(This essay was published in Hong Kong Economic Journal on 23 September 2015.)
The Mandatory Provident Fund (MPF) is back in the news following press reports that next year’s Policy Address will end the practice of allowing employers to use their MPF contribution to offset severance and long service payments. While the Secretary for Labour and Welfare Matthew Cheung says the government is still gathering views on this issue and has no position at this time, the matter has raised concerns.
Some businesses, especially small and medium enterprises, have indicated this will hurt their interests. Labor representatives welcome the change. The issue has been presented in the media as a zero sum issue: one party’s gain is another party’s loss. This is not the case at all. Society will gain hugely if the practice is ended.
The “offsetting” arrangements were introduced as a sweetener to induce business interests to support the MPF when it was introduced in 2000. Before then, individual companies had their own provident fund schemes with some featuring similar “offsetting” arrangements. Voluntary pension schemes were competitive devices to attract and retain good workers. The MPF is a compulsive arrangement applied to all companies and should not have allowed an “offsetting” arrangement in the first place.
I and other economists argued at the time that offsetting should not have been brought into the MPF as a compulsory arrangement for all companies to adopt. It was neither justified nor necessary. In Hong Kong’s competitive markets, the employers’ contributed share of the MPF would be mostly passed onto the employees very quickly, with some passed onto local consumers.
The idea that employers would contribute to the MPF was largely an optical illusion. Given time, it would all come out of adjustments in the wages paid to employees and prices charged to customers. It would have been much simpler if employees were simply asked to contribute 10% of their salaries instead of pretending it was being split between employers and employees. At that time most employees were unwilling to contribute 10%, which of course would have begged the question of why labor groups would want to have an MPF in the first place.
As it turned out, employers benefitted from the “offsetting” arrangements in two ways. First, it allowed them to pass on some of the cost of severance payments and long service payments to employees depending on their ability to make wage and price adjustments. Second, with the optical illusion of contributing to the MPF, they were able to secure the privilege of selecting the investment funds on behalf of their employees. In so doing, banks and investment fund managers were incentivized to provide preferential credit terms to employers rather than better investment returns to employees for the MPF funds they managed.
The result was to create an MPF scheme that was not competitively designed to maximize the returns for the pensioners, but to serve the interests of businesses that wanted credit. Indeed, the only justification for creating an MPF scheme had to be based on the assumption that it would produce better investment returns like the one introduced in Chile in 1981.
Inspired by economist Milton Friedman’s landmark book, Capitalism and Freedom, José Piñera, Labor and Social Security minister during the dictatorship of then president Augusto Pinochet and a Harvard trained economist, introduced revolutionary reforms that overhauled the country’s payasyougo social security system. Chile’s conversion was a cause célèbre for free market economic liberalism in the 1970s and 1980s.
Chile’s pensions system was revolutionary for being the world’s first private retirement benefits scheme. Workers contributed 10 percent of their salaries to a government-supervised scheme, which invested the money in a variety of fixed income and equity securities at home and abroad. This system has allowed Chile to build up one of the world’s biggest pools of high return retirement capital and has served as a model for more than 25 countries around the world, from Colombia to India to Russia.
When Piñera explained the system in 1980 to the Chilean people, he cited a 4% real annual rate of return as an example of the system’s possible performance. Upon implementation its performance has been even more stellar, producing a real annual rate of return of 8.7% over the 34 year period from mid-1981 to mid-2015.
Competition among investment funds kept management fees low and maximized returns. These are features that a system directly managed by government, Singapore’s Central Provident Fund (CPF), did not possess. Without market competition and administrative transparency, Singapore’s CPF achieved a much lower real rate of return than Chile’s during the same period, with an annual mean on the ordinary account of only 1.75%.
A comparison between Singapore’s CPF and Hong Kong’s MPF shows very little difference in the performance of the two schemes. Since mid-2002, when the MPF was launched, to mid-2015, Hong Kong achieved a slightly higher real rate of return of 2.28% over Singapore’s 0.45%. Both funds have miserable track records compared with the Chilean pension scheme, which was able to achieve a real rate of return of 5.48% over the same period.
