Although small and new, SEB's Lithuanian pension fund operation is confident that it will survive the turmoil that is convulsing the financial world. CIO Marijus Kalesinskas (pictured right) tells George Coats why

While the current market turmoil is casting a shadow over the financial system worldwide, in east and central Europe it has the potential to threaten the reforms that over the past decade have seen funded pension arrangements established throughout the region.

Governments opted to replace their unsustainable communist-era pension regimes with versions of the three-pillar World Bank model, under which some of the money flowing into the state pension system is deflected into defined contribution (DC) pension funds managed by specially constituted private pension asset management companies. But the arrangements met with varying degrees of opposition, ranging from those ideologically opposed to ‘the people's' money being run by private ‘speculators' and, even worse, invested abroad, to those worried about how to fill any resulting deficit in the state system.

The financial crisis will have done little to assuage such concerns, observes Marijus Kalesinskas, deputy managing director and chief investment officer at SEB Investiciju Valdymas, the pensions asset management company established by SEB in Lithuania. "The market turmoil is working against private pension funds," he concedes. "But if people think rationally they will understand that it is preferable, and maybe even beneficial, to see such a development in the early days of the pension reform when the funds are still very young than at a later stage. It's beneficial for several reasons. First, to have a market slump at the beginning of a long-term period when the funds are at a low base does not destroy a high accumulated value, but rather creates opportunities for new contributions to the funds to buy assets cheaper. It will allow for pension fund participants who have many years left to save to keep the average cost of assets low. If we agree that the long-term trend of equity and bond prices is upwards, then the low cost base will contribute to a better than average return.

"Second, it is better to have a slump now than later because it will enable politicians and broader society to see how market risks can materialise and to get an understanding of how financial markets can behave in extreme scenarios. That is a good, if very expensive, lesson."

Lithuania's pension asset management companies were established to run second pillar pension funds under legislation passed in 2003. Under the reform, of the 34% of an employee's gross salary paid into the State Social Insurance Office (SoDra) - 31% by the employer and 3% by the employee - about 20% goes to the state old age pensions system. Initially employees were allowed to divert 2.5% of their salary to a private pension fund of their choice, and the legislation foresaw an increase in the contribution rate by 1% of a salary a year to reach 5.5% by 2007, leaving some 15% to the SoDra budget.

But Lithuania made its system entirely voluntary, with no requirement to join a second pillar pension. And no upper age limit was set on joining a pension fund.

The law required that the pension companies offer a conservative fund, with assets allocated solely to the government bonds of EU and OECD countries, and left it up to them whether to offer additional funds with varying levels of risk. SEB Investiciju Valdymas has three funds: the obligatory conservative fund, SEB pensija 1; a balanced fund, SEB pensija 2, and an equity-oriented fund that it added at the beginning of 2006, SEB pensija 3.

When the company started collecting contributions in 2004 they were only a small proportion of rather small salaries. But while other pension funds in the region restricted asset allocation to domestic government bonds irrespective of their investment profile or of regulatory restrictions, SEB pensija 2 included equities from early on. "Through the group's retail banks we were fortunate to posses one of the country's two largest distribution networks for pension contracts," says Kalesinskas. "As a result we managed to gain a substantial market share and so, even from the first contributions, we were able to implement our investment policy. We defined our investment strategy so that from the very beginning our home market for fixed income was not just Lithuania, but the broader central European region and the euro-zone. And when we considered what should be a suitable equity exposure for a pension fund in Lithuania we came to the conclusion that it should be global not domestic."

He identifies two reasons for this: "First diversification. A pension fund is not a hedge fund or even an investment fund so it should be more conservative. This favours diversification, which global investing can assure. Second, and more importantly, pension funds have a long-term horizon. We are just at the start of the process and we have to think about investing to deliver returns and pay out pensions in 20 or 30 years. It is impossible to forecast which particular country or region could produce a superior return over such a long period. And our own experience of how much life in Lithuania had changed over the past 15-to-20 years - moving from the socialist Soviet Union to the market-oriented European Union - gave us as a good example of the structural changes that can occur over such a period. It underlined a need for us to be invested as broadly as possible. Only that can assure the preservation and possible increase of the purchasing value for pension fund holders."

Currently nine companies provide second pillar pensions in Lithuania and collectively they manage assets of LTL2150m (€623m). With approximately LTL690m (€200m), SEB Investiciju Valdymas has 32% of the market.

