Revisiting the NZSF

There have plenty of stories in the last couple of days about the expressed wish of the New Zealand Superannuation Fund to become owner, or part-owner, of new light-rail projects.

There has been a range of reactions, from the gushingingly enthusiastic to the rather more sceptical.  Count me at the extremely sceptical end of that spectrum.  In fact, it is the sort of story that confirms – again – my longheld fears about NZSF.

Towards the gushing end of the spectrum was Stuff politics journalist Henry Cooke, whose piece ran under the heading “Super Fund gives huge vote of confidence to light rail plans”, when it is nothing of the sort.

This is a massive vote of confidence in the viability of the project from some of the savviest investors in the country.


Their proposal would see another huge sovereign wealth fund – Quebec’s – join them in a consortium to build, operate, and own the lines in perpetuity. Exactly how they would get a return on that investment is unclear at this point,

No doubt this is true

Politically this is already a win.

And even Cooke recognises the political nature of all this

By making a proposal on such a political project the Super Fund is making something of a political bet

Concluding that

For today though, this is a vote of confidence from the kind of person left-wing governments usually find it very hard to get votes from: high powered investors. They’ll take it with a smile.

I’m sure the government is delighted.  As their predecessors were when the NZSF and ACC teamed up –  off-market of course – to take part-ownership of Kiwibank, without actually providing any fresh expertise, and in the process reducing the transparency and accountability around (what is still 100% state-owned) Kiwibank.  But in the end these are votes of confidence from public servants, who know which side their bread is buttered on.

As I’ve written about here previously, NZSF aren’t great investment gurus.  They’ve made quite a lot of money taking big risks in a strongly rising global market, but the returns relative to risk, or to taxpayer’s cost of capital haven’t been particularly attractive and –  as even NZSF will acknowledge –  markets go down as well as up.   As for light-rail projects, the NZSF statement noted that around 2 per cent of the Fund is in infrastructure assets worldwide.  That doesn’t suggest any particular expertise in light-rail –  and they don’t point to any in the statement.   And almost any government project can be made viable for an investor if the associated contracts are skewed sufficiently favourably in the investor’s direction.

So this unsolicited (but no doubt welcome) expression of interest isn’t any sort of vote of confidence, and is probably better seen as a fishing expedition, doing what the Fund seems to be good at, playing politics.    Perhaps under the heading of “it is New Zealanders’ money” the NZSF can get a better deal from the government than others might (as NZSF and ACC presumably got a good value-transfer deal on Kiwibank, since no one else was allowed into the mix); perhaps the government might like the idea of an “arms-length” investor rather than putting in money directly and being directly accountable for the results.  Perhaps it will all come to nothing, but NZSF will have shown willing, and earned itself more political brownie points.

We also saw NZSF playing politics last year, with their decision to substantially reduce the carbon exposure in their portfolio.  Reasonable people might debate the economic merits of the judgement they took (I never found the arguments in the internal papers they released overly persuasive), but if it was simply an active management issue –  a bet on where markets would go over the next few years –  they’d have left their benchmarks unchanged, and enabled citizens to monitor risk and return on the punt they’d made.  They didn’t of course –  they claimed credit for the speculative call (which was no doubt popular with many voters, and with Labour/Greens –  and buried it in the benchmark itself, in ways that make it very hard for anyone to check whether it was a good economic call. I wonder if they are even monitoring it themselves, or whether they even care.

On the specifics of the latest NZSF initiative, my view was much closer to this

Retirement policy expert Michael Littlewood said he groaned inwardly at the news the Super Fund wanted to fund two new light rail networks.

He said light rail had a reputation for never finishing on time, cost over-runs and not making money unless it was subsidised by the taxpayer.

“Is this going to add to the security of New Zealand’s future payments of New Zealand Superannuation? I would have thought not.”

Littlewood said the Super fund was taxpayers’ money and if the rail was going to be paid for by taxpayers it should be done so directly.

“I’m not sure what the Super Fund adds to this process.”

Littlewood who co-authored a report last year that called for the fund to be dismantled, said private investments such as this would make that harder to do.

If there was ever a case for NZSF – something I’m not persuaded of (preferring the government to simply run down its debt, and leave investment risk-taking to citizens and private entities) – it had to involve scrupulously avoiding domestic politics.  It was the attraction of a passive approach to investment (hugging the respective indexes which –  among other things –  keeps costs down), mostly in offshore market.

Avoiding politics was always only going to become harder as the Fund got bigger.  I recall during the 2008/09 recession –  when the Fund was smaller than it is now –  the number of idealists and opportunists who were dreaming up schemes that the money in the NZSF could be steered towards.  It will be the same next time round, and the path NZS has been going down over the last few years of its own initiative –  Kiwibank, carbon, and now light rail –  will only increase the risk. And the pressures come from both sides.   People outside will badger governments and the Board/management with clever schemes.  On paper, NZSF is well-insulated.   But people in management and on the Board will have incentives to want to be well-regarded in the community, to be players, and to win and retain political allies.  For not many of them – Board or management –  will these not be the last jobs, last appointments, they are pursuing.   And if they can do it with sweetheart deals –  serving the interests of the government of the day, and of the Board/management but not necessarily the people of New Zealand – all the better for them individually: the return numbers can continue to be flattered, even though some of its returns to connections and to lobbying (often just a transfer among different taxpayer pockets, with lots of fees dripping off the side), not to raw investment expertise.

I’ve written in several recent posts about insights and arguments from the new book, Unelected Power, by former Bank of England Deputy Governor, Paul Tucker.  Tucker’s own expertise is in central banking, but part of the value of the book is in the way he seeks to develop a framework for thinking about the conditions under which it does, and doesn’t, make sense for government functions to be delegated to independent agencies, and the sorts of accountability mechanisms that need to be in place when such delegations are made.   Reflecting on Tucker’s delegation criteria, NZSF increasingly fails that test.

