Markets on the move
Swedish pension funds are in a state of culture shock as they get to grips with two new major pieces of legislation. All will have to raise their game as the occupational pensions directive opens up a veritable smorgasbord of investment choice but in return demands prudence. Meanwhile, the authorities have come close to pursuing the holy grail of prudence too hotly with their new traffic light system.
Sweden is late in implementing the directive but it now seems that new regulations, accompanied by the traffic light system, will go live next year.
The traffic light system is a means for the regulator, the Finansinspektoren (FI), to identify and then engage with pension funds which are in danger of not meeting their liabilities because of their funding level and/or their asset allocation.
The focus of the traffic light system and the directive is on matching liabilities based on the mark to market principle. Cue long bonds. Earlier draft regulations had stipulated that pension funds shown a red light would have to use government bonds – corporate credit would not be allowed. This idea was not popular and fierce lobbying has contributed to the delay.
Last month the FI amended the traffic light system to allow corporate bonds to be used alongside government bonds. “The amendment shows that the FSA has taken seriously the criticism against the original drafts and that it has now completely backed off from the original system, which was quite rigid,” says Mikael Nyman, editor of Swedish pensions journal Pensioner & Förmåner. “By allowing credit bonds, the universe of instruments increases and the life offices will no longer have to invest in long government bonds, which are far too scarce to cover demand. The debate has ceased since the proposal came and everybody in the business seems to feel that they can live with the regime of the traffic light system.”
The directive lifts the investment restrictions, thus shifting responsibility to the boards of pension funds more explicitly than before, which in turn raises the issue of their competence. “The boards of pension funds have no quantitative regulatory guidelines regarding limits for exposures to hold on to any more. They will have to think, argue, act and take on full responsibility for all investment decisions and results,” says Fahlström.
Silva El Hayek, assistant vice-president of Nordic sales and client relations at T Rowe Price in Stockholm goes further: “Pension fund board members are becoming risk managers. The prudent person principle makes the board more responsible. But I think in general the board doesn’t want to have to deal with a strategy for coming out of red light status. It is more likely that the board… will put pressure on the CFO to make sure the fund stays green. Some pension funds with limited buffer capital will have to reduce their risk. As a result it will be difficult to meet the liabilities because the return will be less. And this will make necessary capital injections. We already saw that in reality.”
She adds: “The traffic light is very good tool for risk control but it may restrict the scope of the prudent person principle. I think the most important point is the boards having the flexibility to choose the suitable long-term asset to match their liability rather than focusing on the short-term reporting for the FSA. So the boards will sometimes have to make the choice of bearing the idea of going in the red and having to explain to the authorities. Otherwise we risk throwing the baby out with the bathwater.”
Life companies may suffer more than most as a result of the new regulations. “No one can inject capital, so the future of those low on buffer capital will be questionable,” says Johan Elmquist, business development executive for the Nordic region at T Rowe Price. “They won’t attract new customers with 98% in fixed income.”
In reality the red light is the first of several steps that the regulator will take. So how effective will the traffic light system really be? “The first step is an invitation from the regulator to have a cup of coffee,” Nyman says. “The next is send a chart to explain how the fund will meet its pension liabilities with this or that interesting strategy. To this the authorities may well say: ‘Ok, let’s wait and see how it works out’. So it’s a long way to the hang man. As a result, many pension funds will find it prudent to manage while in red light status by saying that we manage our fund on a long-term basis.”
But in general the sentiment is positive. The old regulatory system which specified rules about what a pension fund could invest in effectively took a snapshot which was not able to foresee the narrowing gap between increasing liabilities and falling asset values. “The traffic light system is forward looking in that it aims to predict any narrowing of the gap or an inversion of the gap,” says Fredrik Wilkens. “The new system focuses on risk, not the assets, so there is more freedom in a fund’s choice of assets but less freedom in terms of the risk it can take. I am convinced that the new regulation will force IORPs to give up guarantees and that we will see a collective movement towards only doing unit-linked pension management, rather than the traditional form of insurance based pension management. Another way of putting it is that the new regulation will force pension benefits in general to become more dependent on what returns the markets can offer, rather than offering a guaranteed predefined return.”
But some pension funds take advantage because in the traffic light system equities are not divided into risk classifications, so 20% of the portfolio in emerging market equities is considered less risky than 25% in local equities. “So this way pension funds can increase their expected return within the asset class while not using more buffer capital and staying green,” says Elmquist.
He fears that the traffic light system might make funds become too preoccupied with their risk profile. “Global bonds hedged to Swedish Kronor
may be good for duration management but all the client will be interested in
is whether it fits into the traffic light
But some pension funds will not even get that far. As Fahlström explains: “There will be a few pension funds without the financial strength to look for the return that
they need to meet their objectives so they will have to match as closely as
The new regulations are broadening the scope for their investment strategies. “Because of the directive and the traffic light system people are rewriting investment policies and changing the way they invest. This means more opportunities for foreign managers,” Wilkens says.
This last point hasn’t gone unnoticed, as Stockholm-based consultant Kristian Nammak points out: “Global money managers are very much focusing on this region; many are looking at opening offices over the next six months.”
