Setting the standard
ATP stands for supplementary labour market pension scheme in Danish and that’s exactly what it set out to provide 40 years ago this year. It started out firmly in the second pillar by providing benefits for those in employment, with others, such as the unemployed, excluded, explains Bjarne Graven Larsen, chief investment officer of the fund.
Now it extends to cover practically everyone in Denmark in employment or not, so it has come closer to the tax based arrangement, he points out. For those on social security, the contribution is paid for them. “So you could call it now the funded part of the state pension. In fact, ATP has probably moved from the second pillar to the first pillar!”
Altogether ATP has 4m members, mostly contributors, and about half a million receiving pensions, he says. The rate of contribution has increased over the years, but even now is only just 1% of the average income, but with a flat rate contribution of just Dkr2,700 (E36) annually, this hits low income workers harder.
“ATP has assets of around DKr270bn ( E36bn) , but there is the additional DKr40bn in the SP scheme to which an overall 1% of salary is contributed.” ATP provides guaranteed annuities, while SP does not, making its benefits more akin to a DC arrangement. The assets of both schemes are managed by his team based in ATP’s HQ in Hillerod. “Even by European standards these are big schemes.”
But as the first ATP contributors 40 years ago were able to pay in and then draw a pension shortly afterwards when they reached retirement age, the scheme started with what he calls ‘a generation effect’, pushing it quickly into deficit. “We started underfunded and stayed that way until 2000 or so, when finally we became fully funded, as it is currently.”
The fund is run by a board, with 50/50 labour market representation and an independent chairman. “The way ATP works is that the contribution rate is agreed by the two sides under the established Danish labour market model. Parliament then agrees this and implements any legal changes if there is a new rate.”
With guaranteed annuities to be funded from the asset base, the investment process starts with an asset liability analysis. “The bulk of our liabilities are very long, some as far as 70 years out in the future, with people living longer and some starting paying in at the age of 15.” The average duration of the liabilities are over 20 years.
“In recent years, we have been making an ALM model, we model our liabilities and then we use Monte Carlo simulations to build our own internal model – a stochastic Monte Carlo-based model – where we forecast all of our assets and our liabilities 30 years out into the future. Usually we do this on a quarterly basis, looking out 120 quarters.”
In addition to paying a pension, ATP will pay out a bonus if it has sufficient in the reserves. “So our bonus policy is important for the future.”
In 2002, ATP changed to the new fair value accounting, which meant marking-to-market assets and pension liabilities. “Up to then the book value of these liabilities did not change when the interest rates changed,” explains Graven Larsen. Then the fund was in the position of other funds elsewhere in that liabilities increase when market rates fall.
One consequence, was that it made sense for ATP to hedge the interest rate from a duration basis. “This is based on the assumption that you reduce risk but there is no loss from having a long duration on your assets. As normally longer duration on your assets will give you better returns than shorter on long time horizons. This was one thing that came out of the ALM study.”
The fund started to use interest rate swaps swaps towards the end of 2001, in a move to narrow “the interest rate-sensitivity gap” between its assets and liabilities. “We started in December 2001, we continued through 2002 and finished in January 2003.”
According to the fund’s annual report for 2002, the portfolio of interest rate swaps had an aggregate principal of DKr 158bn, comprising swaps with maturities between 15 and 30 years.
This strategy of protecting the downside served well, he reckons, despite the more recent rises in rates. “Rates had been dropping for four years before this,” says Graven Larsen. The 2002 report notes that the fund would experience a DKr31.7bn capital loss at the end 2002 position on its bond portfolio were all interest rates to rise by one percentage point.
The ALM study also pinpointed the longer term position of the fund. “We do not match the cashflow exactly. So if you look at the cashflow from our assets, we probably have a small positive cashflow up to 10 years, then an outflow up to 20 years, when there is a small cashflow for another decade, but beyond that not any.”
