Success comes to the nimble-footed
Industriens Pension is the largest of a number of pension schemes based on collective bargaining agreements that were established in Denmark in the early 1990s to provide supplementary pensions for the country’s workers.
The scheme covers the entire industrial sector and has around 320,000 members in 8,200 companies.
The industrial workers’ scheme has a number of advantages that ensure that, unlike many European pension funds, its assets will progressively outpace its liabilities.
One advantage is its fiscal status. Industriens Pension is a not-for-profit life insurance company owned jointly by the Confederation of Danish Industries, which has 35% of the share capital, and six labour unions within the Central Organisation of Industrial Employees in Denmark, which own the remaining 65%.
As a non-profit, labour market-related insurance company, the pension scheme is subject only to a 15% pensions tax on its assets, and not the significantly higher corporate taxes imposed on commercial life insurance companies.
Industriens Pension also has the advantage of being a compulsory contributory scheme, to which both employer and employees contribute.
Since it was launched at the beginning of 1993, successive collective agreements have increased contribution levels. Contributions, as a percentage of workers’ salaries, have risen tenfold from an initial 0.9% in 1993 to 9% in 2003. The current contribution rate is 9.9%. Next year, this will rise further to 10.8%.
This is still well short of the average contribution of 15% in most Danish pension funds. However, these increases have resulted in a steadily growing asset base. Currently Industriens Pension assets are around DKK 33bn (€5.5bn) and this figure is expected to double in the next five to six years At the same time, Industriens Pension has a shrinking base of commitments, in terms of the guarantee.
Older established pension schemes in Denmark typically have to meet a 4.5% guaranteed rate. The maximum rate set by the Danish Financial Supervisory Authority (DFSA). However, Industriens Pension was established when the maximum guaranteed rate had been lowered to 2.5%, and it has since been reduced to 1.5%.
Jan Østergaard, the head of investments at Industriens Pension, says this will reduce the liabilities of the pension scheme in the long run. “We have less than 40% of our membership at a 2.5% level. The rest are at a 1.5% level, and that is a conditional 1.5%, since it would be possible for Industriens Pension to recalculate those guarantees if either the interest rate level becomes very low, lower than the guarantee rate measured by the maximum rates announced by the DFSA, or if people live longer than calculated.
“So we have guarantees of 2.5% on 40% of our liabilities, and that is a diminishing figure because most of the growth will come from the 1.5% and the 1.5% is not unconditionally guaranteed.
“Therefore, it is for a smaller and smaller part of the liabilities. Industriens Pension needs to earn a return after tax and costs of only 2.5% plus a little bit more.” The scheme has done considerably better than that in the past few years, returning 12% in 2003, 10.2% in 2004 and 9% in the first half of 2005.
“We are very happy with these results, after having had two years very close to zero during the equity crisis,” says Østergaard.
The transition from zero to double-digit returns was achieved initially by switching from equities to higher risk credits, notably emerging market and high yield debt. Following the equity market collapse in 2000, the scheme reduced its exposure to listed equities from 37% to between 17% and 18% and increased exposure to credits from zero to between 10% and 12%.
“In effect we moved the risk from equities to credit bonds market debt and high yield,” says Østergaard.
“After the crisis we were able to increase the equity exposure again up to where we are today, which is about 33%.”
The success of Industriens Pension’s nimblefooted investment strategy has been noted. The Kirstein Finansrådgivning Life and Pensions 2004 survey rated Industriens Pension top performer in the Danish pension sector, a remarkable achievement for a relatively young fund.
In its current investment strategy, Industriens Pension has split the management of its assets into two parts, says Østergaard. The first, and smaller part is dedicated to hedging the interest rate guarantees.
“The average duration of our liabilities is very high, more than 25 years and of course that means a lot of interest rate sensitivity. So we have focused on what you could call the free reserves risk – the risk of being insolvent. Even though we have a lot of reserves and we don’t have high guarantees, we think you should care about that risk.”
The move to fair value accounting in Denmark in 2003, well ahead of the requirements of international accounting standards, encouraged this kind of focus on liabilities. “We made a number of simulations to try to learn the behaviour of our liabilities. Now we have a very precise picture of how liabilities will behave if interest rates change and, most important, if rates continue to fall.
“We considered how safe we wanted to be, and we decided that we should at least be able to survive a fall in interest rates to 1% and a 30% fall in the value of equities.”
“Therefore we have increased interest rate sensitivity a little but not much, since we have substantial free reserves. The problem, of course, with increasing the interest rate sensitivity is that you will lose a lot on the assets when interest rates rise again.”
Industriens Pension is using a variety of derivatives, including strips and receiver swap, to achieve this, he says. “Altogether it’s not very much, but it’s enough to ensure that Industriens Pension would not become insolvent in even the most unlikely scenario.”
The main part of the strategy is active management, however. “We believe very strongly in active management, both at a portfolio level – by which we mean
hiring active managers – and also at a tactical level,” says Østergaard.
In the first five years of operation, Industriens Pension outsourced its entire portfolio to external managers. Most of this was managed in a single balanced mandate. However in 1998 Jan Østergaard was hired as head of investments and given the task of building an internal investment department from scratch.
It was decided to take some of the management of the portfolio in-house, in particular domestic equities and fixed income. “The first thing we in-sourced were the bond holdings. Currently about half of total assets are managed internally as a portfolio of non-credit bonds, gilts, governments and mortgages.”
The scheme also diversified its exposure to asset classes, and became the first Danish pension fund to venture into emerging market equities and debt. “We have followed the principle of diversifying as much as possible. The limiting factor in the early years was the very small amount of money and the cost of having a lot of asset classes. But when it became possible we added more and more asset classes, like emerging market and high yield debt.