Tucker’s first criterion is whether the goal can be specified.  NZSF probably passes the test: the goal is something like maximising medium-term risk-adjusted returns.

But the second is more questionable:  “Society’s preferences are relatively stable and concern a major social cost”.   Even sticking to narrow business of investment, it isn’t clear that preferences are stable.  Sticking the money in, in effect, a big index fund is one thing, but plenty of people don’t (now) want carbon exposures, others don’t want whale exposures, others still won’t want weapons exposures, or tobacco exposures.  And others just won’t care.  (Views on NZS itself, of course, vary widely, even in the same political party from election to election.)

That relates to Tucker’s fourth criterion, that the independent agency will not have to make big choices on distributional trade-offs or society’s values, or that materially shift the distribution of political power.  When there is a big pot of money that politicians can quietly encourage their appointees to steer in ways that serve political ends, the case for independence is pretty weak.  No one is compelled of course, but it is a case of a double coincidence of desires.

The third criterion was “is there a problem credibly committing to a settled policy regime?”.  This was a key argument for an independent central bank.  It isn’t obviously an issue when it comes to an investment fund of this sort (where the amounts put into the Fund are determined politically).

The fourth criterion is not that relevant here: is there good reason to expect the policy instruments to work, with a relevant community of experts outside the institution.  Active management won’t make much money (if any) except by chance, but passive management can be expected to generate returns commensurate with the risk taken.  Unfortunately, of course, risk to the independent agency’s returns can be mitigated by within-government favourable deals.

The sixth criterion is that the legislature should have the capacity to oversee the independent agency’s stewardship adequately, and to assess whether the system is working adequately.  In almost no instance do our parliamentary committees provide the sort of effective scrutiny this sort of regime really requires for the cause of democratic legitimacy (a point I want to come back to on the Reserve Bank case).  NZSF doesn’t seem to be any sort of exception.

Politicians will make calls –  good and bad.  Often enough they will waste our money, perhaps with the best intentions in the world.  Sometimes they’ll do good with it.  But the key consideration there is that we can toss the politicians out –  or re-elect them if we reckon they are doing a good job.  We have no such ability to discipline the management or the Board of the New Zealand Superannuation Fund.  That is, of course, by design –  it is how the legislation is set up –  but it doesn’t make that design any more appropriate or legitimate.  And the behaviour of the Board/management indicates that this isn’t just a theoretical concern, but a practical one.  Anyone can see this light rail expression of interest as, in no small part, a political one –  even enthusiastic Henry Cooke recognised that.     That should be no business of an allegedly apolitical government agency, but the corrosive incentives –  such a big and growing pot of money to manage, so many vested interests keen to profit from dealing with the Fund –  seem to make it all but unavoidable.

We don’t need a New Zealand Superannuation Fund: the Crown has no vast stores of net financial wealth that need managing, the risk-adjusted returns are no better than average, and despite the name the Fund is just another pot of government funds, doing nothing for the affordability of public pensions.  All too much power –  over your money and mine –  is vested in the hands of people who themselves face little or no effective accountability, and such accountability as they may feel seems more often served by responding to the interests of governments of the day (of whichever stripe), or feel-good public moods.  Money-pots are dangerous things, in the hands of politicans or those who see their interests aligned to preferences of politicians.  As Michael Littlewood argues, and as I’ve argued previously  – it is past time to wind up the NZSF, using the assets to repay government debt.    If it is to be retained, the mandate should be revised to require them to stick closely to relatively liquid traded assets, and ones with little or no connection to New Zealand governments.


Virtue signalling, with your money

I haven’t written about the New Zealand Superannuation Fund (NZSF) for a while, and a well-informed reader has been encouraging me to get back to the economics of the Fund (and some of the important issues raised in a recent review paper).  I will, but for now I remain of the view that the Fund is serving no useful purpose and should be wound up.

But while we have it, it needs to be run well.

One of the annoying aspects of the Fund is the way in which the Board and management get to take your tax money and mine, and invest (or not) in causes which they happen to find appealing.    Of course, the Act isn’t written that way, but that is what it boils down to.   I’m not too keen on my money being invested in abortion providers or private prison operators –  just to span the ideological spectrum –  but obviously Adrian Orr and his Board don’t have a problem with such exposures.   They, on the other hand, object to tobacco companies and whaling, which don’t greatly bother me.

But the other day, they announced a big new policy shift that has substantially reduced the carbon exposure of the Fund (somewhat puzzlingly, I saw no mention in any of their documents of methane exposures, and as we know in New Zealand at least methane exposures make up a very large chunk of greenhouse gases).

To their credit, NZSF pro-actively released several background and Board papers relevant to this move, as well as several pages of question and answer material (all at the link in the previous paragraph).

This shift is dressed up as a simple matter of economic and financial management.  Indeed, they are at pains to assert that ethical (or presumably political) considerations played no part in the shift.  But, on the material they have presented it just doesn’t ring very true.

For example, they released a presentation to the Board from a few months ago.  In it, the chief investment officer and the “head of responsible investment” told the Board that

We believe climate change is a material long-term risk for which the Fund will not be rewarded.

What they appear to mean is the market prices of shares with (adverse) exposure to climate change and any associated policy responses do not adequately reflect those risks.

It is an arguable proposition, for which you might expect that evidence would be marshalled.  But the Board appears to have been presented with no evidence whatever, just assertions, and questionable economic reasoning.  Thus, on the next page

Climate change is a market and policy failure: markets are producing too many emissions and are over-invested in fossil fuels. We believe carbon risk is under-priced partly because the time horizon over which the effects will manifest is too long for most market analysts – but it is relevant to the time horizon that matters for the Fund.

