Remuneration for management of the Government Petroleum Fund
23 August 2001
The following letter was submitted to the Ministry of Finance on 23 August 2001
We refer to the meeting on 16 November 2000 between the Ministry of Finance and Norges Bank when the Ministry asked Norges Bank to evaluate alternative forms of remuneration for the management of the Government Petroleum Fund. Norges Bank will herewith suggest a new method for calculating remuneration for 2002.
In the management agreement between the Ministry of Finance and Norges Bank, Annex 1 concerning remuneration for 2001 reads as follows:
"Remuneration for 2001 is fixed by the parties to the agreement as 10.1 basis points of the average amount that may be invested in equity instruments according to the benchmark portfolio and 5.3 basis points of the average amount that may be invested in fixed income instruments according to the benchmark portfolio. The calculation of these average amounts is based on the market value of the Petroleum Fund's portfolio, in NOK, at the beginning of each quarter, with the equity and fixed income shares, on average, that the benchmark portfolio contains for the following quarter.
In addition, Norges Bank receives remuneration for the portion of the fee to external managers that is due to the excess returns achieved.
By 1 September 2001, a new review and evaluation is to be made of the preconditions and estimates upon which the remuneration is based pursuant to the first paragraph above, including the size of the Fund and the scope of active management mandates. If, at this time, there is new information which has a significant bearing on Norges Bank's costs, new remuneration rates will be fixed for 2001 pursuant to the first paragraph above.
Regardless of the above, both parties may in the course of the year request changes in the method for calculating remuneration. Any such changes will come into force on the date agreed upon by the parties."
Remuneration for 2001 amounts to 7.2 basis points of the Government Petroleum Fund's average market value through the year. Coverage of performance-based fees to external managers comes in addition. Norges Bank's cost estimates indicate that the remuneration rate will correspond well with the actual management costs.
Norges Bank uses a form of internal pricing to estimate the actual management costs. These prices are documented when Norges Bank sends its proposal regarding remuneration rates to the Ministry of Finance. A cost survey conducted by Norges Bank's Budget and Accounting Department was sent to the Ministry of Finance on 7 January 2000. This survey documented the size of Norges Bank's overhead costs outside Norges Bank Investment Management.
A cost comparison conducted by the Canadian consulting company Cost Effectiveness Measurement Inc. showed that the Government Petroleum Fund's management costs in 1999 were 1.4 basis points lower than the reference cost level, which was calculated by the consulting company on the basis of costs at other comparable managers. This is discussed in greater detail in the Annual Report for 2000 on the management of the Government Petroleum Fund. The result indicates that management of the Fund is reasonably cost-effective. A similar cost comparison will be made for 2000.
2. Evaluation of the remuneration model
The existing remuneration model satisfies the fundamental requirement that Norges Bank must be given an incentive to consciously weigh income opportunities against costs. The model exposes both results and costs of management, and these figures are published in reports to the Ministry of Finance. It is possible for third parties to assess the cost level of management in relation to the results achieved and to make comparisons with other managers.
Remuneration rates are based on the principle of full coverage of Norges Bank's expenses. Every year, the rates have been reduced as of 1 September with retroactive effect for the entire year and remuneration has thus corresponded well with actual expenses. However, the remuneration model may conceivably give the impression that Norges Bank's expenses are always covered regardless of the amount. It may also be inappropriate in principal for the Ministry of Finance to approve expenses related to Norges Bank's management when profit responsibility has been delegated.
On the basis of these evaluations, Norges Bank will recommend a change in the model whereby the fixed remuneration rates based on coverage of expenses are replaced by remuneration of expenses up to a certain limit. It is important that this limit is based primarily on cost information from other managers and thus provides a true picture of the alternatives open to the Ministry of Finance.
Norges Bank will also suggest a simplification of the arrangement for covering performance-based fees to external managers so that the Ministry of Finance will no longer approve each individual agreement.
