It is the proud boast of the Sparinstitutens Pensionkassa (SPK), the pension fund for Sweden’s savings banks, that it has never been underfunded since it was created in 1944.
The fund, a defined benefit scheme, has ridden out the recent storms in the equity markets, principally because of its conservative investment policy.
It has protected the liabilities side of its business with exemplary caution. From 1944 to 1990, SPK was invested entirely in fixed income. Today equities account for only 25% of its portfolio.
Yet it now faces a new challenge. When the provisions of the directive on institutions for occupational retirement provision (IORP), the European pensions directive, comes into force on 1 January, pensions liabilities valuation must be marked to market.
This requirement has arrived in tandem with the new ‘traffic light’ system introduced by the Swedish financial supervisory authority, the Finansinspektionen (FI).
This system , known as the Insurance Company Review, was set up in the wake of underfunding by pension insurers in the early part of the decade. It imposes stress tests designed to ensure the solvency of pension funds.
The combined effect of the IORP directive and the FI stress tests will be to compel the SPK to re-assess its entire investment policy.
Peter Hansson, chief executive of SPK says: “Up till now the strategy has been to cover liabilities with mostly fixed income investments and have the free capita part in equities But going forward from 1 January that’s a totally new ball game.” Hansson is used to such challenges. He joined SPK in 1993 and was responsible for implementing the fund’s decision in 1997 to diversify into equities, and to outsource most of the investment management of the fund.
“We don’t do much in-house, apart from a sort of transaction management ,” he says. “It could be up to SKr1bn (€106m) at times but that’s going in and out.”
SPK also introduced a system of appointing at least two managers for each mandate so that Hansson and his team could compare and contrast performances. “We tend to have managers in pairs. This means that if one goes in one direction and the other doesn’t, we can ask why.”
The fund currently uses eight managers, four domestic and four international, to manage its fixed income and equities portfolios. The four Swedish managers are FöreningsSparbanken Kapitalförvaltning, E Öhman, J Carlson Investment Management and Nordea Asset Management.
The international managers are JP Morgan Fleming Asset Management, and Scottish Widows Investment Partnership for European equities, and JP Morgan Investment Management and T Rowe Price for US equities.
SPK also invests in hedge funds through IndeCap, a Swedish fund of hedge fund manager. This had a performance of 9% with less than 2% volatility last year. SPK has discontinued its exposure to global hedge funds.
“We have an absolute return requirement on top of our strategy, and fund of hedge funds have been a really good thing,” says Hansson.
However, with the impending regulatory changes, the portfolio is now re-considering the management of the portfolio. “For the moment we have a static discount rate that is changed by the authorities on a yearly basis. At the year end there is going to be a liabilities valuation mark to market. So there’s going to be a different way of doing things.”
This could mean a change of approach by the SPK management team, he says. “Maybe we will have investment committee meetings where we might start off with the liabilities rather than the assets, and go from that end. That will be much harder.”
The change in approach will lead inevitably to a change in asset allocation. “We are going to re-do the asset allocation after the beginning of next year,” says Hansson. He does not expect to make any changes until the second quarter.
In some respects SPK will have more investment freedom with the IORP directive. “There is a widening of the investment scope and we will be able to cover the liabilities with many more instruments,” Hansson points out. In other respects, however, its freedom will be more limited. In particular, the traffic light system will force the SPK to invest in durations that are unsuited to its needs.
The current policy of SPK is to keep durations short. “We believe interest rates are going to rise. So for that reason we have a very low duration.
That is the tactical bet, apart from the strategic allocation,” says Hansson.
However, the regulator’s demand for liability matching will compel pension funds to invest in longdate bonds. “In this market environment we have very low interest rates. We shouldn’t be forced to go into 26-year bond duration. That is why we don’t like to go into duration matching.”
Currently the fund’s fixed income investments are principally Swedish government securities, either TBills or bonds. “We don’t distinguish between them.
There is a duration steering mechanism that decides how much you have in either of them. The remainer, between 6 to 8% of the fixed income portfolio, is invested in Swedish corporate bonds. Interest rate movements, together with increasing longevity, are a key concern. Hansson says: “Like every pension fund, SPK is sensitive to interest rate movements. A 1% move in interest rate adds SKr3bn to liabilities . With assets of SKR14.2bn and liabilities of SKr12bn , a SKr3bn swing is very severe.”
Hansson argues that SPK should be regarded as a special case by the regulators because its sponsors are the highly-rated savings banks, whose activities are already regulated by the FI. “What is unusual for the SPK is that we have an implicit guarantee on solvency. The only risk is credit risk. So in that sense we can’t go into an insolvency situation,” he says.
“If, for some reason, we are not able to have reserves being the net value of the future cash flows, we can send an invoice to our banks and they have to honour that.”
