Nordic roundtable: ahead of the game
Written by European Pensions team
Lucas Crasborn, Director of Fixed Income, Netherlands and Nordics, M&G Investments
Per Kunow, Managing Director, Nordic Institutional Sales, MFS Investment Management
Kristina Ilar, Senior Vice President, Northern Trust Global Investments, Northern Trust - Stockholm
Morten Nilsson, Head of International Operations, ATP Pension Fund
Current economic climate
Chair (Laura Blows): What have you found are the key economic concerns facing Nordic pension funds at the moment?
Ilar: In many ways we are facing different challenges compared to Europe and North America in that the home market situation here is very good and the economy is very strong in Sweden and other parts of the Nordics. The main concern for Nordic pension funds is the influence of global markets, monitoring the debt crisis and concerns around inflation.
Kunow: A point for concern is interest rates being so low. In many cases portfolios carry promises of up to 4.5% absolute return targets. Historically, the expected return on risk free assets (the real long bond yield) was around 3%. Today it's around 1% which obviously is a problem. As a consequence, seeking diversification and uncorrelated asset classes is key.
Attitudes to risk
Chair: So how would you say pension funds are now looking at risk? How has that changed in the last couple of years?
Ilar: I think that in recent years we have witnessed more emphasis on the asset allocation. The economic crisis highlighted that the impor-tance of asset allocation had been underestimated for a number of years. There was a large level of interest in tactical asset allocation some 10-15 years ago and that was replaced by a focus on manager selection. We now see an increase in focus on dynamic asset allocation as pension funds found themselves stuck in their strategic positions when the crisis hit, and they were unable to move as much as they may have liked.
Kunow: The point about being more dynamic as opposed to strategic is evident. Finnish institutional investors are clearly diversifying from developed sovereign debt to debt and equity strategies in emerging markets. I think the same situation is happening in Sweden for instance, where investors are definitely moving towards more infrastructure, property and other alternative investments.
Crasborn: We thought we lived in a quite stable and certain world within margins with stable long-term fixed income returns, long-term equity returns and now people realise that's not the case anymore. The range of scenarios have become so much wider that nobody feels certain as to long-term projections anymore, so they want to be more flexible.
Chair: So what are the tools to help with this for pension schemes?
Nilsson: I think the fundamental thing is to understand your risks. Even with a really well-diversified portfolio you would still see the risk classes were more correlated than expected. And with all the uncertainty it is even more necessary to be able to act quickly and be agile, you can't be bound by benchmarks or wait for board decisions, but have to be prepared for relevant events.
Kunow: An example is the Danish pension funds and their pension promises. With the low yielding environment that we have right now, we've seen some funds moving their members from guaranteed products to market return products. That's one way in which investors have tried to overcome the current environment.
Ilar: Nordic pension funds were diversified: they had alternatives, they had real estate, they had everything, but markets failed on all accounts rather than just a limited fall, so there were risks there that they didn't know they had - with liquidity for example. So I believe that diversification is
still something that people are scrambling for, but there is also this concern that it didn't work that well last time so what else do we need to do? The fixed income area was one that was underused for diversification, in Sweden anyway, and I think that's something that pension funds are now looking at.
Changing asset allocations
Chair: Looking at the asset allocation side of things, recently a number of Nordic pension funds have started to invest outside of its home market. Is there going to be a trend there?
Kunow: I think definitely it's a trend that will continue. The Nordic region has always been early adopters of newer asset classes. For instance years ago investors, in particular Denmark, picked up high yield investments and EMD. In Sweden there's a lot of focus on property investments. We have seen infrastructure allocations taking place as well as opportunities within alternative energy.
Crasborn: We see more interest from Nordic region investors in
areas such as real estate debt, as its risk return characteristics are
very compelling, whereas in other parts of Europe it is seen as quite a new asset class. Some other areas, such as the opportunity in asset backed securities, have also been areas in which pension funds, here in the Nordics, have capitalised. There's clearly more appetite for personalised strategies than there is elsewhere.
Chair: The European sovereign debt crisis has revealed that government bonds aren't quite the risk-free safe haven as people imagined they were. So how have fixed income allocations changed? What areas are people now looking at?
Ilar: As index investors we see a need to speak to clients about actually looking at the benchmarks they are using within fixed income and there's more customisation needed there. So we have what we call an actively designed approach to the fixed income area where we sit down and talk about what risks they are willing to take, what duration and what quality, and tailor the benchmark around that and passively manage it. Before, institutions were happy to just take a benchmark off the shelf.
