Keep it simple, stupid
Nina Röhrbein speaks to Peter Hansson, CEO of Swedish pension fund, Sparinstitutens Pensionskassa, about how how he keeps it simple
As defined benefit schemes in the UK and the Netherlands struggle to maintain – or return to – a sufficient funding level, one pension fund in Sweden can claim to have never been underfunded – the Sparinstitutens Pensionskassa, commonly known as SPK.
The fund has never fallen below a funding level of 116% in mark-to-market valuation and currently stands at 145%. This is a result of its cautious approach.
“Due to our taxation right, in other words being able to invoice the sponsoring employers if we were underfunded, and due to the large number of employers in SPK, we have a dual responsibility – financial security for the pensioners and cost efficiency for the employers,” says Peter Hansson, CEO of SPK. “These are our two main strategies – being sufficiently funded to pay pensions in the long term and running the fund very efficiently in the short and long term for those that pay the premiums.”
The volatility that resulted from the introduction of mark-to-market valuations of pension liabilities using the current interest rate curve in 2006 has been handled by SPK through the addition of two extra internal buffers – an extra 15% on top of the buffer required by the traffic light system.
“Mark-to-market meant that we needed to take on an additional LDI approach to manage our interest rate risk,” says Hansson, who is also chairman of the Swedish occupational pension fund association, Tjänstepensionsförbundet. “We needed the extra buffers for our long-dated liabilities to be able to withstand market volatility and were able to introduce them without help from the sponsors. This was implemented with our risk management action tool, the R-MAP system. This allows us to follow assets, liabilities and the funding level on a daily basis. We assess the situation according to a daily risk report and a colour-coded risk matrix of green, yellow, orange-red and black. The warning lights are set at SEK1.75bn (€200m) and SEK1bn respectively above the red light level in the Swedish regulator’s own traffic light system. This allows us to calculate the net interest rate risk per basis point for both the asset and liability portfolios. We then estimate what the next move is going to be, depending on how we believe equities and fixed income will develop.
“This daily risk report has helped us to achieve good returns and safeguard pensions, with the average return for five and 10 years amounting to 6.9% and 6.5% respectively,” says Hansson.
In the summer of 2011, for example, the R-MAP system led SPK to reduce its equity allocation in favour of more bonds and swaps, while in early 2012, it signalled a reduction in the size of the swap portfolio.
Keep it simple
The starting point for SPK’s asset allocation is its liabilities. Hansson says the fund has a KISS (Keep It Simple, Stupid) approach to asset allocation. Around 70% of its strategic portfolio is allocated to domestic bonds, while 20% is invested in non-Swedish and global equities and 10% in Swedish equities.
Alternatives and real estate have not suited the fund’s style, which is why it sold its property portfolio 10 years ago.
The actual asset allocation may deviate depending on market movements or R-MAP system analysis. But liquidity requirements are generally very high.
SPK believes in active asset management. Benchmarks are not a starting point for portfolio construction because the fund thinks each investment should be made on its own merits – not because of a certain index weighting. However, it does use benchmarks to clarify expectations and to monitor market risks. For global equities, it uses the MSCI World All Countries index, the SIX PRX for Swedish equities and a mixture of the OMRX T-bill and T-bond indices for Swedish fixed income.
“Due to the new investment environment, which is preparing for the arrival of Solvency II regulations that are also expected to be reflected in the new IORP Directive, we are currently rethinking all our allocations,” says Hansson. “With its set-up, long-dated liabilities and good sponsors, SPK, unlike Swedish workplace pension providers with an insurance set-up, clearly falls under the IORP regulation but this still means calculating liabilities according to a Solvency II macro curve. Market volatility is going to decrease and for that reason, we will have to adopt a new LDI approach.” Hansson expects a decision on this to be made in the fourth quarter of 2013.
The pension fund faces two major challenges, according to Hansson – how to generate sufficient returns in the next 3-5 years and how to deal with overregulation, with its more costly reporting demands.
