The Mediterranean: Uncertainty reigns

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Cyprus' economic proximity to Greece is causing uncertainty. Nina Röhrbein looks at the effect of regional economic turmoil on the investment strategies of pension funds

Worries over the future of the euro currently cast clouds over the sunny Cypriot skies. The cultural and financial proximity to Greece is unsettling many investors on the Mediterranean island after the country converted to the euro in January 2008.

Around 70% of the capital of second pillar funds in Cyprus is held in cash deposits, which currently attract rates of return of close to 5%. This has discouraged investments in more volatile asset classes. The remaining average asset allocation is split between equities, bonds and real estate.

"The high-yielding deposit rates reflect a corresponding level of risk, given the crisis in the local banking sector," says Philippos Mannaris, head of the Aon Hewitt office in Nicosia. "However, over the longer term and in normal market conditions strategies with 70% cash are not expected to generate the returns required to cover retirement needs."

The large exposure to cash has so far limited the effects of the Greek crisis on pension fund portfolios. With the impact restricted to isolated cases that have invested in Greek government bonds, no major impact has been felt at market level.

But Maria Damalou-Hadjigeorgiou, chief financial officer at the Cyprus Telecommunications Authority Pension Scheme, believes that due to the strong links between the Greek and Cypriot banking system, falling shares have somewhat dampened the performance of pension funds.

She says: "Bank shares are the only liquid securities on the Cyprus stock exchange, which is why most pension funds have a substantial percentage of their domestic portfolio invested in them. In addition, the Greek crisis has
spilled over further, depressing economic activity."

One concern is what is going to happen to the bank deposits, if Greek and some Cyprus banks are nationalised. At least one Cypriot bank looks like it is going to be nationalised, according to Mannaris. "Pension funds are wondering whether their cash is at risk," he says. "However, even with this scenario playing out they should not have any concerns on cash deposits. The main issue being discussed in the market and scaring investors is whether Greece will leave the euro and what that would mean for the currency in Cyprus."

The €273m Hotel Employees Provident Fund (HEPF) has never held any Greek bonds and even its Cypriot bonds only ever accounted for 0.22% of its total portfolio. The respective 35% and 65% falls of the Cyprus and Greek stock exchange in 2010 and 2011 had more of an impact on its capital, although HEPF decided in early 2010 to invest only globally, using the MSCI World index as its reference benchmark, thereby sharply cutting its 6% portfolio allocation to the Cyprus and Athens stock markets from 2009.

Over the past 12 months, the major moves in investment have been the introduction of new asset classes by some of Cyprus' biggest pension funds, primarily global infrastructure funds, funds of hedge funds and, most recently, in the interest of capital preservation, absolute return bond funds.

"We expect this to become a small trend across the market, but given the small size of most local provident funds, obviously with constraints," says Mannaris. "For other alternative approaches such as unlisted infrastructure or private equity, it is perhaps too soon. And no fund can achieve adequate diversification through direct investments."

"Our trustees are looking to invest a total of 2.25% in hedge and infrastructure funds over the coming months, whereas a year ago they did not want to discuss those asset classes," says Marinos Gialeli, general manager at HEPF.

HEPF aims to minimise the risks arising from the new investments through careful manager selection and monitoring. For liquidity purposes, it has chosen to invest only in listed infrastructure companies.

The capital for the new investments will come from the pension fund's 35% cash allocation and the reduction in equity exposure from 15% to 10%.
The remainder of HEPF's asset allocation consists of bonds, real estate and loans to members.

Cypriot pension funds have also begun to look at global opportunities, particularly in equities, in their search for diversification, according to Gialeli.

Mannaris says: "Due to the lack of liquidity and the absence of a secondary bond market, pension funds that hold local bonds seem to be stuck with them. Any new bond allocations are heading into more liquid overseas bonds, mainly through the fund approach."

In May, HEPF decided to exclude government bonds from its allocation to global bonds reflecting its views of the economic outlook of the bond market, making a tactical move into more specialist credit exposure and absolute return bond funds instead with a target of 3-4% above Euribor with minimal volatility.

But according to Damalou-Hadjigeorgiou, the current asset allocation is unlikely to change in the short term because few pension fund boards are eager to invest overseas in the current environment. "However, when the investment climate improves, and trustees become more experienced, we do expect more aggressive implementation of new asset classes," she says.

The only discussions taking place in the first pillar concern raising the retirement age from 65 years. However, after a new actuarial valuation from the social insurance department showed that the solvency position of the national social insurance fund did not deteriorate compared to the last valuation, no concrete reform proposals were made.
With regard to occupational pensions, new draft legislation went to parliament in May. It proposes combining two laws - one from 1981 and one from 2006 - that currently apply to second pillar pension funds.

"The European pensions directive was integrated into national law in 2006, however that law only covers second pillar pension funds with 100 members and above," says Mannaris. "Given the size of the 1,800 pension funds in Cyprus, most of them fall outside this legislation. By relaxing some compliance requirements for the small funds, the new law is trying to bring all funds under one umbrella."

The draft legislation will also attempt to tackle the issue of consolidation of approximately 1,800 pension funds in Cyprus, many of them with less than 20 members, in order to make their operation more efficient.

However, to date the policy-makers' attitude towards supplementary pension funds has been anything but supportive, says Mannaris.

"When policy-makers talk about the pension system, they mainly refer to the first pillar," he says. "There have been no other measures to take the second pillar provision forward, although almost half of the country's labour force participates in second pillar plans".

With average contributions at a decent 14%, according to the DC survey by Aon Hewitt in 2011, the main issues surrounding occupational pensions in Cyprus concern the accumulation phase - in other words the investments - and capital preservation rather than contribution levels.

At present, second pillar pension funds only offer lump-sum benefits, which are payable every time an employee leaves his current employer.

"Statistics from the ministry of labour and social insurance that regulates second pillar funds show that only 30% of the benefit payments from second pillar funds are made for retirement purposes, the rest are made on earlier exits from employment," says Mannaris. "Due to significant demographic pressures on the financial sustainability of the first pillar scheme, it is high time for the government to make interventions to the pensions system and support the role of second pillar funds. It needs to make sure that these pots of money are preserved for retirement needs and delivered through a combination of annuity income and limited lump sums, as opposed to lump sums only."

This is particularly important in the wake of the closures of defined benefit (DB) schemes in 2011 and 2012.

The entire DB system in the public and semi-public sector has now closed to new entrants and will be replaced by less generous defined contribution (DC) schemes. The banking sector took one step further, with most firms in the sector not only closing their DB schemes to new entrants but fully converting them to DC plans for both past and future service of existing employees.

Regulations 1/2010 and 2/2010 - which concern the credentials of trustees and the prudent investment management of pension funds respectively - have had a positive effect on the industry since they came into force two years ago. "These regulations provide a useful roadmap for a more professional approach to pension fund management," says Damalou-Hadjigeorgiou. "Increased regulation will lead to a higher level of professionalism and better fund governance. Most pension funds have proceeded with the adoption of a strategic implementation plan and are exploring ways to implement it, although this process has been somewhat delayed by recent economic developments."

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