This is a hodge-podge paragraph. For a start, climate change itself isn’t a market failure, but may well arise from market failures (costs aren’t properly internalised etc).   But the fact of climate change –  whatever role past policy or market failures may have played – tells one nothing about whether shares in companies exposed to carbon are now fairly priced or not.  They are just two completely different things.

And there is still no evidence presented for the proposition (“belief”) that markets have overpriced these companies (such that expected future risk-adjusted returns on them won’t match those available elsewhere).  Other market participants know as much (or as little) as NZSF staff know.

There was a more detailed Board paper in April containing the final recommendations.   It has more text, but no more analysis of the risks or of why the Board (or we) should believe that NZSF is better placed than the market to appropriately value climate change related risk.    Instead, we get a repeat of the same assertions,

NZSF quote

followed by a sentence which is best summarised as “but we really don’t know”.

There are repeated references to lines such as “ignoring Climate Change presents an undue risk”, but that isn’t even remotely the issue.  The issue is whether (a) the market on average is mispricing that risk, and (b) whether NZSF staff, management, and Board are better placed to evaluate the complex mix of scientific, economic, technological, and political factors that determine how things will play out (and thus what fair value pricing will prove to have been).     Thus, it is quite likely that the market on average has the appropriate pricing of these risks wrong, because much of what is relevant is inherently unknowable.  But if it is likely that the market is wrong, there is no particular reason to be confident which side the error lies on.   And it isn’t obvious why it is easier for NZSF to be confident it is right about this, than about any of the other very long-term risks embedded in many sectors, or in the market as a whole.

There are also hints that really this has little to do with a careful evaluation of financial investment risk and a lot more about politics and “good causes” –  virtue signalling.


Consistent with this political focus, the very first item in the proposed communications strategy reads

“Recommend engaging with the Greens to explain to them the approach we have taken”

(And, sure enough, they were lauded by the Greens – although not for the quality of their financial analysis –  when the new policy was finally announced the other day.)

NZSF’s detailed public story is contained in the Q&A document they released.  This is text that they will have had months to refine, the Board having made this decision in April.

But again, there is no analysis presented or summarised to indicate why the Board is confident the market has it wrong. Instead they seem reduced to lines like this

We believe that now is the right time to act. Even if there remains some uncertainty about global policy, its general direction is consistent with meaningful carbon reductions.

This is the basis for a major strategic investment choice by the Board managing taxpayers’ money??   “General directions” are one thing, assessing market pricing and demonstrating with a high degree of confidence that market prices are wrong is quite another.

Or lines like this

The Mercer climate change study that we participated in during 2015 found that the biggest risk to investors from climate change was to be on the wrong side of strengthening global policy and/or technological disruption. Mercer found that investors who got ahead of the curve could mitigate the potential downside.

Well, of course.  If you read markets well, and judge policy correctly, there is plenty of money to be made.  But doing so is hard…..very hard, and NZSF provides no evidence that they are able to beat the market uniquely well is this particular area of their global exposures.

There is further evidence that this move is about politics and virtue signalling, rather than robust financial analysis.

Will your active managers be allowed to hold stocks that have been sold from the passive portfolio on the Fund’s behalf?
Our active NZ equity managers (who may also from time to time invest in Australia) will not invest in these stocks.

If this were just a strategic view that markets were systematically mispricing this risk, there would be no reason to bar active managers from holding such stocks from time to time (after all, even if one average the market is mispricing this risks, it doesn’t mean there won’t occasionally be opportunities in individual stocks that are exposed to such risks.)

There is very strong sense that NZSF decided to reduce its climate change exposures, and then back-filled the (rather weak) argumentation in support of that.  As it is put early on in the April Board paper, setting the scene for the recommendation.

“a reduction of climate-change related risks for the Fund is a key goal of the CCIS [Climate Change Investment Strategy]”

Perhaps there is some other economic and financial analysis, that they haven’t yet released, to support that strategic preference (I’ve lodged an OIA request to that end) but at the moment it looks like a political choice not a financial one.

The NZSF has implemented this strategic choice by the Board and management by altering their so-called Reference Portfolio benchmark.   They have long argued that the reference portfolio is what their performance should be benchmarked against  (the numbers scream out at one, in large type, when one goes onto their website).  I’ve long argued that is the wrong benchmark for citizens and taxpayers to focus on (useful as it might be for the Board to judge staff active management choices against).  In this case, the Board itself has taken what amounts to a punt (an active call) that the market is underpricing risk in a particular sector.  They need to be evaluated on the results of that call over time, not avoid accountability by burying the implications of their policy decision in what looks like a passive benchmark that is beyond their control.

Perhaps the NZSF choice will be widely popular.  But that isn’t their job.  In fact, it has always been one of the dangers of the Fund.    It isn’t their job to be playing politics by tilting the portfolio towards trendy causes.  If anything, long-term investors (the advantage they constantly assert) might be better positioned to take somewhat contrarian stances, leaning against the tide of opinion at times (but only when backed up with sound analysis).    And if they really believed that the market was underpricing climate change risk, why not be rather more open about the resulting investment choices  –  leave the reference portfolio unchanged, and implement the market call through active management positions?

And you do have to wonder how, in a country where policy is still aimed at opening up further oil and gas deposits, a New Zealand government agency now has an official ban on buying shares in companies that might be developing those resources.  Will an NZSF ban on dairy exposures be next?

