DPM Tharman explains the CPF scheme

'Fair and safe' - Tharman tells how CPF rates are set
DPM also explains how the funds are invested and backed by Govt
By Tham Yuen-C, The Straits Times, 9 Jul 2014

THE Central Provident Fund (CPF) scheme prepares Singaporeans well for the future by providing guaranteed, fair returns on their retirement savings and shielding them from risk as few other pension funds do today, Deputy Prime Minister Tharman Shanmugaratnam made clear yesterday in a strong defence of the fund's performance to date.

And as the Government moves to enhance it, "we must retain its basic strengths and avoid the huge problems seen elsewhere", he added, referring to pension systems that are going bankrupt or passing risk back to pensioners.

Mr Tharman, who is also Finance Minister, also revealed how the Government shielded CPF members from financial risk by pooling CPF monies with its other assets to be managed by GIC.

In eight out of 20 years, GIC's returns were lower than the rate promised to CPF members, but the Government absorbed the losses.

He was responding to questions from four MPs who asked about CPF returns, reflecting public concerns about retirement adequacy in the face of rising costs.

Mr Tharman explained that the basic principle has been to peg CPF interest rates to "returns on investments of comparable risk and duration in the market".

But on top of that, the Government promises to pay a minimum interest. For those with smaller balances, there is a guaranteed interest of at least 3.5 per cent on the Ordinary Account, and 5 per cent on the Special, Medisave and Retirement accounts. That applies to the first $60,000 in the combined accounts.

The Government also provides subsidies to low- and middle-income CPF members through the yearly Budget, such as through Workfare payments and housing grants.

Said Mr Tharman: "While the CPF doesn't provide the highest returns, it provides one of the safest in the world. And these are fair returns."

Turning to how the funds are invested, he said that CPF funds are used to buy special bonds that offer a guaranteed payout.

The money that is invested in these bonds is then deposited with the Monetary Authority of Singapore, and managed by fund manager GIC, as part of a larger pool of the Government's funds.

"This allows the GIC to invest for the long term, including investing in riskier assets such as equities, real estate and private equity," said Mr Tharman.

He noted that if CPF funds were held separately as a stand-alone fund, the GIC would have to manage it more "conservatively" to avoid the risk of failing to meet its interest obligations. Unlike some other retirement savings schemes, the CPF scheme is also "sustainable", he said, noting the "looming pension crisis" in most advanced countries.

The eventual payouts of Singapore's CPF system are funded by the contributions made by a worker and his employer into his CPF account. Unlike other retirement savings schemes, the CPF scheme also offers flexibility for members to withdraw savings for home purchases and for their children's education, said Mr Tharman.

Manpower Minister Tan Chuan-Jin also fielded questions from MPs on the CPF Minimum Sum, dispelling several misconceptions that have been at the centre of controversy of late.

In a Facebook post last night, Prime Minister Lee Hsien Loong urged people to watch both speeches. The thrust of Mr Tharman's speech was that "our CPF monies are safe and earning good returns", while Mr Tan explained how the Minimum Sum gives people a steady stream of income in retirement.

"Our CPF system is sound, and has helped Singaporeans save for their old age. Many countries want to learn from us. But we are not resting on our laurels. We are improving our system to give all Singaporeans peace of mind in their silver years," PM Lee wrote.

Post by Lee Hsien Loong.

Ensuring safe and fair CPF returns
Deputy Prime Minister and Finance Minister Tharman Shanmugaratnam yesterday took Parliament through the nuts and bolts of setting Central Provident Fund (CPF) interest rates and managing CPF monies to ensure safe and fair returns. He was responding to questions from five MPs on whether higher returns can be paid without changing the risk-free nature of CPF accounts.
By Charissa Yong, The Straits Times, 9 Jul 2014

How interest rates are determined for different accounts

THREE MPs - Ms Lee Bee Wah (Nee Soon GRC), Ms Tin Pei Ling (Marine Parade GRC) and Mr Lim Biow Chuan (Mountbatten) - asked how CPF interest rates are determined, and whether the CPF Board would consider paying higher interest rates.

