COMMENTARY RE NATIONAL INSURANCE SCHEME Re: Notes From a Native Son - Feb 5, 10

Subject: COMMENTARY RE NATIONAL INSURANCE SCHEME Re: Notes From a Native Son - Feb 5, 10

Dear Hal et alia,

Your essay on the National Insurance Scheme is engaging and reflects an impressive vocabulary of investing knowledge. I wish to share with you some very recent information as well as some general comments that address several of the queries and issues that you have posed.

[1] RE "The national insurance scheme has inadvertently confirmed what I have long suspected – that its investment policy, or what passed for one, was in danger of leaving future generations of pensioners broke.":

This statement certainly applies to the Social Security system of the U.S.A. and a number of other countries that continue to avoid making necessary reforms of their pension-systems. In Barbados, however, the N.I.S. was reformed more than a decade ago to prevent the fraud that some citizens were perpetrating upon it: working, earning, not contributing and then seeking a national pension. Since 1997, persons who have worked will not be eligible for a non-contributory (Old Age) pension. To claim a contributory pension, one must have contributed for 500 weeks or approximately 10 years.

Next, a major reformation of the N.I.S. took place in 2004/2005 after extensive national consultations to which all citizens were invited to contribute in writing, online and in person at various discussions. This was one of the most important achievements in our post-Independence history because it affects all of us and it was done very well and decades before the anticipated date, under the previous format of the N.I.S., that actuaries predicted it would begin to experience negative cashflows. The key elements of these amendments were:

[a] contributions to N.I.S. were increased by 0.5% per year for four consecutive years on the part of the employee and on the part of the employer; this was a very small rate of change at any point in time but, at the end of four years, the total contribution-rate had increased by 400 basis-points at the level of the N.I.S.!

[b] the monthly ceiling of insurable earnings, which had been fixed at $3,100 for many years was indexed to the rate of domestic wage-inflation and, in just the past 6 years, has increased steadily to $3,900 as of January, 2010.

[c] the pensionable age was made very flexible so that citizens could retire as early as their 60th birthday or as late as their 70th birthday with commensurately increased or decreased pensions (the adjustment is equal to 0.5% of pension per month of increment or decrement).

[d] the standard age for full N.I.S. pension was increased at the rate of 6 months every 4 years for the next 16 years, commencing with the first increment to 65.5 years of age in January, 2006, followed by the second increment to 66 years of age in January, 2010. For most of us, therefore, the standard age for full pension will 67 years.

The cumulative affect of these very small, gradual adjustments at the individual level aggregates to major improvements at the level of the N.I.S. and greatly extends the actuarial life of the national pension-fund. The percentage of increase in contribution-rates is of tremendous significance actuarially. E.g. an increase from 4% per employee and per employer to 6% per each side over four years would actually represent a 50% increase in contributions on the existing base. When you superimpose on this wonderful improvement the benefit of annual indexation of insurable earnings, the effect is compounded. This means a double increase in contribution-dollars to the fund: the rate per dollar of earnings has increased and the number of dollars insurable has been increased. All of this is happening during a period that the rate of employment has reached all-time highs and this further maximises inflows to the N.I.S. pension-fund beyond anything anticipated 10 to 15 years ago when the preparatory actuarial work for reforming the N.I.S. was being done.

Given that the current generation of baby-boomers is the biggest generation in the history of Mankind, the timing of these amendments to our N.I.S. pension-funding will ensure the biggest possible inflows as this generation enjoys its peak of lifetime earnings prior to retirement. In turn, the number of new retirees in each future decade will tend to decline compared with this generation. That extends the power of this large surge of current contributions to support future generations of pensioners.

[2] RE "I also understand there is no, or was not, an expert investment committee. In any case, the recent announcement that the NIS has now created an investment arm to focus on international investing is a serious indictment of past governments – BLP and DLP. What have they been doing with workers’ contributions to national insurance over the years, apart from allowing it to be used as a piggy bank for spendthrift governments?":

To the credit of the N.I.S., there has long been both a Board and an Investment Committee as well as a professional Investment Manager. Thus, the N.I.S. has three key levels of oversight for investments. One of the key additions to this structure of governance in recent times has been Dr. Justin Robinson, who is Head of the Department of Management Studies at U.W.I., Cave Hill; his research-focus has been investments, markets and such like.