We have elections to choose the people who will make policy decisions.  If the public want to ban dairying, or oil and gas exploration, then elect the politicians to make those calls, and hold them to account.   But lets not have bureaucrats and unaccountable Board members pursuing personal agendas (even popular ones) with our money.  If the economic and financial case is really there –  and remember that active management calls of this sort don’t have a great track record globally –  then lay it out for us to see.  On what they’ve released to date, this look much more like a virtue-signalling call than one consistent with the NZSF’s statutory mandate, or with the sort of professional expertise we should hope for from well-remunerated investment managers.





NZSF tries to debunk “common myths”

The Herald yesterday gave over a full page to an unpaid advertorial from a public servant.    Of course, it wasn’t quite described that way, but that is what New Zealand Superannuation Fund chief executive Adrian Orr’s lengthy opinion piece amounted to.  Perhaps we should just be grateful to the Herald that they didn’t charge the NZSF –  and thus the taxpayer – for the advertising space.

It is a strange piece in many ways.  It is unfortunately becoming more common to have public servants take to the media to defend political decisions.   Public servants are there is advise and administer, but politicians are the ones who make the policy decisions and should be called to account for them.     And that is quite clear in the NZSF case.  Parliament set up the NZSF and associated provisions.  Included in those provisions is the ability for the government of the day to (openly and transparently) contribute less to the Fund in any year (and thus possibly for a succession of years) than the formula would otherwise imply.  Given all that, NZSF’s responsibility is simply to invest the money placed with them, and comply with any ministerial directions they are given.  The chief executive works for the Board (the grandiosely-named Guardians) and really has an operational role only.  Neither policy –  whether to have a Fund, how much should be contributed to it, whether the country is better off or not for having NZSF –  nor the actions of The Treasury, are his affair.   Treasury itself has a chief executive, and is responsible to the Minister of Finance.  Policy matters are for the Minister.

And yet yesterday we find a lengthy piece from Adrian Orr billed as “an explanation of The Treasury’s role and how the Fund operates”, although in fact as much space is devoted to championing the case for the Fund.     If there is a case to make on either of these points, surely it is one that should be being made by Gabs Makhlouf or, better still, Steven Joyce?

The article is set up to look like a response to what Orr regards as misleading or erroneous points (“common myths”) from recent media coverage (can we then assume that various other points critics have made are quietly accepted as valid?).  His list is as follows:

• the fund is soon to be “sold down” and would not be effective at smoothing future tax payments;

• capital contributions were intended to only come from Government operating surpluses, with their size and frequency variable and discretionary;

• NZ would be better off paying down Government debt;

• NZ would be better off managing the NZ Super Fund as a passive fund; and

• the fund has missed the investment good times (post-GFC), future returns won’t be as good and hence the fund’s chance of success is compromised.

I’m not sure who has been running either the first or fifth points.  I haven’t seen the first  argument made at all, although I’m one of those who thinks the Fund should be soon closed down and the assets liquidated.  Sadly, there is no sign of it happening.  And as for the fifth argument, the criticism I’ve seen –  and made to some extent –  is that the NZSF total returns have been flattered by strong global equity markets in the last decade or so, and that even so the returns don’t look particularly attractive to the taxpayer once the high-risk nature of the Fund is taken into account.     As it happens, the Fund’s own documents confirm that they also expect much lower returns in future.

It is our expectation, given our long-term mandate and risk appetite, that we will return at least the Treasury Bill return + 2.7% p.a. over any 20-year moving average period.

I noted last week that if one thinks of a neutral Treasury bill rate of even as high as 4 per cent (which is very long way from where we are now) that is consistent with expected future returns of only around 7 per cent.

Reassuringly, in his advertorial Orr outlines very similar expectations

As demonstrated in Treasury’s modelling, we estimate the fund will return 7 per cent to 8 per cent p.a. over the long term

If that is the best he and his team can reasonably expect to do (and it probably is), then it is for us –  voters and taxpayers –  not for him to decide if that is a worthwhile business line for the New Zealand government.

Against the Treasury’s own recommended discount rates, it would fail that test.  At present, their default rate is 6 per cent real.  Add 2 per cent inflation (the midpoint of the target range) to that and you get a required rate of return of 8 per cent.  If Orr doesn’t think he and his team –  using their best professional expertise –  can exceed that, that is useful information for us in assessing whether a high-risk investment management subsidiary is something the New Zealand taxpayer should be owning.

What about his other “myths”?   Orr objects to a view that

capital contributions were intended to only come from Government operating surpluses, with their size and frequency variable and discretionary;

Sure, the legislation sets out a formula, but it also quite explicitly provides for deviations from that formula, and sets no cap on how long those deviations can last for.   And the NZSF legislation was passed at a time when the government accounts were in surplus, and were expected to remain in surplus pretty much indefinitely.   But why does he suppose that Parliament provided for contributions to deviate from the formula?  Quite probably because they recognised that bad stuff could happen –  be it severe recessions, banking crises, natural disasters or whatever, pushing the government accounts into deficits.  Since the macroeconomic point of the NZSF is to be a vehicle to hold and invest increased overall government savings, reasonable people might think it wouldn’t make much sense to undertake government borrowing just so that the government could increases its high risk exposure to international equity markets.   Those who devised the legislation probably didn’t think of the budget drifting back into deficits for years at a time, but it did –  and the legislation was resilient to that change of circumstances.

Of course, Orr and other advocates of the Fund constantly argue that the purpose of the Fund is to, in some sense, reduce the future cost/burden of New Zealand Superannuation.   It does no such thing.   The cost of NZS is, and will be, what policymakers at the time determine it to be –  they can, and often have in the past, changed those parameters.   NZS isn’t a funded defined benefit pension scheme and it isn’t a contractural claim either.  It is simply a choice, made by Parliaments of the day, as to how much, and on what terms, the government will pay to older people at a particular time.

