Swimming against the tide
While the entire European pension industry seems to be fretting about the implications of a Solvency II-style directive for pension funds, in the far northeastern corner of Europe, solvency takes on an entirely different meaning.
The Finnish pension system is based on a solvency framework created in 1997, with a set of new regulations expected to be in place at the beginning of 2016.
And so, as is the case with other Finnish pension insurance companies, solvency capital is the main consideration behind the investment strategy of Etera Mutual Pension Insurance Company.
Its main risk management objectives are to secure the solvency of the company both for the long and short term. In order to manage the risks and solvency, different types of multi-horizon ALM analyses are applied to the company’s market risk positions, including its liabilities. Although the pension liabilities within the Finnish regulatory regime for private-sector pension insurance companies are not marked-to-market with market interest rates, they do include various market risk components such as a fixed minimum interest rate, an equity-return linked liability component and a long-term yield requirement derived from the solvency ratio of all private sector pension providers.
In Etera’s ALM analysis these components are taken into consideration to form a complete view of risks and expected returns.
The top-level risk budget is defined by Etera’s board of directors through capital-at-risk limits. It is based on an analysis of the risk and solvency position, including the requirements of the pension liabilities. The analysis resembles the Own Risk and Solvency Assessment (ORSA) analysis outlined in the Solvency II framework but it is adjusted to fit the Finnish pension system.
“We currently have a solvency ratio of 21% and we can risk part of this in our investments without falling into a solvency trap,” says Jari Puhakka, CIO at Etera. “Once a pension insurance company finds itself in a solvency trap, competing with other providers becomes a struggle.”
Competing is already a challenge for Etera, as the average solvency ratio of Finnish pension insurance companies stands at 26%.
But Etera is making up ground with its investment style – in two years the company’s solvency ratio has improved 3% above the pension system average.
This is down to a change in investment style, which Puhakka introduced when he joined Etera in April 2010. “The traditional long-term investment style, which Etera had in place pre-crisis, does not work with the Finnish solvency-driven framework,” says Puhakka.
“Introducing the new investment style was a challenge as it required a lot of communication, changes to existing policies and processes as well as investments into new front office and risk-management systems. Our aim is to become the best pension investor in Europe. Being awarded best pension fund in Finland at the 2012 IPE Awards is a step in the right direction.”
For the last two years, Etera’s investment strategy has been based on dynamic risk budgeting aligned to its solvency position. It has no pre-determined benchmark indices or asset allocation limits. Instead a risk budget determines the maximum overall risk level and the capital-at-risk limits for different risk components.
“The idea is to have a more diversified portfolio than the average Finnish pension company in order to gain the maximum benefit from diversification,” says Puhakka.
“Usually, the biggest risk factor is equity risk, but we want to have a more balanced view.
Currency, for example, could carry a higher risk for our portfolio than equity risk, especially in view of the ongoing euro crisis. The Finnish regulatory framework is far too limiting in that respect because it only allows us to have 20% open currency risk from the value of our liabilities.”
With the new approach, Etera pro-actively positions itself counter-cyclically in order to preserve solvency.
“When we feel markets are, for example, too optimistic, like at the end of last year, we sharply reduce our risk level,” says Puhakka. “This leaves us to increase risk again when markets correct. The average Finnish pension company has had three quarters of negative returns over the last two years – we have had only one. So the new strategy has paid off, so far.”
In the autumn of 2011 when Etera’s solvency was low but its view on markets was positive it used equity index call options to capture the upside potential. To maximise the use of the risk budget at the time Etera sold interest rate receiver swaptions, thus reducing interest rate risk, and yields rose thereafter. The move paid off with a return of 2.9% in the last quarter, outperforming the competition by 1.1%.
At the beginning of the second quarter of 2012, Etera cut its equity weighting to 5%. As 10% of the Finnish pension insurance companies’ liabilities are linked to equity market returns, its solvency ratio improved when equity prices came down. At the beginning of June, Etera increased its equity exposure back to 20%.
