Too safe for own good
After Norway’s central bank cut interest rates dramatically last year, the country’s pension funds suddenly found themselves challenged to generate return. Their problems are compounded by a crushing weight of regulation.
Norway’s 150 or so pension funds, which managed around NOK115bn (E13.9bn) of pension assets at the end of last year, are being suffocated by excessive regulation.
If that wasn’t enough the very basis on which the asset allocation rests is questionable. “There is a fascinating dichotomy in the Norwegian market,” says Christian Fotland, partner at consultants Gabler & Partners. “We have a split between the asset values which are marked to market and liabilities which are fixed. The framework is split between a real view of things and an artificial view of things.
“Most that use asset and liability management (ALM) want to keep liabilities as a constant, and for these funds ALM is futile,” he continues. “Anyone can discount at a fixed rate. So what?”
Fotland remembers that when interest rates came down last year people said ‘look at all the money we are making with our bonds’. “But they didn’t see that their liabilities were increasing,” he says.
Fotland stresses that the benefits of ALM are very limited in a framework that uses fixed discounting rates for liabilities and hides away market volatility. “We are working hard to make sure ALM is part of regulatory regime,” he adds.
But it is not just the management of pension liabilities that is wanting in Norway. It seems that the assets side of the equation is also challenged by a pensions industry that is just too safe for its own good.
For example, the prevailing legislation stipulates that all pension funds must have at least 100% coverage of liabilities at all times. Any shortfall at any time must be covered immediately by the sponsoring company’s own capital. This makes resilience testing essential for all risk taking. “However, a proactive overfunding approach will typically be well in excess of what is implied from the resilience testing,” notes Pål Lillevold, consulting actuary at actuarial consultants Aktuarene.
So from a funding point of view how do Norwegian pension funds stand? Over the years funding has been high, but the level of coverage has come down a lot recently for a number of reasons, not least contribution holidays resulting from the good investment performance enjoyed before the recent stock market turmoil. Furthermore, legislation was introduced in 2001 which obliged funds return excessive funding to the sponsoring company.
According to Espen Kløw, partner at consultants Pensjon Finans, average funding stands at about 105% at present.
The scope for risk taking for those pension funds with little clearance above 100% coverage of liabilities is therefore limited. “This is the poor man’s trap,” says Lillevold, “which has become widespread over the past three years given the poor performance of the stock market. Many have been forced into this position.”
Lillevold adds: “The only way to be rich in the future is to start being rich now. So a good investment from the point of view of the sponsoring company is to increase the funding ratio substantially out of his own capital to put himself in a position to take a long term perspective.”
However, as Kløw notes: “The extra capital requirement to take market risk costs a lot and many sponsoring companies are not willing to do that.”
There is a further capital requirement which does not take into account individual preferences for taking risk. All pension funds are required by law to have a minimum level of solvency capital. This is calculated according to the same capital requirement rules as for banks, set by BIS (CAD-rules), as follows.
Each asset class is given a weight according to credit risk. Equities, real estate and corporate bonds (except those issued by financial institutions) have a weight of 100%. Bonds issued by companies in the financial sector and municipalities have a weight of 20%. Government bonds, by contrast, have a zero weight. The weighted balance is then multiplied by 8%, and this number is the minimum required capital (solvency capital) for the pension fund.
In addition to a general climate of risk aversion, the result of these diffrerentials in weightings, as Nils Andresen, financial analyst at Nordea Investment Management explains, is that “the market for Norwegian government bonds is characterised by huge demand and limited supply, which may lead to inefficient markets”.
Another important factor that has an impact on asset allocation strategies is the requirement to have a minimum interest rate guarantee, on an annual basis. “One might otherwise allow for fluctuations year by year with a view to achieving a higher rate overall in the long term,” says Lillevold. “For that reason, among others, Norwegian pension funds have tended not to have a very high proportion of equities in their portfolios: typically less than 20%.” The guarantee is 4% which is high by international standards particularly given that prevailing interest rates are well below that figure.
He adds: “The Kredittilsynet, (the Banking, Insurance and Securities Commission of Norway), also sees this as a problem so they have taken an active role to loosen up the regulations in that respect but the ministry of finance appears to be more reluctant to change the regulations.”
Kløw notes that the Kredittilsynet has made some interesting proposals to the Ministry of Finance to make asset management in pension funds more efficient. “They suggest allowing five-year contracts between companies and pension funds or life insurance companies,” he says. “This will …let the pension funds invest more in line with their actual long-term investment period. There has to be some kind of guarantees for the insured in a system like this. The Ministry of Finance has not yet given any positive feedback to this proposal.”
So how have funds been managing their assets, constrained as they are by the house rules of Norway’s state? It seems that many have had it easy for a while. “Until 2002 money market rates were at 7% so there was little incentive to take short-term risk,” notes Kløw. “From the end of 2002 the central bank started to decrease rates which reached 1.75% by the end of 2003. The reduction was very good for bond portfolios.”
Allocation has remained stable in spite of a very difficult market. Equity portfolios overall have been equally split between local and foreign markets. But in bonds and the money market it has been a very different picture: around 85% of bonds are Norwegian and money market placements are almost exclusively locally based. “Asset allocation will remain stable for the next few years until we get better regulations,” says Kløw.