“We aim to generate higher returns by diversifying into more asset classes, diversifying globally and diversifying into different alpha providers,” he says.
“The low yield of Swedish government bonds, such as 1.7% for 10-year bonds, is impacting on the pension fund’s asset allocation, which is why we are likely to reduce our exposure to government bonds and move into other asset or sub-asset classes, such as equities or different types of bonds. In our current strategy, the reason for having bonds, either domestic or global, is to hedge liabilities. In the new strategy, the only reason for holding bonds is to generate returns. But after 20 years of falling interest rates, we are no longer able to generate the return that we need from government bonds. Nevertheless, if there is an opportunity to return to bonds, we will take it.”
As for extra regulations, while SPK likes transparency and reasonable reporting requirements, trying to bring all variations of European pension funds under one umbrella is difficult, according to Hansson.
“There are major differences in the current reporting requirements between the European countries,” he says. “There is now a risk that all the different reporting requirements will add up to uniform reporting. This would not benefit the pensioners because costs are likely to rise sharply, at the beneficiaries expense.”
For efficiency reasons, SPK currently only invests in equities via funds. “Whenever we look at asset allocation, we approach it in the most efficient way,” says Hansson. “This could be funds or discretionary mandates.”
Most of SPK’s asset management is outsourced to strategic partners. Therefore, the tactical selection of government, or mortgage bonds, or credit, is left to the managers, as long as they meet their target return. Hansson and SPK’s CIO Stefan Ros follow up the strategy and control of the mandates.
The pension fund does not use consultants, instead it monitors in-house.
“The most efficient way of asset management for us is to select individual asset managers,” says Hansson. “By outsourcing management, we can reduce costs and remain small enough to be able to have an efficient decision-making process that benefits our members and employers while at the same time being sufficiently large to have the allocations and the support of the market required. We only do strategic overlays such as foreign exchange and liability matching in-house. Risk handling and controlling is also undertaken internally. The only time we get involved with tactical allocation is when the R-MAP is going into defensive territory – what we refer to as SPK yellow in our colour-coded risk matrix – which requires short-term reduction of risk. As long as we are in SPK green territory, the long-term area, we outsource everything. In short, the R-MAP system allows us to take control and to hire and fire managers when we see fit. If we had internal asset management, we would have personnel issues in the case of underperformance. Our low-cost KISS [Keep It Simple, Stupid] approach will still be applicable to our new, more diversified strategy.”
SPK will continue to conduct ALM studies, although, Hansson says a new strategy could divide the study into separate asset optimisation and liability optimisation, meaning they will have to be undertaken differently.
In the R-MAP approach, SPK’s board decides on the funding level and hedging ratio.
The lowest possible funding ratio for the pension fund is around 110%. However, in case of a high level of overfunding, such as 200%, the pension fund may give a discount on the premiums to its employers due to taxation rights.
“We do not think we should have more capital than needed,” explains Hansson. “SPK may grant discounts in an overfunding situation and reset a deficit by using its taxation rights, which is effective for employers and safe for the beneficiaries.”
The pension fund board also decides on risk, defined as the level of each daily move in liabilities that should be matched with assets.
“If we match 100% in this low interest rate environment, we are not going to get any returns,” says Hansson. “If on the other hand we are not matched at all, there is a risk that an overnight movement could translate into 10% additional liabilities. The board decides on the hedging ratio, which currently stands at around 30%.”
The board meets four times a year. Of these, two are strategic board meetings where everything is discussed including new proposed allocations. The asset allocation strategy is reviewed annually by the board.
Efficiency also plays a role in SPK’s plain vanilla approach to environmental, social and governance.
While, the fund asks asset managers to focus on the investment side, it has its own internal set of ESG rules and exclusions such as child labour. An external ESG adviser, Ethix, annually checks every portfolio position and manager for breaches of the internal rules and international standards on human rights, labour rights, environment and corruption and reports back to the board.
“If there is a violation of our rules, we, in corporation with Ethix, send letters to the management of the company to try to encourage change,” says Hansson. “The board then decides on the appropriate action.”