Nilsson: We've had a focus on core countries on the sovereign debt part but especially in fixed income, we have seen that a very large part of our returns is due to the implementation of our strategies so for us it has been evident that it's not only about the strategy but it's also very much about how you implement that strategy and there's a lot of money to be made in doing that right.
Crasborn: What's also interesting in fixed income is how different things are being financed at the moment. Banks are being forced to shrink the balance sheet so there is more capital against long-term investments. We do think that creates very good opportunities for long-term investors like insurance companies and pension funds and we at the moment are trying to see how we can develop this market. An example is social housing. This was financed by the banks for 20-30 basis points overlay and now it's not beneficial for them to do it anymore. We are looking at inflation linked loans, inflation to the social housing organisations where we get 2.5% plus inflation.
Chair: Is this quite early days I imagine, having pension funds invest in these sorts of areas?
Crasborn: Yes, it's very new because it's a domain that was always dominated by the banks. This is all changing now, if you can have a long-term investment horizon that would become very attractive. But that's to develop as few people have the resources to do these things but we feel quite sure that a lot of these sectors will be financed differently in five years than they have been in the past.
Chair: And in terms of turning volatility from risk into opportunities, we've got concentrated portfolios and alternatives like long-short equities. Are we finding more investment strategies heading that way?
Kunow: From MFS's perspective we certainly see a demand for concentrated equity strategies (global, European, etc.) with 20 to 35 stocks. At the end of the day we have an environment where investors are seeking sustainable alpha generation with lower risk than the benchmark, with good down side risk management and upside participation in different market environments.
Ilar: There has been some disappointment over the last few years in active management. We see more beta/alpha separation, so the products in the middle with a low tracking error are losing popularity to the more concentrated high alpha products.
Chair: What about the move towards alternative type assets, for instance investing in alternative energy renewal. Do you find those are going to be stronger areas for pension funds to look at for more diversification?
Kunow: I think that there are certain examples. Recently, PKA and PensionDanmark jointly allocated substantial assets to an offshore windmill park in Denmark. Overall, climate change risk is clearly on the forefront of institutional investors’ minds - leading to investments focusing on sustainable and infrastructure related investments.
Nilsson: We have been doing a lot of alternative investment in timberland, infrastructure, alternative energy etc. Our focus is to find return seeking assets that fit our risk strategies, yet with funding being hard to get in the private sector and also the public sector looking for other ways to finance and develop public functions, interesting new opportunities are coming up. We are also seeing more large deals where pension funds go together, so all in all the development in the alternative space is very interesting.
Ilar: Yes, pension funds are looking for diversification but they are also looking for shock resistant assets and you could argue that infrastructure, timber and similar asset classes, depending what the next shock is, could prove more resistant. I think the Nordic pension funds are in the forefront when it comes to these types of alternatives because there is a long tradition in private equity and timber and it's moving onto agriculture farmland more quickly than the rest of Europe in my opinion.
Chair: So you were saying about the Nordic region leading the way there, what lessons could be learnt for other European countries, how can they look to the Nordic region?
Crasborn: Nordic pension funds give fewer restrictions to their managers when compared to pension funds in other parts of Europe. This enables a good manager to use their skills to generate the alpha that the client is looking for and to manage the risk they're looking for and not be restricted.
Kunow: After the introduction of the Traffic Light System in Denmark, Sweden followed fairly quickly afterwards. These measures are in place to ensure that the pensions system overall and thereby the pension funds and other institutional investors can cope with market shocks during times of severe volatility.
Nilsson: I think the thing we haven't talked about, that other countries could perhaps be interested in, is the hedging strategies and being really clear on what risk you are being rewarded for and what risk you should simply get rid of. So I think hedging strategies will be in focus in the future.
Chair: Is this something that really only the larger schemes in this region are able to look into and if so, what investment solutions could there be for the smaller to medium sized schemes?
Ilar: Particular to the Nordic market, even the larger institutions use pooled products more than I think they do in the rest of Europe and there are pooled solutions available for the mid to smaller pension funds. For example smaller funds can implement SRI overlays via pooled funds, and alternatives are available as fund-of-fund structures.
Crasborn: It also depends on the resources a small pension fund has. So if they have few resources I would say focus on the things you do understand, then maybe source out the parts that are too different but then you do have the cost issue. Otherwise, see how you can diversify and look at well-known asset classes. It's maybe having a fixed fund manager who can allocate managed risk for you, and it's very clear guidance.
