Scrap the MPF
23 June 2005
The HSBC Hang Seng Index Tracking Fund (HSI-MPF), one of the funds you can choose as part of the HSBC MPF range of unit trusts, was launched on 1-Dec-00 with a unit price of HK$10.00. 4.5 years later, on 1-Jun-05, the unit price had risen to $10.37, a gain of just 3.7%. "OK", you might be thinking, "the markets have not been that good, and I'll be saving for the rest of my working life, so I needn't worry about a few years of bad returns".
Think again. It's not the market that's the problem, it's the MPF scheme itself. We'll explain why.
Index tracking funds are usually one of the lowest cost forms of mutual funds, because the manager of the fund has very little work to do. All he has to do is make sure that the fund buys the basket of shares which comprise the index, in the same proportions as the stocks within the index. For example, if a stock represents 10% of the index value, then he puts 10% of the money into that stock. There is no stock picking required, no gruelling research and company visits, and as a consequence, management costs are low. For example, the Tracker Fund of Hong Kong (TraHK), which had assets of about $30.7bn at 31-Dec-04, pays its manager and trustee a total fee on a sliding scale which starts at 0.100% and goes down as the fund gets larger. Last year, it was 0.095%.
Also, because they are so mechanical, index tracking funds do what they are supposed to do, and within a very narrow margin, they track the index. For example, in 2004, TraHK's net asset value per unit increased by 13.17%, while the index increased by 13.15%, both excluding dividends, which TraHK pays out (net of expenses) to unit holders. The Total Expense Ratio (TER) of TraHK for 2004, based on the average fund size during the year, was about 0.135%.
The HSI-MPF, like all MPF funds, does not pay out dividends (because it is saving for retirement) but reinvests the income in the fund, buying the basket of stocks to maintain the same composition as the index. The Hang Seng Index is published by HSI Services Ltd, a subsidiary of Hang Seng Bank Ltd, which in turn is controlled by HSBC Holdings plc.
Now for a dividend-reinvesting index fund, its total return should closely match the total return on an index, assuming that any dividends are immediately reinvested in the index. Thankfully, since last year, HSI Services has been publishing the total return index for its flagship index (HSI-TRI), and the series goes back to the beginning of 1990, which is more than we need for this article, since the MPF only started on 1-Dec-00.
HSI-MPF verus HSI-TRI
When we examined the daily unit values of the HSI-MPF downloaded from its web site, we found some slightly odd behaviour in the first few months, which we will simply ascribe to start-up issues and not worry about. So for the purpose of this study, we will look at the 4 years from 31-May-01 to 31-May-05, starting six months after the launch of the fund, when the bugs had been ironed out.
On 31-May-01, the HSI-TRI closed at 20,011.40. On 31-May-05, it closed at 24,357.54, a total return of 21.7%. Meanwhile, the unit value of the HSI-MPF rose from 9.26 to 10.37, a total return of only 12.0%. That means that the MPF fund under-performed the index it was supposed to track by a total of 7.99% over 4 years, or a compound average under-performance of 2.06% per year. That is more than 15 times the total expense ratio of the TraHK last year.
By comparison, if you could put your money into an exchange-traded index-tracking fund (ETF) such as TraHK, then ignoring the initial purchase expenses (brokerage and stamp duty), and assuming the fund has a total expense ratio of 0.15% per year (we are being generous), you would have made about 21.0% in 4 years, and only lost 0.7% to expenses.
The cumulative under-performance of the MPF fund against the costless total-return index is shown below, with a green line to indicate what the under-performance of an ETF like TraHK would be:
Scary, isn't it? This chart is just for 4 years. What do you think it will look like after 40 years?
In case you are wondering, that brief blip on 13-Dec-01 is probably just an error in the MPF price data and can be ignored. The graph shows well enough how dramatic the MPF fund's under-performance is, and how much better-off you would be if you could invest directly in a low-cost index tracking fund.
The reason for under-performance
The main reasons why the total expense ratio of the MPF fund is so high is the amount of fees it pays.
HSBC, which is probably not unusual among MPF providers in this respect, charges annual management, trustee, custodian and administration fees totalling 1.95% on the net assets of all its equity-based funds, including the HSI-MPF, even though index tracking funds are much less costly to manage.
One of the reasons these fees are so high, apart from the desire of banks to make huge profits, is that the MPF is expensive to administer - tens of thousands of employers across Hong Kong have to fill in complicated forms every month with details of employees who have left the firm, joined the firm, retired or left Hong Kong, recording variations in their salaries, commissions and bonuses, and then someone at the MPF provider has to process those forms and chase down late payments.
