Although there are five different ways of creating an occupational pension the most common, with more than 50% of all pension assets, is still through the book reserves of the employer, according to Klaus Stiefermann, general manager of the Association of Company Pension Schemes (aba). “Then we have four external vehicles of which the biggest is Pensionskasse, the second is direct insurance, we have UnterstutzungsKassen, which is something between being internally and externally funded, and then we have the Pensionsfond, which is the newest and the smallest of our vehicles.”

But despite the variety, many have something in common. “When you look at German pensions from the point of view of an economist the biggest factor is that they are really underfunded in virtually all areas, be it private or occupational,” says Peter Koenig, director of the Society for Investment Professionals in Germany (DVFA). “When you are underfunded the question is how fast can you fill up the capital. The supervisory authority requires Pensionskasse, Pensionfonds and insurance companies to undergo stress testing every year and this has had the effect of limiting the average equity portion of a portfolio. As a result they have lost out over the last three years on all equity upswings and consequently their performance has suffered.”

“Every year our large bond portfolio is the basis of our performance,” says Rainer Jakubowski, chief financial officer of BVV, the pension fund for banking and financial services industry employees. “But the add-on was the result of our equity portfolio, as equity was a strong factor in 2005 because of the market development. A common sense approach would have suggested more equities, but when you compare German pension funds with those in other countries you see that we have a low equity exposure.

“The asset allocation was due to the requirements of the law for German insurance companies that sets an absolute maximum of 35% of the portfolio in equities. And then we have the stress test from our supervisory authority, the BaFin, which drives the entire industry to have quite a low potion of equities in their portfolio.” BVV’s 2005 return was 5.4%. “We had 85% bonds, including credits, just under 12% for equities and the rest in real estate,” says Jakubowski.

“We are going to announce a 2005 return of around 4.5% in our annual report which we will presented to our AGM in November,” says Dirk Lepelmeier, general manager at doctors pension fund Nordrheinische Ärtzeversorgung (NAEV). “Our true figures, what we really earned in 2005, may be 5.5-5.8% but under German HGB balancing rules we are allowed to build up hidden reserves and the more reserves we are able to pile up the more effective future investment plans will be with regard to our risk capital basis. And we are running a very rigid risk-controlled investment model - the more reserves we are able to pile up, the more effective future investment plans will be with regard to our risk capital basis.”

NAEV’s best performance last year came from equities, says Lepelmeier. “Our equity quota is 17-19%,” he adds. “We still run a regional approach, so 60% of our equities are European including the UK and Switzerland, another 20% are North American and the remaining 20% are in Asia including Japan. The best performing market in 2005 was Europe followed by Asia; calculated in euros the return on North American equities was close to zero.”

But NAEV’s largest asset class was fixed income. “We had 45% of our assets in bonds in 2005, with roughly two-thirds of the allocation being in Namensspapiere/Schuldscheine, which is a special type of bond that, according to HGB balancing rules, we can put at 100% in our balance sheet so there is no interest rate driven reaction,” Lepelmeier adds.

“The rest of our bond portfolio was invested in what I call spread bonds, that is corporate bonds, high-yield bonds and emerging market bonds. Another 20% of the total portfolio was mortgage loans, which is a little untypical for a pension fund but we refinance the mortgage loans of commercial banks. And then there was roughly 15% invested in real estate.

“We run a pyramid-shaped real estate portfolio, with the base being some two-thirds that is directly invested in Germany, a middle portion outside Germany but inside Europe including the UK, while at the top we have a REITs portfolio with a worldwide focus. The rest of our assets are invested in cash and alternatives. These are commodity investments which we started in May 2004 and which we like.”

But will the implementation of the EU pensions directive with the introduction of the prudent person principle relax the restrictions? Jakubowski is sceptical. “I can’t foresee any changes here with regards to our supervisor,” he says.

“Pensionfonds and Pensionskasse fall under the directive,” says Koenig. “Pensionfonds were established in 2001 with the expectation that they would provide a German pension vehicle with a European passport, in other words which would become competitive in Europe. So the whole discussion at the time about quantitative restrictions and upper limits in equities was around the Pensionsfonds. But they were regarded as insurance vehicles so their assets and their liabilities had to be discounted at the insurance guarantee rate of 2.75%, compared with under IFRS where there is some sort of prudent discount rate which these days would typically be around 4-6%.

“The implementation of the pensions directive has removed this restriction and under certain conditions they may use a higher discount rate than the insurance rate. But if they are underfunded they are still dealt with in a very restrictive way. “Pensionfonds are just now submitting their plans to the supervisory authority and are discovering that there is still a very restrictive interpretation of the stress testing. They may not fall below 95% of the corridor limit, although it was suggested that the band be increased to 10%, meaning a pension fund could work with 90% of discounted liabilities for some time. “But that’s all still unclear. And so it’s not clear whether Pensionfonds, or Pensionskasse for that matter, will be the vehicle of first choice for German companies, let alone non-German companies when it comes to European business.”

More immediately, Lepelmeier is assessing the impact of the market shifts in the second quarter of this year. “We were near the zero line at the end of the first half,” he says. “What we gained in the first quarter we lost in the second, and therefore we were somewhat back to where we were at the end 2005. But we are reshaping our asset allocation. Most institutional investors in Germany are only focussed on long-only strategies, we are trying to change these long-only strategies into long-short strategies. We do that in the field of bonds by using long-short strategies with durations between, let’s say, plus five years to minus five years.

“We do that in the field of corporate bonds by using a basic investment money market in combination with investing into derivatives with regard to credit default swaps. This gives us the chance not only to earn money when prices are increasing but to have a symmetrical chance to earn money when prices are decreasing.

“In addition, as a result of a yearly ALM study with our consultant FERI we began 2006 with plans to lift our alternative quota to somewhere near 5% by the end of this year. We will increase our alternative sector primarily at the expense of our equities.”

Jakubowski is moving in a similar direction. “By the end of the first quarter of 2006 we became more suspicious with regard to equities and our conclusion was to reduce our exposure,” he says “So on the one hand we sold equities and on the other we strengthened our overlay by buying a zero-cost collar in addition to the overlay strategy was already had.”

And the future? “We are not paid to look into a crystal ball,” he says. But when we look at possible developments are we try to make a probability assessment. So on a mid- to long-term view we will have more alternatives: certainly private equity, probably more hedge funds and we are in the process of a step by step increase in our real estate portfolio, possibility up to 8%.”