PLC Sub-Committee on Subsidiary Legislation of the MPF System

Information Note

Capital Preservation Product

Purpose

This paper sets out our proposals on the Capital Preservation Product which can generate steady investment returns to protect contributions against erosion by high administrative fees and poor investment performance.

Proposals

Investment Options For All Scheme Members

2.We propose that all MPF schemes should have a Capital Preservation Product as an investment option which is made available to all scheme members regardless of their income level.

Stringent Investment Rules

3.To achieve positive investment returns with minimum investment risks, we propose that the investment fund backing up the Capital Preservation Product should be subject to the following investment limitations, in addition to the standard MPF investment restrictions and guidelines -

1. the fund may only invest in the following deposits and debt securities -
   1. bank deposits;

   2. government or other public securities with a remaining maturity of two years or less; or

   3. other debt securities with a remaining maturity of one year or less and a short-term credit rating of " A-1 " given by Standard & Poor's (or equivalent);

2. the fund should maintain an average portfolio maturity not exceeding 90 days; and

3. the fund should have 100% effective currency exposure in Hong Kong dollars.

Unitization of Investment Fund

4.We propose that the investment fund in support of the Product should either be a unit trust or fully unitised fund operating on the unit trust principles denominated in Hong Kong dollars with investment income and profits credited to members' accounts at least once a month.

Restrictions Against Erosion by Administration Fees

5.To protect contributions from erosion by high administrative fees, we propose that no deductions can be made from members' accounts or the investment earnings of the Capital Preservation Product except -

1. to deduct from the portion of investment earnings that is in excess of comparable interest earned from savings accounts to pay administration fees to the trustee or the investment manager; or

2. to pay levy of the Compensation Fund, regardless of the level of investment earnings.

Enforcement of Requirements

6.We propose that the MPF Authority should approve the Capital Preservation Product to ensure that all the statutory requirements are met and such requirements are included in scheme documentation as contractual provisions. Any future changes to the specification of the Product will require prior approval of the MPF Authority. The trustee must file with the MPF Authority within 7 days from the last working day of each month details of contributions made into the Product during that month, details of the total funds under management and the unit price of the Product.

7.Furthermore, the compliance of the requirements should fall within the scope of annual auditing of the scheme. When administrative fees cause an erosion to members' contributions, the trustee will be in breach of statutory requirements as well as the contractual provision. Sanctions can be taken against the trustee by the MPF Authority depending on the nature and seriousness of the breach.

Justification

Investment Options For All Scheme Members

8.It has been suggested that each master trust scheme should be supplemented by a Capital Preservation Product as an investment option available to low income earners to protect their contributions from erosion by high administrative charges and poor investment returns. Since employer sponsored schemes, probably sponsored by larger employers, may also have scheme members with low income, the requirement should be extended to all MPF schemes.

9.In practice, it would be inequitable and administratively cumbersome to confine the membership of the Product to low income earners. A low income earner close to the threshold may become disqualified as a result of receiving a small increase in earnings or temporary increase in income for a few months. In line with our philosophy to permit investment options, the Product should be made available to all scheme members.

Stringent Investment Rules

10.The proposed stringent investment rules are intended to reduce investment risks and the likelihood of negative investment returns as follows:

1. Capital Preservation : Deposits and fixed income instruments can provide positive investment income and preservation of capital. The volatility of returns and diminution of capital from equity investments can be avoided.

2. Market Risk : Capping average portfolio maturity to 90 days, restricting the maturity of corporate and government/public issues to 1 and 2 years respectively will greatly reduce the exposure to market risk (i.e. interest rate risk).

3. Default Risks : The risk of default (i.e. credit risk) is reduced by setting high standard on the credit rating.

4. Risk Diversification : Diversification of assets will lessen concentration of risk from failure of any single investment.

11.The investment restrictions are modeled on the rules governing the operation of money market cash management funds. This is a preferred approach compared to that of guaranteed funds. To provide an investment guarantee, the guarantors would be required to set aside sufficient provisions to guard against investment returns failing to meet the guaranteed rate over the duration of the contract. Since the investments of money market cash management fund are already subject to the stringent investment rules to ensure superior quality with the ability to produce positive investment returns, it would not be cost effective nor necessary to require an investment guarantee. Moreover, the cost of reserves will be passed on to scheme members as a reduction to the investment return.

12.The investment management fees for money market cash management funds are quite low, typically 0.25% compared with the normal 1% for unit trusts. Because of the low management fees, the investment returns from these funds are very often more competitive than bank deposits.

Unitization of Investment Fund

13.Unitization will serve to increase the transparency of the investment operation. Investment earnings will flow through to account holders on a fair and equitable basis. Requiring the crediting of investment earnings at least once a month will ensure a steady flow of investment income to members' accounts,

Restrictions Against Erosion by Administration Fees

14.The restrictions on fees will protect contributions of members from erosion. Some service providers have requested that to enable them to recover their costs the restrictions should not apply for scheme members who withdraw funds within one year of joining. In view of the high staff turnover in Hong Kong and the fact that many of them are low income earners, we regard the one year qualifying period as being too restrictive.

15.Other service providers have suggested that MPF fees are beyond their control and should be excluded from the formula. However, it is our view that fees paid by trustees to the MPFA are for the purposes of monitoring the MPF system. Such fees are of the nature of licensing fees as part of the trustees' costs of doing business just like other operating costs. It would not be equitable for scheme members to bear this costs directly and should therefore be included in the formula. Moreover, the MPF fees are quite small when compared to the investment returns and other administrative fees.