3. Alternative remuneration models
- Covering actual costs
The simplest method of covering expenses is for Norges Bank to send a specification of accrued costs at year-end to the Ministry of Finance for approval and coverage. Complete transparency about the scale of costs is required. However, the Ministry of Finance will in general have little control over how large the remuneration will be.
- Fixed price established by benchmarking
In the current model, the price for management is stipulated in advance as a share of the average total assets. This allows the Ministry of Finance to directly influence cost levels, but so far this has not been done in a manner that has affected Norges Bank's choice of management style. The price has been based on budgeted costs in Norges Bank, but may alternatively be fixed on the basis of average costs at comparable managers.
However, it will not be feasible to use such cost figures without making some discretionary adjustments. This is because other managers' cost figures will only be available from previous years and because there will always be weaknesses in the methods used to compare the Government Petroleum Fund and other funds. Such weaknesses in the cost analysis from Cost Effectiveness Measurement Inc. are discussed in an article in the Government Petroleum Fund's Annual Report for 2000.
The model allows for profits or losses in Norges Bank's management of the Government Petroleum Fund.
- Coverage of expenses within an upper limit
One possibility is a combination of the two models mentioned above, where remuneration from the Ministry of Finance covers actual costs, as in model 1, but is contingent on these costs being lower than an upper limit that is set on the basis of information about costs at comparable managers.
The upper cost limit must be set so that Norges Bank still has room for manoeuvre to adjust the management in a way that is most profitable for the Petroleum Fund, within the management mandate given.
With coverage of actual costs up to an upper limit, Norges Bank will never be able to realise a profit on its management of the Petroleum Fund. For Norges Bank, the most important incentive for cost-effectiveness will be a high net excess return. All expenses that are not viewed as absolutely necessary will weaken this result, which is used as a basis evaluating the management and is published four times a year.
- Pricing dependent on management style
In this model, the remuneration is fixed in advance as in the current model, but is a vector with a number of components. Remuneration varies for active management and index management and for active management in different markets. The total remuneration depends therefore on Norges Bank's choice of management style.
The deviation between the expected and the actual share of the portfolio under active management has largely accounted for the deviation between expected and actual management costs in Norges Bank. This model allows for tailoring remuneration so that coverage of expenses becomes more accurate than in the current model, at the same time as the system of predetermined prices is maintained.
- Performance-based remuneration
Most agreements between Norges Bank and its external managers include both a fixed base price in basis points of the total assets and a performance-based component. This is also a possible model for the remuneration agreement between Norges Bank and the Ministry of Finance. This differs from the above models in that internally generated excess returns affect the remuneration and performance-based fees to external managers are not fully covered.
This model also gives Norges Bank as manager an incentive to achieve the maximum return as well as to be cost-conscious. It allows for transparency about the price of management and it ensures that the Ministry of Finance pays less if the quality of the product delivered is poor.
The model allows for both profits and losses in Norges Bank's accounts and the figures may be larger than would have been the case with any of the above models because the excess returns will fluctuate over time.
The model may also provide an incentive for Norges Bank to reduce its own risk by choosing a lesser degree of active management than what may be desirable for the delegating authorities. Norges Bank's agreements with external active managers set minimum risk limits. An important aspect of follow-up is to ensure that the managers actually take the risk that has been agreed. An important issue in principle is therefore whether the Ministry of Finance wishes to set a minimum requirement for the active risk taken by Norges Bank in its management of the Petroleum Fund.
The effect on the bottom line will not be as important as an incentive in Norges Bank as in private companies where profits may be distributed among the owners and employees and/or provide the basis for further commercial expansion. The limits and transparency that apply to the management of the Government Petroleum Fund already imply strong incentives for Norges Bank to achieve high excess returns at low costs.
Excess return (which is the basis for the fee) is defined very clearly in the agreements between Norges Bank and external managers. The return can be measured accurately because the cost of establishing new portfolios is normally borne by Norges Bank since the Bank manages these processes. In the case of Norges Bank, however, the measured excess return does not provide a complete picture of the Bank's contribution to results due to a number of factors. This is discussed in greater detail in the 1999 and 2000 Annual Reports on the management of the Government Petroleum Fund. If the measured excess return is to have direct financial consequences for the Bank, comprehensive efforts must be made to make corrections for conditions that the Bank cannot influence, such as the scale of new capital that is to be invested in the market.
