“In general one of the major factors behind last year’s performance by Danish pension funds was their interest rate hedge,” says Michael Weischer, investment manager at Pen-Sam. “Those with the highest guarantees, and therefore with the largest hedge, gained the most.”

In 2005 Pen-Sam managed four pension funds, with a fifth, PMF-Pension, being added last April, and life assurance company Pen-Sam Liv. “Pen-Sam Liv is the largest of them, accounting for around 55% of the total balance,” says Weischer. “Our return was around 14% - 15% for Pen-Sam Liv and an average of 16% for the pension funds. Almost all met or exceeded their separate benchmarks for the various asset classes, so our result was due to a question of asset allocation and the size of the interest rate hedge.”

That’s somewhat ironic because the guarantees have been seen as a challenge for some time.

“Quite a few pension funds have moved away from guaranteed products and to an increasing extent are trying to create systems without guarantees,” notes Jesper Kirstein of consultancy Kirstein Finans. “That would liberate the investment strategy quite a lot. Of course, they still have to be able to cover any losses but would not be dependent on what’s happening on the liability side.”

“The high guarantees that many institutions have mean that they still have to be quite safe in their investment strategies,” notes Anne Seiersen head of the occupational department at Forsikring & Pension. “Asset liability management is the most decisive force of course in planning their investments in the future and even though they have increased their equity share, bonds are still the main asset they invest in. That’s a long-lasting trend. Equity was growing last year but more as a consequence of increased value than increased buying.”

However, Kirstein has a different view. “On the asset side, pension funds have increased their allocation to equities,” he says. “And to some extent they are moving away from local equities, which have been excellent in the Nordic region for the last three to four years, outperforming global equities. But they have been saying ‘thank you very much, we’ve received the benefit from this but now we are moving more into international equities’.

“In addition, they are moving more into international bonds. And their accounts for 2005 show an institutional change in the way they report the allocation of assets. Before, they reported ‘we have so many Danish bonds, so many international bonds’ and the international bonds were divided into euros and non-euros, by region or currency and primarily on region. But now they say ‘we have government bonds and mortgage bonds. We don’t care whether they are Danish or whether they are international’. And that, in fact, reflects the way that Danish pension funds think now. They think more in terms of credit or other segmentations and not in terms of issue of country or issue of currency.” “Unlike most Danish funds we are not working with any products that have a minimum guaranteed return,” says Claus Stampe, chief investment officer at PensionDanmark. “This means that our investment strategy is not liability driven, which enables us to invest with a long-term perspective and a higher risk profile. Because of this we have more exposure into equities than most other Danish funds. In 2005 PensionDanmark posted an annual return of 15.3% on assets totalling DKR52bn (€6.9bn). “The return was 280bps above our strategic benchmark for the fund,” says Stampe. “The main factor behind the strong overall result was our equity portfolio, which returned 28.5%, almost 10 percentage points above the benchmark for the equity portfolio. The main drivers behind the outperformance was a decision to underweight the US market. On top of that our equity managers outperformed their benchmarks by on average 300bps and there was also a significant contribution from our internal active currency overlay.”

Peter Damgaard Jensen, managing director of PKA says: “We were heavily overweight in Danish equities, where we had a return of 47% because the Danish stock exchange had a very good year compared with the MSCI World index . We had an overall average return of 18.4% for all eight pension funds that we manage, with individual results ranging from 17% to 19.2%, and that was mainly because the return on our equity was around 30%. Then we had a good year for real estate, which gave a return of 15.1%. In addition, we have a liability-matching strategy, especially with derivatives, and there the return was very high. And of course that was matched by our liabilities rising. On average we were between 30-35% in equities, around 10% in real estate, up to 10% in liability-matching assets and the rest was in bonds, and we have some very long bonds in the liability-matching category. Of course, we were a little worried by the rise of bonds throughout the year and the fall in interest rates which we could feel on the liabilities side.”

