Funds forced to be cautious
Pension funds in the Nordic regions face two main challenges. The first is to improve their investment returns by taking more active risk. The second is to be able to do this in an unsympathetic supervisory climate where the regulators may compel pension funds and insurers to sell equities at the bottom of the market.
This was the main message of the Scandinavian Institutional Investors Summit in Oslo last month. Knut Kjaer, executive director of Norges Bank Investment Management (NBIM), says that the Petroleum Fund needed to increase its active management of both equities and fixed income: “ We take only a third of the risk limit given by the Ministry of Finance. So I am trying get my head of equities and head of fixed income to take more active risk. The active risk we are taking is not increasing the total risk of the fund, so we should do more active management .
“That’s the main charge we have for the whole asset management industry, to build up even more comprehensive active management. For the fund that means also taking more external managers.”
Kjaer also says he would like greater stability in the asset management world. The movement of active equity managers into hedge funds, for example, had made manager selection more difficult.
Michael Weischer, investment manager of Pen-Sam, the pension fund for Danish public employees, says that the ‘traffic light’ system, a stress test set up by the Danish regulator, had forced Danish pension funds to focus on risk and to consider their asset/liability problems in more detail.
“At Pen-Sam we follow a couple of principles. We want to have a very low risk of insolvency and with respect of the traffic lights system we want the lights to stay green.”
Pen-Sam has based its strategic asset allocation on ALM models that incorporate stress testing, Weischer says. “When we did the ALM studies we tried to add the stress test on top of each simulation. In that way we kind of tested for double shock. We pick the worst case scenario and on the top of that we add a fall of 1% in the interest rate and say we want a very low probability of running into problems even in that situation.
“The consequence of that is a very cautious strategic asset allocation. We are able to survive minus 2% on the interest rate and between minus 10% and minus 20% on equities.”
Weischer says Pen-Sam plans to develop its own internal model over the next two years “Then we can report to the financial supervision through the internal model rather than the traffic light model.”
Mikael Simonsen, strategist at Ilmarinen Mutual Pension Insurance, says that derivatives provide a way to square the circle of higher returns and tighter regulation: “The solvency framework in Finland demands enough working capital respective to the solvency border. The solvency border is calculated from an approximation of the volatility in the portfolio. “In March last year Ilmarinen saw great value in the markets but was unable to increase the equity weighting. If you add equities to the portfolio you add volatility to the portfolio. A movement in the wrong direction would have forced selling at market lows.
Simonsen says the problem was structural and demanded a strategic solution: “The only way to gain exposure to the anticipated upturn was to buy volatility with call options. When the markets turned, the options became ‘in the money’, although the gains were diluted from sinking volatilities.”
By the autumn of 2003 Ilmarinen was again able to buy equity risk, he says. “The operation was very successful and Ilmarinen ended the year as the best performing pension fund in Finland.”
The solution to the problem, he suggests, is a new asset class, building on equity risk but with a limited downside: “This can consist of plain vanilla call options, knock-ins, options on dynamic baskets or exotic options.” Ilmarinen has spent e400m to e500m on options, he says.
“This gives us protection when we need it. It enables higher equity exposure and improves our expected return.” Yet he warned that “there is no such thing as a free lunch, and this is not equity risk.”
Matti Leppala, director of international and legal affairs at the Finnish Pensions Alliance (TELA) says that increasingly, pension funds believed that regulators were out of touch with the requirements of modern markets.
“There is a feeling among chief investment officers that the authorities are not up to date in what is going in the market and what the real risks are. We feel that the real risks should be the basis for the evaluation and supervision.
“There are number of regulations on solvency and how assets can be invested, and we have many problems with those. It is very important to get all the returns we can from the market and if there are regulations that limit this possibility we should lobby against them.
“We are trying to lobby for changes in some of the rules. For example, the rule based on the life directives that not more than 5% of the assets of private sector pension schemes should be invested outside the European Economic Area. We are lobbying for 20%.
“We also have problems with indirect real estate investment. The authorities seem to think it is more risky to invest indirectly than in an investment fund that can buy property directly in Portugal. From our point of view this doesn’t make sense. We have lobbied for indirect real estate funds and the possibility to invest indirectly.”
Rolf Skomsvold, managing director Norske Pensjonskassers Forening, the Norwegian Pension Funds Association, says that conference addressed problems that were above the heads of most Norwegian pension funds.
“Only two Norwegian pension funds have assets of over e1bn, and about 25 have e100m. The rest are much smaller than that, which means of course that these funds neither have the capacity or the resources to carry out the complex analyses for developed bond strategies. We need to concentrate on simple strategies.”
Stefan Halldorsson, managing director Lifeyrissjodur Verkfraedinga (Engineers Pension Fund) in Iceland, agreed: “While the funds are in good shape, we have a total of e10bn in assets which means that the average size of pension fund is something like e150m and many are much smaller.”
Yet he says Iceland had to look beyond its shores for investment opportunities. “Iceland is a high income nation with a well-funded second pillar system and the local market is essentially a small market, so we need to invest abroad on a large scale.
“In Iceland it’s a very recent development to be allowed to invest freely. It was only 10 years ago that we were allowed to invest abroad. And it’s only in the past 10 years that we’ve begun to invest in equities.
“So our experience of asset allocation and foreign and equity investment is limited and the regulatory environment reflects that. It has been fairly strict with limits on foreign exposure and equity exposure. As a result we have had to adopt conservative approaches and we still have strict solvency requirements.”
He says that the main focus of Icelandic pension funds was limiting risk. “They have introduced currency hedging, absolute strategies. So there is certainly a willingness to look at different ways to do things. But on the other hand we have little investment freedom. The maximum we are allowed to invest for alternative investments is 10% of assets and we are not allowed to invest in real estate.”
Alf Guldberg, secretary general of the FPK, the Swedish Association for Institutions for Retirement Provision, says that Swedish pension funds also faced funding problems. “The first is the solvency levels. It has been a problem for a number of years, especially the last two years. A number of pension funds have too low solvency which something the possibility of investing in a number of assets. Now the solvency levels are slowly but surely improving.
“The second problem that we all have is longevity. To meet this we need more funding and this makes the task of the fund manager even tougher than before.
“The third problem is the European occupational pensions directive. The final effects of that we don’t yet know. One thing that is sure is that we will have competition from abroad, possibly from UK companies insuring their pensions for their subsidiaries in Sweden. There are possibilities for Swedish companies, since a lot of people are employed outside Sweden. But we will have a new competitive environment that will make the future uncertain.”
However, Alan Pickering, chairman of the European Pension for Retirement provision (EFRP) says that the impact of the directive on the Nordic region would be benign: “The professionalism and expertise within many Nordic countries
suggest that the opening up of the international pensions market should be seen as an opportunity rather than a threat.”