4. Coverage of performance-based fees
Both the current remuneration model and the four first models discussed in section 3 must be supplemented by an assumption that performance-based fees are covered by the Ministry of Finance in addition to the ordinary remuneration. Performance-based fees refer to fees that come in addition to the fees paid to each manager regardless of returns.
The final amount of the performance-based fees will not be clear until all invoices have been received and paid. Since both the central government's and Norges Bank's accounts must be closed before this occurs, estimates must be used for the performance-based fees. One possible solution is to correct for the difference between estimated and final performance-based fees when calculating remuneration for the next year. The first time this may be done is when remuneration for 2001 is calculated.
The current management agreement states: "The Ministry of Finance shall approve in advance those clauses of the agreements between Norges Bank and Norges Bank's managers that have a direct influence on the remuneration paid by the Ministry of Finance to Norges Bank." This means that each agreement about fees with a performance-based component must be submitted to the Ministry of Finance. So far, all agreements have been approved.
Instead of prior approval of each agreement, a new management agreement between the Ministry of Finance and Norges Bank may include specific requirements about the calculation of performance-based fees. For example, one requirement may be that on the margin, the Petroleum Fund shall continue to keep the main portion of the excess return. The management agreement may also include a requirement to send completed agreements to the Ministry of Finance for the purpose of information.
In Norges Bank's opinion, the current remuneration model has worked well. We see, however, that the model has some weaknesses that make it desirable to look for alternatives.
Model 1 with pure coverage of expenses provides little incentive for cost consciousness, while in practice model 2 would not be so different from the current model. Model 4 allows for both profit and loss in Norges Bank's accounts, but in relation to the current model, it would probably be more accurate because an important reason for deviations between expected and actual costs would be eliminated. However, the model would be fairly complicated. Model 5 - remuneration based on excess returns achieved - would not be as well suited for operations that cannot employ increased earnings to raise dividends or expand operations. This would also require fairly detailed clarification of how excess return should be defined. The model would be contingent on a minimum requirement for active risk.
Model 3 differs from the current model in that the pre-agreed remuneration is a maximum price and that the Ministry of Finance would never pay more than the actual management costs. Norges Bank must bear the risk and must cover all costs in excess of the pre-agreed maximum remuneration. For this reason and to ensure that Norges Bank has room for manoeuvre in management, the maximum remuneration amount must be set in accordance with actual costs for similar management in the international market.
A clear advantage of this model is that it gives both Norges Bank as manager and the rest of the world a clear indication of the costs that are acceptable to the Ministry of Finance. The limit should be set on the basis of international studies of normal costs for similar investment management. This will reflect the Ministry of Finance's alternatives to purchasing management from Norges Bank and will ensure that it will in fact be possible to manage the Petroleum Fund in accordance with best international practice. If an upper limit for remuneration is set in this way, it will not be necessary for the Ministry of Finance to follow up in detail the cost components of Norges Bank's management. This will be in accordance with the management mandate that gives Norges Bank responsibility for managing the Petroleum Fund within the risk limits set by the Ministry of Finance.
Norges Bank recommends the selection of Model 3.
Separate coverage of performance-based fees to external managers must be included in the model. Norges Bank suggests that the management agreement includes a specific requirement about the formulation of the remuneration agreements and that the Ministry of Finance subsequently receives the agreements for the purpose of information.
The size of the performance-based fees cannot be predetermined and may be very large some years. This means that when such fees accrue, it will be impossible to fix a final remuneration amount before the closing of the central government's and Norges Bank's accounts. Therefore, an agreement must be made about how deviations between estimated and actual fees shall be handled. Norges Bank recommends that the remuneration for each year be corrected for the difference between the estimated and actual costs in the previous year.