All of the administration costs are borne by the funds - the employer pays nothing but the mandatory contributions each month, 5% of salary (excluding housing allowances) up to a maximum contribution of $1,000, and the same amount is deducted from the employee's salary, for a total contribution of 10%.
But perhaps the biggest reason for the high fees is that the market is price insensitive. The people who decide which MPF provider to pick, the employers of Hong Kong, are not the beneficiaries of the funds. The employees of Hong Kong are, but not until decades later, long after most of them have left their current employer. All the employer cares about, at least in the short to medium term, is complying with its obligations to make the mandatory contributions to the fund. As a result, there is not much competition driven by the fees, and employers are more likely to choose their fund provider based on who they bank with and which bank processes their payroll each month.
Will the MPF feed me, when I'm 64?
When Paul McCartney finally turns 64 next year, his pension fund is probably not something he will have to worry about. But for the average HK citizen, planning on saving for the next 20, 30 or 40 years, what will the typical MPF cost ratio, say 2% per year, do to your savings? Take a look at the table below, which shows how much of the market performance will be burnt up by expenses over a lifetime:
What this table shows you is that if you are 25 years old, and MPF funds continue to run expense ratios of 2% per year for the next 40 years, then by the time you retire in 2045 at the age of 65, 55.4% of your capital and returns from today's contributions will be eaten up by expenses. On the other hand, if the Government scrapped the MPF and allowed you to buy exchange-traded index funds with the same money, with a total expense ratio of 0.15% per year, then only 5.8% would go in expenses over 40 years, and you would get 94.2% of the market's returns for whatever index you were buying.
Of course, you will not always be 40 years away from retirement, and money saved later will have less time to be eaten up by expenses, but on the average, you could still be looking at a 40% hit.
A misconceived policy
The policy intent of the MPF was in essence to force a small minority of people who would not otherwise save any of their salaries, to save for retirement. That's what the "M" stands for - Mandatory. Those who are sufficiently self-disciplined to save on their own did not need the Government to force them to. By forcing people to save, Governments hope to reduce the risk that people will need social security payments, or the "safety net" provided by the state, when they retire.
However, when you retire, after a huge chunk of your mandatory savings has been eaten up in expenses by the banks and fund managers, what you will get from the MPF is a lump sum. And if you are one of the people who needed this Government-imposed discipline, then you are hardly likely to take that lump sum and invest it wisely. You are more likely to blow it in a few wild nights at Happy Valley or on a luxury cruise, and then come back to the Government (the taxpayers) for social security. So the policy intent of the MPF is then defeated. The only way to resolve that would be to require that the MPF payout be made in stages, so that retirees can only spend it slowly. One option would be to require everyone to buy annuities, which pay a fixed monthly income for the rest of their life, however long it is. But again, this would involve handsome profits for the people who sell annuities.
A free market?
Hong Kong claims to be a free market, but mandatory savings represents interference in personal choice. The MPF scheme benefits a few large banks more than it benefits the people of Hong Kong. We call on the Government to scrap the MPF and return personal savings choices to the free market. Let people choose whether to withdraw the accumulated funds and invest them directly, in lower cost investment products, and let the banks and fund managers compete more efficiently for the business. The 10% of salaries up to $20k currently being paid into the funds should be paid directly to employees instead, so that the cost to employers remains unchanged.
Just over 4 years into the project, on 31-Mar-05, there was a total of HK$124bn of funds in MPF schemes and it is growing at about HK$24bn per year. At a 2% expense ratio, the expenses this year alone will be about HK$2.6bn. In 10 years' time, ignoring investment returns, the fund size will be up to about $364bn, and the annual expenses will be $7.2bn.
By comparison, last year the Government spent $12.7bn on elderly social security, including an old-age allowance for those over 70 which is not means-tested and even old tycoons would qualify for.
Those who choose not to save and to rely on the meagre social security payments in Hong Kong, should know that they will not be looking forward to a luxurious retirement, but one with just the bare necessities of life. That is sufficient incentive for most people to provide for their futures.
If the MPF is not scrapped and saving is to remain compulsory, then at the very least, individuals should be free to choose their own "Personal Provident Funds" or PPF providers, and opt out of the employer's choice of provider. That would increase the incentive for employees to shop around for the lowest expense ratio funds in the given category, and to choose between competing fund managers based on performance, rather than being trapped in a bank's in-house fund offerings.
© Webb-site.com, 2005