Regulatory roadblocks in EM: A case-study of the Nigerian pension industry

This is a companion article to the series the in this link

In November 2020, PENCOM, Nigeria's pension industry regulator, released long awaited guidelines for the opening of the transfer window, which allows beneficiaries the ability to change their fund managers once in a calendar year. Along with a related initiative, implemented a couple of years ago, which now allows beneficiaries some measure of choice in stipulating the risk profile of their pension investments (they are now able to chose from among four buckets with different asset allocation bands), this seemingly mundane procedure has consumed the industry for the better part of a decade, accompanied by much controversy and many false starts.

Among the reasons cited for the implementation delays, the regulator often emphasised (rather unconvincingly, as we shall see) the operational difficulty of managing the transition from the monochromatic investment management system imposed by PENCOM on the fund managers thitherto. However, this chain of events also raises fundamental questions about the role PENCOM has come to assume in the industry: how and why has it ventured, for instance, into the business of asset allocation in the first place? This prompts a larger examination of the nature of financial regulation in Nigeria, particularly as it affects the investment industry, pension funds having undoubtedly become by far the most important in this regard.

A brief background

The Nigerian pension industry was primarily conceived to redress broken public-sector defined benefit schemes. Before its emergence, public pension schemes entirely relied on highly volatile government revenues for funding, and operated under a grossly inefficient bureaucratic administration which lacked the requisite capacity and competence for such an enterprise. This led to heart-rending scenes of old-age destitution across the country, owing to the largely unfulfilled obligations to beneficiaries. That the new scheme would be a defined contribution system was a fait-accompli given the condition of the capital markets at the time and the government's eagerness to rid itself of the associated risks, which was understandable given its previous failures.

As a young analyst obliquely involved in hashing out the strategies and modalities for the new system, which largely drew inspiration from the much touted (at the time) Chilean model, this imposed choice carried with it the promising prospects for enriching investment practice and spurring rapid growth in what was to be a much more dynamic domestic capital market. In my opinion, these hopes remain largely unrealised due to a series of mishaps and missteps which shaped the pension industry's eventual architecture.

First, the government decided to create a new regulator for the pension industry specifically, with roles and jurisdiction largely coordinate to those of existing financial gate-keepers, particularly the SEC, a decision that would have profound unintended consequences. For one, it set off a very predictable subterranean tussle for influence which was stacked in favour of the newcomer regulator, as legally mandated wage contributions that fed the new scheme inevitably grew the size of its purview well beyond the incumbent's perennially floundering efforts at expanding the investor base. 

Invariably, this tussle encouraged ill-advised regulatory prescriptions that sought to constitute the pension industry into a monolith with end-to-end control of its own capital flows which, among other things, discouraged critical collaboration with adjacent segments of the financial sector and created a needless and costly duplication of roles and operations across the investment industry. This failure to promote a benign realignment of the financial industry to promote capital market efficiency and reduce coordination costs--along with its tendency to retard rather than promote innovation--represents, in my opinion, the industry's most significant departure from its initial promise, particularly because it was probably the most readily attainable.

Second, the pension industry was just emerging from its embryonic phase when the global financial crisis hit domestic shores in 2008. Rules set by pension regulators had shielded the industry's assets from the domestic equity market boom (largely driven by banking recapitalisation) that immediately preceded the crisis, and its subsequent collapse in the immediate aftermath. The decision to focus pension assets heavily in fixed income may have looked prescient at the time, but only because the industry masked the subsequent cratering of the value of its fixed-income holdings via a regulator-sanctioned avoidance of mark-to-market rules, after the central bank began to spike domestic interest rates to prop up the currency to contain the after-effects of the crisis.

To be fair, the new pension fund scheme emerged into a very underdeveloped investment management industry and faced considerable institutional and operational risks at inception; to which PENCOM had to respond with strong safeguards. However, this laudable initial caution soon devolved into a pathological risk-aversion and increasingly strident micro-management of asset allocation and the investment process by the regulator thenceforth.

Learning the wrong lessons

Whether the decision to stay out of equities was the right one will remain an untested counterfactual, but had the industry marked its bond holdings to market in 2010-11, it is likely that the impact would have been just as bad as the 2008-09 decline in equities, and this is not accounting for the fact that equities may likely not have declined nearly as much or remained underwater for so long had pension funds been serious participants in that market at the time.

Be that as it may, this experience seemed to have the unfortunate effect of congealing a policy bias against variable income investments. Instead, under the pretext of safety, the regulator has since heavily encouraged investment in government-issued fixed income securities. While this has undoubtedly had some beneficial impact in developing the domestic fixed income markets and significantly extending the yield curve, it is hardly a resounding success.

