Getting caught at the lights
Peter Melchior is chief actuary and executive director of PKA, Denmark’s largest admin-istration company for occupational pension funds in the public sector. PKA, like other Danish pension funds, is faced with the question of whether and when to go into the market to buy equities again.
For the time being, it has stopped buying and has reduced its equity allocation. Part of this has been a natural reduction. When equity prices fall, allocation percentages fall without any selling. “Last year our strategy was to have a ratio of 45% and now we are only in the 30s and we don’t automatically buy now,” he says. “The real question now is what is the right equity ratio? One or two years ago everyone agreed it was very close to 50%. Perhaps we are in a new world now and the right percentage is something different.”
Forced selling is less of a problem than knowing when to buy, he says. “There is a problem that you have to sell equities at the bottom of the market and yet you cannot buy them at the bottom of the market. But the real problem, as we see it, is that we do not know where the bottom is. We feel that it would be very naïve to think that this is the bottom and there is no risk in buying equities. Something can happen very easily and quickly and we could have a further decrease of 20% in equity prices or of that order.”
Melchior thinks that the right time to sell equities was probably at the early stages of the current crisis. “I think you could say the first companies that ‘panicked’ and sold out, sold out rather well. We haven’t been forced to sell out. Actually, by the end of July some of our pension funds were buying more equities.”
Under the rules of the Danish Financial Supervisory Authority (DFSA) if a pension fund fails a stress test it can be advised to reduce its risk profile, which means selling off equities. He says this point has not yet been reached.
The DFSA’s so-called traffic light system posits two scenarios: a ‘red light’ scenario where pension funds and insurers must be able to make up their loss in the event of a simultaneous fall of 12% in share prices and a 0.7 percentage point change in the interest rate; and a ‘yellow light’ scenario where pension funds must be able to cope with a 30% fall in equities and a single percentage point fall the interest rate.
Melchior says the DFSA’s system holds few terrors for PKA. “The traffic lights system is very close to our own risk management system. It’s only common sense.”
PKA’s system is superior to the DFSA’s he suggests. “The DFSA model has been made very simple so that everybody can use it. We use our own traffic lights – we don’t use the yellow but we do use the red. They work a little differently, and from a risk management point of view, a lot better than the supervisor’s.
PKA itself has not moved into the DFSA’s red light, although it has occasionally been in the yellow light. “With a yellow light nothing happens. The only thing that happens is that you have to report every three months to the authorities instead of every six months. The red light is the start of a dialogue. Sometimes they will say don’t increase your risks just now and of course you don’t do that.”
Melchior insists there is nothing wrong with a fund finding itself in the yellow light. On the contrary, he says, if certain conditions do not place a fund in the yellow area, its performance must be suspect. “If interest rates decrease and equities fall, and you are still not in the yellow light you really have done something wrong, because then you are clearly too rich and you should have given more bonus to your customers,” he says. “So occasionally you have to be in the yellow light.”
He insists that this need not raise the investment risk profile of the fund. “You can take risks in several ways. You can do it on the investment side or you can pay a better bonus to your customers – that’s my kind of risk.”
Melchior says that the trouble with day to day scrutiny by the regulators is that often problems will sort themselves out before funds have time to consult the regulators. “If equities prices drop, it may only be for a short time. You start the dialogue and you arrange some meetings with the supervisor. And before you have the meeting, the prices go up again, so there is nothing to discuss. But then of course if there’s also the situation when the price goes down and stays down. Then you need your meeting.
“The problem is that if the interest rate drops and equity prices fall, you might simply continue, because there’s no problem continuing your business. Of course, if equities and interest rates stay down for a couple of years you will have to do something. But the question is during that period – when you know that things are not too good – should you take on new customers? And that’s the real problem. Because for your existing customers there’s no reason for you to do anything. It’s long term business, and from the point of view of the long term business you just have to wait and see whether this really is the new market level. That won’t affect your established customers. But of course the new customers are in a completely different position.”
Melchior suggests that another problem with the traffic light system is that companies can move rapidly from a green light to red light. “There have been pension funds that were in the green light at the end of May, with no problems, and six weeks later they were very close to the red light,” he says.
This can happen because funds do not know where the market mean lies, he suggests. “The market will move up and down very much over a period, but the mean is stable. When companies are on the top of one of these upward movements they will find themselves in the green light and say there is no problem But we know from the past 12 months that this movement goes down as well as up. You have to measure it to the bottom of the market because if it has been to the bottom several times in the past 12 months you might except it to return to the bottom.
“This actually happened this year because equities went up a little at the start of the year as well as the interest rate. But then the situation changed and some pension funds very quickly found themselves near the red light.”
These funds have attracted press attention. Press interest in the DFSA traffic light system is inevitable, Melchior says. “We don’t see many headlines that a company is in a yellow light. But it’s different when they move into a red light.They will say of a company ‘They’re red light – that’s a good story.’
Such scrutiny can be counter-productive, he suggests. “The one thing I don’t like about the traffic light system is that some companies might do foolish things to avoid getting into the red light. And that’s not because of fear of the supervisors but to protect them against bad publicity.”
Generally. He believes the DFSA system works well as a ‘default’ system for funds without sophisticated risk management systems. And he suggests that if pension funds feel their freedom to invest is compromised by stress tests, they should perhaps examine the adequacy of their own risk management.