"Last year was excellent for Austrian pension funds and we made double-digit returns," says Christian Böhm, chairman of the Austrian Pension Fund Association (WKÖ). "The main movement in general asset allocation was a slight increase in equity exposure from about one-third at the beginning of the year to about 40% at the end. In addition we increased exposure to emerging markets in both bonds and equities and so we increased diversification."

But not all pension funds took the high equities route. "We offer the so-called life cycle concept where we have three different portfolios with differing asset allocation," says Michaela Attermeyer, who is responsible for asset management at Vereinigte Pensionskasse (VBV), Austria's biggest multi-employer pension fund with one third of the €11.5bn Pensionskassen market.

"Younger members are in our dynamic portfolio, which has a higher risk profile and more equity exposure, and members switch to a balanced portfolio when they are about 40. Then we recommend that they change into the stable portfolio about five years before they retire. So in our view always to have a high equity exposure in all portfolios is not the right concept because the liability side has a part to play in the whole game. So our equity is perhaps a bit lower overall compared with other Austrian pension funds because we are very liability driven."

And the caution was reflected in the 2005 figures. Although all VBV's investments posted performances of between 5.8% and 12% on the year and its overall 2005 return was 9.2%, above its 2004 outturn of 7.7% but below the Pensionskassen average of 11%.

VBV is the result of a 2004 merger between multi-employer scheme VPK and BVP, a pension scheme for the insurance and banking sectors. Its initial months were taken up with aligning the portfolios of the two funds, where one, for example, had no exposure to commodities while the other did. "Now we have the two halves aligned so the allocation is nearly the same in all our portfolios," says Attermeyer.

"It is a characteristic of our fund that we have a diversified portfolio," she adds. "So besides equities, which account for 30%, and bonds, which account for a further 60-65%, we also have alternative investments like real estate and hedge funds."

Earlier this year, VBV said it was considering investing in currency and private equity, with a decision on currency expected by the end of 2006. APK has also dabbled in alternatives. "We made some investments in absolute returns or hedge funds, basically money market plus investments," says Günther Schiendl, head of investments at APK. "That means we took low-risk products, and at the end of last year we found that, of course, they made low returns."

Although APK is also a multi-employer pension fund with different plans, it had a more typical Austrian portfolio breakdown than VBV. "On average our asset allocation is close to 40% in equities, some 3% in real estate, 10-15% in absolute return strategies, and the remainder is bonds, predominately European government bonds plus some diversification in European and US high-yield and emerging markets debt," says Schiendl. "In the fixed income area, at the beginning of the year we increased our diversification into high-yield and emerging markets debt and we found that this was a good thing to do because these markets have lost less or are still positive in comparison with the European government bonds."

"One factor that affected our portfolios' performance is that we align them with our asset liability management framework," Attermeyer adds. "So the asset allocation strategy for each portfolio depends on both the asset and the liability sides."

VBV's report said it would focus more on risk management in 2006 and that it would conduct another asset-liability study.

Nevertheless, the Financial Markets Authority (FMA) is introducing new risk management rules, and for Attermeyer they will represent both a challenge and an opportunity. "The new rules will mean that pension funds will no longer have to obey quantitative limits on asset allocation and asset management but can switch over to the prudent person concept, she says. "So it's also challenging in a positive way."

Böhm also sees the prudent person option as an opportunity. "In Austria we can deliver two different pension products to our customers, one with an implemented guarantee which has quantitative limits for asset allocation, for example a 50% limit on equities, and one without, where investments can be in line with the prudent person rules implemented by the EU directive," he says. "Since the beginning of pension fund investment in Austria we have learnt to work within certain limits, for example on equity and currency exposure. This enables us to look at different investment opportunities, alternatives and so on."

"To move to a prudent person concept we first have to show the FMA that our risk management process is a sophisticated process and to get its approval," says Attermeyer. "We plan to implement the changes from the beginning of the coming year, so we will prepare for the change by the end of December when our financial year ends."

And will the new regime have an affect on VBV's asset allocation? "There will be some impact but the regulation in the pension fund law covering funds with and without a minimum guarantee and allows a lesser and greater equity risk will not allow them to be managed in the same portfolio. So I think the whole portfolio structure will change with the introduction of this risk management framework."

Looking ahead, Böhm notes: "The low interest rates that were another contributing factor to the excellent 2005 performance is one of our problems in 2006. In 1994 to 1999, the previous period of increasing interest rates, we had negative returns on bonds but excellent returns on equities. That is not the situation now."

"Our challenge now is to restructure this absolute return portfolio in a way that meets expectations, meaning delivering higher and stable returns," says Schiendl. "We see this as being very difficult because the big market correction in May basically affected all asset classes. We have seen hedge fund strategies which at the end of March were well into positive territory but which at the end of May were well in the negative area, just as equity products have been. So putting together a consistent absolute return strategy is a major challenge."

The picture of a negative performance in the second quarter of 2006 that has wiped out gains in the first has also been repeated in mainstream asset classes. But Böhm is untroubled. "We should look at the world as it is now and not have too many concerns," he says.

Schiendl is also relaxed about the current outlook. "We need to be very careful not to become overly nervous about inflation expectations," he cautions. One thing that they are not overly nervous about is the general election to be held in October, despite an element of controversy around reforms enacted by the current right-of-centre government. These included a parametric reform of the state PAYG system and encouragement to occupational and private provision.

According to Sigisbert Dolinschek, state secretary for social security, generations and consumer protection, the mandatory occupational pension introduced three years ago into all new employment contracts as part of the reform has already been extended to half of Austria's workers. But the changes, which represented a radical departure from Austria's traditional method of pension provision, have not figured to any great extent on the electoral campaign.

"Any political discussions of pensions have focused on the first pillar PAYG system, with the opposition saying that this government has been very bad for old people and for the pensions system because it made cuts," says Böhm. "But it's the normal cut and thrust you always hear before elections. However, I think that all responsible politicians, whether from the government's side or the opposition, understand that we have demographic changes and restrictions on the public budget so that we have to look elsewhere to build up sustainable pensions and it's better to have the second pillar system in addition to a first rather than to reject such an option because capital markets can be volatile."

Schiendl is adamant that additional reform is needed. "We need further changes," says Schiendl. "For us raising the retirment age is not the answer," he adds. "We think that the most beneficial move would be the granting of tax exemption to the personal contributions of employees to the pension funds as well as of employers. This is not the case now."