Don't look back
The Finnish pension system is still over-regulated and not structured in way that meets the long-term interests of pension funds. Lobbying has had some impact but as yet this is insufficient .
It appears that the market has yet to convince its regulator that the idea that taking a forward-looking view of investments makes sound business sense.
Currently the assets in which a pension fund may invest depends on its solvency ratio. All assets have a solvency classification; the higher the risk of an asset as perceived by the regulator, the higher the classification, so the less the investor can invest in that asset for a given level of funding.
Martti Saikku, head of institutional business at Gyllenberg AM in Helsinki, says: “Strategic allocation is what is really necessary to produce an expected risk and return but this is not possible in the present system.”
The system appears counter-cyclical, as Jyri Viskari, managing director of Helsinki-based Ice Capital, explains: “The risk classifications are ex-ante, which can lead to a situation where pension funds buy risky assets when prices are high and sell when they are low. So this is not an optimal solution.”
Until recently, hedge funds and corporate bonds had been in the highest risk classification, which the industry as a whole considered far too high. However, the regulator responded to industry lobbying by moving hedge funds to a lower risk classification.
But the counter-intuitive nature of the system persists. “Real estate funds are an example,” notes Simonsen, head of tactical asset allocation at Helsinki-based pension insurance company Ilmarinen, which also manages assets for other pension funds. “Large real estate funds are better than direct investments from the point of view of diversifying risk but the regulator gives a higher risk classification to the fund option. Generally the Finnish framework focuses on form not on substance.”
Jauri Häkkä, CIO at the Helsinki office of Kaupthing, takes a similar line: “The regulator’s approach is more is more of a legal nature that doesn’t look at the real risk. It looks at factors like the terms of the investment, whether the asset class uses derivatives, or whether the fund that is being invested in is OECD-domiciled. But these issues are trivial in investment terms. Regulation needs to focus more on strategic risk factors rather than legal factors.”
He points out that there are many new instruments coming onto the market, such as CDOs, that don’t always fit into the regulatory classification. “So there is a lot of speculation as to how a given asset class should be classified in the solvency calculation,” Häkkä says.
Each pension fund has to produce a target return on investments each year. Häkkä notes: “The focus on returns is backward-looking. The regulator should be looking at the asset liability framework. We still have some way to go before we can invest with a sufficiently long investment horizon.”
If a pension fund does not achieve its return target the difference will be taken from the pension insurance company’s solvency capital. The lower the solvency, the smaller the risk capacity.
But if the returns are good enough the pension fund gives refunds of contributions to the employer. The amount repayable to employers is a function only of the solvency ratio of the pension fund. Simonsen explains that this leads to a paradox because generally more solvent companies take more risk, therefore they have a lower solvency ratio. “The most wealthy pension companies have not been able to pay back to clients as much as the less wealthy,” he says.
It is possible that the total expense ratio will be added to the formula for paybacks to the employer’s solvency ratio. However, this is also subject to an anomaly where the outsourcing of management is not considered a cost because it is deducted from the performance, whereas taking a function in-house is considered a cost. “The costs used for calculation are only those that can be seen so it is more profitable to outsource,” says Simonsen. “This is illogical because it has an inverted impact on cost. I hope it is not this dark in other parts of Europe.”
He explains that the solvency ratio is calculated on the last day of December, which presents its own opportunities to the more cunning among Finland’s pension fund managers. “It is very possible to window-dress by selling equities just before that day to increase the solvency ratio and then buying them back.”
A new system is under consideration which will make things healthier, in that the payback will be based on solvency of the fund, not the solvency ratio. “In this way, the richest companies will be paying back to pension funds, not the smartest,” says Simonsen.
Today , in accordance with the solvency rules a private sector pension intitution can invest a maximum of about 25% in equities “Currently the level stands at around 30% due to a long bull market,” says Leppälä. “The ideas for reform, at least right now, are to change the rules so that after a gradual transition period of five years there could be on average 35% invested in equities. It has been said that after this is realised there will be a new assessment of the situation and it is possible that the target maximum equity exposure could then be raised to 40%. But this is just an idea at this point.”
He adds: “The baseline scenario is to increase the current return of 3.5% by 0.5% or 1%.”
The government is also urging pension funds to invest more in small and medium-sized companies, including start-up companies. “The idea is that there should be asymmetric risk sharing so that if the investments in the small companies decline in value then the government will bear a greater proportion of the loss as well as taking more of any gains,” Leppälä explains.
He adds:”Pension funds are quite sceptical as to the feasibility of this solution.”
Indeed. The current limit on the allocation to equities is 20%, and of that the limit on Finnish equities is 40%. “If the 20% is doubled then the quota of Finnish equities will probably double as a result,” says Simonsen. “The Finnish stock market is small and we already have significant holdings in Finland. It would be very difficult for us to enlarge this position.”
He adds: “Finnish politicians and unions want to invest in Finnish companies because they want more power. The Finnish companies in question agree with the proposal because they also want more power. So those that have an influence on the outcome of the debate are all pulling in the same direction. But what Finnish pension funds want is what is best from an investment point of view.”
In other words, a well balanced strategic allocation.
“The pension system is very exposed to the risk of the Finnish economy,” says Häkkä. “Politicians always try to get points by suggesting this or that to save jobs. But it’s not the way a market economy works.”
Viskari agrees with that assessment. He adds: “The measure is totally political and very difficult to understand this from a risk point of view.”
As the challenge to generate returns in a low interest rate environment
persists in Finland, open architecture
is gaining ground. “We manage domestic/Scandinavian and European equities, fixed income, investment grade bonds, as well as emerging Europe with a Baltic Focus,” says Saikku “The rest we outsource. Increasing diversification of portfolios has driven both open architecture and multi-management.” Multi-management finds fertile territory in Finland. Häkkä notes: “The average pension fund is small so the expense of hiring their own investment professionals is significant; the same is true with hiring consultants.”
“There is an increasing interest among clients in attribution analysis and a new willingness to have risk budgeting in place. Investors want to know where to add on risk and need to have someone to consolidate performance,” he continues.
But he notes that in other areas multi-managers are hindered by a lack of sophistication in the market. “It is very difficult to get pension funds to talk about strategy and about outsourcing manager search and selection,” he says. “They tend to select the brand they know. But we are seeing more investors thinking about how to structure their portfolios in a more efficient way.”
As is the case in most other markets, as the need for diversification increases so opportunities for foreign managers advance in parallel. To what extent are Finnish managers under threat? “We always include Finnish managers in our searches,” notes Häkkä. “But once we drill down is difficult to find a sufficiently comprehensive investment process that competes with the global rivals, maybe with a few exceptions in the Nordic and European markets.”
Mikko Eskola is managing director at Helsinki-based Fides AM: “Competition will stay high between the local and foreign for the five to seven largest funds – only they are big enough to be attractive for foreign managers,” he says.
The intense competition in the market has inevitable consequences. Saikku notes: “Buyers in Finland are not that professional; there is no tradition of outsourcing management. Price is higher on the list of criteria than it is in other countries, especially in fixed income where it is getting higher and higher. There is fierce competition over the small number of tier-one clients. But performance definitely comes before price.”