Looking for more financial flexibility
Norway’s public service is the fastest growing sector within the Norwegian pensions market. Employee numbers have grown on average by 2.5% over the past 10 years against a total workforce growth of 0.8%. Wages for municipal employees have grown at 4 % a year over the same period
Kommunal Landspenjonskasse (KLP) is at the heart of this sector and is positioned to take advantage of the expected growth in total assets and insurance liabilities. It was created by the municipal sector and has been central to the development of a funded occupational pension scheme for those customer groups.
KLP’s main business is providing pension insurance for the employees of municipalities, regional and health authorities and the privatised companies associated with these sectors. It currently pays pensions to 130,000 people, and a further 280,000 employees are active members of its pension schemes
Its customers include 361 municipalities and county municipalities, over 2,500 municipal operations and most health enterprises in Norway. Municipalities account for about 60% of the funds, the health sector 25% and corporates 15%.
KLP’s subsidiary KLP Kapitaforvaltning ASA manages KLP’s equities, bonds and derivatives, valued at NOK 126.4bn (e15.1bn) at the end of 2003. Its overall investment strategy is to provide ‘good, stable and secure returns’ for pension clients. To achieve this KLP has made changes to the composition of investments, chiefly by moving into long-term fixed income assets during 2002 and 2003.
Benedicte Bakke Agerup, group finance director at KLP, explains: “It was important to create a composition of the investment portfolio that would give us a stable cash flow and also stabilise the valuation on the balance sheet. That led to quite a big increase in the held-to-maturity portfolio of bonds. The change was effected mainly by selling equities and reducing the portfolio of mark to market bonds and also the money market portfolio.”
The portfolio of held-to-maturity bonds grew from 35% of assets to 49% last year while short dated bonds fell to only 15.8%. The structure of the company’s short-term bond portfolio was also altered early this year when a global index portfolio was established. About half the foreign bonds are managed by KLP Kapitalforvaltning on a tracker basis.
The switch to long dated assets also enabled KLP to take advantage of high interest rates in Norway and produce a yield well above KLP’s guaranteed rate for its policies of 3.3%, says Agerup. “The interest rate on the market at that time was well above 6%. and we were able to lock in the margins well above the guaranteed rate. Interest rates have fallen since so the yield on the held to maturity bond portfolio now is 5.7%.”
KLP’s other objective is to diversify the portfolio. It has done this by increasing the equity allocation at the end of last year and into the current year. In common with other institutional investors in an equity bear market, KLP had progressively reduced its equity allocation from a peak of between 30 and 35% to 5%.
The equity allocation was subsequently raised to 8.5% in 2003, and further increased in the first quarter to 10.5%.
“We have increased our equity positions for two reasons,” says Agerup. “Our risk capacity has increased and we can allow for a higher share of equities which we expect will contribute to an increase in our value adjusted return. The other reason is the higher equities position will contribute to the diversification of the portfolio.”
Further diversification has been achieved by reducing the proportion of equities in Norway and the Nordic market the share of Norwegian equities in relative size and increasing the share of foreign equities.
Agerup says KLP now probably has the lowest share of domestic equities in the market. “That will help us if we have to sell equities because Norway is a small market and the liquidity of the equities decreases a lot if markets fall. So that gives us flexibility.”
The Norwegian equity market outperformed most other markets in the first quarter of this year. Yet Agerup insists that KLP was right to reduce its domestic equity exposure. “We think that it will pay off in the long run. We think that it’s important that, since we are managing long term money, pension money, we should take a long term view in our investment policy.
“We are going to pay out pensions far into the future, perhaps 30 years or so. This is a very long horizon and we think it’s better to stabilise it somewhat. The big volatility in the results of the insurance companies at the end of the 1990s was due to the large equity portion that was on the balance sheet.”
Other KLP asset classes include real estate and loans. KLP invests only in Norwegian property except for a small investment in Denmark. KLP’s Nordic real estate portfolio accounts for 8% of the balance sheet. “We find that an interesting asset class and we will try to find good investment opportunities in that asset class going forward,” says Agerup.
KLP also lends money to the municipalities, either as mortgage and other loan. Lending now accounts for 14.5% of financial assets.
“The loans book makes our balance sheet a little bit different from our peers. It is also another stabilising factor on the balance sheet and gives us stability in earnings and stability in valuations.”
The new investment strategy has roved successful. Adjusted return on capital last year was 8.2% in 2003, including changes in value in the hold the maturity portfolio, the return was 10.7%.
Providing good returns is one way of ensuring that KLP can stay ahead in the growing competition for public pensions business; keeping costs down is another. KLP’s administrative costs are the lowest in the industry, at 0.35% of average total assets in 2003.
“Although we have had a large growth in assets under management the costs as a percentage of the assets under management have remained stable at 0.3% and 0.4%.”
KLP is also changing the way it finances the cost of indexing pensions. In the past KLP has financed the indexation costs through the financial return on the investment portfolio. In future customers will be billed separately for this cost in the same way as they would be if they went to other providers.
“That will of course increase the future profit generation of the company as we will no longer have that return requirement. It also gives us more flexibility in either returning the money to the customers or using it in the company to build up buffer capital. We will be more comparable to the other players in the market.”
The ability to compete will also be improved by a change of status. The board of KLP has recommended conversion from a mutual to a limited company.
The limited company structure will allow KLP to generate buffer and equity capital through the retention of profits.
The current system requires a new customer to contribute equity capital when joining a KLP scheme and may allow a departing client, with the approval of the Kredittilsynet, to withdraw contributed equity capital when changing pension provider.
The KLP board says the current business model is not suited to finance KLP’s expected growth in assets and will place it at a competitive disadvantage. It says an important prerequisite of competing in the municipal pensions market is that KLP should be able to retain existing equity and attract new capital.
Agerup explains: “If a member decides to leave KLP they will get their part of the paid up equity but at the same time they will take their part of the fund with them. So in a way solvency improves for the company. But of course that is not the way we want to build up the equity going forward. So this special feature with the equity model of the company has been one of the reasons the board has recommended the conversion to a limited liability company, because we see that this can influence the competition in the market.”
Under the terms of the conversion, the current members will become shareholders of the company. The new shareholders can decide whether they want to keep or sell the shares.
“We also think that it will be positive for the customers to separate the customer role from the ownership role, so that the customer can decide to be a customer without having to be an owner, ” says Agerup.
KLP needs a two-thirds vote in favour of conversion at a general meeting, before it can apply to the Ministry of Finance for authorisation. It takes a minimum six months from the application to the ministry for conversion before the company receives authorisation.
KLP can afford to wait, says Agerup. “This is a long-term strategy and the company has no immediate capital needs. That is not why we are doing it. We think that it will give us more financial flexibility and we think it’s important to have that kind of flexibility going forward.”