First, the Nigerian government expends a significant majority of its resources on maintaining a bloated and ineffectual bureaucracy with precious little channeled towards productive investments, infrastructural or otherwise. Thus, by allocating a vast majority of accumulated assets to perhaps the single most unproductive major economic actor, this decision effectively frustrated the potential benefits accruable to the economy from the critical capital formation engendered by the industry's emergence. Notably, the ever-worsening productivity crisis this engenders is undoubtedly a major contributing factor to the value destruction from currency decline that continues to threaten long term savers in the Nigerian economy.

This stance has also had the effect of robbing the domestic equity market of a natural anchor-investor at a time when the central bank, in a desperate bid to shore up forex reserves, eased domestic capital flow restrictions. With this void, the typical volatility of foreign portfolio flows, compounded by the economy's thematic vulnerabilities to the fate of global commodities, has tended to induce a certain hysteresis in the capacity of domestic equity markets to sustain positive trends. This has in turn discouraged retail and other investor constituencies from the equity market and considerably undermined its viability as a long-term savings vehicle or growth catalyst. Little surprise then that Nigerian equities remain among the few that are yet to recover from the 2008 crisis.

Ironically, ostensibly to fulfill a mandate to develop domestic capital markets, pension regulators have steadfastly maintained a prohibition on foreign currency denominated investments--even as Naira devaluation has depleted real purchasing power by over 70% since the inauguration of the new pension scheme--effectively depriving long-term savers any hedge against possibly their single most important market-risk factor. Moreover, since it takes iron to sharpen iron, it is quite likely that, by diminishing incentives among domestic operators to interact with and assimilate practices from more developed markets, this policy fosters the exact the opposite of its intended effect, as well evidenced by the (still) stunted development of domestic markets. However, this apparent acknowledgement of a market development mandate by PENCOM perhaps makes its activities on the domestic scene all the more puzzling.

Back to the future

Another lingering issue has been the somewhat schizophrenic handling of industry building initiatives. First, PENCOM threw the doors open to a large number of applicant managers ab-initio and has since licensed several others; which is all well and good for competition, if only PENCOM would actually allow it!

First, with the aforementioned embargo on movement, beneficiaries were essentially stuck with whichever manager they registered with at the very beginning of the scheme. Thus, the industry naturally succumbed to the typical trend of differentiation where players with better name recognition, or perhaps privileged early access to the beneficiary pool, essentially cornered the market for themselves. With no opportunity for a subsequent industry realignment, this has left the first movers effectively unchallenged ever since.

Further, as the scheme grew, its failure to include a built-in identity management framework from the onset began to manifest in problems with beneficiary verification. Incidentally, was one of the factors cited in the delays in launching a transfer window. Incredibly, after having acknowledged the need for biometric identification, PENCOM has prevaricated between building a new system from scratch and adopting a moribund National Identity Card initiative which currently covers mere fractions of a percentage-point of the target audience, years after it was launched. In doing so, PENCOM, for some unfathomable reason, eschews the far more ubiquitous and efficient biometric identity programme which already exists in the banking system, that would have made the transition near seamless.

As yet another example of irrational conflict-of-interests among regulators, this particular issue takes a particularly pernicious aspect because, aside the enormous costs of duplicating the effort, the decision renders both the transfer window and eventual payouts to beneficiaries near-unworkable being conditioned, as both are, on being enrolled in the identity management system. Thus, once again, the spectre of long lines of destitute pensioners caught in the strangle-hold of bureaucratic road-blocks looms ghoulishly in the near future of a system that was expressly conceived to banish it.

Robbing Peter to pay none

Also, as highlighted earlier, PENCOM closely tele-guided the investment process, fixed fees uniformly across board and, for a long time, expressly forbade performance comparisons among the licensed fund managers. This quickly led to eccentricities in the industry: it left the (much) smaller players grappling with questionable viability from the very start which--with the regulator understandably eager to avoid any corporate failures among regulated entities--ended up driving PENCOMs fee-setting to levels wholly unjustified by the scope of services it allows the industry to provide. All the while, the larger players who enjoyed economies of scale effortlessly fed off this largesse, all with no reference whatsoever to subsequent performance. This consideration probably also played an important role in the controversy surrounding the transfer window as it was never clear how much this move would imperil or prosper the weaker players in the industry.

If there is any strategy behind PENCOMs continuing to maintain this state of affairs, the long-suffering beneficiary--who have the insult of unnecessarily high fees added to the injury of weak performance and risk mitigation--is certainly not at its center. At any rate, if they even succeed at all, the transfer window initiative and such like it are probably too little and too late to make any meaningful difference to the extant industry dichotomy.

Clearly, absent fundamental changes, these problems are primed to worsen with the passage of time, a reality which imperils the eventual welfare of beneficiaries who predominantly skew younger in the Nigerian industry. Incidentally, from experience, most of the foregoing issues are rarely acknowledged as problems within the industry. Pension regulators regularly self-congratulate over growth in assets under management--the ultimate vanity metric--with scant attention paid to horizon risk dynamics for savers, or value-added to the industry and the economy in general.

