Going to the limits
Pension fund asset allocation in central and eastern Europe remains constrained by limits. These have been variously imposed to take account of the short investment history of the former communist states, to boost local capital markets and to contain risk. Yet as the asset value of the funds grows, especially in the second pillar schemes with their mandatory components and guaranteed annual inflows, these limits can also impede diversification.
Limits typically include the maximum equity component, self-investment (in associated companies of the pension fund), single-issuer limits, structured products, real estate and foreign exposure. Equity limits in the case of second pillar funds range from 60% in the case of Poland down to 30% in Latvia. In the case of Estonia, Latvia, Lithuania and Slovakia fund managers must provide a choice of funds with different risk profiles, including a pure fixed income option for older clients and riskier funds with higher equity components for the younger cohorts.
In Slovakia’s second pillar system, which started in 2005, each fund manager must offer conservative, balanced and growth funds. Since the system is only compulsory for new entrants to the labour market, the age profile is relatively young and some two thirds of participants have opted for growth funds. However, fund managers are still building up the equity portion. According to Jiri Rusnok, ING’s pension director for the Czech Republics and Slovakia, ING’s growth fund currently has some 8% in equities and 16% in bonds, with the remainder currently invested in money markets.
In Poland the high equity limit combined with a 5% foreign investment cap, the lowest in the region and the sheer size of second pillar funds - €22bn at the end of 2005 - has had some profound effects on the local market. Of the 60% equity cap, there is a limit of 40% on investment into regulated markets, in practice the Warsaw Stock Exchange (WSE), the region’s largest in terms of capitalisation.
Polish pension funds have shares in some 165 of the 255 companies listed on the WSE at the end of 2005. “The pension funds follow a moderate risk strategy, and if their allocation comes close to 40%, it’s obvious that pension funds will be on the sell side, which influences market expectations,” observes Michal Szymanski, chief investment officer of Commercial Union Poland Pension Fund, the largest of the 15 second pillar pension fund companies. In a rising market this self-correcting mechanism of such significant players decreases volatility. “When prices of equities rise, their portion in the portfolio’s value rises as well, and should there be a speculative bubble, pension funds would sell regardless of their price expectations,” adds Szymanski.
Meanwhile, the low foreign investment limit in Poland makes it expensive in terms of trading, legal and other required skills. The average foreign component at the end of 2005 was 1.7% and was primarily in stocks and non-treasury debt instruments. The cost of exposure due to trading costs to foreign markets is high, although given the size of the funds’ asset growth, an increase in the foreign limit in one to two years’ is inevitable to allow diversification, says Szymanski.
Single-issue limits are typically around 5%. Slovakia has an exceptionally low limit of 3% (except for state issues and mortgage bonds), which funds managers consider restrictive. “Given that the Slovak market is very illiquid, we would appreciate this rising to 5% or even 10%,” says Mario Adamek, investment manager at Aegon Dss, one of the six Slovak second pillar pension managers. The 3% limit also applies to exchange traded funds, which provide low-cost liquid vehicles for Slovak fund managers. “This makes it very restrictive, and we can’t diversify our portfolios,” complains Adamek.
Hedging allowances also vary. Slovakia allows for currency hedging of up to 5% of a portfolio‘s asset values. Conservative, fixed-income funds must be fully hedged against currency risk. “In practice that means we can only invest in Slovak crown assets,” notes Adamek. Interest rate risk hedging, however, is not allowed, although in practice local fund managers are buying Slovak crown denominated floating rate note (FRN) euro bonds, because they expect interest rates to rise, says Adamek. In some markets hedging remains totally forbidden. In Poland derivatives were due to be permitted as of 2006, but following the 2005 general election, the new government ruled that they were still too risky.
The minimum return benchmarks that apply in some countries impose another constraint on asset allocation. Polish pension fund companies must produce a minimum return of half the average performance or four percentage points below this - whichever is the lower - over a three-year period, or make up the difference from the company’s capital, a fate that has befallen a several pension fund companies over the past couple of years. Paradoxically, the system makes pension funds reluctant to deviate from the average fund portfolio, and hence to diversify.