Enforcement of Requirements

16.Contrast to the annual reporting on normal scheme operations, monthly reporting will be required from the trustee on the Capital Preservation Product. This will enable the MPF Authority to monitor closely trustee's compliance with the requirements. Timely actions can be taken to protect the interest of scheme members in cases of deficiencies. The frequency of reporting will be reviewed in the light of operational experience.

Full Inflation Protection Against MPF Principles

17.Some Members have suggested that the Capital Preservation Product should guarantee an investment return at least equal to inflation. However, we consider that the proposal is neither appropriate in principle nor feasible in practice.

Principles

18.The MPF System is built on the concept of individual capitalization. It enables scheme members to save for their old age and at the same time make their own investment options in accordance with their own circumstances and risk-taking attitude. The total amount of MPF benefits a scheme member can accumulate depends largely on investment return. The level of investment return he gets is always commensurate with the level of risks he takes. The Government must introduce measures to enable scheme members to make well informed choice and protect them from unduly high investment risks.

19.Under this member choice environment, it is illogical and inequitable in principle to institute a measure which encourages scheme members to choose low risk investment options (i.e. Capital Preservation Product) by requiring other parties to bear the costs of providing guaranteed high return " . Such type of measure would only induce scheme members to make irrational investment choice and eventually become heavy charges on the rest of society.

Immune to Inflation Not Feasible

20.For the practical reasons analysed in paragraph 21 to 26 below, it is also not feasible to require the Capital Preservation Product to provide an investment return that matches with inflation. In the MPF environment, scheme members can switch their accrued benefits between different investment choices in a scheme or transfer their accrued benefits from one scheme to another. Without a long term commitment to a specific fund, it would be difficult to secure a guarantee against inflation.

Financial Instruments Can Only Hedge Long Term Inflation Risk

21.Statistics have shown that portfolios of bonds and shares have achieved returns above inflation over the long term. A bond portfolio can beat long term inflation because bonds are priced to yield a return reflecting the market expectations of future inflation and a real rate of interest. Nevertheless, there is volatility in bond prices and returns due to the changes of inflation rates and interest rates over time. The rate of return from a bond portfolio can turn negative when bond prices are depressed.

22.Compared to bonds, shares are priced to generate higher expected rates of returns to compensate for the higher volatility. Due to the higher potential returns, investment in shares is generally regarded as a better hedge against inflation than bonds over a long investment horizon but at the expense of higher investment risks. Since the returns from bond and equity funds can fall below inflation or even turn negative, they are not an effective hedge against short term inflation.

Inflation Risk is Not Diversifiable

23.There are factors, such as interest rates and inflation, which will affect the prices of bonds and shares in the same direction. For example, an increase in interest rate may depress bond and share prices at the same time. The interest rate hike may be prompted by concern about a rise in inflation. Therefore, even a diversified portfolio in bonds and shares cannot hedge against short term inflation. Similarly, a globally diversified portfolio is not immune to inflation. Hence, inflation risk is not diversifiable.

Returns from Risk Free Investments Cannot Beat Inflation

24.To eliminate the short term volatility in investment return, one can only invest in debt instruments (to give certainty of investment income) issued by the government (to be immune to default risks) of very short term maturity (to be insulated from interest rate risks). However, the interest rates on short term government papers are often set at level below inflation, particularly those from governments with strong finances.

Inflation Index-Linked Government Bonds

25.Index bond, where the interest and principal payments are adjusted by inflation, is a popular investment tool to hedge the inflation risk of pension liability due to indexed payments to pensioners. If held to maturity, an index bond provides a certain real rate of return (i.e. the rate of nominal interest over inflation). The market value of an index bond, nevertheless, still fluctuates with the level of real interest rates in the intervening period. An increase in real interest rate will depress the value of an index bond. As a result, there is no guarantee that the investment returns from a portfolio of index bond will beat inflation every year.

26.In the context of an MPF scheme, contributions made into a fund will purchase units according on the market value of the investment holdings. Likewise, a withdrawal of funds will be based on the number of units and the prevailing unit price. When a member withdraws funds from the scheme, it may be at a time of increase in real interest rate and thus depressed index bond prices. The returns achieved may be higher or lower than the rate of inflation.

Cross-subsidization among Scheme Members

27.It is neither practicable nor equitable to rely on cross-subsidization among scheme members to pay the costs of inflation protection for members who have opted for the Capital Preservation Product. The reasons are :

1. it is not feasible to relocate the profits earned by one investment product to another one which earns less; and

2. it is not reasonable to reduce the level of return of those members who are prepared to bear higher risks to provide an indexed return for those who are not willing to take risks.

Subsidies by Government

28.It is not justifiable to require the Government to top up the gap between the investment return of the Capital Preservation Product and the rate of inflation because :

1. Members choice : It would upset the principle of individual capitalization. We believe many scheme members would simply rely on such a government guarantee rather than appropriate investment options to achieve a real growth in their MPF assets;

2. Use of resources : Government resources will be drained to scheme members of different income levels but not used to help the needy. It would be extremely difficult, if not impossible, to define the scope of low-income in order to limit the scope of government top-up as any definition would unavoidably be arbitrary and unfair; and

3. Nature of system : Although introduction of the Capital Preservation Product is one of the protective measures for the low-income group, it is not meant to be used to resolve all financial problems of this group. The aim of the MPF System is to offer retirement protection but not social security assistance. We should, therefore, still rely on the CSSA scheme to provide financial assistance to the low-income group. This would be more target-oriented and cost-effective, without making the MPF System too complicated.

Mandatory Provident Fund Office
Financial Services Bureau
14 November 1997