Mr Tharman: CPF interest rates are pegged to returns on market investments of comparable risk and duration.

Extra interest - an additional 1 per cent - on the first $60,000 of combined balances also helps members with smaller balances.

- Interest rates on the Ordinary Account (OA) - minimum of 2.5 per cent per year.

OA savings can be withdrawn at any time for home purchases and repaying home loans, or for education.

The OA interest rate is therefore pegged to market deposits that can be withdrawn at any time, like the 12-month fixed deposit and month-end savings rates of the major local banks.

But unlike market interest rates, it pays a guaranteed minimum of 2.5 per cent, or 3.5 per cent for OA balances of up to $20,000. More than half of all CPF members enjoy the full 3.5 per cent on their OA.

This floor of 2.5 per cent to 3.5 per cent is above market rates.

In comparison, 10-year Singapore Government Securities (SGS) - which are government bonds - earned an average of 2.4 per cent over the last 10 years, and currently earn 2.3 per cent.

- Interest rates on the Special, Medisave and Retirement Accounts (SMRA) - minimum of 4 per cent per year.

The Special, Medisave and Retirement Accounts are meant for retirement and held for the longer term.

SMRA interest rates are hence pegged to the rates given for similar long-term, risk-free investments.

They are pegged to the return on the 10-year SGS bond, plus 1 per cent to approximate the total return over 30 years, the typical time for which SMRA monies are held.

The additional 1 per cent is higher than what has been observed for 30-year bonds in international markets and allows for future market uncertainties, such as a sharp rise in inflation over the long term.

This formula would give a 3.4 per cent return, but SMRA has been paying a floor of 4 per cent since 2007, or 5 per cent for balances of up to $60,000. Two-thirds of CPF members earn the full 5 per cent on their SMRA.

In practice, therefore, the SMRA interest rates are well above current market returns.



How the lower income earn higher interest rates

SEVERAL MPs including Ms Lee and Mr Gan Thiam Poh (Pasir Ris-Punggol GRC) asked if CPF members could earn more returns.

Mr Tharman noted that the lower income effectively earn higher interest rates on their CPF balances.

Mr Tharman: A typical lower- income CPF member - in the lowest tenth of Singapore's earners - also has his CPF earnings boosted by Workfare Income Supplement payments and housing grants he receives.

This is on top of the 3.5 per cent interest rate on his OA balances.

If he sells his home to upgrade or downgrade later, the housing grant he has received is returned to his OA to form part of his retirement savings.

Based on current policies, these grants will effectively grow his savings by at least 2.5 per cent per year over 30 to 40 years of his working life.

This means that his savings in effect "earn" a total of 6 per cent interest per year.



How CPF monies are pooled and invested

MR GAN and Ms Lee asked how the Government invests CPF monies. Ms Lee also asked whether CPF members could invest their funds directly in Temasek Holdings.

Mr Tharman: CPF monies are pooled and invested together with the rest of the Government's funds, such as proceeds from SGS bonds and land sales, as well as any government surpluses.

This is done through the GIC, the Government's fund manager.

Temasek Holdings does not manage any CPF monies.



Why GIC does not manage CPF monies directly

MR LOW Thia Khiang (Aljunied GRC) asked why CPF monies, managed and invested on their own, cannot enjoy investment returns as high as when they are managed together with the Government's other net assets.

Mr Tharman: Pooling CPF monies together with the Government's net assets means that these assets can act as a buffer to absorb losses in years when the market is weak.

In such years, when the GIC's returns fall below CPF interest rates, the net assets still allow the Government to guarantee CPF monies and pay the interest on them.

This buffer lets the GIC aim for higher returns over the long term, by investing in riskier assets like equities and real estate.

Currently, it can invest over the long term and ride out the market cycles by taking big losses when the markets go down, knowing that as a long-term investor, it would ultimately stand to gain when markets go up again later.

Things would be different if the GIC were to manage a separate, standalone CPF fund.

