The main distinguishing feature of the pensions system in Finland is the involvement of competing private sector entities in the provision of the statutory first pillar pension.
“The main idea of this kind of system where compulsory schemes are operated by private sector institutions which compete with each other is that with this kind of decentralised administration and internal competition returns will be better than if we had a national state pension fund to run all schemes,” explains Matti Leppälä, director of international and legal affairs at the Finnish Pension Alliance (TELA).
The various types of institution do not enjoy equal treatment, and asset allocation among them varies widely as a result.
Of the total first pillar pension liabilities, between 20% and 25% are funded; at the end of June this funded portion amounted to E83.5bn, according to figures provided by TELA. The rest is financed on a pay-as–you-go basis.
On account of the generosity of the compulsory provision, the significance of additional, voluntary schemes is relatively minor. They account for around E5bn of pension assets.
The main players in the compulsory sector are the pension insurance companies, which run company pension funds. They account for E48.3bn (57.9%) of the total, of which the main providers, Varma and Ilmarinen, dominate the market with around E20bn each.
Employers can also chose to set up their own pension fund as a means to provide the statutory cover, either as a stand-alone company scheme or as part of an industry-wide sector scheme. These schemes are governed by elected executive boards consisting of equal employee and employer representation, and together they account for 8.8% of the total.
In the recent past there has been discussion as to whether the competition between these funds and the pension insurance companies was fair. Until last July, a company that wanted to leave a pension insurance company to set up its own scheme did not have the right to transfer the accumulated funds to the new arrangement. “So there was only movement from the companies dissolving their own schemes and going to a pension insurance company,” says Leppälä.
The remaining 33.3% consists of two major schemes, the Local Government Pensions Institution (LGPI) and the State Pension Fund, as well as some special smaller schemes for a variety of groups including sailors and farmers.
According to TELA the total value of all compulsory schemes grew by 11% last year, largely thanks to better stock market returns. The average real return last year was 7.6% compared with slightly negative returns in 2001 and 2002 and an average of 2.8% for the five years from 1999 to 2003.
At the end of June 31% of total assets were invested in equities, 47% in bonds, 9.2% in real estate and 4.9% in money market instruments. The rest is loans to employers who have the right to borrow money back from the scheme.
The main trend seen is that the investment in domestic bonds and equities, has diminished during the last few years. At the end of June investment in Finland stood at 35.8% of total pension assets, down 3.3% this year; a few years back it was close to 100%. Leppälä agrees that the reason for this is the need to diversify away from the very small Finnish market. “The main markets are Sweden, the US and the UK,” he says. Of the equity portfolio 71% is foreign, and of that 49.6% is outside the euro area.
Where investments in bonds are concerned, the main development has been a gradual move to corporate bonds, which now account for 21% of total assets. As elsewhere they are attracting more attention as funds seek to generate return in the low interest rate environment, as well as diversify away from government-specific risk.
In the main they are investment grade, but as Annika Knekt-Ahtinen, head of institutional business for Finland at JP Morgan Fleming notes, “high yield has become more visible in the market; you need to get the extra return from somewhere.” Inflation-linked bonds are also growing in popularity as a buffer against risk.
Readiness of a fund to take risk lies partly in the question of fund liability. Company schemes are liable to meet their liabilities if they exhaust their assets. But if a pension insurance company goes bankrupt then all the other pension insurance companies have to cover the liabilities.
However, if the returns are good company schemes can keep them and reduce the level of contributions accordingly if they wish; a pension insurance company would give only a partial refund of the contributions.
“This is the main factor which would influence a company’s decision to set up a stand-alone scheme or entrust its pension arrangements to a pension insurance company,” notes Leppälä. And underlying that is readiness, or need, to take risk.
Furthermore, pension insurance companies and stand-alone and sectoral schemes have to cover their liabilities on an annual basis. Olli Pusa of Pusa Consulting notes that as a result of this they are subject to very strict regulations in terms of how much risk they can take, and these are based on the level of solvency capital.
