AIG not packing bags

Tomasz Frontczak, president and CEO of AIG PTE and vice president of the Economic Chamber of Pension Funds, is from the "bulldog breed," an accolade usually reserved for the very best of English Gentlemen. But he was born and bred in Warsaw.
Powerfully built, confident, knowledgeable, and straight talking are the qualities that spring to mind. Therefore, few pleasantries were dispensed before starting the conversation.
Was the rumour (actually a story in Puls Biznesu) that AIG PTE was withdrawing from the Polish pensions market true? "Rumours are rarely true," Frontczak answers. This one isn't. But he is not a happy man, and nor are any of his rivals faced with the regulatory straitjackets proposed by the government.
Three years ago the AWS introduced a radical new pension system in which a second pillar was formed, independent of the state sector, into which a mandatory 7.3% of income is invested. Now there are 17 such pensions funds in the market, of which AIG PTE is the fourth largest. The reform was actually streets ahead of anything attempted in mature west European economies.
"We deal exclusively with this second-pillar money," Frontczak says. "Each member contributes via his employer into his own individual pension. The agreed amount of investment is deducted from his payroll by ZUS and then transferred to us for investment."

Fees, nourishing vitamin M.
"We charge an initial 8.5% plus an annual management charge of 0.6% of asset value," Frontczak declares.
So we turn to the proposals of the Sejm subcommittee to cap fees at 7% initial and 0.4% annual with an additional 0.2% if the pension fund achieves a certain level of performance.
Frontczak turns gritty. He doesn't like this idea at all.
"This shows a clear lack of understanding of commercial reality," he says. "We made our calculations knowing that we are in a long-term business and that we would not break even after two or three years. We invested a significant amount of money into building up the infrastructure. Our shareholders were prepared for a payback period after eight to nine years. If the new proposals go through, then that defers their payback point to 13 or 14 years. As we are meeting our objectives under current circumstances, I see no reason to be nervous."
A qualification, trailing along at the end of this long sentence. "However, should the circumstances change, then who knows?"
This is a frontline director who will mix it with government. It's about making money by the delivery of quality service, in an infant market where there are not enough informed consumers of the product. But there will be. He underlines his responsibility for the day-to-day management of this organisation, while the shareholders take the final decisions. "All the views that I express are my own personal opinion."
He shares the view that the AWS reform was right, if not perfect. "The old system promised you a lot but, once you retired, actually gave you very little," he says. "Under the new system, at least a part of your eventual benefit relates to your salary level so you can understand what your pension is going to be. Pensions are also long-term investments, and any decisions that are made in this area must bear this in mind."
Frontczak sees the proposed changes as a direct assault on market reality. "I believe that changing the rules now is premature and may bring about unintended consequences," he says. "Look, the industry started out with certain rules and regulations upon which the companies coming to the market made their commercial decisions. Meddling now, for no clear set of imperatives, is foolish, when what should really be done is to allow the existing rules to apply for another three to four years in order to allow natural market forces to operate.

"Once the inevitable consolidation occurs, once we have eight to 10 players, then we have an entirely different situation. By then the break-even point would have been reached by the majority. It is then that we can talk about changing the rules."
Solid state, then? Not at all. What is really missing he says is a continuous improvement of certain regulations, which go past their sell-by date naturally because of market forces. And it is not that there isn't anyone there keeping the cloth over their ears. "We, as a chamber, indicated to the ministry certain areas in which these improvements were necessary, and 80% of our suggestions were agreed to," he says. "But the problem is that they added certain other proposed changes which, in our opinion, are against market forces and may be to the detriment of all of our pension members. We should adopt changes that are necessary to improve the system for the benefit of the pension member."
Frontczak has no doubt about where the priority lies. And that should be an increase in financial instruments and increased flexibility in investment decisions rather than applying imposed limits. Then, as the market matures, allow consolidation of the market and then regulate the new market.
The existing law imposes a mandatory minimum return. The performance of each fund is assessed in comparison to others and continued underperformance has to be made up by the company. Evaluations are made on a two-year quarterly return. Never having tripped over this principle before, I want to understand the rationale.
"I can understand the rationale behind it, for when the system was created people were questioning what would happen if we failed to deliver appropriate returns," Frontczak says, delivering the answer with precision. "Today the minimum required level of return is a very artificial setup which guarantees nothing to no one. All professionals in the investment management business know that this type of a solution is temporary and leads to nowhere.

"For example, in Chile, whose pension model is applied here, the difference between the best and worst performing fund after 20 years is merely 0.6% since the asset allocation of portfolios is practically identical."
I feel an electric charge. A difference of 0.6% over a 20-year period between competing pension funds implies a case of extreme conservatism. "You mean that the system does not encourage excellence and outperformance but tends towards the mediocre?" I ask.
"Exactly," he says. The answer is emphatic. "We have now reached a stage when we should give the respective investment officers more freedom as to where to invest. Obviously, their decisions should be monitored, checked and verified. However, before we do so we need to have a wider range of financial instruments that we are able to use."
"And you are being constantly assessed," I interject.
"Yes we are," Frontczak answers, "but the problem with the present method is that it is too short-term. Pensions involve long-term investment decisions, which may take years to provide positive returns. If I position myself with a short time frame, I may take decisions that involve a higher degree of risk in order to produce immediate returns. Within the field of investing for the purposes of providing a pension, this may be against the interest of the pension members.
"When you see articles in the press making comparisons of the performance of pension funds over one month or even one year, it tells you that the person writing the article has absolutely no idea of what pension fund investing is all about. We have to make sure that we provide adequate benefits to our members years into the future, and in order to achieve that goal short-term fluctuation in performance should not count."
Asset allocation within pension funds and all pooled funds is always controlled by the regulatory authorities. However, the range of investments that can be entered into and the percentage allocation that can be used varies. In Poland there is no limit on the percentage that the funds can invest into government bonds, but a 50% limit on equity investments and a 5% limit on investing outside the country. One of the most interesting limits is on the percentage of cash that can be held and the amount of time given to invest the money received.

