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Falling behind?

Thanks to another bull run on equities, the year 2005 was another joyous one for European pension funds. Good times always make investors more talkative and indeed, many European schemes have been in a hurry to disclose impressive returns for last year. For example, aggregate returns for Austrian and Swiss pension funds – 11.4% and 13% respectively – were disclosed as early as late February.
In Germany, meanwhile, an equivalent figure has not emerged due to the fragmented nature of its pension fund industry. In corporate pensions alone, there are five vehicles, with individual company book reserve plans (or Direktzusage vehicles) accounting for 60% of €366bn in assets. Another €88bn in assets are managed by Versorgungswerke – pension funds that serve specific professions like physicians, lawyers and architects.
But even on an individual basis, German pension funds have not been all that eager to disclose their returns for 2005. Part of this is due to their traditional aloofness and part of it due to the returns themselves. Incredibly, net returns from some of Germany’s biggest Versorgungswerke and Pensionskassen (traditional pension funds which manage €76bn in assets) have been between 5% and 6%.
Notable examples include the BVV, a financial services Pensionskasse with €17.7bn; Ärtzeversorgung Niedersachsen (AEVN), a €5bn Versorgungswerk for doctors in Lower Saxony and Nordrheinische Ärzteversorgung (NAEV), a €7.5bn peer of AEVN that serves doctors in the North Rhine region.
The explanation for AEVN’s 5% net return was as surprising as the return itself. While European pension funds have been increasing their exposure to equities to profit from the upswing, AEVN said that in 2005, it was still over-invested in German Pfandbriefe, or high-quality covered bonds. As a result, its return was dragged down by Pfandbriefe yields, which, during the year, hit historic lows.
AEVN is hardly alone in its high exposure to fixed income, which makes up 60% of its portfolio. Industry experts estimate that most German pension funds outside the balance sheet provision of Direktzusage, which is not regulated, still have between 70-90% invested in bonds.
However, high exposure to fixed income is just as common among Austrian and Swiss pension funds. So why are their returns – to say nothing of those from other European pension funds – seemingly higher? Could there be, as some Frankfurt-based asset managers suggest, something wrong with the asset allocation model of German pension funds?
To the first question, German pension fund executives insist that a direct comparison between their returns and those of their peers cannot be drawn due to the peculiarities of the German market. Chief among these peculiarities are German accounting rules (HGB) that require them to understate their actual returns.
“In interpreting returns for German pension funds, one has to bear in mind that in accordance with HGB, they are deliberately shaved down. This enables them to build reserves to deal with the ageing of their members as well as capital market risks,” notes Professor Dirk Lepelmeier, head of portfolio management at NAEV.
Although NAEV reported a net return of 6% for 2005 under HGB, its actual market return was on par with that of Swiss and Austrian pension funds. The same is probably true of AEVN, which has least 24% of its assets in equities. The fund declined to talk to IPE.
On the other hand, BVV, Germany’s largest Pensionskasse, believes that long-term returns could be better were it not for the country’s regulatory environment. “In our view, the regulatory environment is too focused on containing risk. Pension funds like ours face restrictive investment guidelines and have to pass stringent stress tests (from German financial regulator BAFin). This is a key hindrance in, for example, raising one’s exposure to equities or commodities,” says Frank Egermann, head of portfolio management at BVV.
There are two BAFin stress tests that apply to the equity holdings of Pensionskassen and, by extension Versorgungswerke. The first, ‘A-25’, assumes a 25% plunge in equity prices. The other test, ‘RA 25’, assumes a 20% drop in equity prices and a 5% drop in bond prices. BaFin also rolled out in the spring a third test applying to holdings in real estate.
Despite three straight years of positive equity markets, the BVV has only slightly raised its exposure to shares, going from 8% to 11%. Says Egermann: “Our risk budget permits us to raise our equity exposure if necessary. Yet on the basis of our negative view of equity market performance we are not planning to raise our exposure for now.”