“Combining the present low long-term yields and risk premiums in the markets with an expected slowdown in the global economy, we expect lower returns from financial markets than was common for most of the 1980s and 1990s,” says Stampe. “Nevertheless if we can avoid a significant slowdown in the US, we feel that equities are attractively priced compared with most other active classes and if equity prices drop further we will therefore probably start to gradually increase our exposure.”

“At the end of June equities were not doing at all as well as last year but we had a return of around 0.5-1%,” says Damgaard Jensen. “Companies are doing well in Denmark and also in Europe and the US, but there are a lot of people in the market who are a bit nervous. Of course, what is going on with oil prices, interest rates and various political issues like the situation in the Middle East are not helping. Meanwhile, because the interest rate has risen we have lost a little on our bonds, and are down around 1.9%. But real estate it is still quite positive.”

But Damgaard Jensen does not plan to make changes. “I think we are going to stick to what we have,” he says. “Our ALM studies show that we should be around 35% in equities, and we have made our liability matching so that we would be able to stick to that even if the markets go against us. Of course it may deteriorate to the point where we have to do something but we will try to stick to that goal. For the moment we won’t be so heavily allocated to the Danish market and will move more into markets abroad, above all the US.”

“We don’t expect any significant changes in our strategic asset allocation,” says Weischer. In 2005 we had 25-30% in equities, Pen-Sam Liv had 5.5% in real estate and the four funds had around 15%, and they have, as a kind of residual, around 50-60% in fixed income. However, we are increasing the real estate exposure for Pen-Sam Liv through funds and have already given our first six commitments, we are also extending our private equity programme and we are considering various absolute return products. It could be hedge funds or other things; w e haven’t decided yet.”

“Alternatives are very much in fashion,” says Kirstein. “A move to private equity which is certainly a very important trend, although in general it is not more than 2-2.5% of total assets but commitments are a lot bigger.”

Seiersen has seen a similar move. “In 2006 we have seen some of the pension institutions selling real estate, especially housing, to take profits ahead of expected price falls, and looking for greater diversity, increasing their unquoted assets. We have seen great rise, but from a very low level so it is still a very small part of the entire assets.”

“We plan to increase our private equity exposure to about 4% of total asset in the coming years,” says Stampe. “To achieve our goal we will have to commit €100m each year to new funds. So far this year we have made allocations to four buyout funds and have just decided to build up an exposure in infrastructure. Our aim is to have about 2% of total asset invested in infrastructure in the next three years.

“Pension funds are buying into hedge funds, and some have quite substantial allocations,” says Kirstein. “On an overall basis it is not more than a fraction of a percentage but we see it as a trend. Of course this is also due to the fact that interest rates still are pretty low and that the yield curve is so flat. The flat yield curve will increase the attraction of money market instruments and in some way you can term a hedge fund as a money market-related instrument.”

Just how much to commit to hedge funds is a problem for Weischer at Pen-Sam. “It’s a dilemma we are considering at the moment,” he says. “It’s difficult to tell whether a small allocation is having any influence. If you go into hedge funds they should have a significant impact; you should go for 10-15%.

“We are looking at risk control and at manager selection,” he adds. “We have spent a lot of effort on finding the right and best managers and in the last couple of years we have extended the number of external managers significantly. In addition, we have focused on improving the TAA process. And then we have to move within the stress test limits that the financial authorities have set up here. Also we are implementing a new ALM model which we expect will be the anchor in all our quantitative analyses.”

“We are also considering increasing our exposure to different kinds of absolute return products,” says Stampe. “If we decide to do so, they will be included into the portfolio as an overlay. Increasing our active risk budget might be part of a solution to the modest returns we expect going forward, but we are painfully aware that alpha generation is necessarily a negative sum game. Furthermore, in a world of single-digit returns the impact of costs becomes very important, and increasing the allocation to absolute return products is surely having a significant negative impact on a funds investment costs.”

Weischer is focusing on costs in a wider context. “In general we are looking closely at costs and streamlining the organisation to improve our position in a future with more consolidation and a more competitive environment.”