Nordic pension funds are characterised by their high exposure to equities, in particular domestic equities, that over the past few years have helped to increase pension fund reserves through high returns.
But the strong domestic returns also demonstrated the sharp volatility that comes with a large equity exposure. And so many pension funds are seeking to diversify that risk.
PKA, which manages eight Danish pension funds with total assets under management of DKK115bn (€15bn), currently has an asset allocation of nearly 40% in equities, 45% bonds, 13-14% alternatives such as domestic and international real estate and private equity, infrastructure funds and forestry. The remainder is invested in liability hedging assets and derivatives. “Over the years, we have been reducing our domestic equity allocation in favour of a higher foreign exposure,” says Michael Nellemann Pedersen, chief investment officer at PKA. “We started this 13 years ago and two or three years ago we still had a 40% exposure to domestic equities. But from a normal, risk-diversifying point of view that exposure was too high, in particular as shipping company AP Moller is very overweight in the Danish equity market, at around 25%. Today, we have an exposure of 30% domestic and 70% foreign equities.”
However, AP7, the Swedish national pension fund that manages the default fund for the Premium Pension System, increased its allocation to Swedish equities to 20% from 17% earlier this year at the expense of global equities. In addition, it still invests 54% in global equities, 10% in emerging markets equities, 6% in private equity and 10% in fixed income, including 4% in Swedish index-linked bonds, 4% in nominal foreign bonds and 2% in funds of hedge funds.”As we are the default fund within the defined contribution part of the Swedish government pension plan, we compete with around 700 Swedish private pension funds,” says Richard Grottheim, CIO of AP7. “Our target is to deliver a return in line with the average of those 700 private funds. We felt that for the past three years, when the market was moving up, we lagged behind because we did not have enough exposure to Swedish and emerging markets equities.” To mitigate the risk that comes with an overall equity allocation of 84%, AP7 has a currency hedge on the global equity exposure, hedging by 50% back to Swedish kronor. The pension fund also diversifies by spreading its global equity investments over all regions, says Grottheim. “Of course there is a lot more volatility in equities, so to secure your equity exposure you must have pretty high reserves,” says Nellemann Pedersen. “As we have guarantees on our liabilities side that are based on relatively high interest rates, there has been some pressure on our guarantors due to the falling interest rates over the last five years and so we have not done anything to mitigate the risk in equity. But we have a risk management system that can handle the equity exposure.”
PKA has a target equity exposure of 35-40% and believes that over the long term, it will benefit from a stable allocation to equities. But it plans to increase its exposure to non-listed assets including real estate up to approximately 25% over the next two years.
Grottheim says AP7 will stick to its alpha-beta separation approach, without any major changes in asset allocation. The law prevents AP7 from investing in real estate or commodities, which limits its alternative universe. But it did raise its private equity exposure to 6% from 4% last spring. PKA is currently analysing commodities, inflation-linked assets and special equity mandates such as 130/30, says Nellemann Pedersen.
The pension fund is also monitoring the markets following the summer’s subprime crisis but has, like AP7, not been forced to make any changes to its allocation in the wake of the credit crunch.