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Asset Allocation: Uncertainty focuses minds

German pension investors continue to diversify their assets against a backdrop of political uncertainty, writes Rachel Fixsen

At a glance

• Higher US yields look attractive for German pension investors.
• Illiquid strategies are gaining traction, as well as fixed-income alternatives.
• Funds prefer to optimise equity allocations rather than increase them.

With yields on government bonds at about zero over the past year, Germany’s pension funds continue to explore alternative sources of return — within a regulatory environment that has shown signs of leeway. “Many investors have lowered their expectations for returns, and that is one of the changes from previous years,” says Sabine Mahnert, Towers Watson’s fiduciary expert in Germany. “But at the same time they are searching for global yield.”

Regulation of the pension fund sector in Germany varies as there are five types of pension arrangement. Corporate pension schemes, or bAV (Betriebliche Altersvorsorge), when they are structured as Pensionskassen and Pensionsfonds, are subject to insurance supervision (VAG). They face more stringent investment restrictions than direct promise (Direktzusage) pension schemes that use contractual trust arrangements (CTAs) to hold assets. The first-pillar pension providers for professional groups in Germany, Versorgungswerke, are subject to regulations akin to the VAG requirements.

The last 12 months have seen some dramatic changes in global politics, particularly the Brexit vote and President Donald Trump’s election. These may not have transformed the prevailing economic situation in Europe, but uncertainty continues to plague financial markets.

How has this affected asset allocation at Germany’s pension funds? 

Harald Eggerstedt, market expert at Towers Watson in Germany, says the disconnection between the perception of the economic environment and the actual numbers. “The core figures are slowing crawling higher, and it looks as if this monetary policy easing is working, because business confidence, too, is stronger,” he says. Stock markets on both sides of the Atlantic have risen on expectation of at least two interest rate rises in the US in a year, although elections in France and Germany this year are arguably keeping a lid on the potential upside for equities.

In terms of asset allocation, Mahnert says her firm’s fiduciary mandates have a slight overweight to European equities in view of the trend for outperformance in this asset class against US stocks, because of the lower valuations of shares on European markets.

After a bumpy ride for financial markets internationally last year, with bond yields falling dramatically up to a couple of months before November’s US presidential election, the German yield curve has steepened.

Stephen Yeats, managing director at State Street Global Advisors (SSGA) and EMEA head of fixed income beta solutions, points out that although the 10-year Bund was trading with a yield of 0.2% as of February, the key government bond yield had been negative since August.

At the short end of the yield curve, yields have only become more negative, with two-year government paper trading at about -0.9% in late February compared with about -0.6% last summer.

“The yield environment remains very challenging,” Yeats says.“Fixed-income investors in Germany have various choices, and one is that they can go out of their domestic market and look at other European bonds and global bonds. Pension funds have also been looking at adding credit risk, including more high-yield bonds [and] corporate bonds.”

While pension funds in Germany, at least in the form of CTAs, Pensionskassen and Pensionsfonds, have not been investing in Bunds significantly in the last few years, Eggerstedt says the downward yield trend does hit institutional investors through other fixed-income exposure.

Hence higher-yielding fixed-income instruments have become more expensive, but many pension funds have seen no alternative but to buy the paper at expensive prices, according to Towers Watson.

So, Eggerstedt says, many of the funds have been taking advantage of the fact US government yields are now at about 2% to secure higher yields in their fixed-income portfolios, even though this exposes them to the dollar, he says.

“Currency hedging costs have gone up from last year, but there’s still sufficient yield differential for it to make sense,” Eggerstedt notes.

More to illiquid investments

Low interest rates are prompting some pension funds to search for alternative risk premia in their fixed-income allocations. Mahnert says: “They are using emerging markets and yield-high debt in portfolios. Investors have already diversified into that space, so that’s not really new to them, but now they are adding more illiquid strategies, such as strategies in the loan space and direct lending.” 

While the regulation for Pensionsfonds and Pensionskassen restricts the extent to which they can move into higher-yielding bond investments, such as emerging market debt, high yield and riskier corporate bonds, other institutional investors, such as Versorgungswerke are more flexible in how they allocate within the fixed-income space, says Frank Becker, head of client service Germany, Austria and Switzerland at SSGA.

“We could definitely see more expansion into unconstrained fixed-income strategies, such as absolute-return fixed income and smart beta solutions over the last few years,” he says. 

Pension funds’ increased interest in other forms of debt such as collateralised loan obligations (CLO), insurance-linked debt and inflation-linked bonds has been noted by other institutional investment professionals. 

Michael Schütze, managing director and head of corporates and pensions in Germany at Allianz Global Investors, says many of the regulated investors, including Pensionskassen and Versorgungwerke, may already have climbed the risk ladder. “Other ideas need to be developed, leading towards lower risk but possibly less liquid assets and the like,” he says. 

