Over the weekend, the Employees’ Provident Fund (EPF) of Malaysia delivered an astounding 6.15% dividend for the Conventional Savings account and 5.9% for the Shariah Savings account. The news caught many people by surprise since 2018 was a particularly poor year for almost all asset classes globally. Even Lim Guan Eng, the Malaysian Finance Minister is surprised.
Just to clarify, I am positively surprised by this as well and I’ve nothing to complain about. Being an EPF contributor, I do look forward to the consistent dividends that the EPF provides for my retirement funds.
It’s only out of curiosity that I’ve decided to look into the details of how the EPF operates and answer my own question of how it is possible for the EPF to provide such a high dividend for 2018.
I first looked at its 2017 annual report to get some ideas how it allocates its assets. The EPF is guided by a strategic asset allocation plan that looks something like this picture below:
As of the end of 2017, its actual asset allocation is quite close to the above. About 50% is in bonds and loans (EPF also lends out money and collects interest payments), 42% in equities (shares) and about 8% in real estate and money market instruments (aka cash deposits).
In terms of where it puts its money, about 28% of the investment is outside of Malaysia. The bulk of this overseas investment is in equities where the split between Malaysia and the rest of the world is about 50/50 as of the end of 2017.
Since the 2018 annual report is not yet out, it’s hard to say for sure how much this asset allocation has changed since 2017. One could assume that the 2018 asset allocation could be closer to its strategic asset allocation plan above, ie 51% bonds, 36% equities and 13% others.
How The World Did in 2018
2018 ended quite badly for many asset classes. The KLCI was down about 6% for the year while the MSCI World Index (an index for the world’s various stock exchanges) was down 8%. On the other hand, the Malaysian Government Securities (MGS) 10 year bond yield was stable at around 4.1%, while the average KLCI stocks dividend was about 3%.
If we assume that the 2018 asset allocation of EPF to be 51% bond and 36% equities (half in Malaysia and the other half outside of Malaysia), the 2018 returns for EPF could probably end up to be less than 1%.
How is it possible then that the dividend reaches 6%?
EPF’s Unbelievable Profits
EPF reported that it realised over RM29 billion in profit from its over RM300 billion equities in 2018. To those who owned stocks in 2018 and seen the decline worldwide, you may be wondering how this is possible.
EPF has been clear in its annual reports that its gross investment income is based on realised profits. This means, for example, that it needs to sell shares to realise its capital gains on the shares. This is the clue to the puzzle.
Possibly about 1/3 of the profit comes from dividends. The average dividend is about 3% for shares listed in KLSE and about 2% or 3% worldwide. This means that the rest of the profit needs to come from the selling of shares.
If you look at the disclosures of shareholding of popular stocks on the KLSE, you will find EPF constantly trading in and out of shares, particularly in Q4 of 2018. It is possible that it is engaged in short selling as well, betting on falling share prices. I’m guessing that EPF made another 1/3 of its profit from such short term trading activities.
Finally I think EPF made the rest of its profit by selling shares that it had bought a long time ago, realising gains that have been built up from past years. In order words, EPF is selling its shares reserve from past years to realise additional income in bad times such as 2018.
It’s the last point above that allows EPF to realise enough profit to pay out such lucrative dividends during bad times.
And to be absolutely clear, there is no way for me to be sure of the numbers above until the 2018 annual report is made available.
EPF’s Reserves and Retained Earnings
There is a portion in the balance sheet of the 2017 EPF annual report that shows the total amount in contributions from EPF members. Alongside this are two more line items: reserves and retained earnings.
Reserves are the unrealised gains or losses on investments that EPF is still holding. An example is the gains on shares that EPF bought and has not sold. If EPF sells shares that it had bought from the past to realise the profits, then the reserves will decrease. Conversely if EPF buys shares and holds onto the gains as paper gains, the reserves will increase.
Retained earnings is the money left over from the nett profit after paying the dividend (plus and minus some other minor things).
As you can see from the stacked column graph above, the reserves and retained earnings are always present over the years while total contribution amounts from EPF members continue to rise as there are more EPF deposits than withdrawals.
By looking at how the reserves and retained earnings change over the years, we can see that EPF is using this as a buffer to balance out the ups and downs of its investment returns so that it can provide stable dividends to contributors.
The chart above shows the reserve margin, which is the ratio of reserves and retained earnings to the total EPF member fund ((reserves+retained earnings)/(contribution+reserves+retained earnings)).
During the bad times of 2014, 2015 and 2016, the returns of equities is actually less than the dividend declared in those years. As a result, the reserve margin dropped from over 9% in 2013 to just below 5% in 2016.
In 2017, there was a rally in stocks and equities return was above the 6.9%/6.4% dividend declared by the EPF. As a result the reserves recovered to 5.6%.
Since the 2018 annual report is not yet available, there is no way to tell for sure what the reserves margin now look like. But it is surely less than 5.6% and probably below 5%.
As we cheer on the nice 6% dividend for 2018, I do hope that stocks pick up again so that EPF can soon rebuild its reserves. Otherwise EPF may be under short term pressure to reduce the dividend to protect its reserves.