The more risk that a fund wants to take, the more capital it must have to cover any potential losses, with the precise amount being calculated using a formula. Pusa explains that if a fund wanted to invest 50% of the portfolio in equities, it would need assets that were between 130% and 150% of liabilities, depending on the composition of the rest of the portfolio. At one end of the scale, investment in equities from outside the OECD is considered so risky that it is not counted as an asset in the solvency capital calculation. Conversely, if the whole portfolio were kept in cash, no solvency capital would be needed at all.
Prudence seems to be high on the agenda of the powers that be, but let’s avoid overkill if we possibly can. Eero Gauffin is managing director of Helsinki-based consultants EG Aktuaari. “It is a good regulation but perhaps it is not flexible enough. Common sense says that when stocks are at their lowest price you should buy, but when they are at their lowest you don't have the solvency capital.”
Meanwhile local government and state employee schemes are free from this regulation; historically they have had a great deal of autonomy in the running of their affairs. “They can take longer term view; what happens during the years in between is not a problem,” says Pusa. “So they can take more risk.”
The result is that their allocation to equities is much higher than that found in the rest of the compulsory sector, some 42.8% at the end of June compared with 25.9% in the case of the pension insurance companies and a similar figure for stand-alone and sectoral schemes.
Another difference that can be seen in the different asset allocation of the different types of scheme is that sectoral schemes have a higher proportion of the portfolio invested in real estate: some 29.5% at the end of June. Leppälä cites the example of retailers who tend to own their stores which then feature as part of their fund’s investment in real estate.
Stand-alone company schemes have a relatively high proportion of the portfolio allocated to money market instruments. Leppälä explains that the liability of these schemes to cover all losses when returns are bad is the main reason for this. Back in 2000 they had 37.7% of the portfolio invested in equities but this had fallen back to 24.9% by June of this year on account of the bear market.
The solvency regulations are not at all popular; many see the classification of assets by risk as a misclassification, notably where hedge funds are concerned.
“The authorities have made hedge funds belong to the riskiest asset class and haven't taken into account the real risk which varies with the structure of the fund,” says Leppälä. “Some of our members have made an application to the supervisory authority to admit hedge funds to a lower asset class to reflect their real risk.”
He adds: “We have also discussed whether there should be a shift from the asset class based rules towards the prudent person principle.”
He laments that “the present day rules in terms of asset allocation always lag behind the reality of the investment world.”
But perhaps we should not be too harsh on the regulator. “It is an educational two way learning process,” says Annika Knekt-Ahtinen country head for institutional investment at JP Morgan Fleming. “The regulators and asset managers can play a part too.”
She adds: “The challenge for the regulator is to keep up to date with all the different investment instruments in the market and to understand what it is and how influences the investment decision.”
The solvency issue is linked to the EU life directive, in a roundabout way, as Leppälä explains: “Our schemes are not bound by the life directive; this is due to the special relationship our pension schemes were given when we joined the EU 10 years ago. Even though this is the case the authorities have chosen to follow the rules of the life directives as far as possible. Life directives apply to additional, voluntary pension schemes, currently worth E5bn.
Another unpopular piece of regulation can be found in the area of real estate, which represents 9.2% of the assets of compulsory schemes. Currently returns generated on direct holdings are tax free, while those on real estate funds are not. “So it is not advantageous for our members to invest in funds,” says Leppälä.
The logic of the Ministry of Finance is that all companies should be taxed according to the same basic principles, and that it shouldn't make a difference that the business of a company is real estate. “They have not recognised the development in Europe and in the world of the real estate investment trusts and such like,” notes Leppälä.
Here too local government and public employee schemes are on to a good thing, being exempt from the tax.
While pension funds grapple with regulation, the issue of return generation in an environment of low interest rates and uncertain equity markets is forcing managers to think a little more creatively. “Managers have tended to adopt a more passive approach, keeping closer to the index,” says Knekt-Ahtinen of JPMF. “They are now starting to consider whether it would make sense to be active on the asset allocation level. Something that is being discussed more and more is whether tactical asset allocation or active currency overlay could increase return.”
She adds: “It comes down to the size of the plan; resourcing varies hugely. I would say that the big plans are very sophisticated and use a lot of different sources to get that extra return.”