Timo Loyttyniemi, managing director of Valtion Eläkerahasto (VER), tells Martin Steward why the Finnish buffer fund’s sure touch through the crisis means that the latest change to its targets might just be the last
On the face of it, the aim of the Finnish pension buffer fund is simple: to invest its assets until they reach a value of 25% of the state’s total pension liability. At that point, Parliament will take another look at the system and decide on the next course of action. By December 2010, the accumulated pension was estimated to be just over €600bn, giving a present value of €90.6bn using a discount rate of 2.7% above wage and index inflation. With assets valued at €13.9bn at that time, Valtion Eläkerahasto (VER) had regained its pre-crisis funding level of 15%. There is a long way to go.
How long? That’s a moving target. Until very recently, it was felt that contributions and investment returns would get it there by 2020. That has been pushed back a further 10 years.
It’s not the first time that there has been a re-think. From the establishment of VER until the Finnish pension reforms of 2005, there had been a definite (as opposed to a target) end-date, by which time the fund’s assets were meant to have reached a value of either 1.5 times the state payroll, or not less than 20% of the pension liability. That end-date was 2010. The government was right to move the goalposts in 2005; by 2010, the fund was €4bn ahead of the first target but €4bn behind the second.
Why did things get so tight? To a large extent, it was a simple matter of the size of inflows and outflows. VER’s income is basically the contributions of its active members - give or take a few tens of millions from other sources. The original State Pension Fund Act earmarked up to 40% of the annual pensions expenditure as its outgoings.
Tough times for government finances in the 1990s meant that the ministry of finance nearly always took close to the full share (the lowest share it took over the 15 years to 2005 was 33%, and by the end of 2010 the total amount transferred over its 20 years had been €19bn).
Meanwhile, income was shrinking as a wave of major privatisations in postal services, telecoms and the railways reduced the public sector workforce. That is still going on; changes to Finland’s Universities Act meant university staff born after 1980 were transferred into private pension provision in January 2010, for example. Clearly these transfers reduce the state’s long-term pension liability - but they are not expected to provide annual expenditure savings until well into the 2030s and 2040s. At €3.7bn, expenditure is currently 56% of the state payroll. That is expected to peak, at €4.9bn or 84% of payroll, only in 2031 - before running down, as existing baby-boomer members die and fewer young Finns replace them in the public sector, and stabilising at about 33% in around 60 years’ time.
The year of the pension reforms, 2005, was a mixed blessing for VER. Public sector pensions were brought more in line with the private sector provision - including a move to a career average-style accrual rate based on annual earnings. As well as taking away that end-date of 2010, in recognition of the under-funding of the 1990s - and thanks to a strong economy and the sale of some state real estate assets - Parliament gave the fund a two-year break from the 40% rule. In 2006 and 2007, its payments were reduced to just €100,000 and €3.5m, respectively.
On the flipside, the annual drawdown of up to 40% was changed to always 40%, beginning in 2008. Right now, that works out at about €1.5bn each year. Contributions amount to around €1.6bn - leaving a net income before investment return of €100m or so. However, that is gradually going down, and is due to turn negative in 2013.
“That means we will be relying on asset returns thereafter,” as managing director Timo Loyttyniemi observes.
As we have seen, the expectation is that those returns will get the fund to its 25%-of-liabilities funding target by 2030. The annual nominal rate of return required to do so is estimated at 6.2%. That seems pretty punchy: over the 10 years to the end of 2010 VER annualised 5.5%. Over the five years between 2006 and 2010 that drops to 3.6%.
“Right now, 6.2% looks challenging,” Loyttyniemi concedes. “But these calculations are based on a normalised fixed-income environment, and today’s depressed yields are all about subsidies from central banks. This may last for a short period, it may last for a long period - but these estimates are made for a decades-long horizon, so we think that justifies our assumptions of money markets yielding 1-2% and bonds yielding 2-3%. We put the equity risk premium at about 4%, which is at the conservative end of most estimates.”
The neutral asset allocation set to deliver that 6.2% by VER’s board of directors - representing both employers and employees and appointed by the ministry of finance - is 53% fixed income, 40% equities and 7% alternatives. Fixed income can swing between 45% and 70%, equities between 25% and 45%.
Like most investors struggling to navigate between the Scylla of low yields and the Charybdis of the negative equity risk premium, VER is looking to expand its alternatives allocation to 10%. At the moment, real estate funds constitute 40% of the portfolio; private equity, 26%; hedge funds, 22%; and infrastructure, 12%. They all started as fund-of-funds allocations, but are increasingly direct.
“Real estate is our number one priority, and we would like it to represent almost half of our allocation to alternatives,” says Loyttyniemi. “Number two would be private equity. With the financial crisis there was a lot uncertainty and that caused us to pause: would hedge funds treat their investors properly during a crisis; would the problem of over-leverage in private equity and real estate be addressed? Now we can see that both of those issues are being addressed satisfactorily, and so the last two years has seen us expanding the alternatives.”
