Coping with era of low returns
IPE asked three pension funds in three countries – in Finland, Ireland and Slovenia – the same question: ‘How are you meeting the challenge of what looks like a more-than-temporary low in long-term interest rates?’ Here are their answers:
Jari Eskelinen is head of fixed income at Ilmarinen, Finland’s second-largest pension insurance company, which has AUM of e18bn.
“Our system differs somewhat from that in the Anglo-Saxon countries in that we don’t match the liabilities in the same sense as they do. Basically, we have modified long-term target returns. Of course, if the rates stayed extremely low it would make it difficult to reach that target. But we have a balanced portfolio, in which fixed income is only something like 45%, so I don’t see that as a major threat to our operations.
“Also, that situation would be a problem if we saw all the other classes give us unusually low returns. But a low interest rate environment is not a problem as long as we get a risk premium on equities or any other riskier assets.
“So, we haven’t really made any changes in our portfolio in response to low interest rates. However, over the past four years we have been gradually increasing our credit risk and going down the credit curve. This was because we wanted to add new sources of risk and return to our fixed income portfolio. We believe, over time, the returns from a portfolio that includes high-yield and emerging markets are going to be better than from a portfolio without these asset classes.
“And that will help us, again over time, to reach our return targets, without increasing volatility too much. So we will continue this process.
“So while there are some scenarios where things might be difficult for us, I don’t see that as a major threat. The only thing that might cause a rethink of our strategy in fixed income would be if credit spreads went even lower than they are now.
“But while that would probably create some changes in our portfolio, they would be of a more tactical nature; with our longer-term target we would still have more of the higher-yielding assets.
“Nevertheless, if high liquidity stayed in the market for a long time it would change the additional income in every market. In the longer term that would probably bring down the risk premiums in all markets.
“We have already seen that happen in some areas, especially in the credit market, and while that might be advantageous for a short while, it would create difficulties for pension funds like us in the long term because to carry the risk we need to get something out of it, and if the risk premiums are getting very small that would make life more difficult.
“Another explanation for the low long rate and the structural demand from the pensions side might be that markets believe that central banks are on top of inflation so they don’t have to worry about long-term inflation. If that’s the case we could expect our liabilities not to increase as rapidly as before when inflation was higher. And that would balance the situation too.”
Patrick Ferguson is administrator at the Dublin-based Construction Federation Operatives Pension Scheme which at end-February had AUM of e570m.
“This doesn’t affect the fund too adversely. Certainly bonds appear to be doing weird things at the moment – we were anticipating that with the expected increase in interest rates the value of bonds should be starting to fall with a corresponding increase in yields. While yields continue to fall, we feel that this is an artificial situation that will rectify itself in the longer term. We are using our bondholding to match our long-term liabilities and like other institutional investors the fund is trying to invest over the long term but being called to account for the fund solvency over the short term.
“Last November the scheme switched from balanced to specialist mandates. We appointed Crédit Agricole as a specialist bond manager to sweat bonds as much as they could so that they will meet our long-term pensioner liabilities. Since then we have been going through a transition process, having appointed Merrill Lynch as transition manager to move funds between various fund managers This transition of funds was only completed towards the end of February 2005, so it’s very early days for the scheme to judge the result of the changes.
“However, we will view developments on an on-going basis to see how bonds are performing. We hope that the specialised mandate will get a little above the return on bonds in a balanced mandate; we would expect the bond portfolio to outperform the index by about 50 bps.
“Previously we had two balanced mandates where each of our fund managers had discretion as to how much they put in fixed interest, equities or property. But we were unhappy with the asset allocation during the post-2001 downturn. Our fund was holding a significantly higher level of equities than the scheme’s board of trustees were comfortable with, which obviously effected the fund returns during that period, though the fund never fell below 100% solvency.
“So we decided on the change. In a balanced mandate fixed interest tends to be the poor relation of equities, with fund managers tending to focus on equities and fixed interest being something you just hold because every other find manager holds a certain amount of fixed interest to match their clients’ long-term pension liabilities.
“But we have gone into three specialist mandates – fixed interest, consensus equity and active equity – and the percentage of assets in each is decided on advice from the scheme’s investment advisers.
“Depending on how the assert classes are performing we will decide what’s invested in each by directing our significant premium income of between e70m to e100m a year into the relevant asset class.
“Currently, we have approximately 55% of the portfolio in equities – that’s 30% in the active mandate and 25% in the passive mandate – while on the bond side we have 30%, leaving us about 15% in direct-held property. Before the scheme changes its investment strategy our holding in bonds would have been as low as 16% of the overall fund.”
Igor Stepancic is acting CIO of Ljubljana-based open mutual pension fund Generali Zavarovalnica Pension Fund which has AUM of less than e10m.
“Luckily, a year ago when the inflation rate was still high in Slovenia, we took longer positions. So bonds we bought then are doing pretty well. But we buy and hold, we are not like daily traders, and now we are struggling to buy into adequate assets.
“These are mainly bonds because we have more than 85% invested in bonds. This is normal for Slovenian pension funds, which may have up to 90% of their portfolio in fixed income.
“We are buying the same proportion of bonds as we did before but it is harder, the yields are lower. So in the last year we also increased our equity positions slightly, lifting our equity holdings to 8%, from 4%, although under pension fund regulations we could go up to 30%.
“This is mainly to ensure that we meet the finance ministry-mandated benchmark, which is measured on a monthly or a quarterly basis and to which we are required to perform, which puts us under an element of stress.We buy mostly state bonds, which account for some 65% to 70% of our portfolio, and the insurance law that governs investment policy demands that they have to be issued by EU countries. Then we have 10% to 15% in bank and corporate bonds. We have no exotic paper in the portfolio. In addition to regulatory constraints we are part of the Generali group so we also have monitoring and various financial committees to which we report.
“So the strategy we have adopted to overcome the interest rate problem is to buy a lot from private placements so we get better prices. But currently we are not actually increasing the duration. We increased it substantially during the last two-and-a-half years but have not done so for the past four-to-five months.
“And while we are aware of the long-term interest rate problem it is just one of our concerns, with the finance ministry-prescribed benchmark that we have to meet being another worry for us. Fortunately, the benchmark formula was changed last June. Previously we had to be above the benchmark of the yield over two years, with a certain weighting of Republic of Slovenia bonds with a duration or more than one year. If not, as the manager of the fund we had to pay into the fund the difference between what we achieved and the benchmark, so if the benchmark was 7% and we achieved 6% we would have to pay 1%.
“But the yield was based on that at the finance ministry auction and so it had nothing to do with the real market. However, it was a static, not a dynamic, module, and the ministry responded to industry concerns that when interest rates started rising again it would blow up the portfolios.
“So the system has been changed to a more complicated and dynamic formula that takes into consideration the actual yield on the bond market and so it is more realistic.”