Wrestling with the leviathan
Pension reserve funds are fast becoming the giants of European investment. Though most only came into being in the 1990s, they now hold sway over around €420bn in assets between them.
While size can be a real cost-saver for investment funds, allowing them to cut fee margins to the bone in negotiations with brokers, for example, it can also be a burden. With vast sums of money to shift, big players may lose agility in the markets, particularly when less liquid asset types are involved.
John Corrigan, investment director at Ireland’s National Treasury Management Agency, the body that runs the National Pensions Reserve Fund, says that being a large fund presents both challenges and opportunities when it comes to making investments.
“Our size and perhaps more importantly our steady cash flow can make us an attractive partner to property and private equity investment managers,” he says, noting that the NPRF’s government contribution will amount to €1.6bn this year.
“On the other hand, it can lead to capacity constraints in some investment strategies,” he adds. “Overall, we would say it is a strength. It gives us access in the markets, the ability to invest in a wide range of asset classes and also permits the employment of a full-time professional executive - something small funds couldn’t justify,” says Corrigan.
All pension funds segment their investment for diversification purposes, but when a fund is as large as Norway’s Government Pension Fund, splitting assets between a wide variety of managers, spread globally, is essential.
The Government Pension Fund has 24 different investment managers taking care of the equities portion of the fund, and there are a further 19 managers with fixed income mandates.
While Spain’s Fondo de Reservas - like the Social Security Trust Fund in the US - is invested exclusively in bonds, several of the other European funds not only have heavy equity weightings but have recently been diversifying into newer, alternative asset classes too.
France’s Fonds de Réserves pour les Retraites (FRR) says that, like other investors, the strategic allocation of a reserve fund is the most important factor in determining its long-term financial risk and return profile.
It made changes to its strategic allocation in May 2006, including adding new asset classes into the mix such as real estate, infrastructure and commodities, as a way of diversifying risks and achieving a better geographic spectrum.
“In doing so, the FRR seeks to improve the efficiency of its allocation, defined as the return on risk over the long term,” the reserve fund says.
There is a target allocation for the NRPF of 69% quoted equities, 18% alternative assets - which includes property, private equity and commodities - and 13% bonds.
“As the building up of high quality property and private equity portfolios takes time, we are working to achieve this target allocation on a phased basis by end of 2009,” says Corrigan.
Right now, quoted equities make up a higher proportion of assets, at 77%, with bonds at 13%, alternatives at 5% and a further 5% held in cash and currency.
“Our investment strategy is founded on the premise that real assets, such as equities and property, whose performance is linked to the rate of economic growth, will continue over the long-term to outperform financial assets such as bonds,” he says.
When it first took shape in 2001, the Irish fund had an initial investment strategy which focused on equities and bonds, but now it is looking for more of a spread as a way of increasing returns long-term, without making a real difference to its risk profile.
For those running corporate pension funds, the current focus on the shorter-term need to keep assets closely in line with liabilities can be a frustrating distraction away from their long-term need to make the very most of investments. But government buffer funds are largely able to operate with their sights exclusively trained on the far horizon.
“As a buffer fund we have a long-term commitment to the pension system spanning 30 to 40 years,”
says Christina Kusoffsky Hillesöy, communications manager at Sweden’s AP3 fund.
“The long-term essence of our mandate enables us to generate higher returns by investing in assets with long-term premia,” she says.
“We can also invest in asset categories available only to investors able to sign long-term agreements and which have a liquidity premium compared to assets that can quickly be bought or sold without incurring high transaction costs,” she says.
The AP funds also have more room for manoeuvre in their mandates and rules than many other large institutions do.
“Unlike Swedish life insurance companies, the AP funds’ pension system commitments are not valued at market rates,” says Kusoffsky Hillesöy. “This lends flexibility that can be beneficial in certain conditions,” she says.
Alternatives are particularly interesting to AP3 because of its long-term mandate, she says.
“As a rule, these agreements are of a long duration and offer greater potential for high returns than liquid assets,” she says.