In this scenario, the GIC would have to be conservative. It would not accept risks that lead to higher long-term returns, but will aim to avoid any short-term shortfalls.

Its portfolio would therefore not earn as much over time, because lower risk investments typically yield lower returns.

CPF gives fair and safe returns
Deputy Prime Minister Tharman Shanmugaratnam sought to explain in Parliament yesterday how Central Provident Fund (CPF) monies are invested, and why the returns on them are fair and among the safest in the world. Here is an edited excerpt of his speech.

The Straits Times, 9 Jul 2014

THERE is a looming pensions crisis in most of the advanced countries, and the challenges remain largely unresolved.

The first challenge is financial sustainability. In many advanced countries, the "pay-as-you-go" social security system has become unsustainable. As more of their citizens are retiring, the pensions they have been promised are becoming unaffordable to those who have to pay for the system.

Some of these countries have responded with politically difficult but necessary reforms, such as postponing the retirement age or cutting retirement benefits for younger workers.

Most recently, the Australian government has proposed major reforms to its Age Pension scheme, which is the primary source of income for the majority of Australian pensioners today. These reforms include raising the age at which pensions can be withdrawn from 65 to 70 years old.

But in many cases, the severity of the problem has not been acknowledged and reforms have been postponed. In the US, most public pension funds still overestimate their future investment returns, and understate their liabilities. With more realistic assumptions, it is estimated about 85 per cent of US public pensions will go bankrupt within the next 30 years.

The second challenge is to give individuals a fair return on their retirement savings, but avoid exposing them to more risk than they can bear.

As both governments and employers face increasing difficulty in funding pay-as-you-go pension schemes, more risk is being shifted to the individual in many countries. The shift is to pension plans where the worker's savings go into his own account, and he eventually draws on his own account in retirement.

The 401(k) schemes in the US are like the CPF in that the eventual payouts are funded by the contributions made by the worker and employer into his account, not by future workers. But in many such schemes, unlike the CPF, the worker has to choose his own investment plan and bears the risk on investments.

In theory, individuals can expect to earn higher returns over the long term by taking more risk in investments, such as investing more in equities or equity-heavy funds.

In practice, there are three problems. First, the evidence from advanced economies shows that most individuals underperform the market, even when they invest in funds rather than do their own stock-picking.

A second risk is that you may retire when the financial markets are down. A recent article in The Economist (May 24, 2014) described the typical retirement scheme as a lottery because the individuals' pot of money at the time they retire will depend on the state of the markets at the time.

A third risk is that you retire when interest rates are low. The current prolonged low-interest rate environment is in fact a major challenge in many countries, because the pot of money that you have upon retiring now gives you a smaller stream of annuity income for the rest of your years.

Many retirement schemes require or encourage members to convert their capital into an annuity or monthly payout. However, interest rates matter greatly when buying an annuity, and unlike CPF Life, these schemes do not provide a floor on interest rates.

Low market interest rates mean that retirees will receive less income even if they invest on their own in suitable retirement portfolios.

I have provided this backdrop to explain why our CPF system has worked well and provides a strong foundation for the future. It has protected members from risk. The scheme is aimed at meeting basic retirement needs. As many members have had relatively small balances, it has been right to shield them from risk. The CPF has also avoided imposing risk on tax-payers, unlike many countries where ordinary citizens face a much larger tax burden in future, on account of underfunded social security schemes.

The CPF is not a perfect retirement savings scheme, but it is among the better regarded internationally. As PM has stated, we want to improve the CPF to provide greater security in retirement, especially for those with lower wages and to help retirees cope with inflation. We also want to give those who are "asset-rich and cash-poor" more convenient options to get cash from their homes.

But as we seek to improve the CPF or to add any flexibility, we must retain its basic strengths and avoid the huge problems seen elsewhere: First, our CPF system is sustainable. There are no unfunded or sudden liabilities that will burden our children's generation.

