Reforms in Nigeria's capital markets boost prospects for investment in pension funds

While the assets of Nigeria’s main pool of domestic institutional investment – pension funds – have grown rapidly since reform was enacted in 2006, their investment mix has remained very conservative, clustered overwhelmingly in government securities with a so-called risk-free rate of return, which funds have bought to hold. Indeed, asset growth has been driven by the expansion in contributions rather than return on investment. Yet, as the profile shifts towards younger-aged contributors, pension fund administrators (PFAs) will need to rebalance in favour of investments that consistently beat inflation over the course of several decades.

Prompted by the Securities & Exchange Commission (SEC) and the federal government, the industry regulator – the National Pension Commission (PenCom) – is seeking to promote more diversified investments in corporate bonds, equities and alternative investments such as private equity. While these are expected to generate higher returns over their lifespan, there is also hope that they will partly fund much-needed private investment in infrastructure.

Asset Growth

Nigeria’s pension industry assets have grown 30% annually on average since the Pension Reform Act of 2004 was implemented in 2006, according to ARM Pensions, the market’s largest independent PFA. The act shifted the country’s pension system from an underfunded defined benefits scheme to a defined benefits one. By end of the first quarter of 2014, the market counted 20 PFAs and seven closed PFAs, with a combined N4.3trn ($26.23bn) in assets under management (AUM), alongside four pension fund custodians, according to PenCom figures.

Of the total, active retirement savings accounts (RSAs) made up some N2.6trn ($15.86bn), while RSA retiree funds accounted for N347bn ($2.12bn). Closed PFAs contributed another N642bn ($3.92bn), with approved existing schemes accounting for N628bn ($3.83bn). Despite strong asset growth, the market remains under-penetrated, with only 6m active individual contributors out of a pool of 16m formally employed workers and an estimated labour force of up to 80m individuals, most of whom are informally employed, according to the Pension Operators Association of Nigeria. The PFA market itself remains highly concentrated amongst the largest administrators, with the top-10 by size accounting for 84.3% of contributors and 92.13% of contributions by value as of 2012, according to research from investment firm BGL.

Liability Outlook

Growth in assets has been overwhelmingly driven by the addition of younger contributors, rather than return on investment, according to Sart Partners, a Lagos-based financial advisory firm. “There have been more years of sub-inflation rate of return on the RSA Active Funds in the pension industry history,” Sart noted in an October 2013 report on PFAs. Membership of PFAs has been growing at an average of 15% annually since 2006, with some 98% of members active and only 2% drawing benefits. Meanwhile, RSA active funds have been growing at 40% per year on average, outpacing broader industry growth.

The share of contributors under the age of 30 – and thus with over 30 years of contributions ahead of them – grew from 21% in 2007 to 33% in 2013, according to Sart. The new pension reform act, which replaced its predecessor from 2004, was passed by parliament in late April 2014 and will serve to support growth in contributions, with total contributions passing from 15% of salary, at a 7.5:7.5 split between firms and employees, to 18%, at a 10:8 split (see Legal chapter). This has led investment firms like Bank of America Merrill Lynch to predict a more than doubling in the number of contributors to 13m by 2020, while private equity firm Helios Partners, which took a $50m stake in ARM Pensions in May 2014, expects the value of pension AUM will reach $150bn by 2024.

Asset Allocation

Pension fund assets have been overwhelmingly placed in government securities, particularly Federal Government of Nigeria (FGN) bonds. By the end of first-quarter 2014, 63.39% of all PFAs’ AUM – or N2.7trn ($16.47bn) – were placed in FGN bonds, compared to only 14.3% – or N602bn ($3.67bn) – in domestic equities, according to PenCom. The next two largest asset classes by allocation were the domestic money market, with 7.8% of the total AUM, at N335.2bn ($2.04bn), and foreign money-market instruments, with 6.65% of assets, or N286bn ($1.74bn).

