Friday, December 05, 2008Protecting Our Nest Egg

Clarence Faulkner JrThe Social Security Board's Investment Strategy

For many social protection systems around the world, the challenge of long-term sustainability remains at the forefront of discussions. Discussions typically center on funding requirements, reform and or outright failure of established systems. In the Virgin Islands (UK), our forefathers embraced such a challenge early on and today the appointed fiduciaries continue to ensure that the promises made to contributors and their families are honored and will continue to be honored in the future. An Act, no. 17 of 1979 established a system of social security providing pecuniary payments by way of maternity benefits, injury benefits, invalidity benefits, age benefits, survivor’s benefits, sickness benefits and funeral benefits. Today, the Social Security System of the Virgin Islands (UK) is recognized locally, regionally and internationally for its success.

In 1967, the first Chief Minister, Hamilton Lavity Stoutt, expressed concern about the lack of protection for employed persons within the Territory who became unable to work and had no source of income. In 1978, after inclusion in an International Labor Organization (ILO) multi-island Social Security project, Legislative Council approved the introduction of a comprehensive social security system. During 1979 and 1980 regulations were adopted providing the legal framework for the management and administration of the country’s social safety net. On July 2, 1980, the doors of the Social Security Board’s office opened to collect contributions, pay benefits and manage and administer surplus funds.

The social security system is governed by a Board of Directors which is tasked with providing strategic direction on its operational efficiency. The Act charges the Managing Director with responsibilities for the day-to-day activities of the Fund. The services offered by the System are categorized in three branches; namely the short-term branch, inclusive of sickness, maternity, and funeral benefits, the Employment Injury branch and the Long-term branch that encompasses invalidity, survivors, and age benefits. The financing of those branches is achieved via a contribution structure that requires employed and self employed persons between the ages of 15 – 65 to contribute a rate of 8.5% of insurable earnings. Civil Servants do not benefit from sickness benefits; therefore their contribution rate is pegged at 7.5%.

Amongst discussions in recent times has been the protection of the country’s nest egg, which speaks directly to the sustainability of the long-term branch. In February 1985, the first Actuarial Review was performed to measure and estimate the effectiveness of the system. This form of review takes place every three years with the most recent covering the years 2003 – 2006, with the next scheduled review being for the period January 2007 to December 2009. Some of the statistics highlighted during reviewed periods concern population data such as ages of employed persons; fertility and mortality rates, and net migration per year. These statistics are by no means exhaustive and along with additional data provide key indicators in determining the long-term obligations of the Fund.

Section 13 of the Act makes provision for an Investment Committee to provide advice and direction on the management of surplus funds. Surplus funds are the residual proceeds after contributions are collected and benefits and administrative expenses are paid. At present the contribution to benefit ratio stands at 4:1. This indicates that for every $4 collected, $1 is paid out in expenses, thereby providing a surplus of $3. It is the amalgamation of annual surplus funds that provides for the long term branch of the Board.

In 1997, the Board set out to develop an Investment Policy Statement (IPS) that embraced the risk characteristics of its stakeholders. The goal of the IPS is to provide policy and guidelines for the management and administration of the Fund. This document also embodied the mission and vision statements of the Board. It addresses several key areas such as the investment objectives, investment guidelines for fiduciaries, delegation of investment decisions, an asset allocation policy, record keeping, custody, arbitration and termination of service providers.

The process of establishing an adequate risk profile entailed the creation of questionnaires aimed at gathering information from key stakeholders about their appetite for various elements of risk. Once the completed questionnaires were received, the findings were compiled to determine what category of risk the Board was willing to take on. However, it was also critical that the Board studied the demographics of the Territory to appreciate the role the social security system plays within communities.

Another key area addressed was the limited opportunities for investment onshore and the extent to which the Board needed to seek offshore financial services to assist in achieving its mandate. Acknowledging the findings and recommendations of the 6th Actuarial Review dated December 2006, coupled with the combined responses from stakeholders; it was time to determine the Board’s overall risk profile. An assumption that was made during the 6th Actuarial Review was that the Boards’ reserves needed to grow at a rate of 7% in order for the system to fulfill its mandate for an additional 50 years. It was important as fiduciaries, to ensure that at a minimum, the reserves of the Board grew at a rate of return of 7% annually. Additionally, the review projected that the average inflation over the same time frame would be 3%, thus providing a nominal expected return of 4%.

Academic research suggests that the decision to allocate total assets among various asset classes will far outweigh individual security selection and other decisions in respect of impact upon performance. After reviewing the long-term performance and risk characteristics of various asset classes and balancing risks and rewards of market behavior, an asset class allocation was selected to achieve the objectives of the Fund. The optimization process in determining the asset allocation, considered expected rate of return, standard deviation and correlation of and amongst various asset classes. The possibility of natural disasters has also been considered as it relates to the impact on contribution income and local investment opportunities. Upon completion of the analysis it was agreed that the risk profile of the social security Fund be classified as “Moderate Growth”. This means that the significant majority of the Fund is invested conservatively.

The asset classes selected to achieve the Board’s mandate are Cash, Socio-economic Loans, Fixed Income Securities and Managed Assets.