"The average age of participants in our second pillar funds is 36, so fairly young," says Kalesinskas. "Currently the retirement age is 62 for men and 60 for women but it is changing based on parametric reforms that will likely extend the retirement age depending on demographic developments."

SEB Investiciju Valdymas has mapped out both a strategic and tactical asset allocation. "Despite the recent disturbing market developments we are sticking to our strategy," says Kalesinskas. "We should look at the situation rationally and not allow ourselves to be emotional about it. As a result we understand that we should not alter the strategy for tactical reasons. At the asset class level we usually do about five or six changes during a year, not counting regional changes and fixed income durational changes. Of course market developments influence decisions at the tactical level a lot. Any equity exposures have been affected but we have been active in changing allocations between equities and fixed income. We were underweight equities since in June and bought some to reach neutral levels in mid-July. We rode out the September jitters with neutral positioning, but started to increase equities in October."

But has SEB Investiciju Valdymas' relatively small size had an impact on its asset management? "Given our size, we emphasise the importance of simplicity, and we try to stick to that principle in every step we take in terms of alpha-beta separation," Kalesinskas says. "We look for beta in developed markets - western Europe, the US, Japan exposure in equities and so on - and we try to locate alpha generators in the areas of our competence, which we define as central and eastern Europe and where we are more active in taking risks, especially in equities.

"And given our small size, at the beginning we did all of our asset management in-house. But while we could not see any point in outsourcing to external managers we were effectively using some of their solutions by getting market exposures via external mutual funds. We looked for funds that had the qualities we wanted while at the same time being very cost conscious. We have always negotiated the final fee that the pension fund members have to pay, although we understood that because of our size it couldn't be the lowest fee level in the world.

"However, now we are approaching the stage where we will start considering the possible outsourcing of some parts of the portfolio management if we see appropriate terms."

Kalesinskas says that it is difficult under current conditions to say what areas SEB Investiciju Valdymas will outsource.

"At first we only invested in equities and fixed income but in mid-2006 we redefined our strategic asset allocation and included broad alternatives as a third asse t class," he notes. "We decided to increase the allocation over time, depending on the fund's risk level, starting with an allocation of 3.5% for our balanced SEB pensija 2, and 8% for the more aggressive SEB pension 3. We are already close to those limits and have done some portfolio optimisation exercises to establish the best level for alternative investments in our pension funds. We have also understood from various analyses that to have an effect the share of a portfolio allocated to alternatives has to be substantial. Consequently, we decided raise the allocation to close to double the initial allocations."

At SEB alternatives are defined as commodities, real estate, private equity and hedge funds.

"Although we had decided on the total alternatives allocation we still needed to decide on the tactical allocation of each sub category," he says. "Initially, because of the global economic cycle, most of our alternative exposure was in commodities, and as we considered it too late for real estate and private equity we went into some hedge fund or market-neutral investments. But recently we started to go into real estate and now we are considering some private equity, although the latter is more correlated with listed equity and works better in a pro-cyclical manner so we are in no hurry to fill that exposure. Currently, we rely totally on third-parties through investing in various funds or similar structures."

SEB Investiciju Valdymas' pensija 1 and 2 were launched in the wake of the 2001-03 market downturn, and now five years later they are experiencing even worse market conditions. "Many thought that the situation during the second half of last year was the most difficult it could get during this cyclical downturn," Kalesinskas says.

"During that period we managed to achieve very decent 2007 full-year results of 0.6% for pensija 1, 5.8% for pensija 2 and 9.95% for pensija 3, the best result in Lithuania. Our experience in 2008 has been rather mixed, very good relative performance in the first half of the year, but it was affected during the current crisis in the markets (see figure 2). But from initiation, both pensija 1 and 2 have had good returns despite the recent market performance, and have shown that despite the cyclicality of the financial markets it is possible to accumulate wealth via pension funds and that it is the right way to go.

"When we started everyone, including politicians and the regulators as well as the pension funds, was in a learning process and we have seen a lot of improvement, especially in the Securities Commission and the ministry of social affairs. However, in this completely extraordinary situation it is inevitable that some politicians, especially the more populist, will argue about the funds' validity, and I am sure that we will not avoid questions about what pension managers are being paid for when the absolute returns of their funds are negative. But as long as we can prove that we are doing better than our benchmarks and our peers in our country and abroad, we will be able to argue our case."