The public in Hong Kong knows their MPF has very poor results and are deeply unhappy and worried for their retirement. The real problem with Hong Kong’s performance is the lack of effective competition that is aimed at maximizing investment returns for the pensioner.
The “offsetting” arrangement is one of the major reasons why competition has been ineffective. It has produced the wrong type of competition – appealing to the business employers rather than to the employee pensioners. So far, individual portability of account funds has been achieved only for funds contributed by employees, but not by employers.
Another element restricting effective competition is the present arrangement that allows a proliferation in the number of funds that an individual can choose from – currently 457 funds belonging to 6 different broad categories. The whole design of the system is to confuse the vast majority of employees and leads to less effective competition.
The Chilean scheme allows for the full portability of funds to be determined solely by the employee. The basic system is designed to allow the people of Chile the choice to invest in five types of savings funds, denoted A to E, defined by their ratio of fixed to variable return assets. Type A is the most risky one, with up to 80% of its assets invested in equities. Type E is the most conservative one, with a maximum exposure of 5% of its assets in equities. The other ones are intermediate ones in terms of risk and return tradeoffs.
Consider the performance of the Type C investment fund, which aims to achieve an average performance among all fund types. Between mid-1981 and mid-2015 the annual real rate of return achieved by this fund was 8.50%. Over the period from mid-2002 to mid-2015 (the period over which Hong Kong’s MPF has been in operation) it achieved a real rate of return of 5.48%. This is significantly better than the Hong Kong performance results of 3.01%.
A tell tale sign of the lack of effective competition among fund providers in Hong Kong is the hefty annual administration and external fund management fees.
According to a research report released by the Mandatory Provident Fund Schemes Authority in November 2012, its total management fees in 2007 were 1.74%, with external fund management fees constituting 0.59%. This was the highest compared against total fees in Mexico (1.32%), Australia (1.21%), the US (0.83%) and of course Chile (0.60% – of which 0.27% covered the fees of external fund managers).
Administration fees are also the highest in Hong Kong at 0.75%, compared with 0.33% in Chile and between 0.10% and 0.42% in the other countries.
These very large differences fees, and also the rates of return between Hong Kong and Chile over similar periods of comparison, are very troubling. They suggest that the regulation of Hong Kong’s MPF is seriously flawed. Incompetence cannot explain such large systematic differences in returns over long periods of time. These differences suggest that regulatory restrictions may have seriously impeded effective competition.
An early end of the “offsetting” arrangements would allow a change to a fully, individually portable MPF scheme and would improve yields for all. Further reforms to simplify the MPF administration platform would allow individual account holders to exercise a meaningful choice over a much more limited range of funds.
Given Hong Kong’s high labor market turnover, a worker often ends up with multiple separate small funds that are employer designated. Fragmented individual accounts could be consolidated to attain economies of scale. Individuals would find it easier to become better informed about their investment performance and to make intelligent choices. A simplified administration platform would also induce a further lowering of fees.
To allow employers rather than employees to select the fund manager seriously impedes competition. This effectively provides the fund managing industry, including large banks and insurance companies, with a captured clientele. As long as employers are willing to stay with the same fund manager, there will be less need to deliver performance for individual account holders. Full employee fund portability is essential for triggering effective competition among fund management providers. The Chilean example shows clearly that fees can be lowered and returns improved.
Prompt action is needed to improve the MPF. The sooner this is done, the less populist pressure there will be for a pay-as-you-go social pension scheme. Such schemes are destined to be held hostage to politics, inevitably become insolvent, cause negative work effort and savings incentives, produce an enormous fiscal burden as our demographic profile ages rapidly, and damage Hong Kong’s fiscal health.
The government should legislate an early shift to improve yields for all, especially the needy who save less and depend more on a successful MPF. It would mean a life of reduced poverty in old age in the future. The MPF is a preferred scheme; it can be made even better if we allow it to happen. It should not be held hostage to the interests of banks, insurance companies, and employers. It is a matter of old age security for all, and for the less fortunate.