The creation of an investment-arm to focus on international investing is not a matter of the year 2010 only, for the N.I.S. has been investing locally, regionally and extra-regionally for several years. What has been happening is exactly in line with your thinking: diversification plus professional management. The National Insurance Board has retained experts in foreign markets with clear mandates for investing in line with the N.I.S. strategic objectives. The addition of a dedicated "arm" is simply another stage in the evolution and maturing of the N.I.S.'s strategic approach to investments. The key benchmark for all investments is achieving the lowest risk while meeting or exceeding the actuarially determined breakeven rate of return for the long-term viability of the fund. That is, in my view, the simplest statement of the optimal strategy.

This also means that the Government has not been using the N.I.S. as a piggy-bank or slush fund. It is an autonomously governed entity with clear guidelines for all investments. It is actually the opposite: the N.I.S.'s Investment Committee advises the N.I.S.'s Board, which then makes recommendations to the Minister of Finance, who has never failed to approve the decisions of the Board. On more than one occasion, requests from statutory corporations and various segments of the Government have been declined by the Investment Committee. We can easily understand how this would arise: several branches of the Government are not economically operated and/or would not provide a rate of return exceeding the hurdle-rate fo the N.I.S.'s Board. I have seen no evidence, therefore, of political interference as some seem to be insinuating. This is very good news for all citizens: the fund is well managed and conservatively invested for the best matching of the long-term returns with the long-term needs of the contributors to the N.I.S. pension-fund.

[3] RE "The reality is that that money should have been carefully invested, with asset allocation diversified across a number of different sectors and business and economic cycles to reduce risk....Therefore a substantial amount of that investment should be in bonds, mainly government but also corporate, and, given the needs of its members, significantly invested in long-term local and regional assets such as commercial and residential property and small and medium enterprises.":

This is exactly the approach that the N.I.S.'s Investment Committee has been taking. The ideal framework of the Committee for portfolio-management and asset-allocation is:

[a] 10% cash, cash-equivalents and money-market funds [= LIQUIDITY];

[b] 10% local equities and regional equities [= GROWTH];

[c] 10% global equities (e.g. through the big names that you have mentioned) [= GROWTH];

[d] 65% bonds [= INCOME]

[e] 5% real estate [= GROWTH & INCOME]

The actual profile of the fund is largely in line with these allocations e.g. fixed-income is about 63.6% versus target maximum of 65%. Liquidity is above the target-level because equity-investments of suitable risk-return profile have been limited. A major example of innovation and calculated risk-taking by the N.I.S.'s Board is the recent private placement with Sagicor Financial Corporation (a hemispherically diversified holding company); this increased both its own stake in that firm and, strategically, materially increased the percentage of shares owned by Barbadians. In turn, the N.I.S.'s Board is disproportionately well represented in the Board of Sagicor Financial Corporation.

[4] RE "The decision to invest Bds$55m of taxpayers’ money in a ten-storey office block at a time when there is no market for commercial property, apart from the government, seems like carelessness. Where is the demand for such office space and what yield does the NIS expect to get from rents? Is there a total return objective? Further, assuming that corporates would be moving out of the Bridgetown area to re-locate in Warrens – since it is unlikely the market will grow - what would this mean for the nation’s commercial centre, already gridlocked by a number of under-performing retail stores? Broad Street is a ghost town with some of the best known stores making a minimum profit per square foot. I often wonder why one well-known store is allowed to exist in its present form. A much better investment for the NIS, and one that would have been more socially useful, would have been if the state-run body had invested in residential rental stock, which would have made a great contribution to the acute housing shortage and, at the same time, would have formed a key part of a long-term diversified portfolio. More so, if this residential property investment was out of the usual Bridgetown/South coast/Warrens beltway and in an area such as Six Roads in St Phillip or Belleplaine in St Andrews. Such a strategic investment would have served the dual purpose of moving traffic out of the main congestion areas while at the same time commercialising areas that are ripe for development. ":

[a] There continues to be a market for commercial real estate. The rationale for this real-estate investment by the N.I.S.'s Board is compelling. Firstly, the Government will increase productivity and efficiency by bringing into the same building or within walking distance of other offices in the same area (Warrens) multiple departments of the public sector currently scattered across the island. Secondly, morale will improve because workers have been complaining for many years about the condition of many of these existing office-buildings. Thirdly, the Government will reduce its rent expense to the private sector, while providing income to the N.I.S. (a double benefit for public finances). Fourthly, the Government is a first-class tenant that always pays its landlord's bills; this reduces the investment-risks to the N.I.S. in this case.

