THE National Council for the Social Security Fund, with 1 trillion yuan (US$157.7 billion) under management, will have its first trial run with local pension assets.

Since the end of 2011, news reports and announcements about imminent changes to China's pension system have been released in rapid-fire succession. Bang! Pension funds' investment options will expand beyond bank deposits and treasury bonds. Boom! Council Chairman Dai Xianglong reviews plans to consolidate local pension funds. Bam! Government officials are in the process of establishing an independent investment arm to manage pension assets. And finally, Kaa-bang! The National Council for the Social Security Fund will receive a 100 billion yuan mandate from Guangdong's local pension fund.

That latest news clip has turned many heads. However, in reality, the development of China's pension system remains frustratingly slow, and events should be thought of as tentative trial efforts.

Pension ammunition

The social security fund on March 19 signed an agreement with the Guangdong provincial government to run the pensions for at least two years. Chances are the council is going to need help managing those assets down the line.

Whether or not it gives out mandates will depend on its investment strategy: to be, or not to be, aggressive. In the short-term, at least, we believe the fund will take the less risky route, investing over 65 percent of the cash in fixed-income products due to the watchful eye of the State Council and the Ministry of Human Resources and Social Security.

The fund possesses the necessary expertise and capacity to carry out fixed-income investments on its own. Usually, it allocates approximately 50 percent of its assets to fixed-income products, with about 15 percent allocated to equities and about 25 percent allocated to industrial investment.

This may not be the case for long, as the fund targets more equity products and even private equity. The latter has become especially tantalizing because it provided the lion's share of fund investment returns in 2011, accounting for about 70 percent, according to Chairman Dai. At present, with only five people managing the fund's private-equity investments, handing out mandates becomes likely.

Prudent approach

However, we don't expect the fund to be firing local pension assets at unlisted companies anytime soon. Relative to equity or fixed income, private-equity investments require a longer time commitment and may not match the need of local pension funds to meet liability payments.

Recently, both investors and asset managers have been extremely wary of the volatility in domestic stock markets. The social security fund is not expected to risk an aggressive investment strategy there for the time being. However, with the fund likely to receive mandates from other well-endowed provinces, such as Jiangsu and Zhejiang, there will be pressure to outsource a greater portion of asset management.

If and when the fund decides to hand out mandates, competition is going to be fierce among brokerages, insurers and asset management companies. While joint ventures may hold the edge for any offshore investment opportunities, it's unlikely there will be many because all pension liabilities are denominated in renminbi.

We recommend all of the aspiring candidates read between the lines of breaking news and come prepared.

First, candidates will need to demonstrate outstanding investment performance results. The fund will probably favor firms with strong specialization in equity or fixed-income investments. Previous experience working with enterprise annuities or the fund itself will be huge pluses.

Second, it's important to make sure that key decision makers know who you are and what you are good at. Establishing ties with relevant government officials and influential social security fund staff will go a long way when applying for a mandate.

Third, when managing China's pension assets, guaranteeing a minimum return or providing a compensation mechanism in case of losses is common practice. The social security fund guarantees a minimum return on all assets it manages. For instance, it guarantees 3.5 percent return on all individual pension accounts.

Finally, firms should do their homework on the risk appetite and liabilities of the provinces that outsource their pension funds. Understanding their balance sheets, net pension flows and growth will help the development of suitable investment strategies.

Demographics and deficits

Deficits and a rapidly aging population are putting pressure on China's public pension system as a whole. The fragmented nature of public pensions has deterred many migrant workers from contributing. Local government bureaus are holding on to their pension assets fiercely. Most have multitudes of liabilities to pay off. Regulators are scrambling to find ways to ensure that there will be enough money in pension accounts when today's millions of productive young workers hang up their hats and expect retirement income.

According to the government's 2011 China Pension Report, total individual pension accounts should add up to 2 trillion yuan.

However, in reality, there is approximately only 200 billion - funded by only 13 provinces. Fourteen provinces were reported to have payment imbalances in 2010. Accumulated pension funds meant for future generations are being siphoned off in order to pay current retirees.

A changing field

Government officials have repeatedly announced the imminent establishment of an independent pension investment arm. Officials have dragged their feet on it for over a year, but the likelihood of this entity being created sometime this year is quite high. We expect the new investment arm to both manage assets itself and hand out mandates to fund management companies and other asset managers. Many local governments are likely to entrust their funds to this new entity in the form of segregated accounts.

The trajectory of the pension system remains opaque. Implementing plans such as the centralization of pension funds or increasing participation throughout the country faces significant obstacles.

Furthermore, if an initiative or trial program - such as the recent push for more private equity investment - blows up, don't be surprised if liberalization policies get yanked back quickly.

David Willis is an associate with Z-Ben Advisors. Lillian Zhu is a senior analyst with Z-Ben Advisors. Z-Ben Advisors is a Shanghai-based consulting firm with core analytical interest in exploring opportunities available to foreign asset management.