The Business Times, Friday 20 February, 2004

Keep PPP's goals, axe scheme

Solution is to revamp the way intermediaries are compensated with CPF funds, says JOSEPH CHONG

THE CPF Board recently proposed the introduction of privately-managed pension plans (PPPs) under the Central Provident Fund investment scheme. The objectives of the proposal are noble.

Essentially, to help CPF members achieve better returns on their CPF funds, members should have access to managed funds that are cheap to run with good and stable returns. This has been the holy grail of investors.

Apparently, CPF investors in unit trusts and stocks have had poor returns over the past few years, with stocks doing even more poorly than unit trusts. However, is the solution the PPP?

The proposed PPP appears to be another line-up of unit trusts, albeit with 'cheap' management costs and no upfront charges. However, there are already several indexed funds with low management costs and there are already a few advisers in the market who waive the upfront charges for clients. Indeed, as one participant at an industry-CPF Board consultation session that I attended asked: Where is the magic here?

Other than the lack of magic, another problem with the PPP proposal is that it ignores the importance of distribution in the investment management business. The PPP proposal is offering virtually nothing to distributors.

As there are other CPF investment alternatives that pay the distributor, one could be fairly certain that distributors will direct clients away from PPPs one way or another.

Indeed, proof of this is already evident in the marketplace today. Although indexed funds have performed well, managed funds and investment-linked policies (ILPs) continue to attract a lot more money because indexed funds pay a much smaller front load. Obviously, the issue is in distribution and not in manufacturing.

I believe that unless the CPF Board is prepared to spend a lot of money and effort promoting the PPPs on an on-going basis, there is a high possibility that the scheme will not take off.

The CPF Board would essentially have to take on the vested interests of distributors and their thousands of representatives in an on-going campaign of attrition.

Let's examine the crux of the problem - poor returns. Is 'high' fund management cost the reason why returns have been poor in the past few years? I believe this is not the primary reason.

Based on the portfolios that we have restructured and historical fund inflows, there were two major CPF buying waves. The first one was into unit trusts invested across Asia before the Asian financial crisis. This coincided with the initial liberalisation, which allowed CPF money to be invested into Asian markets outside of Singapore.

The second one was into unit trusts invested globally, especially technology, before the bursting of the technology and telecom bubble in 2000. This coincided with the further liberalisation that allowed CPF money to be invested into global equity markets.

The liberalisation of CPF funds is fundamentally correct. Unfortunately, the timing coincided with severe downward inflection points in markets.

Indeed, if we take a longer perspective, which would have diluted the impact of the unfortunate timing of liberalisation, we would have achieved fairly decent returns. Expressed in US dollars, a global equity index such as the S&P 1200 over the past 10 years has delivered an annualised return of 8.9 per cent per annum.

The more well-known US equity index, the S&P 500, has delivered an annualised return of 10.9 per cent per annum over the past 10 years.

This notwithstanding, but with the benefit of hindsight, I believe that the consequences would have been less severe if the necessary regulations (ie, the Financial Advisers Act) and a comprehensive investor education scheme had been in place as we liberalised.

Sound advice and investor knowledge would have mitigated the effects of excessive greed and gullibility on the part of clients, intermediaries and product manufacturers. Indeed, the relative good performance of fund management accounts is an indication that one could get decent performance with on-going guidance.

Fund management expense ratios are not the main culprit for poor returns in the past few years. The poor returns have been due to an unfortunate combination of poor luck in timing and the lack of investor guidance and understanding.

What is the alternative? I believe that we need to accept the reality that there will always be a distribution cost. The issue is to harness this cost to align the interest of investors, intermediaries and manufacturers; and maximise investor guidance and education.

The way we currently allow CPF funds to be used to pay distribution costs is flawed. Currently, CPF funds can be used to pay thousands of dollars for sales commissions and legal fees (when one buys a house) but not a cent can be used to pay for on-going financial advice or even for a basic financial plan.

Using a house-building analogy, this is like being allowed to pay for the most expensive faucets but not the fees for the crucial architectural plan and subsequent architectural project management. Surely, no one in his right mind would subscribe to such a prioritisation.

I am convinced that to achieve the goals set out in the PPP proposal is not to launch the PPP. The solution is to revamp across-the-board the way intermediaries are compensated with CPF funds.

A possible solution is to cap the up-front sales commission payable for all investment-related products, that is, unit trusts, ILPs and endowment products, to not more than one per cent when CPF funds are used. However, investors should be allowed to pay for on-going advice with their CPF funds.

We should also consider allowing, say, up to $500 to be used from the CPF to pay for a financial plan. Indeed, the CPF Board should only allow the opening of an investment account if a financial plan has been lodged with the board, that is, enforce the drafting of a plan before any investing is allowed.

It is a radical solution in thought but not in implementation. Indeed, I believe that existing systems need only be slightly modified to implement the proposed 'radical' solution. The solution is a long-term win-win-win one. Win for the investor, win for the product manufacturer and win for the advisers who build their business models around on-going advice.

Only the frontload-incentivised salesperson, also know as professional product pushers or PPPs, will lose out. Indeed, isn't this the outcome we should desire?