This has never happened, and Hansson hopes it never will. SPK’s current solvency ratio is 110, considerably above its peers. “SPK has never asked for any contributions. We have never been underfunded and we intend to remain in that situation,” he says.
Hansson says that the regulator should recognise the special nature of the fund and ease the risk management requirements. “ I’m looking for either that we shouldn’t be covered by the buffer for not matching the liability duration, or that we should be able to reduce the buffer requirement.”
In the meantime, SPK is adapting to the new requirements as the FI reveals them, he says. “We have done three independent analyses of what we can expect from the traffic light system. But we need to adapt all the time as the next steps become clear, and to take certain safety precautions.”
Hansson says SPK is faced with the alternatives of following the letter of the FI’s requirements in a new investment policy, or devising an overlay strategy, by which it can maintain its existing investment strategy while adhering to the FI’s requirements.
“We can go one of two ways. Either we can do optimisation, coping with the traffic light system, or we can do the financially sound thing and optimise the long-term interest of the pensioners. We can then add a second layer to our strategy in which we use derivatives or some other adjustment to enable us to cope with the traffic light system.”
The use of derivatives for liability matching would be a new departure for SPK. “We don’t currently use derivatives, apart from foreign exchange hedging. But I think it is going to be a new situation for all funds where they are more or less forced to use them.”
The new regulatory environment will mean that, in theory, all asset classes and investment strategies will be up for consideration. “We will see,” Hansson muses. “What is important is being open-minded to every asset class we might be able to use. The IORP directive is pretty much opening that capability up.”
However, Hansson draws the line at some asset classes, though he will not specify which. All he will say is that “there are definitely some asset classes that we won’t go into”.
He has ruled out currency overlay, in favour of currency hedging. “Is foreign exchange a new asset class that we can use for improved returns? When we looked at it last time we were not convinced.
“We did a study and saw that we were actually quite successful in foreign exchange. But that was sheer luck. So we said we aren’t smart enough to do that, so in 2001-2002 we reduced the risk by 100% hedge. That has really helped us, with the Swedish krona going up and down.”
Securities lending is also a long shot. “We haven’t used it and I don’t see why we should use it. But we have some pretty big positions in some companies, and selectively used, I wouldn’t rule it out in the future.”
More broadly, SPK is likely to move from relative to absolute returns, says Hansson. “There is no need for us to hug the index. For us the index is just a steering mechanism for asset managers. Relative returns don’t pay pensions.”
This could mean a change of managers. SPK takes particular pains over the management of its external managers, says Hansson, and turnover is low. “We don’t have any strict rules. We monitor returns on a daily basis, but look at them on a monthly basis. If managers are on the upper levels of the ranking, we let them alone. If they are on the lower levels then we require them to report to us on a frequent, usually weekly basis.
“We invest in the relationship with our managers. And doing so, we consider that they could be right or wrong. If they’re wrong , but they can present a structured reason for being where they are, then we continue to monitor them. If they are not able to explain why they made certain decisions and are unable make it clear to us that they are doing what they are supposed to be doing, then they could be out really fast.”
The aim, he says, is to have an interchange between the SPK team and the managers. “We want to do the numbers, but we want to do them in a structured way that can be controlled by us. So we are feeding numbers relating to managers’ performance figures and key ratios into a system internally, in an independent way apart from the managers.
“Normally we tend to show our numbers to the managers during quarterly meetings where we will ask them why this and that happened.”
SPK’s re-appraisal of its asset allocation will not mean that it takes on higher levels of risk, Hansson says. “Our success story on funding has been as a result of being cautious, and we still have a long-term devotion to caution.”
This caution has paid off. Over the past five years, SPK has outperformed the life companies that comprise its peer group, and this year it has so far returned a yield to date of 5.78% and rolling 12 months return of 8.81% on its investments.
Hansson is not going to spoil this record with forays into fashionable asset classes. “We are not going to be front runners in finding new asset classes. We are conservative in that sense. We are not fancy players who will venture more into fancy asset classes. We are here to pay pensions.”
This pragmatic approach extends to areas of investment such as socially responsible investment (SRI).
Two years ago SPK issued a mandate to Scottish Widows Investment Partnership to run a pan-European equities mandate with an SRI overlay.
It has chosen to invest in the SRI version for the time being, but has an arrangement whereby it can switch to a non-SRI pan-European mandate when it sees fit.
Hansson says that the SRI mandate stands or fall on results. “If we like the investment process of a manager and they have two different versions of their product and one is an SRI or ethical version then of course we would choose the ethical. But SRI has to be a bonus on the top, not the other way round. If the returns are not good enough, we are 100% agreed – the pensions have to be paid first.”