There's an old joke that has a traveller in Ireland asking a local resident for directions. "If I was going there," comes the reply, "I wouldn't start from here."

In many ways this reflects the situation of Finland's asset management industry as pension institutions prepare to find their way from what is widely conceded to be overly legalistic and rigid regulation to a system of more realistically based controls and as asset managers consider how to position themselves to provide the products they will be able to use.

"It was and is still the case that it is not the pension institutions but the authorities who classify the investment holdings and they even tell the investors what kind of investments are acceptable," says Ari Korhonen, head of asset management at Kaupthing Bank in Helsinki. "Anything not listed was not accepted by the authorities. That is not to say that such holdings were forbidden but in most cases they could not be taken into account in terms of solvency. So it was rather complicated."

This situation gave rise to an element of creativity above and beyond the skills normally required for asset management as assets were wrapped in overlays to resemble other more acceptable elements. "It is some kind of legal arbitrage," says Korhonen. "But under the new law it will be impossible because the responsibility will now lie with the investors and it is up to them what kind of an investment they are handling."

So ironically, while the Puro reform proposals are intended to open the market to new products and approaches, one of the first results of their adoption will be the closing down of what up to them will have been a key activity.

Parliament is currently debating reform proposals from the Permanent Negotiating Group of Social Partners that are intended to liberalise the asset management of pensions institutions. The group, known as the Puro Commission after its chairman Illmarinen president and CEO Kari Puro, is an unofficial but nonetheless influential body that for more than a decade has provided a forum for the consideration of pensions issues.

In September 2004 it began examining ways to modernise Finland's regulatory framework for pensions and it reported earlier this year.

As the process began there were those within the pensions industry that wanted a complete break with the over-engineered restrictions and were urging the government to shift the industry's regulation away from the EU life directive and to the then emerging pensions directive with its alluring prudent person principle.

But that is not the Finnish way. Society embraces compromise and rather than sweep away a system that was widely recognised to be no longer fit for purpose, the Puro Commission opted to change it from within, to start its reforming journey from a place many would not have considered an ideal departure point.

"They did not abandon the legalistic approach, it is the basis on which the proposed new regulation is built," says Matti Leppälä, director responsible for international and legal affairs for the Finnish Pensions Alliance (TELA).

The expectation is that the proposals will be passed by parliament and come into force from the beginning of 2007.

And Martti Saikku, director and head of institutional business at SEB Gyllenberg is happy with the process. "A radical change is not going to happen," he says. "I believe that with all these processes you have to make compromises along the way, but nevertheless, compromises or not, I believe that the new legislation is going to be favourable to allowing more equity exposure and better diversification. We will have 20 categories instead of seven which, while not making things more simple and perhaps making them more complicated, gives a mechanism to accommodate an asset according to its real characteristics, like volatility and so on."

And it is anticipated that the effect will be profound.

"The whole package is very complicated but there are quite big changes," says Korhonen. "The new legislation will liberate investments, in terms of real holdings but also in terms of risk levels because pension companies over the next five years will be much more able to accept risk related to equities than they used to be. In addition to the rules governing investments, there are other aspects. For example, at the same time as they were preparing the new investment rules the Puro Commission suggested new parameters in pension institutions' balance sheets. They introduce a buffer against a downturn in the equity markets and the buffer will increase in size over the next five years and that will make a big difference in risk appetite going forward."

"We expect to see the whole regulation of and restrictions on the pension investment companies relax, and we are talking about substantial change," says Christian Uggla, a partner at RAM Partners. "We expect this to have an impact on the whole asset management environment. The ability of pension investment companies to allocate money between different asset classes will change dramatically. We are moving away from a situation where you put an administrative valuation on an asset class to one where the riskiness of every asset class is determined by its own volatility, and where a pensions institution has a lot more leeway to decide its own investment policy."

"The aim is to increase the equity investments but the changes will be phased in over a five-year transition period," says Leppälä. "Then there will be the new notion of ascribing the real risks of an investment rather than that decided on by the authorities. In addition, all the different investment vehicles will have to be transparent both to the pension institutions and the supervisory authority, so the institution will have to be able to explain what the real risks are with each. So even if a vehicle looks like a bond but has an equity investment risk the institution will have to show what type of risk it entails."

"One of the basic ideas was to allow pension industry investors more room for equity exposure if that would be the optimal solution from a risk-return perspective," agrees Saikku. "There is still a cap, but the new regulation would allow approximately 10 percentage points more equity exposure that the current average after the transition phase."

But is raising the equity portion of a portfolio over the cycle to 30-35% from 20-25% over five years such a major advance?

For one thing it will end an anomaly that posed a considerable threat. "If pension institutions were losing money on the equity allocation the risk-taking capability went down, which means that they have to reduce their more risky assets, notably their equity," says Uggla. "That is exactly the opposite of what any rational investor would do. The system allowed a pension institution to increase the risk at the top of the market and decrease at the bottom. In 1991 when equities came off pension institutions were required to sell into a falling market. In 2001 the situation was better and the broad market didn't come off so much because due to history and the asset liability management framework of Finnish pension institutions there was a traditional emphasis on bonds and real estate, and in 2000 bonds and real estate did very well. So although the loss on equities was painful it was not to the extent that it did any major damage. But this choice to allocated to bonds and real estate is what we want the new system to get away from."

