Institutional investors: New rules for pension fund administrators should increase domestic equity and debt activity

The capital markets have seen a significant jump in liquidity over the past 24 months, driven in part by an increase in foreign portfolio inflows. However, domestic investors have played a growing role as the markets continue to rebound from the 2008 sell-off crisis (see analysis). This is in part a reflection of a return by retail investors, but it is the institutional investors – who already comprised 90% of the funds invested in 2012 – who may prove to be the biggest driving force in the exchange’s push to deepen and diversify activity.

This is perhaps best exemplified by the expanded role pension fund administrators (PFAs) are able to play on local capital markets, following a revision in December 2012 of investment guidelines by the National Pension Commission (PenCom).

PENSION REFORM: The new guidelines are the latest in a steady drive to leverage PFA assets to boost domestic equity and debt activity. PFAs have seen significant changes to their scope of activity over the past decade, which have helped to increase their heft on Nigeria’s capital markets. A 2004 act overhauled the industry by setting out a legislative framework for the transparent aggregation and investment of formal and public sector workers’ pension contributions. The legislation shifted Nigerian pensions from a defined benefit scheme to a contributory pension scheme, requiring all enterprises with more than five employees, as well as all public organisations, to provide individual retirement savings accounts (RSAs) with a licensed PFA.

RSAs are funded through contributions of a minimum of 15% of salary, which is split equally between employee and employer for all cases except the armed forces, where the federal government provides all but 2.5%.

FUND VOLUME: PFAs were brought to the market following three licensing rounds held by PenCom starting in 2005. Minimum capital requirements were set at N150m ($945,000) for PFAs and at N5bn ($31.5m) for pension fund custodians (PFCs), all of which are banks. A total of 26 PFA licences were awarded, in addition to five PFCs and seven closed PFA licences to large corporations, such as Shell. However, by June 2012, increased capital requirements of N1bn ($6.3m) led to a wave of consolidations, with several mergers and acquisitions reducing the total number of PFAs down to 22 by late 2012 and then 18 by mid-2013.

The largest PFA is Stanbic IBTC, a subsidiary of South Africa’s Standard Bank, which holds a market share of roughly 20%. Other large administrators, such as ARM, Crusader Sterling, Sigma Pensions and Leadway Pensure, cover a majority of federal government staff, the single largest group of contributors to the industry, accounting for around 40% of those paying into the system, as well as the employees of some larger firms.

UNDER MANAGEMENT: PFAs faced something of a slow start, with just N121bn ($762.3m) in assets under management (AUM) in 2005. However, contributions grew substantially from 2006, with the first 1m formal sector workers covered by the middle of that year.

By the second quarter of 2008, when the number of registered contributors exceeded 3m, the majority of federal government workers had been covered, with compliance also growing among larger corporates. By September 2013, the size of AUM had jumped to more than N3.7trn ($23.31bn) with over 5.5m contributors, a significant rate of expansion and, perhaps just as crucially, a chunk of capital that was ripe for investment.

The PFA industry has managed respectable returns since 2008. In the past five years return on investment has expanded at an average of 20% annually, although this is unlikely to continue given the slowdown in the exogenous environment and the gradual shift by portfolio investors back to advanced economies.

Perhaps unsurprisingly, PFAs have concentrated on lower-return, lower-risk investments, with a particularly heavy weighting in government bonds and money market instruments, with approximately 35% of combined PFA assets invested in government debt alone. This has seen something of a change in recent months, as falling yields on federal government naira-denominated debt since its inclusion on JPM organ’s emerging markets bond index have encouraged a rotation into equities to some extent.

Although countries such as South Africa have raised the limits on foreign investment, PenCom’s risk-averse regulations are widely credited for insulating the industry from the effects of the 2008 downturn. A 2009 report by International Financial Services London, a think tank, found that those pension systems whose investments were most heavily weighted towards domestic government bonds were best insulated from the effects.

CHANGING LIMITS: However, given the impressive increase in AUM – and the scope for medium-term growth given the still-sizable number of formal sector employees who are not yet enrolled in the pension scheme – the potential for leveraging pension fund assets to deepen Nigeria’s capital markets is enormous.

Indeed, the government has shown it is particularly eager to encourage PFA investment on the domestic markets. This began in 2010, with PFAs allowed to invest in private equity and corporate bonds with a “BBB” rating or higher for the first time. However, the biggest change came in March 2012, when PenCom released a draft of new guidelines on investment caps for PFAs, a version of which was finalised in December.

NEW RULES: The new framework, taking effect from the start of 2013, set revised limits for key asset classes. Ceilings for investment in government securities, including sovereign Eurobonds, remain the same at 80%, and private equity caps have stayed at 5% of the total portfolio limit. Corporate debt, including global depository notes, are set at 35% of total AUM, as are money market instruments such as commercial paper and CDs – although money market instruments must meet certain credit ratings and are subject to limits accordingly. More interestingly, PFAs can invest up to a maximum of 20% of their total portfolio in open, closed and hybrid funds, including real estate investment trusts (REITs) and exchange-traded funds (ETFs). Although the potential for short-term activity in this area is limited – given that there are only two REITs, worth roughly $2.36bn, and one ETF – the scope for future growth is sizable. Statements by Oscar Onyema, the CEO of the Nigerian Stock Exchange, to local press indicate that the exchange is targeting another five new ETFs in the coming months.

GROWTH AREA: Infrastructure, however, is clearly the priority area opened up by the new regulations. PFAs are allowed to invest up to 5% of their AUM in any infrastructure fund with over 75% of its projects in Nigeria, and up to 15% of their AUM in infrastructure bonds for projects worth more than N5bn ($31.5m). Any potential infrastructure investments would also require the involvement of a concessionaire with a proven track record, and would necessitate the successful conclusion of an open and transparent bidding process under the Infrastructure Concession and Regulatory Commission Act. Priority areas earmarked include public-private partnerships in infrastructure.

Although this new framework clearly represents a significant loosening of the asset management and investment framework that was previously in place, strong risk management provisions still remain, with PenCom keeping a cap of 5% of AUM on investments in any one corporate entity and allowing PFAs to hold a maximum of 4.5% of the issued capital of any company.

The revised PenCom rules represent a significant change in the framework regulating the investment strategies of several of Nigeria’s largest domestic institutional investors, and should help loosen the purse strings of an industry that is expected to see significant growth over the medium term. However, if the NSE is to reach the target of $1trn in market capitalisation, it would benefit from a further liberalisation of PFA investment caps. Retail investors are returning towards equities but the ability of PFAs to mobilise significant funds means they offer an unusually fast route to deepening the market. In comparison to Nigeria’s rules, the world’s top 20 pension funds invested nearly 40% of their AUM in equities. Given the elevated risk in Nigeria’s markets, it is perhaps unsurprising that PenCom has maintained some fairly robust caps on investment, but should it decide to revisit them, the exchange will likely see an impressive wave of new domestic inflows.