Nina Röhrbein spoke with Loit Linnupold, responsible for Swedbank’s Estonian pension fundsInfluenced by its linguistic ties with Finland, its financial links to the Baltic and Nordic regions, its Soviet past, its EU and euro membership, illiquid stock market and virtually no public debt, Estonia is a unique place in which to manage a pension portfolio.

The biggest player in its pension market is Swedbank Investment Funds, the manager of the Swedbank Pension Funds (SPF), which have €650m in pension assets, €600m of which are in the second pillar. SPF has around 280,000 participants, or 45% of the workforce.

It takes a globally diversified approach in its funds, without a preference for local investments.

In fixed income, the funds have a bias towards Europe, from a currency as well as from a risk perspective. “Historically, our fixed income exposure was dominated by European government securities,” says Loit Linnupold, CEO of Swedbank Investment Funds in Estonia. “However, due to the euro crisis we can no longer treat them as risk-free, which is why we have increasingly moved into European and emerging market corporate bonds as well as emerging market government bonds. While returns have been slightly higher, from a risk perspective this has been a good decision because the diversification has helped us to significantly reduce volatility. European governments are struggling with debt and yields are low. We do not see a solution to this in the long term, which is why we believe it is better to keep some money out of Europe.”

At present, emerging markets make up 2.55% of SPF’s 100% fixed income fund, and between 8-20% for the other three funds. According to Linnupold, this exposure is set to increase. US government and corporate bonds, on the other hand, play a minor role, amounting to 2-5% of the overall fixed income exposure.

Unlike its Baltic and Nordic neighbours, Estonia has virtually no government debt, meaning SPF cannot hold any domestic government bonds. However, through investments in state-owned companies such as electricity producer Eesti Energy and electricity network distributor Elering, the pension investment management company has invested in domestic debt.

“We are having discussions with the Estonian government about the potential issuance of bonds but besides these corporates currently no other opportunities are available,” says Linnupold.

Due to the absence of a domestic government bond market, Swedbank also lacks a counter-benchmark. Although Linnupold says its pension funds are not benchmark-driven, they emulate some model portfolios, in other words use a euro-based benchmark.

Besides some issuer and credit quality-based restrictions, the Estonian regulator places no other requirements and limits on pension investment management companies, leaving them free to manoeuvre with regard to their asset allocation.

In equities, SPF has always had a tilt towards emerging markets, largely due to the fact that Estonia is one of the CEE emerging markets.

“Eastern Europe and Russia are like a home market to us, which is why we have been overweight in those markets and will continue to be so,” says Linnupold. “But, our overall approach is global. Our investment decisions are based on demographics and global growth.”

For the past eight years, the pension investment management company has also had an allocation to real assets.

It invests in cashflow-based real estate funds with an exposure to commercial buildings in the Baltic but also other CEE countries.

In unlisted equity, SPF uses specialist private equity managers and has had a Luxembourg-based pooled vehicle for CEE private equity investments, set up as a fund of funds, since 2008. All together, SPF’s private equity and real estate investments make up around €60m of its pension fund assets.

“We have had internal discussions to replace some of our current fixed income exposure with more income-earning real estate investments because cashflow-based real estate is more attractive to hold than European government bonds,” says Linnupold. “We are currently weighing up the options such as using third-party real estate funds as we do today, issuing a mandate or setting up our own real estate team, which would involve hiring staff. After the reallocation, we will probably become one of the largest commercial real estate holders in the Baltic countries.”

According to Estonian law, pension funds can invest up to 40% of assets in real estate in any of the funds except for the fixed income one. But, says Linnupold, the pension investment management company needs to take its liquidity demands into consideration.

“In Estonia, participants can change second pillar service providers three times a year, meaning they can move all their assets to other fund managers,” says Linnupold. “This requires liquidity management from us because before we see the end-of-quarter numbers we never know how many people are going to leave and how many are going to join us.
Therefore, we always have to keep some liquidity in our portfolios. Due to the small size of the Estonian stock exchange, we treat local listed equities as illiquid investments, similarly to alternatives.”

Although people’s movement between various pension investment management companies have to be considered, Swedbank’s own research shows that only a small group of participants frequently change fund providers.

“Over the 10-year period we looked at, 70% of people never changed or only switched once,” says Linnupold. “A minority of 10-15% moved four or five times between fund managers. But this remains unpredictable business, which is why, although we would like a larger position in domestic real estate, we cannot add too much to our portfolios.”

After the financial crisis, Swedbank decided to split its pension investment business in Estonia in two – the strategic asset allocation is now undertaken internally, while the tactical allocation and day-to-day portfolio management is outsourced to its parent company in Sweden.

“During the financial crisis, a lot of money was flowing from our UCITS funds, which meant we had to cut staff,” says Linnupold. “From a cost perspective, outsourcing these operations to one of the largest Scandinavian fund managers, Swedbank Robur, is highly efficient.

“As we are part of Swedbank Group, we have a tight co-operation with retail banking to have access to its network. It also means we can use Swedbank Robur’s systems, trading staff and fund research.”

Legally, the ultimate responsibility for risk management lies with Swedbank in Estonia.
“Risk management is independent from portfolio management,” says Linnupold. “We cover all kinds of risks, such as market, liquidity, operational and compliance risks. Despite outsourcing the tactical part of the investment management, we monitor how our parent company manages mandates and undertakes stress tests.”

As the pressure has grown on risk management, three full-time staff are now responsible for compliance.

Swedbank aims to produce returns that exceed inflation on the gross side, while the conservative pure fixed income portfolio has to beat the deposit and money market rates available.

“Estonia historically has had high inflation, which is a problem for us,” says Linnupold. “We still have inflation of 4% which – with most of our money allocated to fixed income – as a target is difficult to achieve. In fact, over the long term, no Estonian pension fund has ever beaten domestic inflation because even in the boom years with 20% growth we still had 10.4% inflation. Most years, we were successful in producing above-inflation returns but looking at the 10-year average we still have some catching up to do. However, inflation is declining and when it reaches 2-2.5%, like the rest of Europe, the playing field will be more even. For the moment, we continue to produce global returns that are measured against local inflation. This is why we are looking for instruments that are moving at least at the same pace as inflation.”

In 2011, returns varied between -7.6% and 1.9%, depending on the portfolio, while average inflation stood at 5% for the year. The three-year average returns up to 2011 ranged from 3% to 7%, while inflation for the three-year period amounted to 2.4%.

Apart from inflationary pressures, SPF faces some political pressure to start investing more locally. “There is pressure from lobby groups that more pension money should be invested in the domestic market,” says Linnupold. “However, the Estonian regulator has been quite liberal with regard to our investment decisions. Any other limitations would go against the European regulation on free capital movement. Poland recently lost its case in the European court because it wanted the majority of its pension money to be invested in the domestic market.”