Nina Röhrbein spoke with Gediminas Milieska of SEB’s Lithuanian pension funds, who explains how his firm uses three types of open-ended funds to generate alpha

The nationalisation of the mandatory second pillar in Hungary in 2011 has left a question mark hanging over the future of such pension funds in Central and Eastern Europe (CEE), as governments in the region use contributions to the funds to plug their social security deficit.

Although nationalisation is not much of a threat to pension funds in Lithuania for now, second pillar pension funds remain a delicate issue.

When the new pension system was founded eight years ago, the Lithuanian government gradually increased contributions to second pillar pension funds from 2.5% in 2004 to 5.5% in 2007. However, like in other CEE countries, the financial crisis and global recession led to a deficit in social security contributions and the government consequently abandoned the 5.5% contributions. After several consecutive cuts, the contribution rate to private pension funds was reduced to 2%. For 2012, a contribution rate of just 1.5% is planned but this should rise again to 2.5% in 2013. The levels for the years beyond that have yet to be decided.

Participation in Lithuania’s second pillar pension funds is semi-voluntary - in other words, members do not need to be part of it but once they join a fund, they cannot withdraw the contributions they have made.

“Since 2003, the vast majority of employees - around four-fifths of the total workforce - have joined second-pillar pension funds,” says Gediminas Milieska, CEO of SEB Wealth Management, the Lithuanian subsidiary of Swedish financial group SEB, in Vilnius. “However, the government’s cuts to contributions have left Lithuanians in doubt about the second pillar, which is why newcomers are more hesitant to join a second-pillar pension scheme now, than they were five or seven years ago.”

Several discussions about the future of the pension system are currently taking place.
One of the suggestions made by the government is a ‘2+2+2’ system. Under this arrangement, the government would contribute two percentage points of the social security tax, and if participants pay in another two percentage points from their gross salary, then the government would match that contribution by a further two percentage points, according to the country’s average gross salary.

“This suggests that the government would like to share the accumulation of pensions in the future and move the system forward,” says Milieska. “However, the risk of a ‘2+2+2’ system is that it may not attract enough participation and a default 2% will not be enough to obtain a reasonable pension.”

Some other changes, led by the World Bank, are set to take place in Lithuania’s pension market, too.

“During the financial crisis, a small number of people decided to switch funds at the worst time they possibly could, in other words, they changed their risk profile from aggressive to conservative when the market was at rock bottom, just ahead of its recovery,” says Milieska. “This has led to discussions about whether pension fund members should have a glide path in their chosen fund, which gradually changes risk levels, rebalances the portfolio and moves them to a lower risk allocation, as retirement comes closer. This has yet to be decided but the proposal is to do this once a year, maybe on the birthday of the member, to avoid the market anticipating the changes on the same day. But the project is still in a preliminary phase.”

Based on the experience of SEB - which has 256,000 clients, around 24% of the market share in Lithuania’s second pillar, and 11,400 clients, equal to 50% of the market share, in the country’s third pillar -in the absence of a default, fund members tend to stay with their initial fund selection throughout.

At present, members can submit an application to change their individual pension fund at any time. In practice, though, the investments are frozen in their current specific investment line for two weeks of every month to allow social security to transfer the money into the pension fund.

Managers of second pillar pension schemes in Lithuania are required to offer at least one conservative investment fund. Market demand determines how many additional aggressive or balanced funds the manager wants to offer.

SEB has opted for three open-ended funds, one with a conservative investment line (Pensija 1), one with a balanced investment line (Pensija 2 - which has the majority of members) and one with an aggressive investment line (Pensija 3).

As a relative manager, SEB sets the pension funds alpha targets to beat the benchmarks, which are limited by tracking error. It aims for a value of information ratio, which is alpha divided by tracking error, of 0.4.

That alpha target is achieved through two major processes - traditional asset allocation, including tactical asset allocation, and the selection of instruments.

“We simply look for uncorrelated alpha when selecting instruments,” says Milieska. “We want to have a combination of instruments, which reduces the volatility but generates the same return. Those two are the driving forces behind our investment strategy.”

To generate uncorrelated alpha, the pension funds have certain criteria in their investment strategy: alpha sources must be based on profound processes; a considerable amount of alpha is to be produced in the long term; alpha sources should be different and uncorrelated with other alpha sources in the portfolio; and if the profound processes cannot be generated in-house, third-party processes may be incorporated.

Tactical asset allocation, one of the main sources of alpha, is based on a model incorporating three different layers and time horizons: structural, covering 10-20 years; strategic, covering one to two years; and tactical, covering three to six months. The fund selection involves detailed fund research based on investment philosophy and sustainability.

Another source of alpha are fixed income duration and curve bet overlays.

All three pension funds have composite benchmarks with certain deviation bands because SEB wanted to refine the benchmarks to ensure that they are used to calculate pure alpha. The benchmarks change every one to three years, depending on the long-term view taken.

Dedicated teams select different asset classes and instruments in different regions but the pension funds only invest in government bonds directly - all other asset classes are accessed through funds.

The entire exposure of SEB Pensija 1, the conservative fund, consists of fixed income. The major decision taken with regard to this pension fund is how much is allocated to euro-zone and local government bonds. At present, 63% of Pensija 1 is allocated to euro-zone government bonds and 37% to Lithuanian government bonds, although the average for local government bonds in the fund stands at 25%.

“After a difficult year in 2008, we decided there was too much risk in our portfolios, which is why we completely redesigned our investment process and positioned ourselves conservatively, meaning that we were sceptical on several countries, such as Greece and Italy and did not hold any southern European bonds,” says Milieska. “In fact, we do not hold any bonds below investment grade anymore.”

The balanced fund Pensija 2 has an equity allocation of between 20-60% and a direct fixed income allocation ranging from 40% to 80%, which includes corporate bonds and emerging market debt in addition to government bonds. It can also invest up to 8% in alternative asset classes such as commodities and hedge funds.

The equity exposure is global with half of the assets invested in emerging markets.
“To maintain the purchasing power of our members in retirement we decided to have a high exposure to emerging markets,” says Milieska. “This includes a higher strategic benchmark weighting to CEE in order to reflect convergence to the region and its living standards.”

The aggressive portfolio, Pensija 3, invests between 60-100% in equities although the neutral benchmark level for equities stands at 76%. The remainder is allocated to various forms of fixed income such as government and corporate bonds, high yield and emerging market debt. Similarly to Pensija 2, since 2008, it has also held commodities and hedge funds, which can make up to 16% of the portfolio.

The pension funds undergo at least monthly revaluations of their current positioning. Depending on the market, their portfolios are rebalanced. A thorough review of the strategic asset allocation is undertaken at least every three years.

All asset classes are managed internally with the work divided between different multi-management teams situated in Sweden, Estonia, Latvia and Lithuania. The pension funds also make use of some of SEB’s centralised teams - however, the final decision always remains with the fund manager.

“It is about using the available resources from the organisation but making the decisions here locally,” says Milieska.