Slovakia’s benchmarking system is hugely complex and confusing, and for that reason, predicts Adamek, may well be abolished this year. Two years after a fund’s inception, its average yield cannot be lower than 90% of the market average in the case of conservative funds, 70% for balanced funds and 50% for growth funds. If the average market yield is negative, the absolute value of the average yield of the fund cannot be higher than 111% of the absolute of the average yield in the case of conservative funds, 143% for balanced funds and 200% for growth funds.
The limits will be considered breached if the difference is higher than 1 percentage point for conservative funds, three percentage points for balanced funds and five percentage points for growth funds. If this occurs, pension asset management companies will have to make up the difference from their own sources to the funds in order to reach the average market return.
Performance guarantees are not confined to second pillar funds. Since 1994 the Czech Republic, which has not yet adopted a second pillar system, has had a third pillar scheme with generous tax allowances. Until 2004 the only foreign investment allowed was for bonds issued by OECD member government and central bank bonds; the following year pension funds could diversify into OECD corporate securities.
In practice, the funds have remained ultra-conservative. As of the end of the third quarter of 2005 some 80% of the funds’ investments were in fixed income, including short-term treasury bills, around 10% in money market instrument or cash, less than 1% in real estate and only some 8.4% in equities.
“The main issue is not limits but the economic vehicle - the implicit guarantee of positive returns on a yearly basis, with at least a zero result on individual accounts,” explains Rusnok.
Limits or not, market perception can just as easily influence pension asset allocation. Take Hungary, which on balance has one of the most liberal investment requirements yet one of the most conservative allocation strategies. “Regulation has nothing to do with this,” stresses Peter Holtzer, CEO of OTP Fund Management, the country’s largest pension and fund manager. For both the second and third pillar, there are no limits on listed stocks (until recently there was a 50% cap), and none on state bonds. The funds can invest up to 50% in investments, 10% into real estate (the most developed fund market in the region) and 30% overall abroad, which is due for revision.
Furthermore, there are no minimum benchmark requirements because the pension fund members are owners, not clients, of the fund. Yet aggregate mandatory portfolios as of the end of September 2005 of €4.2bn comprised 74.2% state bonds, 8.2% stocks and 9.5% investment funds. Voluntary pension funds (€2.3bn) were similar, at 75.2%, 8.5% and 6.6%, respectively.
Hungary’s conservatism stems from the practice of funds publishing only annual returns. “The good news is that finally we have a new regulation where funds must publish five-year returns,” says Holtzer. “Once this information is published, it may change the mentality of pension funds towards a longer-term horizon.”
According to Holtzer, funds that had a higher equity allocation in 2005 produced better results. OTP’s fund, for instance, which had 20% in equities, of which 15% were foreign, produced a net real return of 10-11%.
With asset allocation regulations differing so widely across the region, cross-border management becomes challenging. The investment subsidiaries of Estonia’s Hansabank manage second pillar pension funds in the three Baltic States. Robert Kitt, fund manager of Hansa Pension Funds in Tallinn and chairman of the joint asset allocation committee, describes the Latvian market as relatively risk averse, especially regarding equities - it has the thinnest Baltic States stock market - while Lithuanian pension fund participants have shown a strong regional bias.
Second pillar equity allocation limits stand at 30% for Latvia and 50% for Estonia, while the Lithuanian system has none. However, Estonia, unlike the other two, allows investment into unlisted securities. “We can invest up to 10% in unlisted stocks and bonds, and a further 10% in direct real estate,” says Kitt.
When the Lithuanian pension system started in January 2004 the equity portion was around 20-25%, but this is now increasing, according to Kitt. In Estonia the second pillar had net assets of €294m at the end of 2005. Higher risk, equity-weighted funds are proving far more popular in both pillars. Hansa’s equity oriented second pillar fund has around a third of the entire second pillar market. The equity portion last year was around 40% regional (of which a quarter was in the Baltic States, a quarter in Russia and the rest in the new central European members of the EU), and 60% global but with a heavy European bias. “We are looking for growth and over the last six months have moved into Bulgaria, Romania and Serbia,” adds Kitt.