As a result of this, it made a return of 1.5% in the second quarter compared to a loss of -1.2% for the average Finnish pension fund.
Hedging and derivative positions are second nature to Etera. “It is too expensive to undertake active movements in cash positions so a large portion of our activity is in derivatives,” says Puhakka.
“At the end of 2012, for example, over 60% of our exposure to listed equities was hedged with derivatives. For us, there is no reason to carry any interest rate risk at such low yield levels, which is why we have currently almost entirely hedged our interest rate risk.”
Etera has allocated 15% of assets to corporate finance, in other words, all non-listed securities such as different loans and private equity, and has its own in-house corporate finance team for this asset class.
Part of this allocation involves loans to client companies, which have the option to lend, if loans are guaranteed, a portion of their funded amount from the pension company.
Basel III means many banks cannot finance companies in the same way they used to, which has led to pension insurance companies becoming more active lenders.
“The expected returns in corporate finance are higher than on listed securities and as we are selective with our investments we are able to control the risk,” he says.
“Because the Finnish pension system has its own unique solvency framework and we do not have a liability matching approach, we have been playing against Solvency II. Less than 2% is currently invested in government bonds, as Etera does not like their risk/return profile and we can easily go to zero interest rate risk on the total portfolio level.”
Etera also invests 15% of its portfolio in real estate. “This is partly a result of our history [see Historical influences panel] and partly because we believe it is a good asset class, particularly in comparison with government bonds,” says Puhakka.
Recently, Etera has invested in three large office buildings close to the main railway station in Helsinki city centre.
Puhakka says even though one has yet to be built, Etera could already sell all of them at a large profit.
“Even in the best locations, real estate generates a yield of at least over 5% for us, while riskier properties can generate yields of as high as 10%,” say Puhakka. “In addition, the rent increases with inflation. And the right type of real estate is liquid too. Rather than simply doing buy-and-hold in real estate we try to actively sell the properties on and find the right cyclical moment to build new ones, so it can be quite tactical too.”
Etera’s non-listed equity investments make up close to 9% of its total assets. But less than one-third of its private equity investments are Finnish. Etera’s biggest allocations to private equity fund investments are located in North America and Europe.
Emerging market debt has played an increasingly important role since Puhakka joined Etera.
“Instead of having a high equity weighting, we have invested in emerging market debt. So far the return has been as good, while we believe the risk is lower,” he says.
On the equity side, Etera runs a concentrated portfolio. “We try to find companies with the right type of company profile looking at factors such as dividend yield and return on equity, and we want to understand where we invest,” says Puhakka. “They also have to have the right type of risk profile as we try to build a portfolio that is more robust in negative markets than the market average.”
Etera makes uses of quantitative screening tools for global equities. For domestic equities, it does traditional stock picking.
“We do not like managers who talk about tracking errors or information ratios,” says Puhakka. “As an investor we prefer them to have Sharpe ratios and an absolute return type of approach to equity investing.”
Etera began its new investment style with Finnish and European equities but has now been rolling it out across the rest of the equity portfolio.
About half of its equity investments, around 10% of the total portfolio, is managed in-house while the other 10% – mainly US and emerging markets – is outsourced to external managers.
But Etera has now begun to manage some of its emerging markets exposure internally.
“The portfolio manager who was responsible for traditional government bonds now concentrates on emerging market debt and we are building a more arbitrage-type of investing strategies to traditional fixed income markets,” says Puhakka. “We have found good trading possibilities when solvency obligations forced many investors into buying government bonds. We deal with the volatility through the use of swaptions, but overall it is a mainly tactical and opportunistic style.
“Currency is often an underestimated source of risk and return opportunities. Because of our exposure to US equities and emerging market debt we have a lot of currency risk, which is optimised on a total portfolio level. We can use currencies to hedge some of the other risks in the portfolio too.”