[b] Yes, a total return would be significant over the long-term (20 to 60 years) because real estate appreciates steadily in Barbados over long periods of time. Meanwhile, rental income will provide that vital cash-return to the N.I.S.'s investment in the underlying real estate and this flow would gradually increase over time. A comparable private-sector case-study is the Cable & Wireless campus at Wildey, St. Michael. The N.I.S., Life of Barbados Limited and the Fortress Property Fund co-invested to buy this real estate several years ago. The tenant is a first-class tenant by local standards. The rental income increases by 5% each year for the 15-year of the current lease-agreement. Independent valuations rise and fall from one year to another (e.g. the current environment tends to depress either growth-rates of market-values or to reduce the actual values altogether) but, over the course of an economic cycle (e.g. 2001 to 2008), the cumulative net appreciation is large. In essence, the total return is impressive and the cash-return is more than adequate.

[c] I agree with you that Bridgetown remains congested and that it is important to national development to nurture urban and suburban centres in other parishes beyond St. Michael. Warrens has become a fast growing urban centre and Six Roads is clearly very close to it in that respect. Nevertheless, one notices that Bridgetown continues to be the locus of major developments and redevelopments (e.g. Royal Bank rebuilt a majestic headquarters on Broad Street, C.O.B. Credit Union moved its headquarters to Broad Street around the year 2002 and now B.N.B. is consolidating all of its Bridgetown real estate in the amazing re-development of the former C.I.B.C. complex on Broad Street). So the quality of existing real estate continues to rise and to become more attractive to investors. Elsewhere in older urban Barbados, Holetown remains vibrant and the Chattel Village is constantly in high demand by existing and prospective tenants. All of these parallel enhancements of older areas and newer areas of the island lead me to conclude that the market for commercial real estate is growing and, even if the occasional recessionary environment reduced the pace or size of the construction-industry and the real-estate industry in any given year, it is clear that the long-term trajectory of real estate is continually upward and forward in Barbados.

[d] As for diversification and complementarity, one notices that tourism and related real estate are well served by high-net-worth investors e.g. Apes Hill, Royal Westmoreland, Sandy Lane, Crane Hotel, and Lion's Castle. It is not necessary for the N.I.S. to move into such a very competitive niche when other niches remain under-served and deserving of attention. Likewise, public investment in residential real estate remains the preserve of the National Housing Corporation. That entity has struggled for decades to collect rent from its tenants even though its rents are extremely low. Ultimately, in the past two years, the Government has resorted to converting tenants with at least 20 years of tenure to property-owners for little or no extra payment. This amounts to a gift rather than an investment from the perspective of public finances.

From personal research and experience, I can tell you that most residential real estate is public good requiring a dedicated social programme rather than an investment-programme. It is rare in my observation that residential rentals provide a satisfactory cash-return. E.g. I can tell you of a property independently valued at nearly $900,000 and the rental income has struggled to move from $3,000 to $3,500 to $4,000 over the past decade. With a mortgage-loan, it is clearly unprofitable as the rental income does not cover even the interest-component of mortgage-installments. Even without leverage, however, $48,000 on $900,000 (or even $800,000 or even $650,000) would be a very low rate of return in relation both to the investment involved and to the total risks (especially liquidity-risk). After adjusting for all necessary insurances, taxes, maintenance and other expenses, the effective rate of return would not justify the investment. That is why commerical real estate remains a much more suitable investment-class for the N.I.S.'s Investment Committee to consider.