Second, the CPF offers some flexibility for members to withdraw savings, indeed more so than many other social security systems. In particular, by tapping on their OA (Ordinary Account) savings, the vast majority of Singaporeans have been able to own their homes and service their mortgages with little or no out-of-pocket cash.

Third, while the CPF scheme does not provide the highest returns, it gives fair returns and certainly one of the safest in the world. Few systems offer the guaranteed floors on interest rates - 3.5 per cent for OA and currently 5 per cent on SMRA (Special, Medisave and Retirement Accounts) for those with smaller balances, who comprise the majority of members, and 1 per cent less for larger balances. The interest rates are guaranteed by one of the few remaining triple-A rated governments in the world.

The CPF also offers the option to members who wish to place more money in their SA (Special Account) or take higher risks through the CPF Investment Scheme (CPFIS) in the hope of higher returns.

Fourth, on top of the guaranteed interest rates, the Government subsidises CPF members through the Budget in a targeted and sustainable manner. We provide significant help to lower-income members to build up retirement assets, by giving them housing grants in their OA and CPF contributions through the Workfare Income Supplement. Members of the Pioneer Generation also now get top-ups for life in their Medisave accounts.

Taken as a whole, our CPF system prepares Singaporeans well for the future. Based on current policies, a new entrant into the workforce today can expect to draw a retirement income of about two-thirds of his last-drawn pay if he is a median-income earner. This is around the OECD average. He gets a much higher ratio of his previous pay if he is a lower income worker, chiefly because of Government subsidies.

Our key concern is to help the current generation of older Singaporeans who have low CPF balances due to their much lower wages in the past and the more liberal withdrawal rules then.

CPF pays fair interest rates

THE fundamental principle is to peg CPF interest rates to returns on investments of comparable risk and duration in the market. We also structured the interest rates to provide greater benefit to members with small and medium-sized balances by paying extra interest on the first $60,000 of balances.

In determining the rates, we have to recognise the fundamental difference in the purpose of the OA compared to the longer-term SA, MA and RA (SMRA).

OA savings can be withdrawn at any time for home purchases and servicing mortgage loans, or education. It is a liquid account.

The interest rate on OA has therefore been pegged to the 12-month fixed deposit and month-end savings rates of the major local banks. However, unlike market interest rates, it pays a guaranteed floor rate of 2.5 per cent, or 3.5 per cent for OA balances of up to $20,000. More than half of all members enjoy the full 3.5 per cent on their OA.

Members also have options to earn more than these OA interest rates. They can transfer OA savings to the SA so that these become long-term savings, earning higher returns. Those who want to take on market risks in the hope of earning better returns can also invest part of their OA balances through the CPFIS.

The Government also provides subsidies through the Budget to CPF members, targeted especially at lower- and middle-income members. These subsidies in effect amount to a significant boost to what the typical low-income member earns on his balances.

If we look at his OA in particular: On top of the 3.5 per cent interest rate on his OA, he gets Workfare payments and housing grants. When he sells his home to upgrade or downgrade later, the housing grant is returned to his OA as part of his savings for retirement. Based on current policies, these grants will in effect grow his savings by at least 2.5 per cent per year over a 30-to-40-year working life.

In effect, his savings "earn" 6 per cent per annum through the combination of CPF interest rates and government subsidies.

This does not include the OA savings used to purchase the housing asset, which benefits separately from appreciation in housing value. His home is an important retirement asset, and based on its value he can withdraw monies from his CPF balances at age 55.

The OA interest rate, pegged to market deposits that can be withdrawn at any time, is fair.

However, for several years now, the OA has earned the floor rate of 2.5 per cent to 3.5 per cent, well above the market rates. The OA has in fact been earning more than what 10-year Singapore Government Securities (SGS) pays. (The average yield on 10-year SGS over the last 10 years has been 2.4 per cent. It is currently around 2.3 per cent.)

The SMRA, on the other hand, is pegged at 1 per cent above the 10-year SGS. The SA and RA (Retirement Account) are as we all know held for retirement. It is long term savings. As Medisave (MA) balances are also mainly used as Singaporeans get older, we have treated them like the SA for purpose of determining interest rates.