“Our alternative investment portfolio comprises private equity funds, real estate, timberland, infrastructure assets and science investments,” she says. Whereas the property, timberland and infrastructure assets are most effective as risk diversifiers, the main reason for the private equity and life science investments is higher returns, she says.
Corrigan says that the NPRF’s long-term investment horizon means that it can afford to bear market volatility and illiquidity in pursuit of superior long-term return.
The NTMA has tried to get the highest returns it can, at the same time as keeping volatility within
reasonable limits by diversifying across a number of asset classes, he says.
Timo Löyttyniemi, managing director of Valtion Eläkerahasto, Finland’s State Pension Fund, agrees that having a long-term horizon does make investment strategy choices more flexible. But it is not always as simple as that, he says.
“In reality the freedom is not always used as pension funds are managed quite conservatively,” he says. “Short-term return pressures are there for reserve funds too,” he says.
Finland’s State Pension Fund currently has 56% of assets in fixed income investments, 40% in equities and 4% in alternatives, though it plans to expand the alternatives allocation in the next few years.
As alternatives, it counts real estate funds, private equity funds and absolute return funds. “We have diversified more each year,” says Löyttyniemi.
One area the NTMA is focusing on now is in identifying sources of uncorrelated alpha, says Corrigan. “Towards the end of last year we brought three currency managers on board in order to put an active overlay on top of our 50% passive currency hedge,” he says.
“The combined effect of the managers will be to vary the hedge between limits of 40% and 60% - this is an example of the type of initiative we are interested in taking in order to add value to the fund,” he says.
So reserve funds - like any other European pension fund - are constantly finding new ways to boost returns on the capital they have been entrusted with.
But just how does a pension fund determine how well or otherwise it is managing its investment, when it has no true peers to compare itself too?
öyttyniemi says comparison is straightforward as long as one unpicks the different investment components before making the judgements. “Pension funds may be compared against each other if one looks at various risk exposures,” he says.
“Comparisons are useful but never perfect. It is natural that the performance comparisons are usually made against domestic peers, but strategic benchmarking is worth doing internationally,” he says.
In Ireland, the NRPF’s governing legislation makes it quite clear how performance should be judged: the NTMA is required to establish benchmarks against which its investment performance can be assessed, says Corrigan.
“Our overall benchmark is a relative benchmark weighted according to our strategic asset allocation,” he says.
“We would regard our peer group as including other state funds and large institutional investors such as US and European occupational funds,” he adds.
Even though the agency recognises that each fund has its own individual liability profile and investment horizon, it would reference their returns, asset allocations and investment approach as a useful “sanity check” on what the agency is doing, says Corrigan.
The fund governance model for the NPRF is set out in legislation, he says. Based on the prudent person principle, it does not specify quantitative investment constraints, he says.
The Commission - the board which governs the NPRF - has very wide discretion in how the fund’s investment strategy is implemented, he says. “The intention behind the legislation was to replicate the mandate a typical board of pension fund trustees would have,” he says.
“We haven’t identified any issues where we feel we have been frustrated because of our governance model.”
In Finland, even though the ministry of finance - which supervises the State Pension Fund - had the opportunity last year to issue general governance guidelines to the fund, there have been no changes to basic governance, says Löyttyniemi.
Since Europe’s pension reserve funds are so different - with different levels and methods of funding, for example - is there anything they can teach each other? Only that it is good to keep moving forward and developing, says Löyttyniemi. “Each reserve fund has its own characteristics,” he says.
“As liabilities and plan time horizons differ from each other, investment strategies may differ too. Also, local cultural aspects play a role. Each fund is unique. Generally, however, funds should always keep on developing their practices.”
Differences or not, staff at Europe’s diverse pension reserve funds find face-to-face meetings invaluable, according to John Corrigan.
“We do meet regularly with the other reserve funds and we have found this a very useful forum for the development and comparison of investment approaches,” he says.
Prospects for a UK reserve fund
Despite the UK’s state pension woes, the subject of putting at least a portion of pensions on a funded basis has not even come up for debate.
