Germany: Forced into strategic moves
Occupational pension funds are adapting their investment strategies to continuing low-interest rates and the impending IORP Directive. Nina Röhrbein reports
Two main factors are driving the investment strategies of the occupational pensions sector in Germany – the ongoing low interest rate environment, and the impending Solvency II insurance regulation and the related IORP II Directive.
Thomas Huth, responsible for pension solutions at Deutsche Asset & Wealth Management, notes that most defined benefit pension arrangements suffered a reduction in funding status of 6-8% in 2012, due to an increase in their non-hedged liabilities.
Risk budgeting and cash-flow matching
“Since then, awareness of liability risk has increased, but now that interest rates have probably reached their lowest point, further hedging against falling rates no longer makes sense,” Huth says. “However, there are enough other risk factors – such as inflation, credit and longevity – that can and probably should be hedged, which is why LDI strategies are spreading.”
Jörg Ambrosius, CEO of State Street Bank in Munich recognises the importance of cash-flow management. “Occupational pension vehicles are looking for assets that generate a steady cash flow,” he says. “Those delivering greater diversification and hedging are preferred. To create such hedges, derivatives play a more crucial role than they ever did in the past. In that respect, the German pension market is catching up with the previously more advanced investment strategies of the Netherlands, Switzerland and the UK, in line with national legislation.”
If restrictions were lifted, according to a survey by the German investment funds association BVI and Kommalpha (see page 43), German Spezialfonds would invest twice as much in equities and two-and-a-half times as much in real estate as they currently do, increasing exposure from 12% to 24% for equities and from 6% to 14% for property.
Bonds, on the other hand, would be sharply reduced from 61% to 41%. Sovereign bonds and Pfandbriefe would suffer particularly. The majority of occupational pension funds’ investments are currently invested through Spezialfonds.
“German pension funds do not dare to buy property at the moment because they will struggle to sell it on once Solvency II comes into force,” says Thomas Richter, CEO at the BVI. “Equities cannot be held at the desired level due to the 25-49% of net assets they are required to hold as reserves under Solvency II, although the current equity level of insurers could legally be much higher than the 3-4% as it currently stands.”
Others see a change of investor regime. Carlos Böhles, head of institutional business at Schroders in Germany, says the industry is entering a new phase in which risk is being redefined. “Institutional investors have been forced to make new moves in asset allocation. Corporate credits, however, remain the greatest area of interest to them,” he says.
Böhles has witnessed more requests for proposals for global, European and emerging markets equities recently than in the last few years. Exposure to emerging markets continues to grow in popularity, specifically in Asia, although there is now the risk of a bubble in those markets.
“There is no alternative as far as investments are concerned,” Böhles adds. Schroders’ clients are split – some have moved out of emerging market bonds in the belief the 10-15% returns of the recent past cannot be repeated, while others are encouraged to remain invested in fixed income in those markets and diversify even further by moving into emerging market corporate credit, for example.
Bond portfolios, in particular, look very different today than they did a few years ago, Böhles says. They are better diversified and investors increasingly hold absolute return strategies.
A step ahead of Solvency II
Many Pensionskassen, direct insurance and Pensionsfonds have already changed their asset allocation to reduce risk and prepare for Solvency II, according to Oliver Bilal, head of distribution for Germany at Pioneer Investments. In other words, they hold less equity, more sovereign bonds and more investment grade corporate bonds.
“Pension funds and insurance companies are currently retreating to assets such as bank loans, well-known infrastructure investments and renewable projects, but those only make up a percentage point of the entire asset allocation, and therefore it does not really help them to drive returns,” says Bilal. “They are looking at corporate bonds, which also provide attractive returns. Their credit risk is perceived to be low, sometimes lower than that of government bonds. In addition, they benefit from a low equity charge under the Solvency II regime.”
Many investors reduced equities in 2008 and again in 2011, mostly for risk budgeting reasons. But this trend began to reverse in 2012, albeit in moderation, as risk management and risk budgets have become the most important factors in asset allocation strategies.
“With Solvency II looming, institutions will switch from regulating their asset allocation via quantitative limits to allocating according to risk budgets,” predicts Marcus Burkert, head of institutional consulting at Feri. “At the moment, large consultancies see big demand for credit funds that offer any kind of alpha over government bonds. Infrastructure, in the meantime, has the advantage of long-term contracts, relatively well forecast cash flows and long durations, and has therefore become a widely discussed investment idea in the pensions world.”
On the equity side, Böhles sees interest in smart beta strategies, which is seen as a form of portfolio hedging in times of market weakness. “Over the last few years quality stocks and growth companies have been in favour,” he says. “Now there is a move towards value strategies, stocks that are perceived to be cheap and which will benefit once the economy picks up again, including financials and peripherals.”
With regard to emerging markets, institutions are equally invested in emerging market bonds and equities, and local currency bonds.” Böhles says high yield became popular in 2012 as the risk is not perceived to be as high as equities. Investors often added high yield to an investment grade credit portfolio.
Away from govvies
Overall, the outflow from sovereign bonds has remained limited as the process takes time, and some investors are required to hold onto their sovereign exposure. But diversification from government debt is continuing.
“However, nothing compensates for sovereigns,” Böhles says. “And if everyone buys corporate bonds it makes them more difficult to get hold of and sell later, as there may be liquidity issues.”
Bernhard Holwegler, head of pension consulting in global solutions at Allianz Global Investors in Frankfurt, says there is interest in alternatives, particularly infrastructure debt and other illiquid asset classes, aside from fixed-income spread investments, like high yield and emerging market debt. “The willingness to take risk has had to increase but the risks are embedded in a risk-management concept,” he says.
Property remains attractive, particularly to investors who undertake asset-liability hedging and matching and need long-term cash flows, says Böhles, despite the qualms about Solvency II.
“With regard to property, several of our clients have left typical core-plus products to go to opportunistic real estate or to broaden the real estate idea to include debt secured by mortgage or infrastructure,” says Burkert.
“But again, just like with pure infrastructure, this all takes place within a 5% bracket of the overall portfolio.”
Private equity is popular as a substitute for traditional equity investments, according to René Höpfner, principal at Mercer in Germany. On the hedge fund side, the picture is mixed. Some investors do not want to return to this asset class, as they no longer believe in market neutral and absolute returns, while others still want diversification benefits hedge funds offer.
“However, the execution has changed,” he says. “In the past, investors approached hedge funds via umbrella funds, today they mainly invest in single funds. UCITS structures are popular because they are implemented easily and are transparent.
“As it becomes increasingly difficult to achieve target returns of 4-5% with fixed income, long-only investments, German pension funds have had to shift from fixed income to real assets such as real estate, infrastructure and renewable energy,” says Höpfner.
“As a result, exposure to alternatives will rise. In line with regulation, insurance-based pension vehicles can invest up to 35% in risky assets including equity, alternatives and high yield, but, due to their volatility, equities have played only a minor role in the past. Today investors need a diversified mix of risky assets to achieve their target returns.”