Terms of Reference of a Committee appointed to assess the equity portion of the Government Pension Fund Global

The Government Pension Fund Global (GPFG) is an important and integral part of the fiscal policy framework. The Government Pension Fund act stipulates that net government revenues from petroleum activities shall be transferred to the GPFG. An amount is transferred back to the fiscal budget annually pursuant to a resolution passed by the Storting, to cover the non-oil budget deficit.

The Ministry of Finance has established an investment strategy for the GPFG with an emphasis on long-term expected risk and return considerations. The investment strategy has been developed over time on the basis of thorough assessments and analyses. It is an established practice that any significant changes to the management of the Fund shall be submitted to Parliament. This facilitates sound long-term management of the Fund, thus enabling the petroleum wealth to benefit both current and future generations. The choice of the equity portion in the GPFG’s benchmark index is the most important decision in terms of expected risk and return for the Fund.

Some key developments:

• Equities were included in the benchmark index for the GPFG in 1998 with an initial portion of the benchmark index of 40 percent. In 2007, a decision was made to increase the equity portion to 60 percent. Bonds and real estate account for the remaining 40 percent. The real estate investments are currently being built up, and may represent up to 5 percent of the Fund’s capital. The fixed-income portion is reduced correspondingly as and when the real estate portion is increased. The Ministry of Finance is currently considering whether to increase the 5-percent cap on real estate investments as well as whether to permit the Fund to be invested in unlisted infrastructure. The Ministry intends to address this in the report on the Government Pension Fund to be submitted to Parliament in the spring of 2016.
• Market fluctuations will cause the equity portion of the Fund’s actual benchmark index to deviate from the stipulated 60-percent weighting. In order to ensure that the risk of the Fund over time does not differ significantly from that implied by the choice of equity portion, rebalancing is carried out if the equity portion of the actual benchmark index deviates by more than +/- 4 percentage points from the stipulated weighting of 60 percent. The rebalancing rule has a certain countercyclical aspect to it. The Fund will acquire additional equities when equity prices have declined in relative terms, and reduce its equity holdings when equity prices have increased steeply.
• The GPFG has increased considerably in value since the first capital contribution in 1996. The market value of its investments was NOK 7,019 billion as of end September 2015. This is equivalent to more than two and a half times the GDP of the mainland economy. Also, the GPFG has become an important source of funding for government expenditure. In 2016, about 1 of every 8 Norwegian kroner of public sector expenditure will be funded from the GPFG. The larger size of the Fund has also resulted in a significant increase in the value of the Fund’s fluctuations, as measured in Norwegian kroner. Given the market value of the Fund at the end of September 2015, the expected annual fluctuations in its value are estimated at almost NOK 700 billion.
• The investment strategy of the GPFG is largely based on the expectation that over time, investors will be compensated for the long-term risk of equities being higher than that of bonds, through a higher expected return (equity premium).

Bond yields are currently very low, also for bonds with a long time to maturity. This results in a low expected real return on the Fund’s fixed-income portfolio in the short and medium term. Low interest rates also affect expected equity returns, but the relationship between the interest rate level and expected equity returns is uncertain. Historically, bonds have served to reduce fluctuations in the value of the GPFG. The scope for further bond price gains is now limited by the low bond yield level, whilst the scope for price losses in the event of increasing bond yields are considerable.

The Committee shall analyse expected risk and return in the Fund for different equity portions, and may recommend changes to the equity portion. In assessing the equity portion, the Committee shall, inter alia, consider the Fund’s objective, time horizon and size, as well as expected outflows from the Fund.

Furthermore, the Committee shall assess whether a change in the equity portion should have any implications for other main aspects of the investment strategy, such as the composition of the equity and fixed-income benchmarks, including the amount of credit risk in the fixed-income benchmark, the rule for rebalancing of the equity portion and liquidity requirements of securities included in the benchmark index.

The Committee shall base its assessment on the premise that the GPFG is a savings fund, seeking to maximize its international purchasing power over time. Furthermore, the Committee shall assume that the current framework for fiscal policy is maintained. The estimates in the National Budget for 2016 show that ongoing cash flows from petroleum activities will for many years going forward serve as a buffer enabling the State to fund the non-oil budget deficit without net annual outflows from the GPFG  expected to exceed annual expected Fund returns.

The Committee shall also assume the asset allocation to other asset classes than equities and bonds in the Ministry of Finance’s mandate for the management of the GPFG. The Committee shall take the ongoing assessment of real estate and infrastructure investments, cf. the above discussion, into consideration. The Committee shall not evaluate Norges Bank’s management of the GPFG or the scope for deviations from the benchmark index. The assessments of the Committee shall be based on realistic assumptions and recognised research.

The Committee is requested to submit its report by 15 October 2016.