Pension funds' investment behaviour has come under heavy criticism from all sides due to the financial crisis, writes Peter Baenziger. Appropriate asset allocation was a major challenge for Swiss pension institutions in 2009
The year 2009 will go down as one of the best years in pension fund history as far as performance is concerned. A fact which certainly nobody would have believed after the annus horribilis of 2008 and the no less unpleasant start of 2009. However, despite this good news, it was a difficult year for those in charge of pension institutions. The full extent of the severe losses on pension fund assets sustained in the wake of the financial crisis was only recognised at the beginning of the year. Those in charge had to put up with harsh, media-driven criticism from people worried about their retirement credit balance and from politicians eager to tighten regulations.
Pension funds, however, not only had to withstand this flood but were also busy extinguishing the fire on the investment side. Against the background of deficient cover and, at least at the beginning of the year, financial markets that plummeted inexorably and without exception, the search for the most appropriate asset allocation and the most sensible measures was not an easy undertaking. Only when it turned out that the recovery beginning in March 2009 was not just a flash in the pan, as it has continued more or less constantly until today, did the Swiss pension funds gradually manage to get out of the headlines.
Simplified investment regulations
However, as some time passed before there was no longer any doubt that the recovery would last, the negative headlines and market turbulence still had a decisive impact on the investment decisions taken in 2009. Under heavy criticism from all sides, without any support from an adequate cover ratio, faced with tighter regulations and in an investment environment that was highly demanding anyway, the scope available to those in charge of the pension funds was certainly restricted in comparison with previous years.
The fact that the BVV2 investment regulations was revised with effect from 1 January 2009 also has to be taken into account when considering the asset allocation and its modifications compared with the previous year. The main adjustment was the introduction of a limit for alternative investments, which was fixed at 15%. However, this also means that hedge funds and private equity have been explicitly permitted as investments for the first time.
In addition, subject to giving adequate reasons, the upper limit may be exceeded. All in all, the category limits were greatly simplified; for example, the restriction for foreign borrowers was deleted. This means that there is no longer any differentiation between Swiss and foreign real estate, while the upper limit of previously 55% in total (Swiss 50%, foreign 5%) has been cut to 30%. This investment category, however, differs from bonds and equities in that a certain domestic share is still prescribed by stipulating that foreign real estate may account for a maximum of one third. This greater freedom of decision is accompanied by higher requirements, though, and more responsibility on the part of the boards of trustees.
Swisscanto's Pension Funds Study examined these topics, showing how - and how many - pension funds responded to the changes in investment regulations last year. The data discussed below refer to the details provided by 278 autonomous and partially autonomous pension institutions with total assets of CHF379bn (€266bn). The results therefore cover more than 60% of all insured persons (around 2.1m). Figure 1 shows that only about every tenth Swiss pension fund actively responded to the revised BVV2 regulations in 2009. The lower real estate limit required some 42% of pension funds to reduce their investments in real estate.
On the other hand, the majority (58%) responded by increasing their share of real estate. It is very possible that some pension funds took advantage of the now abolished foreign limit to profit from the enormous undervaluations on international real estate markets. Such a move would have enabled pension funds to markedly improve their diversification, which is of central importance for them, as the investment category of foreign real estate is not strongly correlated either with domestic real estate or with other investment classes.
Things look similar, even if at a larger scale, in the case of the alternative investments, which are explicitly licensed for the first time: Two thirds of the pension funds in the study increased the share of alternative investments in their portfolios. Advantage was thereby taken of the simplified licensing of this investment category in Swiss pension institutions' portfolios. This development must certainly also be seen in the context of improved diversification and the in-part unique opportunities to invest last year.
A third changed SAA
Not unexpectedly, other reasons for adjusting the strategic asset allocation in 2009 included the events on the financial markets and the change in risk capability. Figure 2 illustrates that just under one third of all Swiss pension institutions participating in the Swisscanto pension funds survey adjusted their strategic asset allocation last year. However, adjustments were not made at the same rate by private and public pension funds on the basis of the reasons mentioned above. Although events on the financial markets predominated for both kinds of pension funds, the private funds gave in to pressure more often and made modifications. In contrast, the changes in risk capability had more influence on the public funds. In view of their lower average cover ratios, this fact certainly makes sense.
Different lines of attack
In the majority of cases, however, pension funds refused to diverge from their long-term alignment. Admittedly, those pension funds which adjusted their strategic asset allocation show a not inconsiderable heterogeneity, as figure 3 illustrates. Whereas pension institutions were still in relative agreement as to domestic equities, generally underweighting them, underweights and overweights in foreign equities and also bonds roughly balanced out. This was very different from Swiss real estate; over 60% of those pension funds which effected a change, increased their commitment in this investment category. A simple explanation for this is furnished by the marked need for security and the high degree of uncertainty in view of the markets plummeting one after the other around the world. The Swiss real estate market proved to be the absolute exception in a global real estate environment undergoing a crisis, and drew swarms of investors on account of its stable and, in a context of low interest rates, attractive investment yield. Alternative investments, of course, were considerably underweighted by security-conscious investors.
Indeed, a comparison of actual and target figures shows that at the end of 2009, the share of alternative investments in pension funds' portfolios was below the figure given in the strategic allocation (figure 4). Owing to the aftermath of the financial crisis, this also applied to equities, of course. On the other hand, some five months ago, Swiss pension institutions still held nearly 4% more liquid funds than planned in the long term. Bonds, too, and to a lesser extent real estate were overweighted last year on account of their promise of higher security.
Nevertheless, last year's asset allocation got closer again to those of the years before the financial crisis, as the comparison over several years (figure 5) reveals. Compared with 2008, the shares of bonds, real estate and liquidity declined, while the equity share rose by 4%. This, however, was still 2 to 3% below the levels in the years from 2005 to 2007. But the crisis-induced developments of 2008 were clearly giving way to ‘normality'.
Public funds more offensive
With regard to tactics, a relatively large discrepancy between private-law and public-law pension institutions can be seen in figure 6. Whereas in 2009 only around one-quarter of both forms of pension fund were below the lower limit of their tactical asset allocation for equities, nearly half of the private-law pension institutions temporarily suspended rebalancing. The corresponding figure for the public-law pension funds was some 15 percentage points lower. On the other hand, 50% of the public-law pension institutions already started to make additional purchases in the first quarter of 2009.
At this still very uncertain time, only 30% of the private pension funds had the courage to make additional purchases. In view of the public funds' rather lower cover ratios, these findings do come as quite a surprise. Because, in principle, a lower risk capability results in reduced risk as defined in the investment strategy, meaning that pension institutions with a lower risk capability tend to have a lower equity share. However, such situations entail the dilemma that the low cover ratio actually requires low investment risks, while it is only by taking (higher) risks that the pension assets can be significantly expanded again.
In principle, it has to be taken into account, though, that each individual pension fund's investment strategy is heavily determined by individual factors such as age structure, legal form, cover ratio and primacy (of contributions or of benefits).
Peter Baenziger is CIO at Swisscanto