For the past two years, Watson Wyatt has been researching how Malaysia's M$200 billion ($53 billion) Employees' Provident Fund can reverse declines on its returns on investment, with a final report and recommendation due in March, 2003. The final result is likely to de-emphasize investing abroad and look at ideas such as contracting investment responsibility to companies and workers or creating a private pension plan akin to Thailand's.

Danny Quant, Watson Wyatt's managing director in Kuala Lumpur, says the EPF's main problem is that it is a victim of its own success: it is too big. With up to 20% of it invested in local equities, it now owns around 8% of the Malaysian stock market, and up to 15% of the top companies. This has created governance issues. The EPF does not have board representation on these companies, and although it has a large internal research capability, it is more academic than practical, and is not suited for managing a myriad of businesses.

Furthermore equities are counted at book value not market value, which has fallen, leaving the EPF with unrealized losses. Because the EPF does not have to account for stocks at market value, this doesn't create a systemic problem, but it does mean that EPF is forced to sell those few performing stocks in order to generate the cash used to pay out annual benefits to members.

Meanwhile returns, once a healthy 8% per annum, have steadily fallen to 2001's 5% return on investment. One reason is low interest rates mean returns on cash (about 20% of the portfolio) are a measly 2%. Another problem is a shrinking sovereign bond market. By law at least 50% of the EPF's portfolio must be in government bonds, but declining issuance has sharply reduced supply, forcing the EPF to apply annually to the Ministry of Finance for an exemption. The MoF has complied by letting the EPF reduce its government bond allocation to 30%, but the EPF is already bumping this new floor.

"This leaves the EPF with the practical problem of what to invest in," Quant notes.

In the short term, the EPF has been cutting benefits, but this is obviously not acceptable politically. Yet without structural reform, the EPF is unlikely to improve its return on investments to an acceptable degree.

Fortunately EPF's managers and the government are aware of this, and are prepared to make real, not cosmetic, adjustments, Quant says.

Watson Wyatt is outlining several options for the EPF to consider.

First is international diversification of investments. This is an old, obvious option that the EPF has long considered. It actually had a mandate out just before the Asian financial crisis forced Malaysia to impose capital controls and peg the ringgit. Quant says this remains a longer-term necessity that is recognized by most people in KL, but will remain difficult with a fixed exchange rate. Moreover, the EPF would need to invest a substantial amount over a long period to realize gains; with foreign reserves of $30 billion, investing $1-2 billion will impact the nation's reserves.

"We expected at the beginning this study would justify overseas investment," Quant says. "But that expectation has been tempered because the economy has not recovered quickly enough and the global environment is not very good. In practical terms, the country is not yet ready to invest wholeheartedly overseas, even though the rationale is understood and accepted."

A second option is to embrace domestic alternative investments, such as property. Right now the EPF allocates under 1% to property, mainly by owning its own offices. Quant suggests the fund could create a property trust, to which local institutions could also subscribe. The EPF would have to find the right managers from outside the organization.

Entering private equity is another option, to help finance Malaysia's infrastructure, manufacturers and exporters. The risk here is that it would probably crowd out domestic bank lending to these areas. Traditional corporate lending in Malaysia is at a low, as it is for banks across Asia, with consumer banking the main growth area. Domestic banks are only targeting a handful of corporate borrowers or projects. Were the EPF to enter it could mean even less opportunity for local banks. The EPF could invest in private equity overseas, but this opens it to political attacks.

This leaves two other ideas Watson Wyatt is fleshing out, both of which are radical. One is to allow personal pension and retirement plans funded by individuals, as now exists in Thailand. Quant notes the EPF already has a flawed version of this at the withdrawal stage. For balance holders with M$50,000 or more, they can shift a portion into domestic mutual funds or annuities. This favours old, rich people û those who don't need assistance. But younger contributors are the ones facing a future crunch due to poor performance, and Watson Wyatt is looking at ways to mobilize their money.

The most radical notion, however, is to contract out EPF investments via corporate pension plans. This would see companies establish their own defined contribution plans and have private-sector mutual fund companies manage the assets, thus taking care of EPF's problem about how to handle new contributions. It also takes corporate governance issues out of EPF's hands. Last, it would enhance domestic capital markets by creating more buyers and develop the mutual fund industry.

"Contracting out is a new idea and needs to be thought out," Quant says. The concerns include a lack of infrastructure to manage it (for example, mutual fund companies have experience investing but would require administrative networks to be set up) and the need for companies and individuals to start making investment decisions. Establishing life cycle funds is an obvious way to go, but these would have to be tailored to Malaysian requirements. This would also create unprecedented strains on the large bureaucracy of the EPF.