The returns on the SMRA have been enhanced over the years. When we set the new basis for SMRA rates in 2007, our aim was to peg it to the rates for similar long term, risk-free investment. The best peg would have been the 30-year government bond, because 30 years is the typical duration for which SMRA monies are held.

However, as we had not started issuing a 30-year SGS in 2007, SMRA rates were pegged to the yield of 10-year SGS plus 1 per cent to approximate the 30-year rate.

The 1 per cent spread on top of 10-year government bonds was in fact a little generous, as it was higher than what has been observed for 30-year bonds in international markets. However, it was fair and reasonable, giving allowance for future economic and market uncertainties, such as if inflation picks up sharply over the long term.

Going by the formula for SMRA rates, we would be paying about 3.4 per cent today on SMRA. (This is higher than the actual yield of 3 per cent on the 30-year SGS, which is not widely traded.) However, we have maintained a floor of 4 per cent on SMRA, or 5 per cent for balances of up to $60,000. We have renewed this floor each year since 2008. Two-thirds of CPF members in fact earn the full 5 per cent on their SMRA.

This is a fair system of returns for the SMRA. The CPF in essence pegs SMRA returns to long-term SGS, but it has also been paying a floor of 4 per cent to 5 per cent that is well above market rates in the current environment. We have shielded members from the risk of low market rates.

How CPF monies are invested

THE CPF Board (CPFB) invests CPF members' monies in Special Singapore Government Securities (SSGS). These are issued specially by the Government to CPFB. The payout from the SSGS is pegged to the interest rates that the CPFB is committed to pay its members.

The Government guarantees these SSGS bonds, so that CPFB faces no risk of being unable to meet its obligations to its members. This is a solid guarantee, from a triple-A credit-rated government. The triple-A credit rating reflects Singapore's very strong financial position, with the Government's assets comfortably exceeding its liabilities. Both Standard and Poor's and Moody's recently reaffirmed our credit rating, noting that our strong net asset position provides ample cushion against shocks.

What does the Government do with the proceeds from SSGS issuance? It pools them with the rest of the Government's funds, such as proceeds from the tradable SGS, any government surpluses, as well as the proceeds from land sales.

The comingled funds are first deposited with MAS (Monetary Authority of Singapore) as government deposits. MAS converts these funds into foreign assets through the foreign exchange market. A major portion of these assets are, however, of a longer-term nature and are hence transferred over to be managed by GIC.

The SSGS proceeds are not passed to Temasek for management. Temasek manages its own assets, and does not manage any CPF monies.

How the Government meets its SSGS obligations

WHAT these investment arrangements mean is that CPF members bear no investment risk at all in their CPF balances. Their monies are safe, and the returns they have been promised are guaranteed. Neither does CPFB bear any risk, regardless of whether GIC's investments earn or lose money in any particular year. The risk is wholly borne by the Government, on its own balance sheet.

The Government pools the proceeds from SSGS with its other assets, and invests long-term funds through the GIC. The GIC does not, in fact, manage SSGS monies on their own, separate from the Government's other assets. This is an important distinction.

GIC is fund manager for the Government, not owner of the assets and liabilities. It seeks to achieve the Government's mandate of achieving good long-term returns, without regard to the sources of the funds that the Government places with it.

Over the long term, our investments in GIC have earned a creditable return. For example, over the last 20 years, GIC earned 6.5 per cent per annum in US dollar terms, which translates to 5 per cent per annum when expressed in Singapore dollars.

But that is not the whole story. This average long-term return masks wide fluctuations in returns from year to year. Over the last 20 years, there were eight years where GIC's investment returns were below what the Government pays on SSGS.

A good example was the global financial crisis. GIC's portfolio value in US dollar terms declined by about 25 per cent during the 14 months from October 2007. GIC's performance was similar to that of other funds with a similar mix of asset classes, but it illustrated the market volatilities faced by every long-term investor.

