Written by GCS Research Analyst: Jackey Li
As the average life expectancy of the global population rises and fertility rates decline, the proportion of older people in each country is growing rapidly. In response to the global population ageing crisis, the World Bank published the report “Averting the Old Age Crisis” in 1994, which pioneered a reference framework for the establishment of a pension insurance system, proposing the famous “three-pillar pension insurance system”.
1) The first pillar, A state-run pension scheme providing a basic income, which is a “low insurance” for old age “.
(2) The second pillar funded occupational pension plans that accept contributions from individuals and employers.
(3) The third pillar, private pensions, is a pension system in which individuals save voluntarily and are encouraged by the government to purchase pension insurance through relevant tax incentives, providing more protection for individuals with higher income and insurance needs.
Data source: AXA
With China’s ageing population, pension protection has become a major social concern. In order to increase pension income, the Chinese government has started to promote the development of a personal pension market and in this context, pension FOFs have become a highly sought-after investment vehicle.
Although pension FOFs are still a nascent concept in China, they have been a well-developed and commonly traded model of retirement in Western economies for almost half a century. In this article, we will explore.
- A brief description of the main forms of pension FOFs
- A brief overview of the history and current status of pension FOFs in the US
- The impact and opportunities of China’s pension FOFs in the era of personal pensions
What is a pension FOF?
A fund of funds (FOF) – also known as a multi-manager investment – is a type of pooled investment fund that invests in other types of funds. In other words, its portfolio contains a different underlying portfolio of other funds. These holdings replace any direct investments in bonds, equities and other types of securities.
A pension FOF is a publicly offered securities investment fund that aims to pursue long-term sound appreciation of pension assets, encourages investors to hold them for a long period of time, adopts a sophisticated asset allocation strategy and reasonably controls the risk of portfolio volatility. In China, pension target funds should be operated in the form of fund of funds or other forms approved by the CSRC. A pension target fund in the form of a fund of funds is referred to as a pension target FOF fund. Pension target FOF funds should adopt a mature and prudent asset allocation strategy to control the downside risk of the fund and pursue long-term sound appreciation of the fund.
Strategically, pension FOFs are mainly divided into target-date and target-risk strategies.
Target Date Fund (TDF): A type of mutual fund FOF that allocates assets according to a sliding equity curve, – from an aggressive style to a solid style finally adopting a conservative style towards maturity, while different styles represent different levels of equity asset allocation ratios. The target-date pension FOF rebalances the portfolio over time so that the fund’s portfolio tends to be conservative, adapting the portfolio’s risk to the risk-taking capacity of investors at different ages. In other words, as the investor’s life cycle continues and the investment target date approaches, the fund’s investment style changes from “aggressive” to “prudent” and then to “conservative”, with the proportion of equity assets gradually decreasing and the proportion of non-equity assets gradually increasing. The proportion of equity assets gradually decreases and the proportion of non-equity assets gradually increases. These funds are sought after by employer pension scheme funds.
In contrast to TDF products, TRFs require employees or investors to make an active choice at the time of investment: 1) to choose the level of risk according to their investment preferences; 2) to choose the level of risk based on a maximum return model (which allocates assets to maximise returns based on standard deviation, returns and other relevant data, subject to certain constraints) and the investment style given by the fund company and the corresponding equity ratio. 3) Choose an asset allocation based on a maximum return model and an investment style given by the fund company with a corresponding equity allocation.
In the US, for example, TRF is smaller than TDF, at $0.42 trillion in Q2 2021, less than 25% of TDF over the same period, and the share of other investors has been greater than 50% since 2006. This suggests that US pension plan holders prefer to invest in TDFs that they do not actively choose, thereby providing them with a relatively stable cash flow near retirement, rather than holding a certain level of risk all the time.
Data source: ICI
Lessons and thoughts on US pension FOFs
The number of FOF funds grew from 838 in 2008 to 1,469 at the end of 2019, with net asset size soaring from US$469.33 billion in 2008 to US$2,543.95 billion in 2019, a compound annual growth rate of 16.6% during the period, more than double the growth rate of US mutual This is more than double the growth rate of US mutual funds over the same period. Both in terms of volume and scale, it can be seen that US FOF products are favoured by US investors, which is inextricably linked to the development of the US fund industry over the decades, the improvement of the pension system and the fund companies’ own development needs.
