From ugly duckling to swan
Michael Kjeller of KPA Pension tells Nina Röhrbein about his fund’s transformation
“A decade ago, KPA Pension was regarded as the ugly duckling of Sweden’s pension industry – recently we were told we had become a swan,” says Michael Kjeller, CIO at KPA Pension.
The fairytale became reality during the financial crisis.
“The main reason why KPA Pension is viewed differently today is because of the way we handled the financial crisis,” explains Kjeller. “We entered the crisis with strong interest rate protection on our liabilities and found ourselves in a position where we were able to sell that protection at a time when it was expensive to buy. In addition, the positive effect of our interest rate protection allowed us to start investing in equities in the first quarter of 2009, this had a tremendous effect on solvency.”
After a negative performance of 3% in 2007, the pension fund generated a positive return of 6.3% in 2008 as most pension funds posted losses. This was bettered by a performance of 12.4% in 2009.
Consequently, its solvency ratio – relative to peers – took off. It stood at 143% at the end of June, compared to 105% in 2002.
At the same time, the nominal average annual return stands at 5.8% over the last five years, well above that needed to meet hard guarantees and the average long-term return target of a real return in excess of 3%.
“But the financial crisis has also demonstrated that we cannot be certain to live happily ever after,” admits Kjeller. “There will be other challenges ahead for the pension industry. However, given KPA Pension’s strong solvency ratio and cashflows and the experience we have gained from the past we feel confident that we can continue to do well.”
KPA Pension started in 1922, insuring 400 people in 11 towns. Since those days, its activities have multiplied many times over. It currently takes care of the pensions of over one million employees of Swedish local authorities, regions and municipalities. The pensions are regulated by collective agreements between employers and unions, the main one of which is KAP-KL. This agreement offers premium-based defined contribution retirement pensions, defined benefit retirement pensions and survivors’ pensions. The individual schemes are negotiated between the different employer and employee organisations. Employers pay in an amount equivalent to 4.5% of salary annually, which the employees may themselves invest in either traditional pension insurance or a unit-linked pension scheme.
“Like other pension funds, we want to maximise the benefits of our policyholders,” says Kjeller. “But, we have a huge responsibility in managing the occupational pensions of so many people, most of whom have a relatively low income. This is why we strive to provide the best pensions possible without endangering hard guarantees.”
In its early days, KPA Pension was entirely owned by the Swedish Association of Local Authorities and Regions, an employer organisation. Today it owns 40%, while 60% is owned by the insurance company Folksam.
Ten years ago, its assets under management amounted to SEK5bn (around €580m). As of 31 August 2012, assets under management, however, stood at SEK86bn, or over €10bn.
This is largely due to the fact that KPA Pension has been the default choice for occupational pension fund provision for local authority employees over the last decade, in other words employers and unions have agreed to invest the occupational pensions of those who have traditional pension insurance with a guaranteed repayment and do not actively make another choice with KPA Pension.
The fund is currently the pensions administrator for 80% of Sweden’s local authorities and municipalities.
KPA Pension’s asset management is shared with Folksam, which has 20 portfolios with assets under management of over SEK300bn.
“We want to take full advantage of the economies of scale, but still control and run risk in-house,” says Kjeller. “Thus, we do some of the management internally while other duties are outsourced. KPA Pension’s level of risk, for example, is tailored using equity, fixed income and foreign exchange derivative overlays. The tailoring and the execution of such derivative transactions takes place in-house.”
Property investments are managed both internally and externally. But KPA Pension’s standardised equity and fixed income mandates, as well as most of its business administration, are outsourced to one of Scandinavia’s largest asset and mutual fund managers, Swedbank Robur.
The benchmarks used for its external mandates are the OMX index for Swedish equities, the MSCI World for foreign equities and the OMRX index family for fixed income.
“Swedbank Robur is doing a good job but given their low tracking error mandate, they do not immensely affect KPA Pension’s total return,” says Kjeller. “More than 98% of the return is a result of the efforts of the board and the employees of KPA Pension.”
The board sets the bandwidths for the asset classes, before the CEO and asset managers make a precise decision on the asset allocation within the given limits of the framework.
As of 30 June, KPA Pension’s asset allocation consisted of 27% equities, 68% fixed income and 5% real estate and alternative investments. Its small, 1% allocation to alternatives consists mainly of private equity investments such as wind farms.
While most other pension funds have set sail in the direction of emerging markets, KPA Pension’s current emerging market exposure across equities and debt equates to only 1%. The fund sold its US and euro bonds in the spring of 2007 and has only invested in Swedish government and covered bonds since. The pension fund has no plans to invest in high yield.
According to Kjeller, KPA Pension’s asset allocation should at any point in time be optimal, taking into account its long- and short-term targets, legal constraints, available capital and its outlook on the financial markets.
“We try to keep an active approach to risk management and given the turbulence of the financial markets we have done a lot of it in recent years,” says Kjeller. “Our equity exposure, for example, has varied between 25-45% in the last couple of years. We have learnt from the financial crisis that we need diversification only in very difficult situations but even then we can only rely on true causal diversification between assets.
“Overall, we prefer to further develop areas we already consider ourselves to be good at rather than enter new asset classes. This is why we do not invest in commodities. We also want to make sure not to build an inventory of small and odd investments that cannot make a significant difference to our bottom line return.”
Kjeller says that asset liability management studies were important five to ten wyears ago when mark-to-market evaluation of technical provisions was introduced. “Nowadays, such studies are of less importance although of course, the actuaries keep a close watch on how liability cashflows develop over time,” he says. “That input is important for the long-term view on the asset management of the fund.”
In 2007, KPA Pension underwent major structural changes.
“The real life test of our internal structure was during the financial crisis and its aftermath,” says Kjeller. “It confirmed to us that our model works when it is needed the most, and this is reflected in our solvency ratio, which is slightly higher than pre-crisis. It is our strong cashflows that distinguish us from most other pension funds. The cashflows are certainly in favour of KPA Pension going forward.”
But falling interest rates have taken their toll on KPA Pension as much as others, lowering the solvency ratio in recent months as well as reducing its available risk capital.
And so in June, after extremely low rates for 10-year bonds, the Swedish financial supervisory authority proposed a temporary floor on the discount rate used by pension funds.
“We understand why the supervisor recently changed the rules for calculating technical provisions during the financial crisis and why a temporary interest rate floor was established,” says Kjeller. “However, it is difficult to tell whether the floor has had any effect on Swedish interest rates. It has certainly not influenced the way we invest money. We recognise the logic behind the introduction of the floor and the proposed ultimate forward rate, which is in preparation for Solvency II. But while we welcome the long-term stabilising affect of those changes, their immediate effect has been to our disadvantage. Although, true economic risks always stay the same, major changes in the legal framework affect pension funds’ activities and financial markets. These changes make hedging activities more difficult.”
If interest rates stay at similarly low levels in the future, KPA Pension will have to shift its focus from volatility to yield, which is likely to affect its asset allocation.
But Kjeller is confident that KPA Pension can continue to cope with its guarantees, at least for the time being.