Danmarks Nationalbank said in a report on the country’s pension sector and alternative investments that the providers have room to invest more, on top of the DKK750bn (€100bn) already held or committed to.

But the central bank also warned in the financial stability and risk analysis published yesterday, that a higher allocation to alternatives – including unlisted equity, infrastructure, direct credit, and real estate – at pension funds could tighten liquidity if interest rates rose.

The bank said: “The pension sector’s alternative investments of DKK500bn have provided diversification and stable returns.”

According to the report, the firms have already made pre-commitments to future investments of around DKK250bn.

“Most companies have room to invest even more in alternatives if deemed appropriate in terms of risk and return,” the central bank commented.

“An increased share of alternatives can impact both solvency and liquidity, where especially liquidity can become tight if e.g. interest rates increase. Strong management of short- and long-term risks is thus important,” it said.

Citing figures for the end of 2020, Danmarks Nationalbank said most pension companies in Denmark held alternatives, with the median firm having a 14% allocation, but added that there were big differences between the alternatives weighting of individual providers.

One company had more than 36% of  its assets in alternatives, while others had almost none – and there were large differences in the types of alternatives individual companies had.

“The mere share of alternatives implies that the performance of this asset class will be important for the sector in honouring future benefits while also introducing new risks and opportunities,” the bank said.

“This reflects the combination of different business models, solvency and liquidity constraints,” the bank said, referring to a chart showing that exposure to alternatives was higher in portfolios backing “unconstrained” average-rate pension products, rather than other types of product.

These included average-rate products which were solvency constrained due to low bonus reserves, or market-rate products – which attribute net investment returns directly to members and generally do not offer financial guarantees.

Noting that the sector currently had substantial commitments to future alternatives investments, the central bank warned: “Although all companies remain highly solvent, their additional investments may bring them closer to a point where stress or mis-estimation of fair value could trigger solvency problems.”

Some companies had more freedom to increase their alternatives allocations than others, according to the report.

“The analysis illustrates that some companies will never really be solvency constrained, e.g. if they have market-rate products and average-rate products with large bonus reserves, whereas others can relatively quickly get in a situation where solvency makes binding constraints on their future investments in alternatives,” it said.

Rising interest rates could cause liquidity problems, the bank warned:

“In a case of rapidly increasing interest rates, the sector will need liquidity to cover its variation margin on interest-rate swaps. At the same time, the holdings of Danish and German government bonds, used to access intraday liquidity via repos, will depreciate in value,” the report said.

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