Over the past three decades, one of the important factors driving the rapid development of FOF funds in the US is the advent of an ageing US population and the expansion of pension assets following the reform of the pension system. As pensions are characterised by long-term investment and highly risk-sensitive, they are not suitable for investing in the stock market in large proportions. Therefore, the FOF product model featuring risk diversification, asset allocation and the pursuit of long-term stable appreciation has become the preferred choice for pension investment in the US. Pensions have provided a stable and continuous flow of long-term capital for the development of US FOFs, and the decline in net cash inflows in a weak market is much lower than the average for the fund industry. According to the Investment Company Industry Institute (ICI), about 60% of retirement investment plan participants hold Target Date Funds (TDFs), and 99% of TDFs are FOFs.
The US pension system is structured around employer-sponsored retirement plans (including Defined Benefit (DB) and Defined Contribution (DC) plans sponsored by private sector employers and government employers), Individual Retirement Account (IRA) and annuities, which are quite large. At the end of 2019, US pension assets totalled US$32.3 trillion, of which US$9.9 trillion was invested in DC and IRA assets, representing 46.48% of the net assets of mutual funds across US registered investment companies, meaning that nearly half of the total assets of the US mutual fund industry came from DC and IRA plans.
IRAs are more flexible than DC plans (which can generally only invest in public funds). The IRS Regulation document and 590-A (2021) specify that the assets that an IRA cannot invest in are life insurance or collectibles (e.g. stamps or artwork) and that if funds in an IRA are invested in collectibles, the funds will be deemed to be distributed in the year in which they are invested, resulting in an additional 10% tax on early distributions. In addition, for certain assets (e.g. real estate), the IRA trustee may impose additional restrictions on the investment (e.g. no investment in real estate). For other financial assets, such as mutual funds, deposits, individual stocks, etc., IRAs may invest without restriction as long as the investment of the assets does not directly affect the interests of the trustee and related relatives.
According to ICI data, the share of the third pillar, Individual Retirement Savings Accounts (IRAs), has been increasing year on year; DB and DC plans have the largest share but are decreasing year on year; Annuities have the smallest share
Data source: ICI
The impact and opportunities of China’s pension FOFs in the era of personal pensions
The Opinions of the General Office of the State Council on Promoting the Development of Individual Pensions was released in April 2022. The introduction of China’s personal pension system has provided a broad market space and development opportunities for the development of pension FOFs. Prior to the introduction of the personal pension system, China’s pension protection was mainly based on social insurance and the development of a personal savings pension system was relatively slow. The introduction of the personal pension system, on the other hand, has enabled more residents to understand and participate in pension investments, providing more demand and investment opportunities for pension FOFs.
At present, China’s personal pension market is still relatively new, but the government has started to encourage financial institutions such as banks, insurance and securities to enter this market. At the same time, the government has also stipulated several policy measures to encourage residents to participate in personal pension investments, such as tax incentives.
As we can see, pension funds seek long-term stability in portfolio performance and diversification of risk through asset allocation management. It is clear that compared to ordinary funds, FOF-type pension funds are more in line with the philosophy of the “Guidelines for Pension Target Securities Investment Funds (for Trial Implementation)” and can better realise the risk-return characteristics of pension funds.
According to Wind data, since the approval and issuance of public FOFs, as of the end of October 2022, the number of public FOFs was 356, with a total management scale of over RMB200 billion. Among them, there are 84 target-date funds, of which the number of funds with maturity dates of 2040 and 2035 is high; there are 107 target-risk funds, of which the number of stable FOFs is high. Although the size of the pension FOF market is still relatively small compared to the size of the overall fund market, the development prospects of the pension FOF market are promising as the policy continues to promote and the market continues to mature.
Of course, there are still some problems and challenges in the development of pension FOFs. For example, due to the relative immaturity of China’s pension market, coupled with the lack of transparency and illiquidity of FOFs themselves, the selection of investment targets and risk control aspects of pension FOFs need to be focused on. In addition, some investors’ understanding and awareness of pension FOFs is not yet deep enough, and further education and popularization of the market is needed.
All in all, pension FOFs are an emerging market with great potential for development. As policies continue to improve and the market continues to mature, it is believed that pension FOFs will play an increasingly important role in the future market, providing residents with more comprehensive and reliable pension protection.