[5] RE "The population in Barbados is about 300000 (this year’s census will give a definitive figure) and is projected to grow to about 450000 by 2050. If the rate of reproduction remains static, about 2.1 per cent, this 50 per cent growth will be an enormous burden on the future liabilities of the national insurance scheme. However, when immigration is factored in, the likelihood is that the majority of immigrants will be younger and at the prime of their reproductive years, so in reality, this projected 50 per cent growth may well be an underestimate.":

[A] The rate of reproduction might well be in the vicinity of 2% but the demographic growth-rate has been much less than that because fertility-rates are counter-balanced by mortality-rates. The impact of immigration warrants assessment, of course, but this also has counter-balancing factors. (E.g.emigration has been a major fact of life for the past 120 years of Barbadian history cf. the Panama Canal exodus of "Silver Men", the outflows and mortality associated to the two World Wars of the first half of the 20th Centurty and the major peace-time outflows in the 1950s and 1960s to Europe and to North America). Imputing a 1% demographic growth rate even over a very long period (e.g. 2010 to 2050 is 40 years) yields a population in the region of 415,000 rather than 450,000 and that is both absolutely and relatively significantly less.

Also keep in mind that the rate of indexation is in the range of 3% to 4% per annum for the insurable earnings on which N.I.S. contributions are computed. This far exceeds both the rate of fertility and the rate of demographic growth. You have only to do some basic future-value calculations in a financial computer or in Microsoft Excel to see the large long-term improvement that is attributable to each additional percentage-point of extra contributions over such growth-rates. Here is a hint: in six years, the monthly maximum of insurable earnings has risen from $3,100 to $3,900, a total of $800. Extrapolating for the next 30 years, this yields a simple forecast of $3,900 + [ $800 x ( 30 years divided by 6 years ) ] = $7,900. Total N.I.S. contributions are 21.35% of insurable earnings each month but the pension-benefit is only 40% to 60% of the contributors' insurable earnings over the best 5 years of their contribution-life. That maximum of 60% applies only to persons who contribute for at least 36 years; hence, many persons working a typical total of 40 to 50 years (given rising pensionable ages --- previously 65 years, currently 66 years and rising towards 70 years) will actually have over-contributed in relation to their effective benefits. So, in the Barbadian model, there is an additional benefit of over-contributions (especially by higher-wage contributors), which far exceed the value of imputed over-payments (i.e. the excess of the minimal contributory pension of roughly $671 per month over the basic pension-benefit of 40% of the insured incomes of those with low wages).

[B] We must also realise that most immigrants make contributions to N.I.S. but do not stay here long enough to claim from it. A large number of immigrants are ineligible for pensions because they do not contribute for enough years to be eligible and/or do not live here long enough to become claiming pensioners. To this extent, I argue that immigration INCREASES the total long-term inflows into the N.I.S. funds. E.g. I know many Guyanese professionals and non-professionals alike who contribute to the N.I.S. but their spouses and children are not nationals and have to pay full price for medical services and for schooling; they are not eligible for any N.I.S. benefits in many cases. We also witness the major inflows from the offshore sector from highly paid individuals who will later return to the countries from which they came to Barbados, leaving all of their contributions here while claiming none of its benefits. Remember that the minimal contributory period for an N.I.S. pension is 500 weeks and many expatriates on the island leave long before 10 years of residence here e.g. Intel, Caribbean Data Services, and PRT among the larger examples.

A useful proxy is the ratio of corporate income taxes from offshore companies to demestic companies' corporate income taxes: this is roughly 60:40. Even after adjusting for the transitory impact of economic recessions like this one, we can see that the absolute contributions from the offshore sector continually rise over the long term. It is also clear that a significant percentage of personal income taxes arise from the offshore sector, where senior skilled executives typically pay more in P.A.Y.E. (and N.I.S.) alone than the gross salary of most wage-earners in the domestic sector!

Moreover, the profile that you have painted of immigrants as being younger and productive augers well for the N.I.S. because the aforementioned reforms will capture a larger and larger portion of their contributions at a time when the pension-fund remains enormously in surplus. This will both extend the life of the national pension-fund and increase the projected annual surpluses beyond our lifetime. The rather stringent proposed amendments to the Immigration Act further amplify this point: even immigrants who become married to Barbadians will no longer automatically be accorded permanent status; they will earn this only after a minimum of 2 years of marriage. Such measures will continue to increase the contribution-base will reducing the projected numbers of ultimate beneficiaries --- a double benefit to the rest of us who contribute to the N.I.S. and will actually live here and retire here.

Yours sincerely,
Brent Shuffler, 231-4480; 428-9295