And thus, although the legislation talks of the purpose being

to establish a New Zealand Superannuation Fund with sufficient resources to meet the present and future cost of New Zealand superannuation

it does nothing of the sort.     NZS spending is met out general budgetary resources.  There is certainly a default formula for calculating how much would go into the NZSF and how much be withdrawn from it, and those numbers are tied to some estimates of future NZS expenditure.   But tying bows around money, and putting some of it into an entity labelled “New Zealand Superannuation Fund”, then transferring some of back in future decades to the general account, doesn’t alter that affordability one iota.  Of course it designed to look that way –  NZSF was always substantially a piece of political theatre  –  but it doesn’t.

Two things (in this area) can improve overall government finances.  First, higher taxes (than otherwise).   That is what happened during the years in which the Crown was contributing to NZSF (when large surpluses were being run).  But those higher taxes could just as easily have been devoted to repaying government debt.   And second, prudent management of the resources the Crown coercively (“taxes”) takes under its control.   And that latter is really the case for NZSF.  If the Crown can take your money, put in a high-risk investment management subsidiary, and make more money than you could then, possibly, taxpayers as a whole are made better off.  But even there the test isn’t whether they do a bit better than a government bond interest rate.  After all,

  • the money has been taken coercively in the first place, and there are large (perhaps 20 per cent) deadweight costs of taxation,
  • the government’s investments will typically be risky (high variance),
  • over time, the quality of governance of public entities tends to corrode,   and
  • in the private sector the evidence of revealed behaviour is that people don’t take discretionary high risk investments on without a considerable margin above the cost of debt being in prospect (thus private sector hurdle rates of return typically seem to exceed 10 per cent).  Risk has a (high) price.

But in his determination to defend his empire, Orr simply ignores most of this.    And as we know, over the period both funds have been operating the other big pool of government financial assets –  those of the ACC –  has been managed to achieve better risk-adjusted returns than NZSF has managed.

He also continues to ignore the international evidence that casts severe doubt on the ability of fund managers to add value by active management.    This isn’t my main concern about the NZSF –  although their “active management” returns are overstated, by the way they construct their so-called benchmark –  but simply continuing to recite actual results from a short period (recall that, although Orr never mentions it, their own documents talk about a 20 year horizon being necessary to evaluate performance) proves nothing.

I was also rather astonished at Orr’s apparent attempt to claim the tax the Fund has paid as a net gain to New Zealand. Perhaps it looks that way to someone paid to manage a particular dollop of Crown money.  But Orr is smart enough to have heard of opportunity costs.  Had NZSF never been set up, the money would have been used for other things.  Some of it might have been used, through lower business tax rates, to build new private sector businesses (the economy itself would be bigger as a result).  Some of it might just have ended in private savings vehicles.  And some of it probably would have been consumed.  All of those alternatives would, in turn, have given rise to additional tax revenue.  It probably wouldn’t have been as much as NZSF has paid –  larger fiscal surpluses and higher taxes probably did slightly raise national savings rate –  but it would verge on dishonesty if a public servant were to claim that tax as a net gain to New Zealanders.

Orr wraps up his piece with the claim that

The Super Fund is an independent, non-political, for-profit entity with a specific purpose: to partially pre-fund the cost of retirement benefits for future generations of Kiwis.

Actually, it was a piece of political theatre, set up to help the buttress the political case for doing nothing about the parameters of NZS, in the face of large increases in life expectancy.  Running surpluses is one thing (and a quite different thing), but NZSF is simply a high risk investment management subsidiary of the New Zealand government, dressed up in gaudy rhetoric about future pensions.   There probably should be many more political questions asked than there are being posed at present.   Questions for policymakers –  not ones that Orr, as an operational public servant, apparently keen to grown his empire, has much to offer on – should include those around how attractive it is for the Crown to own a high risk fund that will generate particularly large losses –  and perhaps pressure to liquidate the fund at the trough of world markets –  at just the sorts of times when government finances will typically be under most stress from other sources.

(Someone drew my attention the other day to the average remuneration of NZSF staff.   The 2016 Annual Report tells us they paid $29.632 million to 112.2 FTE staff, which works out to an average of $264000 per employee –  over everyone from Adrian to the support staff.  Yes, funds management tends to be a high-paying industry, but I found it a surprisingly large number for a New Zealand government agency, that –  looking forward, and on the chief executive’s own numbers – doesn’t expect to exceed a realistic weighted average cost of capital.)

My bottom-line assessment remains that I ran in my earlier post

And so my bottom line is that we should be thankful for the reasonable returns we’ve had from NZSF to now (through some mix of luck and skill), but that since we can’t count on anything like those sorts of returns in future (even NZSF say so), and even the returns to date are really only sufficient to compensate us for the risk run on our behalf, we’d be better off locking in the gains we’ve had, closing down the Fund,  liquidating the assets over a couple of years, and using the proceeds to repay public debt.    Our government does not need to be in this game –  unlike, say, the governments of Norway or Abu Dhabi, with genuine wealth to manage and smooth –  and the returns to doing so don’t look that attractive.   As the Crown is already heavily exposed (both through the tax system and its other extensive asset holdings) to the ups and downs of the domestic economy and global markets, strategies that reduce risk, rather than increase it, seem intuitively more appealing.  The NZSF logic is the opposite of that.

In the meantime, if the government believes in the case for NZSF, it would be good to hear it from the ministers we elected, not the operations guys we pay to manage the money parcelled out to the Fund.