So what will the new asset management landscape look like?

"We don't know all the consequences yet but from our point of view it can only be positive because there will be more demand for asset management services and product diversification, and we can work more freely within the alternative space," says Saikku. "There will be some extra room for equity exposure but I'm not sure that it will automatically be the case that investors will increase their equity, that would be too easy. One could get a more effective portfolio without necessarily increasing the equity allocation but by getting greater diversification - going to Asia, to Japan or emerging markets, and the same with fixed income. So even within the traditional space there's lots of room for diversification and more effective portfolios without actually increasing the equity exposure."

"Typically, asset managers focus on fixed income and equities and try to do active products," says Jyri Viskari, managing director at Icecapital Asset Management. "Pension institutions can invest more in equities but that is not the only good thing from the Puro proposals. They can diversify more, use alternative asset classes that have been quite problematic in the past, for example commodities, listed real estate, hedge funds, infrastructure investments, structured products. There are alpha sources in private equity rather than in listed equities large caps, for example. I think that the growth will be in private equity. The larger players have already invested in private equity and mid-sized investors typically have some domestic private equity funds and will move to it now in a bigger way, but they need some diversification. The trend will go towards areas where the market is emerging and the rate of growth is high. These asset classes can also be interesting because they have characteristics that are not similar to mainstream products, they do not correlate with equities or bonds and the expected returns can also be very good. In addition, indexation is not very usual here but looking internationally it is a clear trend and it is coming to Finland. And we need active products so a separation of alpha and beta is also coming to fixed income investments."

And real estate? "Historically pension institutions owned real estate directly but over the last two years or so we have seen a decisive switch towards funds," says Uggla. "It is obvious that when they sell one of their direct holdings they won't buy Finnish funds they will buy real estate funds in Europe, Asia and the US in an attempt to diversify."

"The new holdings will be much more diversified which should mean good things both for the pension institutions and for us because we do play a role in providing them with new ideas in fields such as private equity and hedge funds," says Korhonen.

"I see hedge funds going down because people have seen some disappointing results over the last six months and are taking some money off the table," says Peter Preisler, head of business development (EMEA) at T Rowe Price.

Korhonen agrees but is more optimistic. "A couple of years ago many people were very interested in hedge funds, then many were disappointed," he says. "But now they are getting interested again."

"Hedge funds are very expensive as an asset class in terms of asset liability management where they tie up a lot of capital due to their low collateral value, indeed and the same collateral value as private equity which had a clearly higher expected return, so pensions institutions couldn't hold much of it in their portfolio," says Uggla. "The system does not take into account the real riskiness of a hedge fund portfolio, but rather sees it as an administrative class that bundles elements together depending on, among other things, where they are domiciled instead of their real riskiness or volatility or whatever other measure may be used. So three or four years ago in the pension world hedge funds were something that the cat brought in. However, a year ago the regulation was changed so that a small portion of a portfolio could be lifted from virtually zero value to more or less the same level as real estate, and this has brought hedge funds pretty much in to the arena. Under the new system the collateral value should reflect the riskiness of an asset and we believe that at that point in the present environment hedge funds will be a very attractive asset class for pension fund managers."

"We are still very much on a learning curve," says Korhonen. "The problems with hedge funds arose largely because of technical issues. People are still thinking about quite basic questions like how to handle hedge funds within their human resources. It may be that they only have a couple of people managing the whole portfolio, so are they able to decide whether to hire new people to handle the new asset class, and there are not that many people available and it may not be an economical solution, or will they do something else. And they will have to co-operate with service providers like us."

"That reform will enhance the need for expertise within the pension institutions, and if they don't have it there will be a legal obligation for them to acquire it from outside, from asset managers or other service providers," adds Leppälä. "And the changes will create a need for more information and more understandable information for all the parties concerned: the pension institution, the board of the pension institution and the supervisory authority."

"The base for our activity is analysis and reporting services," says Korhonen. "And we can provide this to clients. So we are not only an asset manager but also something like a consultant."

"The risk budget is there, they need to know how to use it," says Saikku. "The product areas that are going to be increasingly important is global equity, equity outside Europe, alternatives, hedge fund of funds products, hedge funds, real estate, private equity, and I believe it might be an interesting situation for traditional asset managers like ourselves. We are having to look at our offerings to cover all of that. As a major player you can't be a niche provider, you need to provide across the board."

So will an asset manager have to cover all the ground in the new post-Puro environment? "It depends on the asset manager's strategy," says Viskari. "If it tries to do everything itself then it would really be difficult to compete with the big investment banks, but if you co-operate with them it can be very fruitful. And if you try to do everything yourself you may find it very difficult because the solutions that investors will seek are global. They can invest in Finnish equities themselves as they have the local knowledge and experience so don't need a Finnish asset manager to do that. But they need help if they go abroad and the question is who will they co-operate with. If you can package things it is possible to offer services to these clients. We know the needs of Finnish clients better than the big investment banks."