The Euro is forcing Irish pension funds and other investors to reevaluate their strategies, says Claire Kearney of Montgomery Oppenheim
In Ireland, as in every other country across Europe, the single currency will bring with it far- reaching changes, not only to pension funds and the pensions industry, but also to capital markets and to the supply and demand for savings and investment vehicles. Unlike every other country in Europe however, Ireland occupies quite a unique position within the EU, epitomising the contrast between old and new, developed and developing, the core and the periphery and nowhere is this more apparent than in the savings and investment industry.
Although the Irish economy is small in a European context, accounting for less than 1.0% of GDP growth for the region, it is nevertheless a very vibrant economy and one which has achieved an average growth rate in excess of 7.0% over the past seven years.
A recent survey conducted by the Irish Association of Pension Funds estimates that the total value of Irish pension fund assets in 1997 was IR£25.7bn ($41.7 bn). This is roughly equivalent to 52.9 % of 1997 GDP and represents growth of 34% on a year earlier. This recent growth in pension fund assets is largely attributable to an average investment return of approximately 30% earned by Irish pension funds during this period, driven in no small part by the return of 50.46% achieved by the Irish stockmarket during 1997.
Despite Ireland's comparatively small share of Europe's GDP (See Fig 1) it can be seen that in terms of pension assets per capita, and perhaps contrary to popular opinion, Ireland is considerably more developed than some of its larger European counterparts in this respect, and would be a mid-ranking European on this measure.
In terms of the challenges that lie ahead, developing the ability to manage change is going to be the critical discipline for the new millennium. One of the most immediate consequences of the introduction of the euro is that the definition of 'domestic'assets in Irish pension fund portfolios will be re-drawn, and this will inevitably change the geography of Irish pension fund portfolios. Taking the Irish pension fund market as a whole shown on Fig 2, it can be seen that Irish assets accounted for 60.4% of the total, with Irish equities accounting for 26.6% of total assets, and Irish fixed interest assets accounting for 20.9% at year end 1997.
While comparable data for segregated portfolios is slightly different, the broad thrust is very similar. At the end of 1997 segregated Irish pension funds held approximately 55% of their total assets in Ireland, with roughly 27.7% in Irish equities, 15.2% in Irish government gilts and 12% in other assets including cash and property.
This weighting of portfolio assets to the domestic currency acknowledges pension funds' requirements to be able to meet ongoing, and potentially unexpected, liabilities in the domestic currency in question. The removal of existing ERM exchange rate risk with the creation of the single European currency, effectively brings 11 and potentially 15 countries into the definition of the home or 'domestic' currency (ie the currency in which future pension fund liabilities will be met).
This will have some important implications for Irish pension funds. Firstly, the definition of 'domestic' assets will increase significantly to include all the participating 'Euroland' countries. This could potentially rise to as high as 75% of total pension fund assets inside a decade. Secondly, while Irish pension funds may continue to hold substantial positions in Irish equities based on solid investment fundamentals, the imperative to do so at a portfolio level will undoubtedly be diminished.
The Irish equity market, with a capitalisation of IR£46.41bn at end June 1998, is small in an absolute sense within a European context representing just 0.7% of Europe's (inc UK) market capitalisation. However it a relatively well developed market when measured against other criteria. For example when one looks at equity market capitalisation as a percentage of GDP, Ireland emerges as a mid-ranking market with a score of 96.2%. At the upper end of this scale lies Switzerland with a score of 288% and then the UK with a score of 155%, while at the lower end of the scale lie Germany and France with scores of 41% and 42% respectively.
Another frequently voiced criticism against the Irish stockmarket is that it is a highly concentrated market, and certainly it is true that a small number of stocks have traditionally accounted for a significant proportion of the quoted equity. For example at 31 December 1997 10 companies accounted for 70.2% of the total market capitalisation of the ISEQ Index and at a sectoral level, the financials have been the dominant grouping in the index for many years. However it must also be acknowledged that the Irish market offers some top quality companies like the Banks, CRH, Smurfit and Kerry Group, which rate very favourably on any international comparison. Furthermore, the success and diversity of new companies which have come to the market in recent years, for example, Elan, Ryanair, Esat, Iona Technologies and Marlborough in recent years carries a very positive message for the market as a whole.
Another important issue for consideration is the impact that the changing architecture of bond markets will have on pension funds' holdings of gilts. Within the European bond markets shaped by convergence these opportunities will no longer exist as the transition to a low inflation low interest rate environment has been completed
It can be clearly seen from published data that the proportion of fixed income securities in Irish pension fund portfolios has begun to decline as yields have fallen to historic lows and pre-EMU cross currency risk has diminished over the last couple of years.
For portfolios with benchmark outperformance requirements for fixed income assets this will inevitably require new diversification opportunities, and against an economic backdrop of steady growth, low inflation and low interest rates the corporate bond market should be able to fill this need, replacing credit risk with currency risk in Irish and European pension portfolios.
However, this will begin to change with the single currency as European borrowers will be able access a unified capital market where both risks and costs are reduced. Ireland fits perfectly into this model having at present, a comparatively un-developed corporate bond market, and a growing number of corporates with ever ambitious funding requirements.
In the years ahead the investment focus will inevitably have to move to embrace a type of equity analysis which is capable of delivering in-depth sectoral and stock specific research, and putting this into a pan- European context for an Irish pension fund. This will place increasing significance on quality and level of effective European investment resources that individual fund managers can put in place.
In the interim, one of the most topical issues at present for Irish pension funds concerns the timing of the transition of the 'domestic' portfolio into fully representative 'domestic EU-weighted portfolio', and in the final analysis this must be a decision best taken by Irish pension funds on sound investment 'value criteria'. However it is clear that the first task for Irish pension funds will be to ensure that appropriate benchmarks are put in place, and that the funds investment objectives are both correctly defined and effectively evaluated.
Claire Kearney is director at Montgomery Oppenheim in Dublin