Comparing ACC investment returns to NZSF’s

I’ve written quite a bit over the last few weeks about the New Zealand Superannuation Fund.  My argument is not that they have done badly –  indeed, some evidence suggests that over a relatively short period (since their own self-assessment benchmark is a rolling 20 year horizon) they have done rather well – but rather that what they do isn’t worth doing at all (for citizens and taxpayers).   Total returns have been rather risky – interviewed on Radio New Zealand the chief executive called it a “high octane” fund – and don’t stack up that well against rate of return requirements the government generally expected over that period for discretionary investment projects, or with the sorts of hurdle rate private sector entities typically use in evaluating projects.

One reader has suggested several times that I show the data for the ACC investment performance.  The value of ACC’s total assets is currently quite similar to that of NZSF.

To give credit to NZSF, their investment performance data is much more easily available (on their website) than that of ACC.     But I did track down a couple of charts of ACC’s investment performance and ACC provided me with the annual data behind those charts, going back to the 1992/93 June year.

These are the headline numbers for the two government entities for the 12 full financial years in which both were operating.

acc and nzsf

What will no doubt stand out first is that ACC’s returns have been much less volatile –  less risky –  than those of NZSF.  They are very different funds, with very different mandates and different appetites for risk.

The numbers the two agencies supply are not exactly comparable.  The NZSF returns data are pre-tax and after costs.  ACC is not liable for New Zealand tax, although they note that they pay a small amount of foreign withholding taxes.  Their numbers are also reported before allowing for some investment management expenses.  This is from their Annual Report

However, returns are shown prior to the deduction of other investment management costs of $42.4 million (including fees paid to external fund managers and the remuneration of our investment staff), which would have detracted 0.135% from investment returns in 2015/2016.

In the remaining calculations in this post, I have silently deducted 0.135 per cent per annum from the ACC returns to produce numbers more closely comparable to those NZSF provides.

Over the 12 years both agencies were investing, NZSF produced (geometric) average annual returns of 9.5 per cent.    ACC managed 8.3 per cent average annual returns over the same period.  But the big difference was in the volatility of those returns.   For NZSF, the standard deviation of the annual returns was 13.9 per cent over that period, while for ACC it was only 4.8 per cent.   That is pretty low level of risk.  (I’m a trustee of the Reserve Bank’s superannuation scheme.  We have historically been a deliberately relatively low risk fund, and over the same period the standard deviation of our returns has been similar to ACC’s.)

You can see in the chart above where it really makes a difference.  Over 2008/09, at the height of the recession (here and abroad) and financial crisis, ACC had a bad year.  Returns in that June year were -1 per cent.   At NZSF, they lost 22 per cent of the value of the assets.   Fortunately that was still 22 per cent of not that much.

In an earlier post, I looked at the Sharpe ratios –  returns relative to the variance of those returns –  for NZSF.  It is a commonly used metric in looking at, andcomparing, funds managers.

NZSF’s official performance benchmark is the total returns of the fund relative to the (risk-free) Treasury bill rate.     ACC doesn’t use that metric, but lets see how the two organisations compare on it anyway, again over the 12 financial years 2004/05 to 2015/16.

Average return above T bill(percentage points) Std deviation(percentage points) Sharpe ratio
NZSF 5.7 14.6 0.39
ACC 5.2 5.8 0.90

And recall that NZSF’s own document suggest that over the long-term they don’t exepct anything like that level of returns: they aim to produce “at least” 2.7 percentage points above Treasury bill yields.

Both ACC and NZSF like to report on how they have done relative to benchmarks that they themselves have set (the “reference portfolio” in NZSF’s case).   That can be useful in assessing their active management returns and allowing the respective managements and Board to assess whether active management is worth doing at all.  It matters less to taxpayers, especially in the NZSF case, where there isn’t wealth that has to be managed, but rather we have to take a view on whether having the Fund –  funded from taxes and borrowing – is worthwhile at all (and where the benchmark is designed in a way that makes it not too hard for the NZSF to beat).   As I noted, the official performance benchmark for NZSF is performance relative to Treasury bill.   But for what it is worth, here is the same sort of table for what both organisations might call their ‘active management”.

Average annual active mgmt returns (percentage points) Std deviation (percentage points) Sharpe ratio
NZSF 1.8 3.2 0.56
ACC 0.9 0.8 1.13

ACC’s performance, even on this measure, is pretty impressive, both absolutely and relative to NZSF’s.   ACC has a longer-run of data, and the performance over the full 24 years of data is quite similar to that for the 12 years for which we can compare ACC and NZSF.

I’ve tried to ensure that all my numbers are accurate, although there is always some risk of error in combining differently formatted numbers etc.  But the key point really is in the headline numbers in the graph above.  Over the 12 years to date –  when NZSF has done better than they expected –  ACC has earned average total returns a bit less than those of NZSF, but they have done so by taking on much less risk.

And as I”ve highlighted in the various NZSF posts, NZSF’s sort of investment strategy tends to lead to very big losses at just the times when Crown finances are  put under greatest stress anyway (in severe economic and financial downturns).  That is a distinctly unappealing feature, and a risk profile more akin to that adopted by ACC over the years also looks as though it would be a better approach to take to any other Crown investment management subsidiaries.  Those with long memories will recall the intense fiscal pressures –  some real some exaggerated – in 1984, 1990/91, 1998/99, and 2008/09.  In future downturns, the last thing we need is huge investment losses amplifying pressures for politicians to “cut and cut now”.   It is fine for technocrats to argue that markets will bounceback.  Often they do, but it is a great deal of unnecssary risk for taxpayers to assume, or for them to rely on politicians and appointed technocrats to manage.

As a final note, I’ve been critical of the reshuffle of Kiwibank shares among various Crown agencies, which reduced NZ Post’s share, and resulted in NZSF and ACC owning around a quarter each of a retail bank.  In neither agency’s case does that look particularly good.  If things go well, both NZSF and ACC might do rather well financially –  after all, they were the only credible and politically acceptable buyers.  But neither ACC nor NZSF has any expertise in retail banking, and difficulties of handling any potential failure of Kiwibank –  and the inevitable pressures for government bailouts – are only compounded by the dispersed non-expert ownership all still on the overall balance sheet of the Crown.