Nilsson: Smaller pension funds will need to consolidate in one way or another because the investments are getting more and more complicated and investing cost efficiently while understanding what kind of risk you are taking and developing the processes to support this is time constraining and expensive, so you will need in-house resources and scale to support this.
Chair: That brings us on to governance. Where do you feel the responsibility for the governance of schemes actually sits?
Nilsson: Ultimately it lies with the non executive board or board of trustees. From our point of view the key thing around the governance structure is having clear objectives, what are you trying to achieve and what kind of risks are you willing to take to achieve that? Once this is in place the next crucial thing is that there is a clear delegation and the necessary execution power to the management team. To obtain this we have among other things developed a dynamic role that gives management execution power within parameters that links our exposure to our bonus reserves on a day to day basis.
Kunow: Governance is clearly important. In some cases, however; we have experienced that the governance structure is too rigid
and therefore we welcome the opportunity to have a more open dialogue with the institutional investor - especially with the board.
Chair: So how do you feel the corporate governance can be improved, how can that be overcome?
Nilsson: I think basically it needs to be a two-tier system, so the non executive board sets direction and supervises the management team - but also clearly delegates the execution to management. When these two roles get mixed up the governance structure will become inefficient and will not be able to fulfil its purpose.
Ilar: During the crisis there was an inability to move quickly and
make short-term decisions and maybe to make some longer-term changes in an investment portfolio, that wasn't ideal from the investment manager point of view. So I think that delegation is important in order to handle the dynamic element of a crisis.
Chair: I suppose adding to the complexity are changing regulatory issues. Which do you feel are particularly affecting the Nordic region?
Kunow: With Solvency II implementation; no one knows the final impact on institutional investors ability to take risk. For example, in insurance companies risks are made based on credit maturity which was originally the case, so as a long-term investor you would get punished if you have long-term maturity debt on your balance sheet. We think it's not right. Now they are probably going to change it again to match that, if your liabilities match better with your assets then that is fine, so if you have mis-matches in numeration then that will get punished. The outcomes are so uncertain and the consequences of how your balance sheet should look are extreme.
Nilsson: But that being said I personally think it's quite good if we can harmonise some of this across Europe because it has a huge societal impact if the pension systems are unhealthy, both from the perspective of the social stability in securing people’s retirement, but of course also in that the pension funds are large institutional investors. So if it can be harmonised in a good way I believe that will be quite important to our economic strength in the future.
The future of the industry
Chair: So with all these issues facing pension schemes, how do you feel the nature of the Nordic pension schemes may be changing in the next few years?
Nilsson: For the past many years the innovation in the industry has primarily been around handling the risks for the pension fund or the sponsoring corporate in the DB world, but there is desperate need for innovation focused around helping the members handle the key risks; investment risks, interest rate risk and the longevity risk. I think over the coming years, there's need for a lot of customer centric innovation. And that puts a strain on lots of small pension funds but also on larger funds’ business model. There's a need to innovate how you create your portfolio to get the returns the members need and how you can develop new solutions that are taking care of members both in the accrual phase but also in the payout phase. The new ATP product is designed to handle these risks, and in Denmark we see an increasing move toward lifelong products.
Crasborn: Morton, you mentioned about longevity and obviously it's part and parcel of the business that we are in - but there is evolution for how to hedge or at least deal with that challenge. Some of the statistics that I've seen show that every year longevity increases by a couple of months, so obviously over decades this is quite significant for the institutional investors, especially as you have less and less people contributing and more and more people taking their benefits out.
Chair: I suppose the challenge with moving away from guaranteed returns is trying to preserve faith in the pension system. There's so much change going on that we in the industry are trying to deal with, how do we keep ensuring a reputation that pensions are still a viable means of saving?
Crasborn: The point there for me is that all the innovation and ingenuity has been around how we can get rid of the liability from our balance sheets and I think it should be centred upon how can we give our members a better product that we can actually pay for. So I think that needs to change because if it continues in this trend there will be no faith in the system.
Chair: We are ending on a cautionary note there but looking back over our discussion, it seems that the Nordic region’s pension funds are early adopters to new approaches, for instance with regards to asset management, changing allocations and looking towards alternative investments. In fact, we have even mentioned some examples of innovation in the Nordic region, such as hedging strategies and allowing more fund manager freedom, which may be of benefit to other European pension funds. It seems that despite the upcoming issues facing Nordic pension schemes there is confidence that the region will innovate and rise to these challenges.