But in the short term it will be difficult for foreign managers to take a big share of assets under management, at least in the short to medium term. “Pension fund portfolios still have a significant home bias,” says Fahlström.
Nammack points out that local equities account for between 35% and 50% of portfolios but that this will decline as pension funds seek to diversify.
The move to long bonds - when it comes - will draw money out of equities. Stefhan Klang, a director at Stockholm-based Catella AM notes: “As we are an active manager in Nordic equities we think we will have less money to manage; pension funds will invest a lot more in fixed income funds because of the constraints of taking risk. We will have to compete more fiercely for those equities that will remain. So business will grow less quickly than in the past.”
Elmquist points out: “Most Swedish companies issue bonds in euros but once they know that there is demand they will also invest in Swedish Kronor.”
But equities still have an important role to play. Current bond yields mean that many pension insurance companies will be hard hit by the new regulations. “There are guarantees ranging from 2.5% for contracts signed today to 4 or 4.5%,” says Nyman. “There is no way that they can meet this through the bond market. Pension funds have been saved by the Swedish stock market which has done very well.”
But we must exercise caution here, as Fahlström explains: “Because of the volatility of equities we may have to wait as long as 10 to 15 years to have an overall positive return from the equity market risk premium,” he says. “So we think the route for many pension funds will be to go with the stock pickers to capture that extra return as well as diversifying the volatility of the overall risk premium.”
Hedge funds have also been a popular investment choice in Sweden. “The crash was more severe in Sweden than elsewhere because of the weighting to telecoms,” says Nammack. “Investors were forced a rethink and hedge funds were the obvious place for the downside protection and because if they moved to bonds their funding positions would never recover.”
He adds: “Mutual funds are not allowed to invest more than 10% in another fund. But local hedge funds are regulated and governed under the category Swedish National Funds so they have full flexibility. So quite a robust hedge fund market emerged.”
Swedish hedge fund manager Brummer is well known to Swedes. “Investors felt comfortable with someone they know and a product that is both onshore and regulated,” says Nammack. “When hedge funds first became popular many invested in single funds; typically the next step was to look at fund of funds. But by the time investors understood them and the many foreign funds of funds obtained approval, returns started to be boring. So now pension funds are waiting to see what happens. They are also a challenge in this cost conscious market.”
The case for hedge funds is not what it was. “The average hedge fund return is 4.5%; meanwhile equity markets are very strong, which is refocusing interest from funds of funds back to traditional equities,” Nammack continues. “But equity returns have been stellar so we are back to where we started.”
One of the main trends in asset management currently is that institutional players are starting to use funds much more than discretionary management. “They want to take care of asset allocation themselves and use funds for that,” says Klang. “And of course the fund has a history, administration is easier and switching from fund to fund is quicker and less problematic.”
Pension funds are also starting to look more at style, and the first pillar AP funds are leading the way. “Those pension funds that have good resources are using the AP funds’ approach as a model,” says Klang. “Pension funds are no longer just interested in super performance – they are also interested in investment style. We won’t be kicked out for one lousy year but we will be if we change your manager or style.”
As the issue of quality increases in importance the main local banks are suffering. Fahlström refers to a report from the mutual fund association which showed that for the year to date 56% of net new fund investments went to the big banks compared with 64% last year. “The big banks fear being at the bottom of the ranking more than they want to benefit by being at the top, so they don’t take risk,” he notes. “They would rather be a little behind the benchmark.”
The quality issue is becoming critical. Wilkens explains: “Managers are performing poorly, one reason being that hedge funds have drained talent from the banks; retaining exceptional personnel has been a problem. The banks have not been able to adapt to the new environment.”
Local players’ lack of geographical reach is also part of the problem: “People who have left their positions with the big local banks have done so because they say in long run this place will not be a competitive global player,” says Elmquist. “Gradually local managers are teaming up with external managers and opening doors to open architecture.”
Most local investors who invest internationally will increasingly seek managers based on quality rather than convenience. “Just being local won’t be enough in the future,” Nammack notes.
The performance problem is due partly to a lack of competition between the pension institutions. “You can’t move money from one asset manager to the other without paying taxes on any profits,” Klang says.
The issue of quality has raised the question of performance fees. Nammack refers to a recent poll in the Watson Wyatt global fee study that surveyed willingness to convert to performance fee structure. “Sweden was the only country with a 100% willingness to convert,” says Nammack; he agrees that the reason may be motivated by value for money.
Klang agrees: “There will be more performance related fees in the future. Costs efficiency will grow in importance – if nobody breaks the index then the role of fees will be more important.”
A key area of the new traffic light system will be that pension funds will need to report their position regarding their ability to meet their liabilities based on funding levels and asset allocation. To enable them to do that asset managers will have to provide significant additional reporting.
Fahlström expresses some concern. “One big local player said we are never going to be able to comply with this,” he notes. “Those that take this stand will find themselves at a big competitive disadvantage. Only a few managers have explained to us how they are going to provide reporting for the traffic light system.” The first reports will have to be submitted next April. “So managers must get going,” he says.
There are some clear examples of managers that are taking the matter seriously. “We are now investing in a much better back office and middle office services to take care of client needs including the traffic light,” says Klang of Catella AM.
With competition hotting up local players cannot afford to neglect this challenge.