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Competitive advantage

Political eyes are being trained on Denmark’s successful labour market’s schemes, which have achieved a spectacular level of second pillar coverage, but how competitive are these often mandatory schemes and should they be made more competitive? The debate is ongoing, with the publication of the report of the Bremer commission set up by the government making a number of recommendations.
Steen Jørgensen, who runs the Finanssektoren Pensionskasse (FSP) in Copenhagen, believes he has little to fear from the report. On a daily basis he sees the competition faced by his scheme for those in financial services. “We have individual agreements with the different financial institutions using us. So to a much greater extent than other labour market arrangements, we are competing with life insurance companies. Our biggest customers are Nordea and Danske Bank and part of their workforces are with us, while other employees have their pension plans with Danica, Danske Bank’s insurance company, or with Nordea Life and Pensions. So we are really compared with them to ensure we have the same products, services, returns and so on. This makes it very competitive.”
Life is interesting as consequence, but certainly not easy. “So we have to provide a higher benefits at a more sophisticated level than other labour market schemes, while abiding by the rules of pension schemes.” As to any changes following the Bremer report, he says: “We already comply with most of the recommendations.”
The country’s labour market plans live under tight financial constraints. Since industry-wide pension funds have no owners and consequently no sponsors, he points out that if a scheme is under-funded it will be taken over by the Danish FSA in order to be reconstructed to avoid bankruptcy. “There is no where for us to go for extra capital”. This of course is one reason why the authorities were so quick to move in on schemes with their tough solvency requirements system to make sure schemes were fully funded at all times in past three years of market turbulence.
That’s certainly the downside, but on the positive side for members is that virtually all investment returns can be distributed to them. Insurance companies have other costs to pay, including very often their shareholders. “In these times of low return margins, this gives pension funds a large comparative and competitive advantage.”
Though the FSP can trace some of roots back to the 1950s, its history really began in 1979 – “that’s the year from which we start our counting”. It has 15,000 members, of which two thirds are active and 1,500 are receiving benefits. With assets of E2bn plus, the fund has over DKr1m (E135,000) on average per member, a figure that brings home the importance of the fund to all involved. “It drives home the message of FSP’s responsibility that what we do does matter!”
Dominating FSP’s strategy is the guaranteed return to members of 2.75% each year. Here, Jørgensen counts his blessings in that it is much lower than for other funds, which may guarantee up to 4.5%. “So we have not been under the same constraints or strains that others have had to face.”
FSP did not have to take out many of the interest rate hedges that other pension funds and life companies did recently. Under the supervisory definition of ‘fair value’ accounting that
funds had to adopt, so long as interest levels above 2.75%, FSP operates with additional reserves, while many other funds with higher guarantees would be in a deficit situation. “They had to hedge those positions to remain solvent.”
One outcome is that funds’ performances can no longer be compared. “If you only guarantee 2.75% and you obtain returns of 3.5%, and then take the discounted cash flow 0.75% pa over 20 years, that gives you an immediate reserve under what is called the ‘bonus potential’.” While that improves the reserve position, it is not included in the fund’s investment returns.
Funds with returns of 3.5% and guarantees of 4.75% will have an amount deducted from their reserves as they have to be solvent in order to meet that discounted cash flow, he points out. “To cover the strain on reserves, they have taken out interest rate hedges, which brings them back into a solvent position.”
That payment which improves their position is included as an investment return and included in their overall returns figures. “This is somewhat asymmetrical,” Jørgensen observes. “Our way of improving the position is not included as part of investment returns, while theirs is.” In his view this part of the system works less than perfectly.
Some funds reporting returns of, say, over 7% this year could have 3.5% of this accounted for by the hedging exercise on their reserves. By comparison, a fund like FSP showing a return of 3.5% from their investments will have in reality done equally well, but of course show nothing additional for the hedging.
Overall, using a lower guaranteed rate gives much more transparency as to what the true returns are, he feels.
The portfolio is constructed on an efficient frontier basis, rather than being based on an ALM approach, partly because this fits in better the country’s supervisory system. “We look at what we have to invest in terms of risk budgeting and ask where can this be best placed.” This is done once a year, but is reviewed frequently.
The active managers are given an out-performance brief on a three-year basis. “We ask them to take a longer term view too, but they are still inclined to follow the benchmarks.”
Jørgensen, acknowledges that as the fund is looking for an absolute return, there is an inherent contradiction with having a regard for the benchmark at the same time. “That’s a problem we have not solved yet,” he quips. “We have been tempted to give them an absolute return figure. But then how do you know what risks they are taking to get those? This is one reason why we have moved more towards indexation.”
The fund in 2001 had over 40% in equities, but during the latter part of that year and the beginning of 2002, this was reduced to 10%. “This was a combination of market losses and our worries for the outlook for equities generally.” This was not just a consequence of the Danish supervisors famous or infamous traffic lights system to judge funds’ financial position, but also a reaction to the post 9/11 world.