New Zealand Superannuation Fund: does it pass commercial tests?

There has been a great deal of coverage in the last few days of the New Zealand Superannuation Fund, all prompted by the news that the chief executive, Adrian Orr, had been given a substantial pay increase by the Fund’s Board, over the objections of the State Services Commission and the then Minister of Finance.

I don’t have a strong view as to how much the chief executive should be paid.  In general, I also don’t have a particular problem with that amount being determined by the Board, without ministerial involvement.  Then again, this is simply a body managing a large pool of (borrowed) government money, and I couldn’t see a particular problem if the relevant Act was to be amended to make the terms and conditions of the chief executive a matter determined by the Minister of Finance, or the State Services Commission, perhaps taking advice from the Board.   After all, that is exactly the model that applies for the Governor of the Reserve Bank.

Amid the recent media coverage, there has been a lot of hyper-ventilation about the performance of the Fund, and of Orr himself.  In his Dominion-Post article, Hamish Rutherford reports that

One commentator suggested if Orr had achieved such a return in New York he might have made a billion dollars.

That seems unlikely frankly.   Orr simply isn’t –  and I wouldn’t have thought he’d claim otherwise –  some investment guru, blessed with extraordinary insights into markets, prospective returns etc etc.  He was a capable economist, and a good communicator (at least when he doesn’t lapse into vulgarity), who turned himself into a manager and seems to have done quite well at that.   He always seeemed skilled at managing upwards, and his management style (in my observation at the Reserve Bank) seemed to err towards the polarising (“are you with us, or against us”), attracting and retaining loyalists, but not exactly encouraging diversity of perspectives or styles.  He isn’t exactly a self-effacing character. (That is one reason I’m not convinced he is quite the right person to be the next Governor of the Reserve Bank.)

The New Zealand Superannuation Fund has made money, both before and since Orr took over a decade ago.  Of course, amid a trend increase in global asset markets it has been hard not to.   The NZSE50 gross index, for example, has increased at an annualised average rate of about 9.8 per cent per annum since 1 September 2003 (when the NZSF opened its doors).

As for how good the NZSF have been, it is probably too early to tell.  Don’t take my word for it: here is how they themselves put it

It is our expectation, given our long-term mandate and risk appetite, that we will return at least the Treasury Bill return + 2.7% p.a. over any 20-year moving average period.

The Fund has now been operating for only about 13.5 years.  In some respects, the returns to date look quite good –  they’ve averaged 5.6 percentage points per annum above the Treasury bill return –  but for a Fund with the sort of risk parameters they have adopted one can only really evaluate performance over very long periods.  And global asset returns have been pretty attractive over much of the last 15 years.  Will that be repeated?  Will there be a big sustained correction?  The only honest answer is that no one knows.  (And the 20 year time horizon is probably a reason why the institution’s CEO shouldn’t be remunerated to any significant extent on some investment performance formula –  unless there are clawbacks built in for the next 20 years).

But even on the returns to date, it might be reasonable to pose some questions.    The Fund puts a lot of emphasis on expected returns, and not a lot (at least in the published material) on the risk they are running.    In some respects, that is in line with Parliament’s mandate for them to be

maximising return without undue risk to the Fund as a whole;

What, we might wonder, is “undue”?   Who decides, and under what constraints?

A common measure of risk, especially on assets that are frequently marked to market, is the variability of returns.    One tool for relating returns to risk is the so-called Sharpe ratio, which compares the incremental returns obtained through the fund manager’s investment management choices (ie the margin above a risk-free rate) with the standard deviation of those returns.  If the resulting number is very low, the incremental gains might often be prudently best treated as “noise” –  good luck, perhaps, rather than the result of a consistently superior investment strategy.  On the other hand, all else equal a high Sharpe ratio, over a reasonable period of time, provides greater reassurance that the fund manager is adding value.   When I ran the Reserve Bank’s financial markets operations, we had able staff proposing all sorts of clever active management schemes to add value to our foreign reserves operation.  Sharpe ratios were one of the tools we used to evaluate prospective and actual results.

How has the NZSF done on that metric?  Since it opened the doors, the average annualised return has been 9.9 per cent (recall that NZSE50 return of 9.8 per cent).  Treasury bills –  the Fund’s risk-free benchmark –  provided an average return of 4.3 per cent, so the average margin over the Treasury bill return was 5.6 per cent.

But the standard deviation of those annual excess returns over the full period since September 2003 is around 13.5 per cent, for a Sharpe ratio of just over 0.4 per cent (and these are all pre-tax numbers).  That is pretty low.  In other words, while the headline returns –  through a period of strong asset price growth –  may have looked impressive, the risks they have been running have been (deliberately and consciously) high.   I checked, by way of comparison, the returns on the low-risk (low return) superannuation fund I’m a member (and trustee) of: since 2003 the standard deviation of the annual returns on that fund since 2003 have been around 4.5 per cent.

Adrian Orr has now been CEO of the NZSF for almost a decade.  In that decade, annual returns (above Treasury bill) look to have averaged just over 5 per cent, but the standard deviation of those annual returns has been higher at around 17 per cent.  In other words, the Sharpe ratio for the Orr years, is even lower than that for the full period of operation.  But, as a reminder, the Fund itself reckons one needs a 20 year run of data to evaluate their investment management performance.

