Slow task of rebuilding
Like the adverts for Carlsberg beer, the Danes believe that they probably have the best system in Europe when it comes to pensions coverage. Granted the Dutch will have more in terms of funded assets per head, but Denmark’s second pillar occupational membership at an estimated 95% of the workforce must put the country at the forefront of European provision.
The transformation in Denmark came with the labour market agreements establishing a mandatory system built into the wage negotiation process, that cleverly required low contribution rates initially but required these to increase gradually over time.
But that does not mean that the Danish system has been problem free in the years of crisis that affected Europe and rest of the world. One of the features of the labour market approach is that the plans have no owners or sponsors, which is good in that there are no shareholders or others looking for part of the returns, but it also means that there are no deep pocket to tap if funds get into financial difficulty.
The supervisory authorities are acutely aware of the need for funds to be fully funded and took draconian action during the equities market crash to keep pension funds solvent through its ‘traffic lights’ monitoring process. This has had ongoing and major implications for asset allocation in Denmark.
“The effects of the traffic lights has forced funds to reduce their allocations to equities quite dramatically,” says Jesper Kirstein of consultants Kirstein Finans in Copenhagen. His firm monitors the asset movements and results of Danish funds in an extensive study each year. His figures below show the shift in allocation over a five-year period.
“This figures at the end of 2002 show that foreign equities have been reduced significantly,” he says. This strikes him as somewhat bizarre since one of the positive factors in Danish pensions in recent years has been its internationalisation. “In the years 2001 and 2002, the proportion of international assets has decreased, with the share of equities falling more than that of international bonds.”
This was because funds were reducing equities, he explains, but in doing so, it was easier to sell foreign portfolios than Danish ones because of their greater liquidity. “I regard this as a temporary phenomenon.”
The other phenomenon was the move to increase the weightings in foreign bonds – mainly high yield. “High yield came onto the market at the right time, as funds reduced their equities,” he says. “Funds were looking for an asset that would supply risk diversification.” Also, he points out that under the supervisors traffic light system of stress tests for funds, they are only interest rate sensitive, so the implicit risk of high yield being higher than normal government bonds is not taken into account.
Kirstein also points to the demonstration effect in the Danish market. “We can observe a leader-follower effect, as a number of funds are aggressive about new ideas.”
When the full picture emerges for 2003, he expects to see that equities will have improved from just under the 20% mark at end 2002. “Firstly, market price rises will have lifted the proportion, and secondly funds have been coming back into equities,” he says. “The way the traffic lights work can give you room for this.”
But he also points to the new accounting rules that introduced the ‘bonus potential’. The system look at how funds are positioned relating to the rate of interest they guarantee. “So if a fund guarantees 2.5%, but is obtaining 4% returns, it does not have to put aside so much by way of provisions. The difference between the two rates is called the ‘bonus potential’. This amount can be used to offset losses in other classes, which means funds can increase their allocation to equities.”
Funds will be able to rebuild their portfolios on the back of this, he reckons, but so far not many funds have started to use this route. Consequently, his prediction for the equity proportion in Danish funds is to come in below 25% for last year. Longer term he expects equities to increase, but not to the levels they were before the crash.
The E2bn Finansektoren Pensionskasse (FSP), which looks after members in a number of Danish banks, was one of the funds that cut its equity holding back from 40% in 2001 to 10%. “This was a combination of market losses and worries for the outlook for equities generally,” says Steen Jørgenson, managing director of the fund in Copenhagen. And there were others, notably PFA Pensions which cut back equities to around 7%, while other funds were able to maintain a 30% ratio.
From the new ‘fair value’ accounting rules perspective so long as interest rates are above its guaranteed return rates of 2.75%, FSP is operating with additional reserves. This will give it some leeway to move back into equities – to the extent that it wants to. The fund has increased its exposure to US and European equities last year, but will not rush the move back into equities. “If over the next three to five years the outlook is favourable to equities we will move back into them.”
Another pension fund manager agrees with this assessment. “Asset allocation will depend on where the markets are heading. So if equity markets start to fall again, funds will be forced back to asset liability considerations. It will be a matter of selling equities and buying protections. But if markets are stable then exposure to equities will be built up again.” So there is still a danger of history repeating itself.
So what impact has the need to buy protection to cover the guarantees when the equities slumped and interest rates fell? “Most, but not all funds, were buying protection,” he says. “There should have been more discussion as to whether it was in the interest of members to buy this protection just to protect these minimum rates of guarantee. We have all been pushed by the supervisors, the stress test and the media to a degree.”
The extent to pension funds were buying protection in the form of swaptions depended on the amount of their guarantees and their levels, he says. “Funds acted differently, with the larger and more professionally run funds being the first to buy protection. If you are a small fund it was more difficult to buy it with a lack of suitable personnel.” There were just three or four investment banks active in the market and the covers became more and more costly. “You saw the implied volatility of these products increasing very quickly.”
He reckons that there were around DKr800bn of guarantees in the system and around 60% of funds hedged their portfolios to some extent. “The cost of having these on their books must have come to 25 to 30 basis points of assets. This is a cost that could show up for years to come in their returns.”
While mid-2003 may have marked a see-change in markets, there are some challenging years ahead, he believes. “If you make some expected return calculations for different funds based on current asset allocation, based on mid-2003 figures, many of the funds with high guarantees will have after tax returns below their guarantees, requiring payments to be made out of their reserves. These funds are missing out on the equity recovery and will get punished when fixed income rates rise.”
As FSP has guarantees of 2.75%, it is well below those of other funds with commitments of up to 4.5% to meet. This meant the fund did not have to take out many of the interest rate hedges that others did, says Jørgenson. “We have not been under the constraints that others institutions have had to face.” The current objective for FSP is 15% to 20% in equities, with exposures of 7 to 10% in real estate, with most of the balance in a range of fixed income.
Good returns are of course the way out of the bind of meeting guarantees. Returns averaging over 4 to 5% make it hard to build up the necessary reserves as these are the levels funds need to distribute to members. So the issue then becomes one of finding extra basis points in yield, hence the interest in high yield and emerging market debt, which explains why perhaps as much as 5 to 10% Danish pensions assets are in high yield, and that some have gone beyond that with perhaps 12%. It has worked well – so far,” according to a pension fund manager.
International bond investment is set to increase, according to Kirstein, as Danes now see their fixed income market as part of the bigger Euro-zone market. It is just a matter of time before Denmark signs up for the euro, in his view. To obtain the longer maturities and higher investment grade corporates will push investors internationally as will emerging market debt. “We would have thought emerging market debt would be much more a core focus. More investors are looking that this area.”
The real estate area is attracting funds, whether first time investors such as Industriens (see page 33) or an established player like JOP (see page 33). Kirstein predicts increasing interest in real estate, with some specialist investment funds being launched, which will be of interest to the mid-sized funds particularly. Though others fears that a bubble may be forming here.
As equity proportions fell, so did the commitment to private equity, where the figures show a 1% allocation at end of 2002 . This should increase particularly through use of funds of funds, says Kirstein. The JOP fund has long established private equity portfolio and its aim is to have 10% of the equity portfolio committed to this. We mainly work through funds of funds here,” says Henrik Franck, investment director.
At FSP, Joergenson points out that the fund has a 6% commitment to private equity of which half has been invested. “We have been involved since the early 1990s and seen returns of 20% pa during that decade.”
But hedge funds have yet to make an impact, in fact they barely record a blip on the allocation radar. “While there is talk about hedge funds there is little action,” Kirstein sums it up. “A factor is that Danes hate black boxes.”