"We have a 5% cash limit," Frontczak says. "As we receive the money from ZUS, we have two days in order to invest it. We need to be productive. Under present circumstances, we are not as productive as we could be for the simple reason that there are not enough financial instruments that we can invest in." Back we are to the illiquidity of the Warsaw money markets, and the cash which is running about looking for a home, which it doesn't find among the enticements offered on the WSE.
"As an example in principle, I would love to invest more in the economy, but in order to do so I need the appropriate financial instruments," he says. "People talk about improving the infrastructure, but where are the bonds to finance this improvement? Nowhere. Where are the bonds to finance the highways? I am not in the business of building highways, I am in the business of managing money, and therefore I need the appropriate financial instruments in order to do so."
He's realistic that at this stage of the country's development we cannot expect to have an identical situation to that of the west, and we have to run the gauntlet of opening up liberal financial markets.
In the US and the UK, pension funds exercise powerful clout as they are the largest holders of equities in the respective markets, owning about 50% of quoted equities. I ask what percentage of quoted equities do pension funds own on the WSE?

"I would assume around 25%," Frontczak says. "The problem here is that we have a situation of low liquidity, and we may be sitting on stock that we cannot sell. For example, early in 2001 our assessment was that the market was about to decline, and therefore we decided to close a position. Because of the low liquidity on the WSE, it took us 50 days in order to complete the disinvestment. Therefore, you make your decision today and wait another two-and-a-half months for it to be completed."
This problem of "liquidity," of being able to sell when you want to, is one of which mere mortals are not aware. The sheer terror of making a correct decision and watching the share price fall as the position is unwound in stages brings on more than sleepless nights, especially as your own disposal has the effect of depressing the price further. Financial instruments now exist which can be used to prevent these problems or at least partially solve them; they are called derivatives.
"There is a plan to allow derivatives at some point in time, but hedge funds are not allowed," Frontczak says. "The ministry and the regulator concluded that hedge funds are too risky, and that is why we are not allowed to invest into them."
So there we have it. In Poland as in most other countries, there is a lack of understanding by the politicians and bureaucrats of what the requirements of investing for pension purposes are all about. Politicians want to rid the state of the increasing liability of past promises made, and the bureaucrats want to control a situation that they do not understand and which will outlive their individual lives.
"Exactly," Frontczak exclaims. "The problem with most politicians is that they do not have a long-term horizon. All that most of them are concerned about is the next election.
"As far as the bureaucrats are concerned, I am trying, really trying, to understand their mentality. In the past, everything was regulated in this country, both wages and prices. You paid the same price for celery, regardless of whether it was stale or not. Now as we are in a market economy, you can no longer determine the price of everything. If you do not allow market forces to work and wish to regulate, then you have to be prepared to take responsibility for the outcome. Therefore, the existing rules applying to the way we are remunerated should remain until after the market forces have done their work."
It seems to Frontczak that such folk do not understand the complexities of the market, of how it works and evolves, and therefore they prefer simplistic solutions to complex problems. What they do not personally understand they therefore exclude. That is why, as an example, the pension funds are excluded from hedge funds and have access to a very restricted range of financial instruments. However, whether they like it or not, the financial markets will open up. That is in the natural order of market forces.

There are many incomprehensible things in life and financial services, and the one that I cannot understand is this: the private sector is being used to provide individual pension benefits, but then the money that is invested is to be considered as "public money" and, as such, not allowed freedom of investment. I ask Frontczak for clarification.
"Interesting," he muses. "It is a good point of discussion with the ministry of finance, but to my mind the money that I pay to my pension fund should be treated as my money. This money is taken from my salary, a salary that I negotiated with my employer. It is my money for my benefit. That is what the whole purpose of pension reform was about."
"What if the government-of-the-day disagrees?" I query.
"Then once we are a member of the European Union, we may allow a third party to decide who is right and who is wrong." Frontczak answers.
He confirms that the funds may in the end take their case to Brussels. They are looking at the machinery to do it.
Inside each of us there is a desire for an ideal world. It cannot be attained, but the desire is always there. I wonder what the ideal solution would be.
"Not to go against market forces and let the market decide," Frontczak says. The answer is swift and sure. "Adopt changes that are necessary to improve the system for the benefit of the pension members. Increase the number of financial instruments available to us, increase our flexibility in investment decisions rather than applying imposed limits, and allow us to try and achieve over-performance rather than squeezing us into a reversion to the mean.
"It makes absolutely no sense to change the rules upon which we have made commercial decisions at this stage and gives a very bad signal to potential investors in the Polish economy."

And that story about AIG packing its bags?
"Who would be stupid enough to put us up for sale right now?" Frontczak laughs. "As I have said, we are meeting our targets and objectives under current circumstances. The crucial question is who will want to buy and at what price. Asking those two questions eliminates any rationale for that particular article."
There is another world out there called "pensions." It is of no interest to the ordinary man in the street until it's too late, until the promised benefits do not materialise. Others are attracted to it because of "assets." They wish to use it or to control it. What they are unable or unwilling to understand is the other side of the coin. They are called "liabilities" or "benefits" to you and I, and they are to be there in the future for our lifetime. And we are living longer and longer.
The investment of today's assets for liabilities that are to emerge years into the future is a complex skill requiring a very different time frame to the norm. It should be left to the professionals who should be assisted in their endeavours rather than hindered.
But as with all things financial, it requires two fundamental pillars, which are competence and trust. I would have no problem in doing business with Mr. Tomasz Frontczak.