Fighting shy of equities
In Norway there are 130 private pension funds and 23 municipality pension funds managing about NOK90bn (e11.8bn) of assets, where the 90/10-rule applies – 90% of the asses are managed by 10% of the pension funds. Statoil and Norsk Hydro have the biggest pension funds, with about NOK13bn each under management each, since Oslo Kommunale Pensjonskasse (with NOK22bn under managementhas) has been converted into a life insurance company. In comparison the eight life insurance companies manage about NOK495bn of assets, of which about 50% relates to occupational pension schemes.
The Norwegian pension funds have historically been bond investors. This is due to tradition as well as strict government regulation. Pension funds are regulated under the same general rules as Norwegian financial institutions (life insurance companies and banks). The regulatory regime influences the pension funds’ investments in three areas:
q through direct allocation ceilings (a maximum 35% equity investments and 20% foreign exchange exposure of technical reserves);
q through reserve requirements (corresponding to the Bank for International Settlements equity requirement for banks – 8% of risk-weighted total assets. Higher equity investment implies higher reserve requirements);
q through prudential rules for the board linked to risk testing of the investments according to a standard risk scenario. (The Banking, Insurance and Securities Commission of Norway has specified a stress testing scenario which states a 30% fall in value for domestic stocks, 20% fall in value of international stocks and a 2% parallel interest rate increase domestic and abroad. All these events are to take place at the same time. Prudent investing is to keep the investment risk within the limits of the booked excess reserves to be able to cover a financial shock caused by the above scenario.)
According to our models, the probability of the stress test scenario is less than 1%. The effects of such rules are that the pension funds have to restrict their investments in expected high return asset classes, such as equity, to meet the standard and/or the sponsors have to accelerate their payments into the pension funds to allow them to build excess reserves to meet the prudence rules. Before 1992 pension funds could allocate a maximum 12% to equities, which was then increased to 20%. In 1998 the equity investment ceiling was lifted to the current maximum of 35%. In 1995 the pension funds were allowed to invest unhedged up to 20% of total funds internationally, which is the current maximum.
We have developed a peer group index for pension funds (P&F-index) in Norway. About 75% of the Norwegian pension funds, according to assets under management, report through the internet their quarterly performance and allocation figures.
The aggregate numbers reported to us in 2001 show that the trend in pension fund asset allocation towards higher equity investments is about to stagnate or be reversed. Equity allocations have been reduced from 25% to 20% in 12 months. This is quite a large change considering the low level of equity exposure in the first place. It seems that the pension funds have not dared to keep up the higher equity position they had in the middle of the year, but had allowed the decrease in market prices to reduce the allocation to about 20% by the end of the year.
The Norwegian pension funds began increasing their equity exposure gradually in the 1990s due to the regulatory changes and good returns. In 1999 this process made a huge step and the equity allocation jumped from 22% to 31% in a single year. The market effect over the past two years seems to have reversed this trend and the current equity allocation figures are back at the 1997 level (see figure 2). The strong promotion of foreign bonds seems not to have had any effect on as the average allocation to foreign bonds was reduced by three percentage points.
In 2001 the total return of Norwegian pension funds was 1.7 %. This compares well to a market benchmark portfolio of 1.4% and the arithmetic average of the Norwegian life insurance companies of 0.6%. The low equity and foreign assets exposure enhanced the Norwegian pension funds’ performance for that year. Figure 3 shows the returns in various asset classes and the dispersion around the median. The differences in performance among the various asset classes are quite large. We assume this is due to active management and small portfolios containing few instruments and therefore picking up a great deal of unsystematic risk and tracking error.
In the current year we expect no big changes to take place. Quite a few pension funds are preparing proposals to their sponsor to increase employers’ contributions and at the same time make some adjustments to their investment strategy towards more diversification and replacement of some investment managers.
Caspar Holter is a partner with Pensjon & Finans in Oslo