Making the impossible possible
The European Patent Office’s Silvio Vecchi talks to Hugh Wheelan
A sign in large red letters above the entrance to the Munich branch of the European Patent Office (EPO) reads: ‘The possible plan of the impossible’ – a slogan that could translate well to the running of a pension plan for employees in three European countries covering Europe-wide patent applications for 19 different member states.
The organisation, which covers the 15 EU countries plus Cyprus, Monaco, Switzerland and Liechtenstein, established its pension reserve fund in 1985 in its embryonic form, prior to which the scheme was run via the budgetary system.
Over 4,000 employees in the EPO’s four offices in Munich, the Hague, Berlin and Vienna are all covered by the defined benefit (DB) pension plan of which two thirds of contributions (16%) is employer paid and the remaining 8% paid by the employee.
Silvio Vecchi, administrator of the e1.7bn fund, explains: “It was decided to establish a funded reserve scheme here in order to eventually help the office meet the future costs of pensions within the organisation’s budget.
“The funds assets are predominantly managed in-house by a team of three portfolio managers, one dealing with European equities, one with fixed-income and the other with international equities managed principally via mutual funds.”
Vecchi himself oversees the overall investment strategy. And he adds that the most significant investment developments within the fund took place in June 1997 when the fund carried out its first strategic asset allocation study.
“A couple of years ago it was decided to give more importance to equities than bonds in the fund, which certainly wasn’t the case in most German institutions at the time. We carried out an ALM study which showed we could go to our present level of approximately 60% in equities and 40% in bonds, depending on tactical arrangements. The fact that the fund is a very long-term investor, because the first possible payments will not happen for at least the next 10 to 15 years, means we can make investments that are a little bit more daring than others.”
Vecchi notes that although he has responsibility for the general day-to-day investment policy of the fund, overall strategy and the most important general issues affecting the fund are decided by a supervisory board consisting of patent office members nominated by the president, employee representatives and administrative council delegates of the member states.
“Issues such as the implementation of the strategic asset allocation study, for example, which was carried out by Towers Perrin in London, would be decided by the board,” he says.
Prior to the fund’s equity shift around a quarter of its investment was held in real estate and internal loans made to the patent office, a factor which Vecchi explains was used to facilitate the asset transition. “At the time of the strategy change we were receiving an important inflow of money by virtue of redemption of these loans and disposal of real estate assets. Most of these payments were then transferred over a three-to-four-month period straight into equities to up the allocation and this averaged out the overall cost.”
The fund also switched a portion of cash that was invested in short-term instruments over to shares in October of the same year at the time of the mini stock market crash.
In June last year though Vecchi also made a proposal to the board that they define the domestic market as Euroland – with the euro implementation looming on the horizon.
“Since then we have had a solely Euroland ‘domestic’ view with around 40% of the fund invested in Euroland equities. The current investment scenario comprises this 40% holding along with approximately 15% invested in the remaining developed equity markets – principally the UK, US and Japan, and 5% in emerging markets,” Vecchi says.
“On the bonds side we have approximately 30% in bonds of Emu currencies and companies, which could also include corporate issues in Emu currency by an American company for example. On top of this there is a portion in international bonds of around 7% and the remainder of the portfolio is a minimal cash holding.”
Vecchi says most of the fund’s bond investments go down to AA ratings, although a small portion of the portfolio is in single-A issues.
Bond exposure prior to the transition was very much towards German and Dutch gilts with the major liability focus of the scheme previously in the Deutschmark and guilder. “All the employees are in Euroland now, so since the beginning of this year the issue of currency for the contributions to the fund has gone,” he notes.
Investment in the ‘domestic market’ is direct and thus the responsibility of the fund’s European equity and fixed-income in-house managers.
However, outside of Euroland the overwhelming part is managed through external mutual funds with a raft of managers including Mercury, Flemings, Fidelity, Parvest UBS, Indocam, Baring, Templeton, Foreign & Colonial, Schroder and Deutsche Bank.
Manager selections are made by the in-house international equities manager. The mutual fund investment criteria, however, is imposed by the board, Vecchi says, with the plan allowed to invest up to 5% with one manager and 2% in any single investment fund.
A small part of the fund is also permitted to be managed via derivatives managed in-house, although the board stipulation is that these are to be used exclusively for portfolio risk protection and in order to carry out and facilitate investment positioning or structural changes.
“If we take any ‘additional’ risk through derivatives then it is supposed just to facilitate any kind of transition management. The derivative use up until now has only been through the purchase of put options and the selling of index futures.” Global custody to the fund is carried out by State Street.
Investment performance has been comfortably above the long-term objective. On a rolling five-year basis annual returns have averaged 11.6% against the 5.3% expectation marker.
The question of investment taxation though is where the fund really benefits from its European status, as Vecchi explains: “Although the building here is in Germany it is viewed as neutral European territory and the tax treatment of the plan is applied accordingly. The EPO is an international organisation and from the fiscal point of view we are not classified as German. Therefore we are not supposed to be subject to normal country taxation rules for those member state organisations under the EPO umbrella. If we invest in the US and Japan though, we are of course subject to normal fiscal rules.”
The fund of Geneva-based CERN, the nuclear research centre, also enjoys the same tax privileges. In terms of the fund’s benchmarking Vecchi says that for shares the fund uses MSCI indices and EFFAS indices for bonds. And he points out that in the future it is possible the fund will have to slightly modify its strategic asset allocation in the light of movement in the markets over the past two years and according to recommendations that may arise from studies the fund regularly carries out.
“There has definitely been a reduction in the risk premium on European equities, for example, and we are looking at this at present. Also, the relationship between domestic euro bonds and foreign bonds in Japan and the US has changed fundamentally over this time and the new euro environment has added further issues to be considered. As with many other institutional investors we have been looking to invest on a more sectoral basis for European equities. At present, we are operating a matrix approach where we look at the country and the sector together using broker research.”
And Vecchi feels that only time will tell how the fund runs its money in the future. “There are no plans at the moment to outsource any more of the assets, but of course this depends on the future financial scenario of the investment markets.”