Schütze says there is a clear trend away from the older core fixed-income investments in government bonds, into what it calls new-core investments, such as sub-sovereign bonds or infrastructure debt.

Real estate allocations have increased in pension fund portfolios, he says, although many market participants are aware that price levels are already high. “The appetite for infrastructure debt in Europe and even abroad is very high, possibly even higher than what is currently coming to market, and is investable,” he says.

A low-yield environment may tempt investors into riskier investments than they would normally be comfortable with, Yeats says, but most institutional investors he speaks to remain sceptical about taking on too much risk. “You don’t just have to take on one type of risk, you can take on global exposure,” he says, adding that the solution here is to try to blend risk.

For investors willing to invest on both sides of the Atlantic, the divergence between the economies of the US and Europe offers risk diversification benefits. But increasing risk levels is not an option for most pension funds, Becker says. Even though they are not subject to the more onerous Solvency II regulation, they still have to invest in line with actuarial rules, so they have to keep investment risks in check.

And while there is stronger demand from the bigger German institutional investors for real assets, small to medium-sized investors still struggle to follow them because of their size and the cost of the additional risk management. 

With the Bundestag to decide on the introduction of new pension vehicles without guarantees – effectively defined contribution (DC) but more usually termed defined ambition or target pension – could the overall of German asset allocation landscape be about to change?

“The schemes to emerge may be pure DC but can also involve intergenerational risk sharing,” Mahnert says. “They could start out with default asset allocations, perhaps similar to current lifecycle models and with a traditional attitude to risk.” There are likely to be a few competing models of the new type of pension on the market, she predicts, although in aggregate the asset allocation is likely to end up similar to that of today’s pension funds. 

Future risk patterns

Equities performed well in 2016, so will pension funds increase their allocations? Becker says the overall equity allocation of pension funds has remained stable, recent strong performance notwithstanding, and what has been seen recently is a rebalancing back to previous levels.

“For the German pension sector in the current regulatory environment, we do not see a change or an increase in equity allocations overall, but rather a diversification within the asset class, with investors paying more attention to factor investing,” he says. “What we have seen is an increase in minimum volatility strategies, and pension funds are looking out for risk reduction strategies,” he says.

Mahnert says the firm is advising clients to improve their equity allocations rather than change their size.

“Pension fund allocations to equities are relatively simple, being either passively run, or involving just one or two managers who are benchmark hugging and not producing much alpha for the fees they are charging.

“Our advice is to maximise every source of return available and that means complementing low-fee passive exposure with concentrated high-conviction active portfolios where you need a fair amount of diversification among managers and styles,” she says.

The allocation to liquid-equity strategies, which can also include some thematic investments such as listed infrastructure, can then be augmented by private-equity strategies to access an illiquidity premium as a further source of return,” she says. 

Herwig Kinzler, partner and CIO for Mercer in Germany, says the firm is slightly sceptical about high-yield bonds, because spreads have narrowed over the last year. “We don’t see any more narrowing, and this might be the end of the credit cycle,” he says. “What we see in terms of fixed-income asset allocation at pension funds in Germany is a trend towards investment strategies that are not tied to a benchmark – unconstrained bonds.”

Mercer’s latest quarterly dynamic asset-allocation study, which outlines the relative attractiveness of asset classes against strategic allocations, shows that nearly all asset classes are underweight in portfolios, and as a consequence there is an increase in alternatives – particularly in the illiquid space.

Another characteristic of current asset allocation is lower duration. Kinzler explains: “There is always a hunt for yield, but there’s also a fear that at some point they will increase dramatically. For this reason, many of our clients do not want to have high duration positions,” 

Last year, Pensionskassen and Versorgungswerke were granted a 7.5% allocation for asset-backed securities. “This is a new quota,” Kinzler says. “For some clients, equity and high-yield quotas are already as full as they can be, and the pension funds are now adjusting by filling up the new quota – which is typically not done in one step.”

The ideal way to proceed here, he says, is to diversify exposure over vintage years, by waiting for a good fund to open rather than hurrying to invest in a mediocre fund that is already open.

However, early this year there were concerns that changes to rules could limit investment in alternatives after BaFin tried to clarify investment guidelines for Pensionskassen and Pensionsfonds.

German pension funds do have significantly higher allocations to real estate compared with other European funds. “These assets are held as physical assets, though, and REITs are not very popular,” he says. “It is a very traditional investment area, and has tended to be focused on core or core-plus assets, located in good cities in Germany, such as Berlin, Munich or Stuttgart – and in premium locations. However, it has become hard to make money in those locations these days, and it is largely German and foreign investors who are interested in preserving their capital that invest in those areas,” he says.

As for pension funds that need to achieve their target returns, a much more diversified, global approach is needed, Kinzler says: “The biggest move here is outside Germany, but also into specific fund vehicles in Asia. In terms of sectors, pension funds are moving into logistics and hotel properties in particular.”

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