment to make it did expose the GSF assets, albeit gradually, to volatile, and generally weak, share markets over the next 18 months. History may have turned out differently and it is true that share market investors do face this kind of volatility continually.
Mercer IC believes that the use of the Equivalent Capital Value (ECV), in absolute terms, in respect of the margins valued and discount rate used, to communicate the value to the Crown of alternative strategies, may be flawed and further work has been suggested.
A divergence in interests exists between the solvency metric important to the Crown and the portion of that metric the GSFA has responsibility for. Due to these diverging interests (between components of the unfunded liability) Mercer believes the prior recommendation remains valid – that is, to split actual experienced annual changes in unfunded liability between those that relate to asset risks and those that are liability related risks. While technical in nature the issues are important to an assessment of the metrics used to measure the value to the Crown of GSFA’s decisions.
GSFA’s business planning is quite thorough. There are many current issues which require it to have a clear vision of its mission and to move early to anticipate changes in its operating environment. Mercer IC hopes that the 2006 Review will help to remove any uncertainty about the specific risk tolerance which is to guide the investment of the Fund’s assets and help to rationalise the funding process. Both of these initiatives would release resources which could then be applied to unresolved issues within the business plan. GSFA itself has already identified a number of strategic issues and these are to be covered in the 2006/07 Statement of Intent. Mercer has also suggested an approach to conducting an annual health check for GSFA.
The GSFA has identified the key risks associated with out-sourcing the scheme’s administration and has in place reporting systems and processes to monitor and manage those risks.
The agreements and the processes in place to ensure business continuity are extensive and in accordance with best practice.
Any worthwhile review has to take a detached, objective approach to evaluating the effects of all of the main factors which have impinged on the investment performance of the Fund assets since GSFA took over the reins. GSFA applied its own professional and experienced resources to its tasks as well as recruited advice from specialist investment consulting firms.
Throughout the Review Mercer has referred to doubts about the appropriate investment objectives for the Fund which left two key questions for the GSFA to decide for itself. First, what is the appropriate risk tolerance for the Fund assets? Secondly, how quickly should the Fund’s assets be transferred from its former to new structure?
How the second question was answered by GSFA has been more influential to investment performance in the review period than the first. Decisive action to begin immediately to move to a new structure was followed by an extended period of share market weakness in the world. The Fund could have been more sheltered from this weakness had GSFA delayed beginning its transition indefinitely, pending less market volatility. Section 14 expresses Mercer’s views about this issue but also emphasises the openness of the GSFA in expressing its intentions to the Crown and the thoroughness of the processes it employed.
Mercer has looked for evidence that the exit strategy was somehow binding the Authority to enter the markets in lockstep, but even the GSFA itself has assured the Review that there was no such close connection. Mercer has also weighed up the evidence that few schemes abroad and possibly none in New Zealand, which already had market exposures, took pre-emptive actions in 2002 to adopt more defensive stances. (There were instances however of defensive market entry strategies for very large funds.)
Neither did the Crown itself provide any opinion on when GSFA ought to begin its transition.
On balance, Mercer’s opinion is that, in spite of all of the factors beyond its control and a variety of other relevant factors, the investment performance of GSF since the changeover in 2001 could have been better. GSFA might have instead adopted the view after a separate and formal report on the issues that it was not appropriate for the GSFA to proceed with any transition at all at that stage. Mercer IC views such a call however as a very fine judgement to make. But having taking on the responsibility for these decisions then GSFA was backing its judgements about whether there was undue risk to the Fund.
Since 2003 performance has been influenced positively by the funds being by then fully transitioned to the benchmark portfolio, by a strong recovery in global share markets, and by the tax effectiveness of passive global equities when these markets do provide capital gains.
For the full period since inception until March 2006 the return on the GSF assets was approximately 6.1%pa after tax, compared to 4.3%pa after tax for a fund fully invested in NZ Government Stock. The original target outperformance against the latter metric was 3%pa which was later lowered to 2.5%pa. In its first 4.5 years the outperformance was 1.8%pa (6.1% less 4.3%).
New Zealand has been extremely well served by GSFA and this opinion on investment performance has been extensively qualified throughout the Review, especially in the context of appropriate interpretation of new legislation and putting that interpretation into day-to-day practice.