Regulations stipulate a maximum share of equities of 35% in pension portfolios which includes a combined maximum share of private equity and hedge funds of 5%. Some more stitching for Norway’s pensions straightjacket.
Norwegian pension funds have become more international in their investment approach. The reason? Diversification. Norway is a very small capital market and because of that it is more volatile.
“Large players can have a big impact on the market through certain transactions,” says Lillevold. “Foreigners have accused the Norwegian market of being unprofessional in that bigger investors have been able to manipulate the development of certain equities.” He adds: “I agree with this to some extent.”
Norwegian pension funds have low exposure to foreign bonds. There are good reasons for this, as Kløw explains. “Firstly, almost all foreign bond investment is hedged back to Norwegian kroner. This makes sense since the foreign exchange volatility is high relative to bond volatility.”
“In addition the law requires funds to hedge foreign exposure above 20% of the pension funds portfolio,” he continues.
This portion is often used for foreign equities, given that the risk of the investment is diversified by the currency risk.
Kløw adds: “The foreign exchange hedged foreign bond investment gives more or less the same interest rate as the Norwegian and you save the additional effort in investing abroad.”
Kløw identifies a further restriction in that “Norwegian pension funds cannot easily exploit the main advantage of investing in foreign bonds: increased diversification in a much bigger investment grade bond market. This is due to the higher solvency ratio referred to earlier.
“As far as we know Norway is the only country that practises these rules for pension funds and life insurance companies,” he adds. “We very much hope these rules will be removed in the future.”
Kløw points to one of the main concerns of pension funds, namely the interest rate risk and the widespread fear of an increase in rates. “So pension funds are shortening rates from an average of three to an average of two years,” he says.
In terms of investment vehicles, mutual funds are used more than discretionary funds because most pension funds are relatively small. “It’s not economically feasible for them to set up their own portfolio,” says Kløw. “Only a few of the largest pension funds use discretionary funds.”
Real estate is still a very small part of the overall asset allocation picture. “One reason for this is that there are not many good products,” notes Kløw. “Institutions are relatively small so real estate funds need to be set up. Aberdeen is the first to set up a fund.”
On this subject Fotland notes that “the landlord mentality of buying a property and sit back and watch the money come in is growing among pension funds”.
So what of alternative investments? “Private equity is a problem for many Norwegian funds because they are too small to provide sufficient capital,” says Fotland.
He adds: “Certain large Norwegian companies would have pension funds very traditional not use pension money for risky investments even it there was a large tax incentive. They tend to look at famous losers in private equity and not at those who have made money.”
Kløw argues that alternative investments do have their uses today: “The dramatic fall in interest rates has made people much more willing to look to alternatives. But as people are not familiar with them they will not be significant for some years.”
Aktuarene’s Lillevold points to something more alarming regarding the attitude towards alternatives: “Some pension funds in Norway see alternative investments like a lottery ticket more than as a means to diversify risk,” he says. “They look at these assets in isolation. The issue of diversification is not sufficiently on the minds of Norwegian pension funds.”
So do trustees and boards lack sophistication? Lillevold points out that “things that you would expect to see in other markets, in-depth analysis, ALM studies for example, have not been very common in the Norwegian market”.
But he adds: “I would say that there is an absence of professional planning among pension funds, but not a lack of sophistication.” Just as much of a handicap nonetheless.
Kløw believes that the behavior of funds is driven less by lacking sophistication than heavy regulation. “We see the same asset allocation picture among different pension funds in Norway and some of them have big international companies behind them and have access to information,” he says. “They can take more market risk than average but still have to follow the same rules.”
But Fotland has less patience. “Finance here is so much geared towards borrowing rather than investment. Investment is not looked at as an academic exercise. The approach is very unsophisticated.”
He provides some historical insight: “Asset management here is in its infancy. Ten years ago there was no asset management in Norway other than some mutual funds.”
Lillevold believes that the EU pensions directive, which has to be implemented by September 2005, will address many of the issues relating to asset allocation and trustee expertise.
The directive does allow for some flexibility in terms of what individual countries implement, and Kløw is concerned that the Norwegian authorities will try to get away with implementing the minimum. “If they keep many of the current regulations the situation will not be sustainable because there will be a lot of cross-border activity and Norwegian institutions will not be competitive,” he says. “We hope that the committee will see that the current situation is not sustainable.”
In respect of the directive Rolf Skomsvold, general secretary of the Norwegian Pension Funds Association points out that "Norway follows the EU directives on finance and insurance since 1994 when the (economic) agreement between EFTA and EU came into force. It looks as if Norway follows EU-regulations more closely than any other EU country”.
This should go some way to reassuring the sceptics.
The Bank Law Commission, of which Skomsvold is a member, is working on the implementation. “We will implement the directive," he adds.
Another major future development, as Nordea’s Andresen notes, is that “significant changes in the accounting rules for pension funds will most likely result in mark to market valuation of the liabilities”.
He adds: “We believe this will increase the demand for long duration bonds, as pension funds to a greater degree will hedge against interest rate risk. Hedging interest rate risk will, in addition, increase the demand for derivatives. Mark to market valuation of assets and liabilities will most likely increase the demand for ALM studies because of a need for re-allocation and knowledge about the new risk factors.”
It seems that those responsible for regulating Norway’s pensions industry are slowly having to face up to the real world.