The PFAs placed 5.31% of their assets, or N228.4bn ($1.39bn), in local real estate; 1.86%, at N79.9bn ($487.39m), in state government and corporate bonds; 0.22%, equal to N9.3bn ($56.73m), in private equity funds; and kept 1.07%, or N46.2bn ($281.82m), in cashon-hand and other highly liquid assets. While the rise in allocations to domestic equities has been only marginal, up from the 10-11% in 2012 to 14.3% in the first quarter of 2014, the additional stakes in equities have cemented PFAs as the single largest source of domestic investment, ahead of other institutional investors and the retail market in particular.

“Retail investors remain burned by the 2008 experience,” Eno Atoyebi, portfolio manager at SIM Capital Alliance, told OBG. “Pension funds remain the largest source of domestic investment in equities.”

This is still a far more conservative stance than the regulatory ceilings, last changed in late 2012, of 50% of AUM in domestic equities; 20% in mutual funds; 15% in infrastructure bonds; and 5% each in private equity and infrastructure funds. The cautious nature of the PFAs’ investment mix is explained partly by the relatively high-yielding nature of “risk-free” government bonds, which yielded annual returns above 16% up to 2011 and still remain over 13% in 2014. Although administration fees and commissions of 2-3% lower the absolute returns from FGN bonds achieved by pension funds, the returns remain above single-digit inflation, though they could be vulnerable to sudden inflation upsurges.

Liquidity

Domestic pension funds raised their exposure to the domestic equities market late in the two-year bull run from early 2012. “Liquidity from the PFAs has been the main driver of higher turnover since the fourth quarter of 2013,” Layi Olaleru, head of equity trading at Cordros Capital, told OBG. Although PFAs have expanded their exposure to equities in 2013 in particular, their general approach is to buy and hold securities. Thus, while the initial investment by PFAs causes a bump in turnover and liquidity, it is rarely sustained.

“Pension funds may have grown their exposure to equities in the past year, but they buy and hold, so this does not create momentum in the market,” Egie Akpata, head of capital markets at UBA Capital, told OBG.

Indeed, while PFAs drove a surge in liquidity, particularly on the buy side, in late 2013, domestic investment as a share of total turnover slumped in 2014. While foreign portfolio inflows increased 45.9% year-on-year (y-o-y) in the first quarter of 2014, domestic investment dropped some 46.02%, with the total value of transactions up only 3.71% y-o-y.

The management of the stock exchange itself recognises that while domestic institutional investors account for the lion’s share of domestic holdings on the exchange, their share of turnover is much smaller. “Most of the domestic trading is retail, since there is no strong portfolio management culture amongst Nigerian institutionals,” Oscar Onyema, CEO of the NSE, told OBG.

Regulating Change

Pressure for reform is coming from several directions. Although it is unlikely to increase the level of active portfolio management, and consequently liquidity, by PFAs in the short term, it is hoped that diversifying PFA investments beyond sovereign fixed-income securities can channel more funds into the real economy, improve returns and overcome the challenge of the government’s gradual reduction in issuance of local-currency bonds. “The below-inflation return on investment underscores the fundamental need to search, structure, develop and invest in alternative asset classes that have the potential to beat inflation sustainably,” Sart noted in 2013.

The last annual change to PFAs’ asset allocation limits came in November 2012, but did not lead to significant diversification of investments. Additionally, PFAs must maintain a reserve fund of 12.5% of after-tax profit to handle any future losses. The SEC and the stock exchange have long argued for greater exposure to non-fixed-income securities, a point that is now conceded by PenCom leadership.

“We have a huge amount that can go into the development of infrastructure, but what we have now is an underutilisation,” PenCom’s director-general, Chinelo Anohu-Amazu, told Bloomberg in June 2014.

Beyond the existing limits, PenCom has considered relaxing requirements for investable assets in ways that would be key for capital markets with relatively short track records. The NSE is proposing that PenCom allow investment in firms with only three years of financial statements, down from the current five.

While PenCom doubled the ceiling on local equities investments from 25% in November 2012, it only allows investment in firms that have paid dividends in at least one of the last five financial years. Another constraint may be the requirement to invest in private equity funds with established track records – which, in Nigeria’s relatively nascent industry, are few and far between.