Based on the NZSF’s own data the monthly returns are also pretty volatile.  The standard deviation of monthly returns (over the risk-free rate) over the life of the Fund has been around 3.3 per cent.    Given that many of the Fund’s holdings are quite illiquid, one probably shouldn’t put too much weight on the monthly return numbers, but it is a reminder of just how much risk the NZSF is incurring –  not for itself, but for the taxpayers of New Zealand.  At best, they might just have been getting compensation for the risk they’ve taken, but there doesn’t seem to be anything exceptional about their performance given that level of risk.    That, in itself, isn’t intended as a criticism: why would we expect a public agency in New Zealand to be able to add much (risk-adjusted) value, whether through asset allocation, or tactical departures from their own internal benchmarks?  But it is a bit of a reality check.  And as Hamish Rutherford noted, on deals like Kiwibank, the super fund’s returns are, over time, likely to be flattered by the privileged position NZSF had going into negotiations –  there were very very few buyers acceptable to the government, and ACC and NZSF will have known that, and reflected it in the price they offered NZ Post.

My own unease about NZSF is rather more fundamental, and doesn’t reflect on any of the individuals involved in managing the funds or the organisation.   The NZSF is often loosely described as a sovereign wealth fund.  In fact, it is nothing of the sort.    Norway and Abu Dhabi have sovereign wealth funds –  accumulated from the proceeds of the sale of state-owned natural resources (oil and gas).   It is real wealth, and needs to be managed somehow.  Of course, it could all be passed on to citizens to do with as they please, but there are plausible –  not necessarily 100 per cent compelling –  reasons for managing the flow of the proceeds of the sale of a large non-renewable natural resource over time.    If so, the money is there and has to be managed somehow.

By contrast, the New Zealand Superannuation Fund arose because successive governments took more in taxation from New Zealanders than they needed to fund their operations.  At one stage at looked as though the New Zealand government would manage to build up a large financial asset position.  But, except briefly just prior to the 2008/09 recession, they didn’t even manage to do that.  Instead, we now have a quite large stock of government debt outstanding, $33 billion of which is used to run a state-sponsored and managed quite-risky hedge fund.   It is a discretionary commercial operation, and it should be evaluated on the same sorts of grounds Treasury and the government lay down for other investment projects.  And given that risk imposed on us by the government is risk (capacity) we could ourselves otherwise choose to utilise elsewhere, it should also be evaluated by looking at the sorts of returns private sector businesses require in analysing possible uses of capital.

Treasury has recently revised downwards the pre-tax discount rates it recommends government agencies use in evaluating projects.  Their default recommended rate is now 6 per cent real (or around 8 per cent nominal), but over most of the period of the life of the NZSF they were recommending a real discount rate of nearer 8 per cent.  They continue to assume an equity risk premium of 7 per cent.  Against those sorts of asssumptions, average annual nominal returns of 9.9 per cent just don’t look that attractive, especially when subject to huge variability (that 13.5 per cent annual standard deviation).    I don’t know what assumptions NZSF are making about expected absolute returns over the next decade, but it would be a bit surprising if they were forecasting/assuming returns as high as those on offer for the last 14 years.

Another way of looking at whether the NZSF is a good business for the Crown to be in, on behalf of taxpayers, is to look at the returns private sector businesses require.  I’ve linked previously to a nice article from the Reserve Bank of Australia, drawing on a survey of private sector businesses asked about what hurdle rates they used in approving/declining investment decisions.  I summarised it previously thus:

They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours.   In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers.     The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.

And here is one of their charts


Bottom line: private citizens shouldn’t want governments getting into businesses –  especially not relatively risky businesses –  where the returns are less than 10 per cent.

There are other reasons to be concerned about the economics of the NZSF:

  • putting money into NZSF required tax rates to be higher than otherwise (as would the shared commitment to resume contributions at some point).  Higher tax rates discourage some economic activity that would otherwise occur here, and New Zealand tax rates are not now unusually low by international standards (our company tax rate is quite high),
  • the scheme involves all New Zealanders in direct financial exposures to companies/industries they may disapprove of. NZSF attempts to get round that with their ‘socially responsible’ investment policy, but your view of “socially responsible” companies/activities may well differ from that of your neighbour.  Personally, I’d be quite happy to have money invested in whale fishing companies.  Many others might not.    Making those choices simply isn’t a natural or necessary business of government.
  • large pools of government financial assets encourage the misuse of those funds in the event that the country/government comes under financial stress at some point in the future.  Those sorts of tail risks aren’t captured in the monthly or annual standard deviation numbers.
  • NZSF, being a quite high risk fund, tends to perform well in periods when the government’s finances are not under stress, and to perform badly (very badly in 2008/09) when government finances come under most stress. Because the assets are quite widely held, it provides some protection against some sorts of shocks, but in any severe global economic and asset market downturn –  the sort of event New Zealand is never immune to – the NZSF investment strategy simply ensures that when problems hit they are compounded by investment losses.  As the government is already, in effect, an equity holder in all New Zealand business (through the tax system), it isn’t obvious quite why it should be attractive for New Zealanders to have the government further compound their exposures.  To take those risks might be reasonable for the prospect of exceptional returns, but the NZSF strategies look to do little more than cover a bare minimum cost of capital –  while aggravating our problems when things turn bad.

The NZSF may have been a sensible practical political option back at the start of the 2000s.  Governments were running large surpluses, positive net financial assets were in prospect, and the retirement of the babyboomers was still a decade away.   It makes little sense now, and if anything is a distraction from the necessary discussion about adjusting the NZS eligibility age in line with the longer-term trend improvements in life expectancy.  Rather than debate how to remunerate the CEO, or whether Board members should be replaced, we’d be better to look seriously at winding up the Fund now,  reducing the risks taxpayers ar exposed to and using the proceeds to repay government debt.