“It has been good for us to be invested early in these asset classes and they have given us a tremendous return.”
In June this year, Industriens Pension’s portfolio was invested 27.5% in Danish nominal bonds, 14.3% in foreign nominal bonds, 5.8% in emerging market bonds, 9.6% in Danish index bonds, and 6% in foreign high yield corporate bonds.
The lower-yielding corporate bonds are less attractive, says Østergaard. “We haven’t invested in any investment grade corporates because we haven’t really found a reason to do so, neither with regard to enhancing expected return nor reducing risk. If spreads should widen, however, that could be a different situation and we would consider investing in them.”
Industriens Pension also decided in 1998 to take some of the management of Danish equities in-house.
Currently it shares the management of the domestic equities portfolio with Copenhagen-based BankInvest.
Yet in spite of its growing financial muscle, Industriens Pension has decided to leave the management of foreign equities to external managers, The strategic asset allocation to foreign equities is 20%, double the allocation for Danish equities, and the decision to out-source is a reflection of their importance within the portfolio, says Østergaard: “Since foreign equities is strategically one fifth of our total assets, it’s very important how we do things there.
“We might be able to run foreign equities portfolios in-house cheaper than using external mandates. But we find that what we get from external managers in terms of different styles and processes, thereby improving a lot of the risk return characteristics of the portfolios, is a very good argument for continuing using external mandates.
“What we should be good at is hiring and monitoring external managers and building up an internal expertise in that. That’s what we should use our resources for.”
Growing asset strength has enabled Industriens Pension to implement what it considers the ideal structure for managing foreign equities, says Østergaard.
This is a structure of purely regional mandates. It has divided the world into five regions – North America, Europe, Japan, Global Emerging Market, and Developed Asia; that is, Hong Kong, Singapore, Australia and New Zealand.
“We don’t use global mandates any longer. In our experience, the problem with global mandates was that the different regions are so different in nature and the possibilities of adding value are so different from region to region that it seemed very difficult to find the right philosophy and process for the whole world.
“So now we try to find for each region the right type of mandate. The right philosophy, the right process, the right type of risk, the right amount of tracking error. In that way we can use our risk budget more efficiently.”
A major problem of running global mandates is squeezing any added value out of large-cap US equities, which represent some 50% of the market. Industriens Pension does not attempt to create a lot of added value from this market, and instead has two enhanced index mandates for US large caps, run by Invesco and Quantitative Management, both based in US.
“They’re very cheap to run compared with high alpha mandates,” says Østergaard. “They don’t add a lot of alpha but they have a very good information ratio. We think that’s the best you can do about that market. So far we haven’t seen any convincing arguments that high alpha mandates consistently add alpha for US large caps.”
Industriens Pension takes a diametrically opposed approach to US small and mid caps, however. It uses Axa Rosenberg to actively manage a US small-cap mandate with a high tracking error. “This gives them lots of possibilities for adding alpha, and we’ve had a lot of alpha from that market.”
The juxtaposition of active and semi-passive mandates enables Østergaard and his team to take tactical bets, weighting US large caps versus small/mid caps. They can do something similar in the European equities market where they have two large-cap mandates, run by UBS and JP Morgan in London, and one European small-cap mandate, run by State Street Global Advisors in Paris.
The regional structure also allows them to make tactical regional bets, says Østergaard. “We use the MSCI World, in which, for example, you don’t have any emerging markets, so any exposure to emerging market equities is going overweight for us.
“This is an area where we think we have performed extremely well in our active management strategy and where we have recently we have increased our overweight. Some 20% of our current portfolio of foreign equities is in emerging market equities.”
Østergaard sees Developed Asia, which accounts for only 3% of MSCI World, as a gap in the structure, and is currently looking for a manager for this region.
“This has been a market where it has been possible to add a lot of alpha and we are going for a mandate with a quite high tracking error.”
Industriens Pension is also looking for a second global emerging market manager in addition to the current manager, Pictet Asset Management. “We are very happy with Pictet, who have performed well since 1999. The reason for hiring another merging markets manager is that it has turned into a big asset class for us and we feel we should have at least two managers to diversify risk.”
Industriens Pension has also taken an unusual approach to unlisted equity investment. “In the beginning we invested through a small number of global funds of funds just to start with the necessary risk diversification. They have fulfilled expectations so far and we have a satisfactory return from them. “But the extra level of administration is expensive. So we decided at a quite early stage that in our private equity investment process we should build up internal expertise in private equity.”
Investment is spread between Europe, US, Denmark and the rest of the world across a variety of private equity vehicles, principally buy-out, venture, mezzanine, fund of funds and secondary funds.
“Currently we have made about 20 commitments since 2000, the main part since 2003. To reach our target of 2.5% of total assets - and a long-term goal of 5% - we have to commit at least DKK 1bn every year. This means at least five funds but probably closer to eight funds a year.”
Industriens Pension still uses fund of funds in areas of private equity where admission is difficult and local knowledge is essential, notably the US venture market.
“It’s a market where the difference between the top performers and all the others is very big. If you can’t reach the top performers then you shouldn’t be there,” says Østergaard.
Another example is the European mid market buyout, which requires strong local expertise. Expertise is the key, as Østergaard acknowledges. “In private equity, we have built up a network of contacts rather than waited for the phone to ring or the e-mail to arrive.”
This sums up Industriens Pension’s approach to asset management generally, he says. Developing investment know-how means more than building appropriate investment skills in-house. It means knowing whether to hire, when to hire and who to hire. This approach is clearly paying off.