Despite Danish banking scares, the local pension funds were unscathed by the financial troubles - at least until earlier this year. Brendan Maton explains why

Hellerup is an affluent northern suburb of Copenhagen, not quite home to foreign ambassadors but good enough for many of Denmark’s industry-wide pension funds, commercial providers and their subsidiaries.

Down by the quay the latest arrival, in a plush new white-stone headquarters, is one of Denmark’s largest banks. In years gone by, the new neighbour wouldn’t have merited a second glance. But in 2008, banks and property are a dangerous combination. So far this year, five banks have been bought at fire-sale prices, most of their woes caused by over-ambitious lending to real estate developers, exposed ruthlessly by the global credit crunch.

There are almost 200 banks listed in Denmark, rather a lot for just 5.5m inhabitants. The largest - including Saxo, owner of new headquarters in Hellerup - have not overstretched themselves. But lured by the country’s property boom, several smaller players tried to grow fast and leap up the league tables. They included Roskilde, which more than quadrupled its loan book in five years to become the country’s eighth-largest bank, before crashing this summer.

The central bank stepped in to take over Roskilde while others, such as Forstaedernes Bank, found a haven with larger competitors. Nykredit, the country’s largest mortgage lender, agreed last month to absorb Forstaedernes, which first came begging in August.

Danish pension funds, by contrast, seem to be in rude health. Unlike the banks, they were forced to increase their reserves - rather than their ambition - back in 2001. At the time the introduction of the traffic light system caused much pain. Having built up equity holdings in the late 1990s, funds were forced by the regulations to sell them near their low in the bear market.

The good news seven years on, is that of 61 entities (insurance companies and industry-wide funds) covered by the traffic light system, only three were in ‘amber’ at the end of June, the last date available for full figures.

Amber signifies that an institution is unlikely to maintain its solvency requirements should equity markets fall 30% and interest rates fall 1%.

Red envisages underfunding should rates fall by 0.7% and equities by 12%.

As a note of interest, on 14 October Iceland’s stock market fell 77% and rates were cut by 3.5% the following day.

However, only a committed pessimist could see this scenario in Denmark. Despite the fragility of banks at home and overseas, Danish pension funds are strong. So much so that the government has already brought them together with banking chiefs to see whether funds would provide much-needed liquidity. ATP, the DKK300bn (€40bn) nationwide supplementary scheme has already announced it is stepping in with DKK30bn, after earning a government guarantee on the loans.

Other funds declined to comment on the record but are believed to be looking at opportunities. One noted that deals would be bilateral, that is between individual funds and individual banks.

Tough solvency rules undoubtedly have projected funds into a strong bargaining position. But a couple of other benign characteristics that Danish funds do not share with their peers in other European countries should also be noted.

First, many of the largest industry-wide arrangements are just teenagers, less than 20 years old and receiving far greater inflows than they have to spend on contributions - or in the current market lose on investments. For example, Industriens Pension lost DKK2.1bn on investments in the first half of this year but received DKK2.7bn in new contributions.

The second extra characteristic is the diminution or removal of guaranteed returns. Although Denmark’s is often described as a defined contribution system, the presence of guarantees gives a form of defined benefit. Traditionally, those guarantees have been up to 4.5% but increasingly funds are looking replace them with bonuses conditional on performa nce, similar to the Dutch policy on inflation-linked pension. The retirement fund for architects, for example, no longer guarantees bonus rates each year.

ATP has gone a step further and switched to a calculation whereby future beneficiaries will receive the average of annual long-dated bond prices aggregated over their working lives.

Such moves, whatever other advantages they bring to pensions managers, bring flexibility on solvency requirements.

However, the great short-term threat remains worsening market conditions. Danish funds may be well funded and with increasing flexibility on benefit payouts but they have no special immunity from depreciation of assets. Although the country is renowned as the birthplace of liability-centred investing, several funds chose not to use swaps to lower volatility. In an unprecedented move, the regulator has asked for a quarterly update on solvency levels to this September (usually only funds in amber supply figures every three months).

Full figures were not available at time of going to press but the funds IPE spoke to seemed resilient despite the turmoil.

PensionDanmark, the industry-wide fund for caterers, crop-pickers, woodsmen, unskilled municipal labour and construction workers, has a capital base of DKK5.5bn on assets of DKK70bn. The base - not total assets - would have to diminish by DKK400m to enter amber light territory.

Paul Brüniche-Olsen, (pictured left) chief executive officer of the DKK30bn teachers’ pension fund, Lærernes Pension, told IPE that his fund was about 150% funded at the end of September, which gives it a green light. But Brüniche-Olsen is still concerned about the future: “The effects of the credit crunch on the real economy are only starting to show. This is much more worrying for us.” He looks to 2009 gloomily, predicting lower rates on bonds out to 10 years and anticipating that equities will be flat for the next 15 months.

So where are Danish funds turning to protect their solvency levels? Government debt is number one on the list but the Danish mortgage bond market also has attractions.

It might seem the greatest irony that anyone should seek refuge in mortgage bonds, the misselling of which began the current financial meltdown. But this surmise does not do justice to the Danish market.

No less an investor than George Soros has implored the US to reform its home-loan system on the Danish model, which has operated for more than 250 years. The system’s essential strength is that each bond is its own issue, so there is none of the obfuscation of credit risk that is ruining trust in the US. Credit risk is nailed to each borrower. Even if the house is repossessed, the debt remains for life with the borrower. Any future income for him or her, even 20 years after the repossession, would be liable to appropriation by the authorities. This keeps both parties to loans, lender and borrower, sensible. The transparency also comforts any issuer.

At the same time, the system is flexible: mortgagees are free to pay back loans whenever they wish, whether interest rates go up or down.

At the start of last month, the Danish government, in line with several other governments in Europe, announced that it would protect all bank deposits. Two weeks later the association of Danish mortgage lenders made it clear that it wanted no such guarantee for mortgage loans; the system withstands current tests unaided.

Which brings us back full circle to ambitious banks making foolish property loans. Certainly, the residential market has enjoyed champagne times and the hangover has begun. Depending on their own fortunes, locals either boast or note wryly that prices in Copenhagen have risen faster than in London. But the worst of loans were to developers, who are outside the well-functioning residential market described here. Some lenders did not even demand collateral, an approach euphemistically summarised as “a lenient credit culture” by central bank governor Nils Bernstein when announcing the takeover of Roskilde.

While the building cranes are still in action around Copenhagen, it is generally accepted that much real estate is in fact ‘dream’ estate. Prices have slumped and herein lies some danger for pension fund portfolios - how to factor in the depreciation. Unlike listed securities, property cannot be marked to market every day. With no instant valuation, some funds are believed be more optimistic than others on capital appreciation.

The financial supervisory authority, the Finanstilsynet, points out that valuations must be in line with legislation - the traffic lights include recognition of real estate prices. More profoundly, as part of the tightening of its supervision it is asking individual pension funds for more explanation of their property portfolio’s individual valuations.

The likelihood of a pension fund failure, despite woeful investment prospects, is negligible. But already the gossip in Hellerup is turning away from fallen banks to the prospect of red lights.