Quite tellingly, PENCOM officials reportedly justify this series of policy incongruencies by triumphantly affirming their commitment to adhere to the "Chilean Model", apparently oblivious or unconcerned about the many problems that have since bedeviled that once vaunted model. This incredibly myopic stance clearly illustrates the staggering superficiality of what passes for policy-making among many developing-market regulators.

A question of vision

This brings us back to the critical initial question about the appropriate role of financial regulators in a developing market. The prevailing attitude seem to be to use the many problem and shortcomings of these markets as cover for a tepid and unimaginative scope of activity. But who, exactly, are regulators relying upon to tackle them?

As the actors with primary responsibility and power to set incentives in these critical sectors of the economy, I believe emerging market regulators must re-interpret their role from mere gate-keeping to a much more strategic function. To them and no one else does it fall to galvanise talent within (and outside) their economies, and create frameworks to promote growth, development and active value-creation within their spheres of influence.

This could very well be the critical differentiating factor between regulators in developed and developing markets. Whereas the former can usually take this element for granted, it is near impossible for the latter to achieve their primary objectives, or indeed anything meaningful, without this context to their roles--as I hope the foregoing excursions help illustrate. Crucially, we note that this does not at all conflict with their fiduciary responsibilities (e.g. ensuring well being of retirees, in this instance) but indeed clarifies and facilitates its fulfillment. 

It is true that the capacity for such an onerous task can hardly be expected to reside within a given regulatory entity. However, properly understood, this role is one of a facilitator who helps coordinate and unleash the creativity available in the private sector and elsewhere. This opens up a different and much more attainable perspective; one which suggests building broad coalitions from within and outside its industry (or even shores). Whether it is in bringing together multiple parties to execute large scale projects of mutual interest, creating open frameworks to tackle specific industry challenges, or carefully structuring and opening up broadly beneficial investment opportunities--all the while actively promoting talent and skill transfer with implementation--this calls for long-term vision and a higher commitment.

To this point, it is crucially important for emerging market regulators to adopt out-of-the-box thinking. There is certainly a lot to learn from the experiences and practices of developed markets but they cannot be seen as a template to be blindly replicated. These systems evolved under the unique conditions of the markets in question and best serve their own circumstances. Besides, the world around us is always changing and developmental initiatives have to be forward-looking, since with technological and environmental changes come new opportunities that may conflict with practices fossilized in the status quo.

The road to Damascus

The changes needed to set developing market regulation on a winning path demands creativity, openness, courage and, yes, that very rare selflessness which is nonetheless so critical in emerging markets, where institutional weaknesses are pervasive. This is a mentality that prioritizes collaboration, goal-orientation, flexibility, and experimentation; where recognition of the need for learning and adaptation shifts focus away from rigid prescriptions to providing robust guardrails. The role played by Chinese regulators in promoting their pace-setting fintech giants are useful pointers in this regard.

For instance, rather than allowing fear of potential corporate failures among regulated entities to dictate policy to the detriment of societal good or primary regulatory objectives, focus shifts to making such failures as graceful as possible e.g. by setting up appropriate early warning systems and providing targeted protections for key variables (e.g. client assets) in the event of failure. Or, rather than imposing outright bans on financial instruments, products or initiatives for fear that appropriate levels of knowledge may be lacking with the regulator and/or industry, focus shifts to creating appropriately sand-boxed capacity-building pilots aimed at enhancing industry-wide skill.

Finally, in the context of the foregoing discussion, it is of critical importance for the regulator and industry to develop appropriate metrics which encompass the intricately related developmental and fiduciary goals. As such, focus should be, not so much on the size of pension fund assets, but on the ability of managers to surpass concrete value-retention benchmarks (e.g. inflation) and the variety and accessibility of instruments that enable them to achieve this.

Relevant questions for a financial regulator include the following: Do the managers have to knowledge and tools to achieve the objectives of the scheme? Are the key risks appropriately identified and addressed? Are they optimally dispersed across the economy? Has the industry secured growth initiatives within the economy that best align with their ability to achieve their fiduciary objectives (e.g. access to inflation linked securities), etc.

Properly constituted, such metrics can help quantify progress made towards promoting these and similar goals, or addressing the attendant problems. Further, reference to these metrics in goal-setting could help guard against the temptation to take shortcuts and succumb to the widespread institutional weaknesses. Also, to the extent that these goals are shared across several regulatory verticals (as they absolutely should), they can help cement collaboration and unity of purpose in driving broader, mutually beneficial economic initiatives.

Many of the suggestions in this segment may appear aspirational, but in the context of our discussions elsewhere on the risks posed by trends in technology and the global financial industry, they are no less decisive for being so. Further, the ground-breaking achievements being facilitated by regulators in other emerging markets like China and India suggests that not only are these goals attainable, they may represent the only path to continued financial autonomy for less developed markets.