He adds that while the BaFin permits Pensionskassen to hold up to 35% in equities, “I challenge you to show me a Pensionskasse that can pass a stress test with that kind of exposure.”
Lepelmeier and Peter Hadasch, head of the Є1.2bn Pensionskasse for Nestlé in Germany, disagree that German pension funds are over-regulated. According to them, the funds’ ability to invest in equities or in alternative asset classes is simply dependent on their risk budgets. Indeed, risk budgets at many Pensionskassen and Versorgungswerke were hammered during the equity market crash of 2000-2003 and have only recently recovered somewhat.
“In our experience, neither BAFin nor its stress tests are a barrier as far as returns go. We have been under its supervision for 45 years. But if you compare us with other Nestlé schemes in the UK, US and Switzerland – which have optimal investor conditions – you’ll find that over the long run, our net return does not significantly differ from theirs,” comments Hadasch. Nestlé Pensionskasse’s return for 2005 was also on par with that of Swiss and Austrian schemes.
Other German pension fund executives point out that again, assuming the appropriate risk budget, the use of derivatives or strategies like global tactical asset allocation and portable alpha are not in the least hindered by regulation.
“The BAFin is, for example, very liberal when it comes to the use of derivatives by Pensionskassen to get a better handle on long-term investment risk. I don’t think you can call this excessive regulation,” notes Andreas Poestges, head of portfolio management at Barmer Pensionskasse, a €1.6bn fund for a state-run health care company.
But while returns from German Pensionskassen and Versorgungswerke are much better than they appear, industry experts stress that, as exemplified by AEVN’s over-exposure to Pfandbriefe, there is a diversification problem.
“The fact is that German institutional investors are still not diversified enough in their asset allocation,” says Uwe Rieken, managing partner at Faros, a Frankfurt investment consultant that has pension funds as its core clients. “Although many would want to invest in alternative asset classes, they are unfamiliar with them and don’t know how to integrate them into their risk budgets. A learning process is taking place, but it may be going too slowly.”
To back up his assertion, Rieken cited a recent study by German asset manager Union Investment. The study indicated that a large majority of German institutional clients were not only far too risk averse, but more importantly, limited their investing to equities, bonds and real estate.
To better diversify their portfolio, German pension funds have the option of using investment consultants, and there certainly is no shortage of them in Germany (See IPE supplement “German Investment” November 2005). Yet unlike in say Switzerland, where pension funds rely heavily on consultants, funds in Germany tend to take what Mercer Investment Consulting in Frankfurt calls a “do-it yourself mentality” toward investing.
Comments Rieken: “We know from our daily experience that many institutional investors are overwhelmed by many aspects of asset allocation. The thing is that Germans usually do not want advice when it comes to (investment) opportunities. They feel the opposite when it comes to avoiding risk.”
Rieken also claims that asset managers in Germany are complicating matters by offering services particular to consultants, particularly asset-liability studies. “This reinforces the false impression that investment advice can be had for nothing. So what happens? Some ALM studies from asset managers land in the trash, because one) there are quality problems and two) investors see the conflict-of-interest between their advising and their products.”
Asset managers that provide investment consulting – including Allianz Global Investors, Metzler Asset Management, Goldman Sachs – deny that there is any conflict-of-interest in their dealings with pension funds. They stress that the schemes are in no way obliged to invest in their
products, adding that in many cases, they even encourage the client to hire an investment consultant.
In any event, Hadasch of Nestlé Pensionskasse says that under-diversification at German pension funds can largely be explained by a ‘natural home bias’. “Indeed, this phenomenon is widespread among our Anglo-Saxon colleagues as well. On the other hand, investors in smaller countries like Switzerland and the Netherlands, do not share this bias, as the rarity of opportunities compels them to look beyond their borders”.
But Hadasch also agrees that German pension fund executives should seriously consider getting outside investment advice for two simple reasons. “The quality of advice for pension funds has improved significantly. And if the executive gets the right kind of advice, the benefits will more than make up for the costs of such advice,” he says.










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