Nina Röhrbein analyses how the current financial and interest rate environment is affecting German pension funds' asset allocation

"German pension funds are in no-man's-land, stuck between the old regime with its high interest rates and a new, low-interest rate environment," says Carlos Böhles, head of institutional business at Schroders in Germany. "While they still manage to live off the hidden reserves of the good old times, the question is how long this will continue, particularly once interest rates and inflation start to rise."

German accounting standards allow the country's pension funds to spread returns over time, meaning they can fall back on their returns from earlier years to meet their guarantees. In addition, they tend to have buy-and-hold portfolios, which allow them to avoid realising losses when interest rates rise. Hold-to-maturity investments typically also produce coupons with a return of over 4%.

But in the future, based on their current investments and interest rates, pension funds are unlikely to meet their return guarantees, which typically range between 3-4%.
To receive relatively stable coupon payments and control volatility, they have started to move into asset classes such as high-yield bonds, emerging markets, real estate and convertibles. Some pension funds, particularly regulated ones, also invest much more opportunistically through the use of instruments such as risk overlays with an explicit floor if markets head south.

"In the end, there are only two ways to get out of this low-interest-rate environment - either to cut, particularly guaranteed, benefits or to carry more significant equity or some alternatives risk again," says Peter König, CEO of the German association for financial analysis and asset management DVFA. "Only in those asset classes will pension funds find the high-yield generating capital they need. Pension funds are equipped to invest long-term and carry this risk. But it is difficult to get this message across in a risk-averse environment, preparing for the arrival of Solvency II."

While in most cases existing benefits cannot be cut, future benefits are likely to be less generous. "Even the best performing insurance-like pension funds of 2011 have already reduced their total interest to 4%," says Marcus Burkert, executive manager at Feri Institutional & Family Office. "CTAs, which previously had a guarantee of up to 5-6%, are also in discussions to cut it as far as possible."

But despite the interest-rate dilemma, the overall strategic asset allocation of German pension institutions - direct pension promises, direct insurance, support funds, Pensionskassen, Pensionsfonds, Contractual Trust Arrangements (CTAs) and Versorgungswerke - has changed little over the last few years.

At present, German pension funds tend to take mainly interest rate and credit risk but stay clear of real assets or absolute return strategies. "Investors stopped investing in asset backed securities over the last two to three years," says Böhles. "This lack of diversification coupled with a financial ideology based on a relative performance of asset classes has stood in the way of a more pronounced trend to absolute return solutions and led to a dependence on interest rates."

Regulated pension vehicles such as Pensionskassen, direct insurance and other insurance products have maintained a low, one-digit exposure to equities since the financial crisis.

Few changes occurred in the asset allocation of CTAs either. "They may have undertaken some de-risking or liability-driven investment (LDI)," says Herwig Kinzler, head of Mercer's investment consulting business in central Europe. "With an LDI strategy they are probably invested in risky assets to an average of 30%."

According to the association of company schemes (AbA), German insurance based pension funds have a 66-80% exposure to fixed income, while real estate only makes up 2-10%.

One trend in fixed income has been to replace peripheral bonds, typically with corporates, absolute return type fixed income mandates and emerging market debt. Some pension funds also replaced their peripheral bonds with real estate because it produces coupon-like returns.

"Italy, however, has emerged as an interesting investment because based on its spreads it is no longer viewed as part of the periphery," says Martin Katheder, head of German pensions business at Allianz Global Investors (Allianz GI).

Investments in corporate bonds are nothing new to German pension funds. "Corporate bonds have always been a popular asset class for German institutions," says Kinzler. "Based on international accounting standards, the discount rates of liabilities are linked to the corporate bond yield. A typical matching asset class for CTAs is a combination of corporate bonds and duration. For regulated vehicles, corporate bonds have more recently become high quality replacements for government bonds because they typically issue 3.5-4% in guaranteed interest rates, which German Bunds or other AAA-rated government bonds cannot do at the moment."

"Investors have realised that many corporates present a lower risk to them than certain sovereign bonds," adds Böhles. "We expect 3-4% return on corporate bonds with a good credit rating this year. The question is whether this diversification will also jump to equities because we have arrived at a point where more risk needs to be taken again."

Dynamic asset allocation has become more popular too. Depending on the individual risk budget, high yield and emerging market bonds make up on average around 5% of the allocation of German pension funds. "Investors are taking more risk but by holding bonds with a lower credit rating rather than equities," says Burkert. "However, exposure to riskier asset classes is only being undertaken with an overlay or capital preservation approach despite overlays costing investors 1.5-4% in performance in 2011. Alternatives such as infrastructure, private equity, commodities and absolute return products are added to a certain extent but are not the main focus of pension funds."

Some CTAs though have begun to invest anti-cyclically in equities. "In the past, it was always one asset class that was seen as delivering a risk premium, such as government bonds," says Kinzler. "Now it is much more about tactical investments with a tendency to increase equity exposure if the markets are right. It is a much more short-term driven activity than the previously long-term horizon on equities and coupled with diversifiers such as hedge funds."

With regard to property, German pension fund investors have broadened their horizon beyond core German real estate and started to diversify globally. At the same time though, there has been a trend to move out of property funds and back into direct or pooled investments with other pension funds.

"Capital preservation is more important to German pension funds today than yield," says Katheder. "They try to limit the downside risk through risk management systems and a shift to safe spreads. The shadow cast by Solvency II and its capital adequacy rules has only encouraged this behaviour."

But paradoxically, the current capitalisation of German pension funds would not be sufficient under the new regulation, which German pension funds also expect to apply to them to some extent. Solvency II, Kinzler believes, will lead to dramatic changes in asset allocation due to the current mismatch in duration. Typically the average duration on the assets is 5-7 years, while that of the liabilities is 15-20 years.

"Under potential solvency related new requirements, we expect increased demand for real estate, infrastructure, private equity, commodities and renewable energy," says Katheder. "For real estate, it may prove to be more beneficial for pension funds to invest in direct mortgages than property. Apart from the asset allocation, the main challenge for pension funds under possible new regulations are increased transparency and reporting requirements."