The Cash component of the Fund is invested locally and primarily in certificates-of-deposit. The process of managing cash depends on the best available savings rates for assigned durations.

As part of determining the Boards’ risk profile, the Board recognized that it also bears both a social and economic responsibility to the ongoing development of the Territory. Cognizant of this, the Board established an asset class referred to as Socio-economic loans, which provides funding to government and government related agencies that aid in the social and economic development of the Territory.

As the local government does not issue debt securities, the Board has opted to seek Fixed Income Securities offshore. The minimum requirement for such instruments to be purchased is investment grade (BBB) and tradable on an internationally recognized exchange. The Managed Asset segment of the Fund involves the purchasing of shares in fundamentally sound companies with the opportunity for value appreciation over time.

The unique nature and characteristic of the Board and its beneficiaries warranted implementation of the target asset allocation over a period of time rather than being implemented at once.

After adopting the IPS, the Board aligned its existing assets with that of the new policy. Practices were established that upon maturity of certificates of deposit, fair negotiations between the Board and each financial institution occurred in an effort to obtain the highest saving rates possible. The Board in its ability to negotiate also investigated what each institution does with its proceeds, be it secondary lending in the form of mortgages and personal lending or the utilization of external treasuries.

When seeking investment opportunities locally, the Board evaluates each opportunity based on its merit. For example, the Board performed a net asset valuation and feasibility study to determine whether the Board should have invested in the construction of the new Peebles Hospital. The analysis studied the economic impact in terms of a long-term investment and the potential cash flow to the Fund. More importantly were the social implications a fully functioning modern healthcare facility would have on both the social security and the community at large. Some of the benefits projected were increased efficiencies in the diagnosis, treatment and return to the workforce of patients, and a reduction in benefits expenditure. The potential employment opportunities created with the new facility, in addition to a positive economic multiplier, increases the contribution base and the surplus rate. The Board resolved that this project was indeed a ‘win-win’ both socially and economically. A sum of $35 million was committed to the construction of the new hospital.

The Fixed Income Securities segment utilizes the institutional trading desks at major investment firms. This process entailed a rigorous review of the services and processes of each identified firm and its key personnel. It is absolutely critical that such individuals and firms have the adequate resources to effectively execute and settle trades on behalf of the Board. It is important to note that because of the 4:1 contribution to benefit ratio, liquidity is not an immediate requirement. Since the majority of the population falls in the range of 25 - 45 years of age, the adoption of a passive ‘Buy and Hold’ strategy has been utilized. This means that the Board negotiates or constructs an instrument, agrees to terms and conditions, purchase the security and hold until maturity. During the life of the security the Board collects the agreed coupon payments and upon maturity, 100% of principal invested is returned to the Board for reinvestment. The Board does not permit any one institution to hold more than 20% of its Fund. Further, the Board also establishes segregated accounts and does not permit the lending of its Securities.

The process of managed assets highlights the establishment of independent consultants, specialist style managers and due diligence firms. Through its rigorous review, the Board identifies consultants that only provide consultancy services; they must not manage money directly. Such consultants must meet predetermined standards. Next, the Board solicits the services of an independent due diligence firm that only provides an opinion on the management and performance of the specialist style managers. As with other segments, this segment of assets must also comply with the Board’s overall risk profile. Because of the nature of the assets, 70% value stocks and 30% growth stocks was determined for this segment of the Fund as best suited to meet the Board’s needs. It was deemed prudent to diversify geographically with a weight of 80% U.S. and 20% international. Specialist style managers who met the Board’s criteria were selected to assist the Board in achieving the agreed ratios. To confirm that each specialist style manager complies with the specific assigned mandate, regular attribution analysis and appropriate quantitative and qualitative reviews are performed. Each specialist style manager is judged against relevant benchmarks and the overall segment against composite benchmarks. Specialist style managers are not permitted to custody the Fund’s assets. Those assets are managed via the use of trading platforms typically set up through Custodians. Should a specialist style manager be terminated he or she will not have direct access to the assigned account.

To explore every avenue of transparency and accountability, the Board has access to a law firm that specializes in reviewing 10ks filed with the Securities Exchange Commission (SEC) on all listed companies. The review of the filed documents will identify any discrepancies that can impact the ongoing decision to invest in a company. The Board does not utilize hedge funds, mutual funds, private equity or emerging markets at this time and will not engage in such services unless it is deemed feasible to add them to the platform.

For any social security system to continuously meet its obligation without having to charge workers and employers excessive contribution rates, a growing economy is the first ingredient necessary for success. The next critical element to be considered must be a well designed system. Both factors have contributed to the Board’s success now and well into the future. The local system has reaped the benefits from high levels of economic growth over the last 28 years and is firmly placed to meet future obligations. The success of the Board hinges on strict discipline in the management of its affairs as it continues to honor its commitments by paying benefits in a timely manner. Over the last 10 years the performance of the Fund has seen a required yield on long-term reserves reduce from 7% to 5.5%. The Fund continues to maintain at minimum, a nominal rate of return of 4.0%. While the forecast for the global economy appears flat, the long-term sustainability of the Fund is indeed intact.

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