But of more immediate consequence was the ALM result was that the fund should have at least 15% of equities in the portfolios. “This is the level that minimised lots of risk, due to the diversification effects, even though equities are more risky than bonds. Since you are not 100% matched on the bond side, such diversification is good.”
Also, the trade-off between a 15% and 100% equity proportion certainly increased expected returns and pensions payouts, but risk was increased as well, he points out. “We found the trade-off between extra risk and returns was quite favourable and have decided we should have around 45% in listed shares on a long term basis.” As there is a 5 to 10% private equity on top of that, the combined portfolios would have a 50% plus equity exposure, he points out.
At that point all this became somewhat academic, when contrasted with was happening on the ground, where ATP was facing some massive challenges. As Graven Larsen says: “There is no point in doing the right thing in the long term, if you are not going to exist longterm, so we had to take short term constraints into consideration.”
The fund comes within the resilience tests of the Danish Financial Supervisory Authority, the famous or infamous green traffic light system, which is designed as a measure to assess how big a blow any fund could sustain in the short term. “After September 11, when we were at the 50% equity level, the market value dropped in just one-day to 42%.”
The ATP knew it had to react. Immediately, it stopped the rebalancing programme, and reduced the short term goal to 45%. “The fund’s reserves had decreased in the short term, and in order to be certain that there was no danger of coming into the FSA’s red light area, we decided to bring down the equity proportion further.”
Graven Larsen acknowledges that it can be debated whether this is an optimal way to operate a portfolio. “In retrospect, looking at the equities we sold off after September 11, we were pleased about that, and we wondered if we should have sold off more, as prices continued to fall. In the end we did stay around 40%.”
In those traumatic months, ATP also decided to close the duration gap and to concentrate on reducing the income rate risk by further hedging. “In mid 2002, as we had not fully hedged by that point, and interest rates continued to fall, we lost some reserves here too and, of course, equity prices were going down as well!” So in mid 2002, the fund cut equities first to 30% then to 25% and then to 15%.” In money terms, the reduction was from DKr 100bn at the start of 2002 to DKr35bn by the year-end, he says. “Around DKr35bn of the reduction was due to market falls, with DKr 30bn being sold.”
It was the liquid stocks that went first, such as US equities. But the European stocks were hedged with FTSE and Eurex 50 futures. “The Danish equities we held onto, purely for liquidity reasons. As a result the Danish markets fell less than the European markets.” With the domestic market doing so well in 2003, the ATP found its geographic equity mix has served it well. “Our local content had risen from 30% of the portfolio to 70% by the end of 2002.”
In the equity build up since then, it is the foreign element that is being restored. “Our goal is to reach and maintain the 70% non-domestic exposure. In fact we took the opportunity to sell Danish stocks last year. We sell when the there is positive sentiment in the market, and the market has always been outperforming when we sold. In fact when selling illiquid stocks, you can find that the price will rise the more you sell, as your activity in the market actually creates liquidity and attracts investors in causing prices to rise further.” But to sell in depressed conditions, just causes severe price falls. “This means it is hard to manage the relationship between domestic and international holdings so that you are on track at any particular time.”
Bond levels in the portfolio moved in an almost inverse relationship to the equities over the past three years. At the end of 2002, their proportion was over 63%, up from 48% at the end of 2001. The bulk of the portfolio is in government and mortgage bonds; mortgage related accounted then for 30.4% of all assets. During last year the bond proportion went up further to 77%.
The longterm goals are for bonds 35 to 40%, equities 45 to 50% and alternative assets 15%, consisting of 5% real estate and up to 10% private equity. But the board decides what precisely to do in the next year or so, given the current levels of reserves, and the other factors that need to considered.
“The fundamental question is whether the reserve levels are high enough to enable the fund to move towards its longterm goals.” At present, with more than adequate reserves, the fund could move from its relatively low 15% weighting to a much higher level, Graven-Larsen points out, and some steps are likely in that direction. “But the move is more likely to be done gradually, rather than over a short period of time.”