Even over the five years following the crisis, ended March 31, 2013, GIC earned an annualised return of just 2.6 per cent in US dollar terms, which translates into a mere 0.5 per cent in Singapore dollar terms. GIC's annual report explains the reasons for this weak recovery from the crisis, especially in illiquid asset classes like real estate. Its five-year annualised returns are expected to improve significantly going forward.

Hence, while the Government expects to earn returns through the GIC over the long term that exceed what it pays on SSGS, and has done so in the past, there is no assurance of GIC's returns exceeding SSGS interest rates over shorter periods, much less every year. This is also because of the guaranteed floor on CPF interest rates, which do not follow declines in market interest rates.

How then is the Government able to meet its SSGS obligations in the years when the markets are weak and GIC's returns fall below what the Government has to pay SSGS?

The Government has a substantial buffer of net assets, which ensure that it can meet its obligations. In years when investment returns are poor, the net assets have helped to absorb any losses and ensure that the Government can meet its obligations on the SSGS as well as its market-traded SGS. Correspondingly, when investment returns are strong, the net assets grow.

Therefore, no extraordinary measures have been necessary to enable the Government to meet its SSGS obligations in the years when GIC's returns fall short.

It is this role of the Government, with its significant net assets, that ultimately allows the CPFB and CPF members to be shielded from risk. The Government, through GIC, expects to earn good returns over the long term, but the volatility can be substantial from year to year. The Government has been absorbing that volatility, and protecting CPF members.

This is also the reason why no market player, other than the Government, is able to take on the CPF obligations. The guarantor is not merely playing the role of a long-run investor. It also must have significant capital that provides a buffer when the markets are down.

Our CPF system is hence sustainable, so long as the Government continues to run prudent Budgets, and invest the reserves wisely. Then the Government's balance sheet will remain strong and investment returns over the long term can continue to meet our debt costs.

However, the GIC's good long-term returns also reflect the fact that it is managing the Government's assets as a pool, which includes the Government's unencumbered assets - that is, assets that are not matched by liabilities. This is a key feature of our system. It allows the GIC to invest for the long term, including investing in riskier assets like equities, real estate and private equity.

A standalone fund would have to be managed much more conservatively to avoid the risk of failing to meet CPF obligations. It would not be aimed at accepting risks that enable good long-term returns, but at avoiding any short-term shortfalls. Consequently, the returns it would earn over time will be lower than what the GIC can achieve in its current role.

Finally, I should emphasise that the investment returns in excess of the SSGS rates that the GIC expects to make as a long-term investor are not simply hoarded away in our reserves. 50 per cent of the returns from our reserves flow back to our annual Budget through the Net Investment Returns Contribution (NIRC). This currently adds about $8 billion to the Budget annually. The NIRC has provided the Government valuable resources that have allowed us to embark on new priorities for Singapore, including enhancing our social safety nets.

The Singapore Government's guarantee is a key safeguard.

CPFB, besides its own internal auditors, is externally audited by professional audit firms approved by the Auditor-General. As for Government's investments, I can assure members that GIC is audited on a regular basis.

GIC's financial statements are independently audited by the Auditor-General every year.

Its audited financial statements are submitted to the President and the Council of Presidential Advisers annually. The President also has full information about the size of the reserves and the performance of GIC's investments. GIC's investment performance over five, 10 and 20 years is also made public through its annual reports.

Let me just reiterate that our CPF system is sound, and provides a solid foundation for Singapore's future. It is not a static system.

Whatever we do to improve the system, we must provide fair returns to the ordinary member, who is unable to take on much risk, and ensure that the CPF remains sustainable over the long term. The Government should continue to subsidise CPF members, especially those with lower incomes, but these subsidies should be provided through the Budget, so as to ensure the CPF is sustainable.

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DPM Tharman Shanmugaratnam's Reply to Parliamentary Questions on CPF Interest Rates and Investment of CPF Funds

IPS Forum on CPF and Retirement Adequacy

CPF Facts and Fallacies