In any country, the main problem with setting up a fund to finance future state pension obligations when the existing arrangements are one of pay-as-you-go, is that one generation, the transition generation, ends up paying twice for its pension, says David Blake, director of the Pensions Institute at City University in London.
While existing pay-as-you-go state pension systems work on the basis of an implicit contract between one generation and the next, a pension fund works by each generation paying for its own funding, he points out.
The question that has to be answered before such a plan has any hope of coming to fruition, says Blake, is can that transition generation benefit from it?
“Obviously, you have to have a well-informed electorate,” he says. Either that, or governments in countries that have set up pensions reserve funds are not being fully frank about the cost the transition generation has to pay, he says.
Apart from likely objections from the current working population, who would be the ones having to pay twice, there is another reason why the subject of a pension reserve fund has not been raised, he says.
“One of the reasons the government in the UK would be hostile to this, is that it would start putting pressure on it to recognise promised future pension payments as part of the national debt, just as the coupon payment on government bonds already are, and the government has been anxious to avoid this,” says Blake. “It would bring up the whole issue of precisely what liabilities the state expects future generations to honour.”
But perhaps the relatively paltry level of state pension benefits in the UK means there is no need for a reserve fund anyway.
Pension reserve funds are built up to avoid the peak in contributions to PAYG pensions that would otherwise happen when the ageing of the population is at its greatest level, says E. Philip Davis, professor of
economics and finance at Brunel Business School, Brunel University.
“In the UK, with a relatively ungenerous PAYG pension system, there is no requirement for such a fund,” he says.
Though there are some obvious benefits to having a pension reserve fund, there are disadvantages too. Davis sees several. “They may be invested in government bonds so in effect no different from PAYG, or be invested in a wider range of assets but subject to political direction and hence not efficiently invested,” he says.
Apart from this, they could tempt politicians to ease fiscal policy if the assets accumulated were not sufficiently earmarked for pension use, he says.
Rise of reserve funds
Twenty years ago, the truth began to dawn. Halfway through the twenty first century, the demographic bulge would leave a serious dent in state pension resources. This grim realisation spurred many European governments into action, establishing several pension reserve, or buffer funds, across the continent.
Though they are a diverse group, all the funds were meant to work on the same basic principle. Government would make contributions now, when the proportion of workers to pensioners was still relatively high, the money would be maximised through investment and used later on to smooth the impact of the ageing population on the public pay-as-you-go pensions system.
Back in 1989, Portugal led the way, setting up its pension reserve fund - the Instituto Gestão de Fundos-FEFSS, or Social Security Reserve Fund. Next came the Norwegian Government Pension Fund and Finland’s State Pension Fund, both of which were established in 1990.
In Norway, the fund was initially the Government Petroleum Fund, only taking on its current name and form in 2006. It is by far the largest pension reserve fund in Europe; with assets of €221bn - equivalent to around 73% of GDP - it is as big as all the others put together.
It was only in 1998 that the Norwegian fund diversified its investments away from government bonds, first adding equities to the investment universe, and then including non-government bonds in 2002. Sweden set up its series of buffer funds - the AP-Fonden - in 1999. Most of them - AP1 to AP4 and AP6, are funded through the state budget, with contributions representing 16% of wages and salaries; a further 2.5% is directed via the Premium Reserve Pensions Authority to the much smaller AP7.
In 2001, Ireland and Spain both set up reserve funds. Ireland’s National Pensions Reserve Fund arrived on the scene in April. Every year, 1% of the country’s GDP is earmarked for contributions to the reserve fund, and drawdowns are envisaged as being made between 2025 and 2055.
While the NRPF’s investment is heavily weighted towards equities, Spain’s Fondo de Reservas invests exclusively in bonds. France established the Fonds de Réserve pour les Retraites in 2003, its role from 2020, being “to cover a significant proportion of the funding needs of basic pension plans for employees in the private sector as well as self-employed crafts people and retailers.”