“We felt that even as a long term investor, equities were not the place to be for the next 12 to 18 months.” Many of Denmark’s funds have been rethinking their commitment to the equity market as longer term investors, he says. “There has been a lot of comment about funds no longer taking a long term perspective. Funds certainly did buy at the top of the market and sold at the bottom due in part to the traffic lights system, but we have become much more focused on the active tactical allocation process. So early in 2002 we were saying with a poor outlook for equities, it made sense to substitute fixed income.”
To prove the point, FSP had a positive return of 3.2% in that year, putting it among the top five of Danish funds. “We did take our losses on the equity portfolio in 2001, so we took the punishment immediately. But you cannot invest by looking in the rearview mirror and we certainly lost on those investments.
“We said we would not get that money back in 2002 or this year, but that does not diminish our resolve to be back in equities to benefit from the recovery and the upturn,” he emphasises. If over the next three to five year the outlook for equities is favourable, FSP will move back into them, as indeed the fund has already done.
“Now we are deep in the green as far as the supervisory authorities are concerned,” he says. “We regard the traffic lights system as a kind of a risk budgeting. So green shows that your risk budget is relatively high, so you can hold more equities. Due to the volatility of the markets up to earlier this year, we decided not to, as volatility is part of your budgeting. But more recently we have increased our holdings of US and to a lesser extent European equities.”
The basic stance of FSP is that if things can be one in-house they can be done more effectively. “Don’t forget that we have to pay 25% Danish VAT on any services we outsource!” However, some areas are outsourced not on the grounds of cost, but to keep management focused. “We are a smallish unit of 30 plus people and a management team of six people.” So property management is outsourced so as not to distract management. “Much of our fund management is outsourced because we believe there are money managers with the capabilities to cover all equity markets and it would just not make sense for us to try and control,” he says. “But we still want to be master in our own house and if you outsource too much you lose influence and the ultimate decision.” Danish fixed income is handled in-house. “We work together with some of our major managers to have their input into our asset allocation process.”
The current objective is 15 to 20% in equities, 7 to 10% in real estate, with most of the balance in fixed income.
Earlier this year, over 75% of the fund was in bonds when it held 47% in Danish bonds, 17% foreign bonds, 9% in high yield, 3% in Danish index bonds. On the equity side Danish holdings are 5% and foreign 8%, with real estate at 7%, private equity 2% and other assets 2%.
The fund has adopted a core satellite strategy as it has largely moved away from active management because of managers’ benchmark fixation, according to Jørgensen. “We find that fewer and fewer active managers are outperforming the benchmarks, because even if they have a strong opinion, they do not dare to follow it.” If active fees are typically between 50 and 100 basis points and the manager is to produce total returns of say 4 to 6% pa, that fee is a huge proportion of the performance, while the fund also takes on the risk of underperformance as well. “Why not pay a few basis points for indexed mandates and then discuss if you want enhanced or other products.”
Most of FSP’s international equity mandates are indexed currently. “While the bonds are not indexed, they do follow their benchmarks closely,” he says. While the high yield bonds are certainly not indexed, the fund limits the credit risk it wants to take.
The Danish stock market has had a spectacular year so far, being Europe’s best performer. But he sees the local market very much as a defensive one, where such sporadic bursts take place. “The recent Moeller-Maersk merger accounts for 20% of the market,” he points out. “Our returns on our Danish equities were over 30% for the first three quarters of 2003.We’re just enjoying the experience.”
But the fund did not buy traditional fixed income at the time of making the switch from equities, as it moved into corporate bonds, particularly at the high yield end of the spectrum. “Our view is that we still want exposure to the corporate sector, but we want the coupon payment to ensure some kind of income.”
There is a 6% commitment to private equity, of which around half is invested currently. Having been involved since the early 1990s, and seen returns of 20%pa during the decade, Jørgensen. “We are pleased about this. We have worked for the whole period with one firm – we reckon it is very much a people business.”
The real estate portfolio is made up of directly held Danish properties, mainly residential. For overseas exposure, the fund set up Britannia Invest with some other local institutions to invest in the UK and saw some good returns there from an outside London office portfolio. It has other indirect fund investments, but find costs much higher than investing directly itself.
On the manager selection front, the fund works with consultants Frank Russell.
The cut in equities has resulted in a decrease in the numbers of external managers to five, though some have more than one mandate. He is wary of mandates that are too small, as you may not get the same level of attention from managers as a bigger client will.
Some manager were inevitably let go when FSP reduced its equity content from 40 to 10%, he says. The current manager roster is Northern Trust for US and Europe large cap, Fiduciary Trust small cap Europe, Deutsche Bank corporate bonds, SEB AM, European IG bonds, T Rowe Price and Deutsche Bank for high yield. The custodian used is State Street, while Frank Russell do the performance measurement.
His wish for the coming year is to deliver the level of service to members that they have come to expect from FSP, showing that “small is beautiful”. But also providing competitive rates of returns. “Compared with any life company providing pensions, our competitive advantage is in our costs, disregarding investment returns. Our annual costs absorb just 0.2% of the return, life companies are anywhere from 0.6 to 0.9% – so if investment returns are 5% from both, we provide 4.8%, they 4.1 to 4.4%, but if life company shareholders are looking for their return of 0.5% on assets, then life returns are down to 3.6 to 3.9%. That’s the competitive advantage we have to focus on to stay in business.”

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