Portugal on the beaten path

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Nina Röhrbein discusses how the prudent person approach, coupled with global financial crisis, has affected asset allocation at Portuguese pension companies

When the financial authorities introduced the prudent person-plus approach in 2007, they removed most of the limits that previously applied to Portuguese pension fund investments.

Following this and in the wake of the financial crisis - has anything changed in the asset allocation of Portuguese funds?

The average asset allocation of Portuguese pension funds at the end of June 2009 was 61% bonds, 22% equities, 15% real estate and 2% alternatives, according to Hugo Rocha, consultant at Watson Wyatt's Lisbon office.

The 22% equities allocation was split into 9% Portuguese, 5.5% other euro and 7.5% non-euro, international equities.

The typical bond exposure consists of around 18% euro government bonds, 15% fixed income (corporate bonds), 28% float rate (corporate bonds) and 1% international bonds, such as UK, Swiss, US, Asian and emerging market bonds.

Portuguese pension fund mandates tend to be balanced. "There is no sign of pension funds wanting to implement specific mandates within the balanced mandates," adds Joao Pedro Palmela, head of institutional client services at F&C Investments in Lisbon.

"The asset allocation very much depends on the individual pension plan," says José Luís Borges, head of pension investments at BPI Pensões, which is the pension fund manager responsible for the pension fund of Banco BPI, one of Portugal's largest financial institutions. In addition, it manages the pension funds of 100 other enterprises, including the local branches of multinational companies, foreign banks and large Portuguese companies, which involves more than 40 portfolios including four open-ended pension funds, equalling a total of more than €3bn in assets under management.

"But you could say our open-ended pension funds are typical representatives of the average Portuguese portfolio."

The largest one, the BPI Valorização Open-ended Pension Fund, has a central, strategic allocation of 25% in equities. Its equity allocation is split between more than 90% international equities and less than 10% domestic equities, while its 60% bond allocation is mainly made up of EU government bonds although the pension fund also has a significant allocation to both financial and non-financial investment grade corporate bonds.

Its alternatives exposure exclusively consists of hedge funds and hedge fund-like strategies in the UCITS-III format.

The central allocation for property in the Valorização Open-ended Pension Fund is 10% of the total portfolio - although this currently stands tactically underweight at 2.5% - split between around 40% domestic and 60% other European real estate.

Portuguese pension funds started investing in hedge funds in 2002 and their allocation to the asset class increased over the last three to four years to around 4% in 2008, before falling to around 2.5%, according to Rocha. But only two large pension funds are currently invested in private equity. "Private equity is still very small in Portugal," he says. "Alternative investments tend to be hedge funds only."

Typically, the investment policies of Portuguese pension funds are based on asset/liability management (ALM) studies, with the goal of minimising risk.

The benchmarks are usually a weighted composite, based on the central allocations to each asset class in the investment policy. In equities the most common benchmark is the MSCI Europe Total Return Local Currency index and in bonds it is the Effas All Maturities >1Yr (EUR) index, according to Borges.

But with regard to asset allocation, not much has changed with the financial crisis, says Rocha. "Pension funds reduced their equities and hedge funds exposure and invested more in government bonds and cash," he says. "But again this was mainly because they follow the market, it was nothing unusual."

"During the crisis our pension fund clients tended to avoid major moves in their asset allocation because everything changed so rapidly," adds Palmela. "Instead they stuck to what they knew in terms of their long-term asset allocation and waited for things to settle down before reassessing their liabilities and portfolio."

The asset allocation of BPI's pension funds also remained more or less the same.

"Because of the large allocations to mostly government bonds, pension fund losses in 2008 mainly remained in single digit figures and so were better than in many other countries," says Borges. "Therefore, the financial crisis did not have a large impact on strategic asset allocations. Most of our pension fund clients kept their allocations and did not venture into any new classes recently."

Nevertheless, the average equity allocation fell from 33% at the end of 2007 to 19% at the end of 2008. It further dropped to 17% in March before increasing again to 22% at the end of June, as equity markets improved, according to Rocha.

"Exposure to hedge funds declined slightly during 2009 but we expect it to pick up again in the future," adds Palmela.

One of the trends in the Portuguese pension market has been a bold move from defined benefit (DB) to defined contribution (DC), as some companies wanted to avoid the risks associated with DB.

"DC plans typically have a larger allocation to floating rate securities compared to DB plans," says Borges. "This implies lower interest rate duration, therefore lower sensitivity to changes in long term interest rates."

"DB plans tend to have more fixed income, while DC plans allow members the choice to allocate according to different individual risk profiles although they too are essentially conservative," says Palmela. "And I do not see any drivers for that to change.

"Apart from some of the bigger schemes that still run DB plans, the DB market has become very small. That also means the number of pension funds that might implement liability driven investment (LDI) is very small."

And LDI could become one of the emerging trends in the Portuguese pension fund market.

"We have started to have meetings with clients about LDI over the last few months," says Rocha. "But it is early days and so we do not know whether they will adopt this or whether it will change their investment strategy."

"In terms of future asset allocation plans, we have seen some interest in LDI strategies and inflation links as a separate asset class," agrees Borges.

F&C has also had conversations about LDI with its clients - but no one has implemented the strategy yet. "It is a decision process that is taking too long, particularly as it really is an opportunity market," says Palmela.

This could be because attention is focused elsewhere and funds currently remain focused on recovering last year's losses.

"After the credit crisis of 2008, investors started to look at credit at the beginning of 2009," says Palmela. "And as much of the new trend of 2009 has been credit-related we have moved a small part of our portfolio to convertibles."

The change from DB to DC has allowed pension funds to offer different risk profiles, among which participants can choose.

But this has had no immediate effect on their risk management. "Portuguese funds tend to run low risk, fixed income-heavy portfolios, even when they allow participants to choose their allocations in their defined contribution plans," adds Palmela.

As the asset allocation of Portuguese pension funds is typically matched according to their liabilities, risk is seen in its whole content, not only within the portfolio but in consideration of the impact it has on the sponsor's financial position.

New normative no 8/2009-R - which was introduced in June 2009 - aims to guide pension fund managers on how to deal with the different underlying types of risk they face, reinforcing the pension fund management's transparency and accountability requirements.

All fund managers were required to submit a proposal to the pension authorities by the end of September, detailing an action plan on how they will deal with risks, which then has to be implemented by 31 December 2010 to come into effect in January 2011.

While Rocha believes the normative will eventually lead to differences in asset allocation, so far it has had little impact.

"What it specifies in terms of risk management and internal controls, we have already been incorporating to a large extent in our operations," says Borges.

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