The bonds portfolio (80% in-house managed, augmented with 23 external active managers) has also been expanding. The strategic neutral allocation rose from 53% recently, and VER currently runs a slight overweight - despite the universe of EMU government bonds, which have a neutral weight of 45% of the fixed income portfolio, shrinking.
“We changed the benchmarks at the start of 2010,” Loyttyniemi explains. “Although we still use a standard BarCap index for inflation-linked, for nominal bonds we moved to a composition comprising just seven countries - Finland, Germany, Netherlands, Austria, Belgium, France and Italy. Earlier this year Italy was removed.”
On the corporates side, accounting for 35% of the bonds portfolio, while some investors have been constructing benchmarks that exclude financials or issuers domiciled in the euro-zone periphery, VER has, so far, resisted. “We have discussed that internally but, so far, we and our managers continue with the standard benchmarks,” says Loyttyniemi. “We have been successful with tactical bets against those benchmarks, such as an underweight to financials. Overall, our external managers do tend to be closer to the benchmarks, which is one reason why the active positions we have taken in-house have tended to be quite large.”
Despite the yields now on offer, VER is not ready to consider the peripheral euro-zone’s bonds - or even those of the EFSF - as an active credit play. “There are enough good opportunities in credit to avoid these things that could present you with nasty surprises,” as Loyttyniemi puts it.
Two examples are high yield (built up to a €250m portfolio) and emerging market debt (€740m).
“For 2012, we plan more emerging market debt, which accounts for about 10% of the bonds portfolio today,” says Loyttyniemi. “Diversifying away from the euro into local-currency emerging markets not only makes sense in terms of longer-term appreciation of those currencies, but also if we see depreciation of the euro thanks to today’s difficulties.”
But these markets are not immune to “nasty surprises”. High yield and local-currency EMD were among the biggest losers in the Q3 risk-off trade. VER benefited from some profit-taking in high yield earlier in the year, after moving quite aggressively into credit in 2009 - but was still clearly exposed. On emerging markets, Loyttyniemi says that it has been good for the fund this year, but also “a bumpy ride”. Add the fact that its nominal sovereigns exposure has a fairly short duration of around 4-5 years (money markets account for 15% of the bonds portfolio), and one can see how VER lost some of the benefit of its exclusion of the euro-zone periphery and financials. The fixed-income portfolio has returned 2.8% year-to-date to end Q3 - not bad, considering that its average annualised return over 2006-10 has been 3.6%, but not as strong as more conservative investors that are tilted more decisively to safe-haven bonds.
Still, at whole-portfolio level losses were limited, thanks to the underweight in equities, implemented in earnest since May 2011 (VER manages about 40% of its equity allocation in-house - mainly Nordic and some other European positions - with the rest outsourced, half active and half passive, to around 30 managers). After strong performance in the Nordics during 2010, VER took some profits, and it has also been underweight Europe.
“The Nordic markets, and especially the Finnish market, have tumbled quite substantially during the recent sell-off,” says Loyttyniemi. “The emerging markets have fared a bit better - thanks to fundamentals, but also currency fluctuations that have been quite substantial lately. Longer-term we are looking for more exposure there, but we are cautious on how and when to do that.”
Pragmatism defines VER’s approach to equity risk-taking. The fund came out of the August correction down only slightly, and there is now a sense that the time to re-assess that underweight might be drawing near. “Uncertainty has increased massively, of course,” says Loyttyniemi. “But, still, for a true long-term investor these levels are already starting to look very attractive indeed.”
Don’t expect a big move just yet, however. In contrast to 2008 and 2009, when VER moved aggressively and early to buy some €550m in corporate bonds and €950m in equities, this time the uncertainty around the euro-zone problems makes it more circumspect. “We see days when the market responds strongly to speculation about some huge rescue package coming together, but there remains a huge problem with the political process and a very real possibility of accidents,” warns Loyttyniemi. “We are prepared to wait until the situation has been addressed for the longer term - but we also know that our position can change very quickly if it needs to.”
The track record shows great skill in deciding when and where to take active risk. In general, taking away the alternatives allocation, the volatility of returns to the fund does not diverge much from that of the returns to its multi-asset benchmark: beta tends to be in the 0.8-1.0 range and Sharpe ratios are similar to those of the index. But 2010 stands out dramatically: the fund’s volatility was the same as the benchmark’s at 5%; tracking error was low at 0.3%; beta was neutral at 1.0; but the Sharpe ratio was considerably higher (2.2 versus 1.9), delivering a remarkably high information ratio of 4.5 against the benchmark.
“In 2010, both the fixed income and equity teams were able to generate value added,” explains Loyttyniemi. Off-benchmark investments in fixed income like high-yield and emerging markets delivered, and country and duration decisions paid-off, too. In equities the underweight Europe and overweight Nordics, emerging markets and selective small-caps also went well. This year has clearly been tricky for everyone, but VER has essentially been on the right side of the big trades again. After six tough years in the markets, facing a big test to get back in-line with its annual return target of 6.2% in an investing environment that only seems to worsen, the fund needs to maintain that sure touch. Then, 25% funding by 2030 will begin to feel like an expectation as much as an ambition.
This article was first published in the January issue of IPE magazine.