Germany: fending off stormy weather

Christine Senior explains what Germany is doing to protect its pension assets amid recent market turmoil

Pensions fund investments in Germany have escaped the worst ravages of market turmoil. This can mainly be attributed to their more conservative style of investment policy. Equity allocations, at the ten to 15 per cent level for regulated pension vehicles, are relatively low by comparison to pension funds elsewhere in Europe. And funds have avoided exposure to the toxic credits that have been so damaging to investors.

Nevertheless, after the blows suffered by German banks IKB and Sachsen Landesbank through their subprime exposure, the regulator, BaFin, is keen to avoid a similar situation with pension funds, and is being thorough in making checks. BaFin wants to keep an eye on how institutions are dealing with the current situation, how they are protecting their investments and how they can fulfil the guarantees to pension fund members.

One effect of the current market dislocation is that de-risking has moved centre stage. That involves not just looking at the volatility of the equity markets but also other risks such as longevity, which need to be managed.

"Companies are trying to manage longevity risk, not just volatility," says Michael Freisberg, a principal at Towers Perrin. "If you have a pension plan, which has payout options for lifelong pensions, you have longevity risk. Companies want to modernise this and that means a more conservative approach – maybe you use swaps, but you have a higher portion in bonds rather than in volatile equities."

The market downturn is forcing German pension funds to rethink their investment strategy. Assets outside the traditional limited bond/equity menu are increasingly coming under consideration.

Torsten Köpke, practice leader, investment consulting at Watson Wyatt Heissmann in Frankfurt, notes a tendency for investors to consider a holistic view of investing, rather than each asset in isolation.

"Quite a lot of investors are not only looking at different asset classes but at different return drivers," he says. "They try to find asset classes that are not reliant on the same economic movements as equities and bonds. They are looking for uncorrelated alpha, for a combination of asset classes, for managers with different styles of investing. Before there was no tendency to look at the overall picture. Most of the time it was like a herd behaviour. I think professionalism in investing has increased over the last 24 months."

The search for diversification has led to consideration of alternative asset classes, such as hedge funds. But pension fund investors face peculiar German restrictions on investing in hedge funds of funds. BaFin has demanding rules on transparency, so that not only the fund of funds, but also the underlying funds, must be transparent in their investments. This is anathema to the funds, which prefer to keep their investment secrets under wraps, and it limits the range of funds available.

"There are only a small number of hedge funds of funds you are able to invest in," says Köpke. "Combining funds that comply with these restrictions could sacrifice performance, because only 10% of the universe are able to."

The rule is widely acknowledged as needing revision but it will require amendments to legislation and Köpke doesn't expect this to happen before the turn of the year.

Recent turbulence has seen some investors lose faith in active management. BGI has noted an increased interest in passive investments for both bonds and equities. Nicky Merriman, head of BGI's institutional business in Germany, says: "For Germany we have never experienced such an increase in demand for index mandates as we have seen this year. I think this is partly the result of the credit crunch and partly because the majority of active managers are underperforming and not consistently producing alpha.

"With European corporate bonds, I believe some active mandates have been significantly underperforming and there is a big flight to safety into indexed European corporate bonds. Some people are even going so far as requesting customised benchmark mandates, taking banks out of the index."

But the flight to passive management seems not to have been across the board. At Mercer, for example, head of investment consulting Herwig Kinzler, has not noticed any such change of direction, but says that clients come to Mercer specifically for advice on active managers.

Kinzler highlights a distinct divergence between the reaction of regulated pension vehicles like pensionskassen and pensions-fonds and unregulated vehicles like CTAs. For the first category the reaction has been to adopt a more conservative investment strategy by reducing their risk budget, while the latter have stood their ground.

"I would say there have been dramatic changes in asset allocation for regulated investors," he says. "German pensionskassen and similar have lost risk budget and had to follow a more conservative asset allocation. They either reduced their allocation to risky assets via futures or options, or they physically sold risky assets. However, with unregulated investors – typically corporate CTAs – there have not been massive changes, they don't have to obey stress tests. They are real long term investors, so they haven't changed."

Though book reserves, the traditional route to financing pension obligations, remain popular, contractual trust arrangements (CTAs) have also found favour as off balance financing vehicles for corporate pensions. But until now the main uptake of CTAs has been among quoted companies that have to report under IFRS. Larger companies, particularly DAX constituents, can opt for their own CTA, while medium sized enterprises may prefer the multi employer CTAs launched by banks, asset managers and consultants which reduce costs.

Next year a change to the local German accounting rules for book reserves will bring them into line with IFRS accounting rules. The discount rate will in future have to reflect the seven year average market rate and future salary increases must be taken into account. The change will bring home to companies, particularly the Mittelstand, the mid-sized, often family owned, companies, the effect of pension liabilities on their balance sheets. It could have some dramatic consequences.

"Most German companies don't follow IFRS accounting, but traditional German accounting," says Raimund Rhiel, chief actuary at Mercer in Germany. "Until now according to tax laws there was a 6% discount rate with no allowance for future salary and pension increases, but in future it will be similar to IFRS accounting. Many companies will be surprised their pension liabilities will go up by 30 per cent maybe 40 per cent, they will be more aware of the pension risk and pension problems."

This, says Rhiel, is likely to increase demand for off balance sheet pension funding, through CTAs, pensionsfonds or insurance vehicles.

"If pensions turn out to be a problem for the company then they have to deal with it," says Rhiel. "Maybe some will close their pension plan to new entrants or for future service. Some will change from a defined benefit scheme to a less risky plan, a flat euro amount plan or a cash balance plan. This will be the consequence."

Of course many German companies would prefer to cut their defined benefit pension obligations, and move to more of a DC model, but they are constrained by regulations that prevent pure DC schemes. Any type of pension arrangement must incorporate some kind of guarantee of around 3 per cent annually, which rules out DC arrangements.

"We don't have a legal environment where you pay and forget," said Freisberg at Towers Perrin "It's not possible in Germany. It would be nice to have the legal environment to run a pure DC arrangement. Companies try to do what they can, they use cash balance plans. To get pension liabilities off their books is desired by a lot of companies."

Another change afoot is to the so-called time accounts which have become a popular way to finance early retirement. Pioneered by Volkswagen, time accounts enable employees to save in a tax efficient way using salary sacrifice to finance early retirement, or sabbaticals and career breaks. Employers may pay in additional contributions. Time accounts offer some investment options, but they are effectively pure DC with no obligation from the employer to give guarantees. But changes are currently under discussion to introduce guarantees, which could reduce the attractiveness of time accounts for employers.

"Time accounts have been quite flexible until now," said Rhiel. "There are no legal restrictions. But the German government may introduce some more laws on a possible return guarantee that must be given by employers. This would then restrict the willingness of employers to offer such systems. If they have some risk, they will only offer investment options where the probability of loss of money is zero, which will restrict the chance to get higher returns. This will limit the attractiveness of such models."

Written by Christine Senior, a freelance journalist