But the immediate question in the equity asset allocation is the composition of the international portfolio. “This is probably the mot difficult one. One view is to weight by market cap, but on the other hand, with a DKr pension payment requirement, how relevant are US or Australian assets? It’s not obvious to me that the MSCI World weighting is at all relevant. But every ALM study will recommend portfolio diversification.”
The outcome has been a strong allocation to Danish shares with a strong home bias as a consequence. “We think a 30% allocation of the equity portfolio is about right for the domestic market.”
As Denmark is integrated economically now with the EU and moves more in line with the euro-economy, then the allocation to Euroland should be more pronounced than say MSCI World. “So Europe should be 60% of the international portfolio, the US with its highly efficient equity market no more than 15%, Japan 7.5%, with the balance in global emerging markets.”
Most of the European assets are managed in-house, on an active basis. “We have one small cap active external manager, outsourced to Hermes Focus Funds.” The US is an outsourced passive mandate, managed by Danske Capital; while Japan is two active outsourced mandates with Capital International and Martin Currie. For emerging markets there are three external managers – F&C, Mellon’s Boston Group and Schroders.
It is during Graven Larsen’s time with ATP that the move to external management was made. “Some five years ago, very little was outsourced. In fact in the US, we had nothing at all besides a high tech portfolio which we sold in 1999, and reinvested in the passive strategy,” he says. The 2002 accounts show that this outsourcing has been achieved at an average costs of 20.5 basis points. “Real investment costs were 5.1bps relative to the overall portfolio,” it points out.
The same time frame has seen the numbers involved in ATP’s investment management increase from just 12 or so. “When I was recruited the role give to me was to build up a ‘best practice’ international asset management house, where we now have 60.” In addition, 11 are located in the private equity area and 25 in real estate, with over 100 in total. “We have hired the right people.”
“The private equity area is probably the one where we have the highest ambition for setting the standards of the industry – something that we want to do for all our areas in fact.” But ATP went about this in a very unusual way, by setting up its own subsidiary dedicated to PE, exactly as if it was a commercial operation creating a fund-of-funds. “We established a limited partnership, hired partners who obtain carried interest. They have to invest their own money, have their own investment process and the way they screen the market, their databases and their due diligence and all their process follow best practices. So we are convinced this is an area where we can do well, as well as changing the standards in the Danish market.”
The timing may not have been the best, but in his view “you do not go into new areas because you think the timing is right, it is because you think the asset class is attractive on a long term basis”. Such a business, building up the skills and competencies, can only be created gradually, over five or seven years, he reckons. In fact, with a fund of funds, the whole process of commitment and allocation is spread over years, so the timing issue becomes less important, as it as a strategic decision. “That said, I am really happy that we did not start three years earlier as everything we have invested is post 2001.”
The real estate portfolio is handled through a separate company, which had assets of around DKr10bn.
Other alternatives are under review. “We have decided against hedge funds,” he adds. “Currently, we are not allowed to invest in commodities, but it could be in the future, as well as convertibles and whatever!”
In mid 2002, ATP took the step of hedging all its currency exposures in the portfolio. “Our analysis showed that currency exposure in the equities creates volatility, but no expected returns, but by full hedging we can get a lower volatility in the total portfolio, with the same expected return. So we get rid of some unwanted risk.”
As part of the public debate current in Denmark to give pension scheme members more choice, ATP is introducing a new web-based platform from January next year on which members will be able to choose between ATP products and any Ucits funds from Denmark or elsewhere.
“Fund providers will have to comply with our technical requirements and information requirements, but we do not evaluate whether we think they are good investments or not. If your funds meet to the criteria, they get automatic access to the platform,” says Graven Larsen.
The approach on fees will follow Sweden’s PPM’s philosophy to an extent. “Our view is that investors should get the same fees and conditions that ATP would obtain if we went out and negotiated with suppliers. So they will obtain their funds at institutional rates.”