A warning against herd mentality
German pension funds display a typical herd mentality, according to Helmut Konir, director, Russell Investment Group, and responsible for the German market. "Pension funds tend to group together in terms of asset allocation, and hide behind average returns," he says. "The thinking is, why should you stand up and be different if there is a risk that is not going to work? After several years of excellent performance by the German mutual fund market, there are still net outflows of equity. That says it all about the attitude to equity investing."
Fixed income makes up around 70-80% of many pension funds. This dependence on bonds is explained partly by the regulatory framework, with a 35% limit on the equity portion of the portfolio for insurance type Pensionskassen, but also, according to Konir, by cultural factors.
"It is partly a lack of financial knowledge and education of the people on the board of trustees, or running the pension fund," he says. "For instance, a doctors' pension fund will have some doctors on the board. And German pension funds have never seen publications like the Myners Report, which would help."
Konir warns: "Those guys have been very lucky because, apart from the past couple of years, interest rates have been coming down. Looking forward, however, we will be seeing lower yields on the bond side."
Herwig Kinzler, head of investment consulting Germany, Mercer Investment Consulting, says that, in contrast, the portfolios of unregulated funds, such as contractual trust arrangements (CTAs), vary from having nothing to 70% in equities, with the average around 30% in equities.
As for regulated pension funds, however, Kinzler agrees the situation is different.
"For those pension funds, risk budgets are limited, so equity exposure has decreased over the past year or two," he says. "But overall, we see a trend for diversification within bonds and equities, adding global equities and credits or high yield bonds via separate mandates, and/or giving more freedom to existing managers."
Dr Torsten Koepke, head of investment consulting, Watson Wyatt, Germany, says: "For the past few years, many German pension funds have mainly been investing in things like government bonds and European equities. But that's starting to change."
He says: "The smaller pension funds still tend to be quite conservative compared with other countries. The change we see is for the larger companies, particularly the DAX30 companies or US or UK-owned companies. Most of these have CTAs in place, so they outsource corporate pensions and related assets, and that means they are able to invest more in their governance budget and have more return-seeking asset management."
Michael Schuetze, head of investment advisory, pension markets at Allianz Global Investors, says changes are taking place in terms of the appetite for alternative investments.
He says: "Most corporate pension funds were created in the past five or six years, and set up conservatively, so they invest in equities and bonds. But everybody is now starting to develop the structure further. So alternatives, absolute return-type investments and real estate are coming into view. Over the coming years, the asset allocation will shift away from traditional asset classes into a wider spread."
Schuetze says that, under the alternatives banner, private equity is preferred over hedge funds by German pension funds, as it is a long-term investment.
"Furthermore, corporates think of private equity as real investments," he says. "Corporate treasurers understand how to invest in other corporates, so they understand the underlying issues, risks and rewards, even though they invest via private equity funds. In contrast, hedge funds are perceived to lack transparency.
"They also invest in real estate - European or global, rather than German. They are attracted by the prospect of stable cash flows, and using funds or REITs enables them to use a portfolio approach."
"The appetite for alternative investments is increasing, mainly driven by non-regulated investors [CTAs] and bigger pension funds," agrees Kinzler.
He also says that the main differences in investing between the larger and the smaller German funds are that larger funds are typically more diversified, and also have the resources for investing in new products.
"However, it is not always a question of size, it is sometimes also a question of
openess to new products," he says.
There is, however, another influence on asset allocation, and that is liability-driven investing (LDI).
Nikolaus Schmidt-Narischkin, head of pension solutions, Deutsche Asset Management, says: "With German corporate pension schemes, about 50% (€250bn) of all claims are direct pension promises, most being fairly traditional DB schemes. Only about 40% of those claims are funded, due to the fact that corporate pensions in Germany have traditionally been funded on balance through building accruals or pension provisions. The move towards off-balance funding via the US equivalent of a trust (CTA) or Pensionsfonds has only been going on for the past five or six years, and is mainly motivated by German corporates switching towards IFRS accounting standards."
Schmidt-Narischkin says that with the German DAX30 companies, for instance, German pension assets allocated to equities are roughly 30%. This is somewhat less than comparable corporates in the US, the UK or the Netherlands, although equity quotas within the DAX vary from company to company.
"There is as yet no clear overall trend with regard to shifts between the asset classes within the last year or two," says Schmidt-Narischkin. "Some of the larger companies have lessened their equity exposure considerably during that time, shifting away from a balanced to a liability-driven investment strategy. LDI generally implies removing unrewarded risks like interest rate and inflation risks. Typical partial LDI hedges usually leading to a reduced equity exposure, interest rate and inflation swaps, total return swaps…equity and credit spread protection strategies. [They also mean] a closer matching of liabilities, by either cash flow matching or extending the duration of assets; and diversification of the remaining risky portfolio [with] equities being diversified into alternative assets such as foreign exchange, commodities and hedge funds."
Meanwhile, there is a shift towards the use of pooled funds.
"Historically, pension funds tend to use segregated mandates," says Schuetze. "However, over the past two or three years, they have started to invest more in pooled funds, to achieve diversification. It's also easier and cheaper: if a pension fund wants to invest €20m in, say, US high yield bonds, it is easier to do so via a pooled vehicle rather than set up a separate account."
But Koepke sees a different reason for the growing popularity of pooled vehicles.
"Over a third of invested money is in mutual funds," he says, "And the reason is accounting standards, namely IFRS. As a result, you cannot have more than a 20% share of an individual investment. Most of the time it is difficult to find four other investors to co-invest. So pension funds invest in mutual funds. That means probably a worse performance, and higher costs, as the mutual fund structure is tailored towards the public, not you. Everything is worse, but the accounting is easier."
As for how things will develop over the next few years, Konir at least is fairly sceptical.
He says: "In future, we don't see a big change. Equity prices will rise, leading to more equity investing, but far below what should have been done in the past."